Regulation

Business / Financial / Pensions / Regulation — 0 Comments
15
Jul 10

Pension Insecurity

Substantial recent financial media focus has been lavished on subprime mortgages, credit derivative bets on a decline in the residential housing market, flash crashes in the stock market, bank insolvencies, major corporate bankruptcies, and sovereign debt defaults. They have paid less attention and provided less insight into the perilous state of pension funds.

Both public and private pension funds face an emerging crisis.  We need to examine some disturbing trends in both sectors.

New Jersey Pension Fund Crisis

In No Garden-Variety Pension Crisis, Andrew Briggs asks hard questions about the funding of New Jersey’s public pension plans.  If the state used private sector pension accounting, the underfunding would rise from an already horrendous $46b to a mindboggling $170b.  This deficit is more than five times the 2011 $29.4b state budget.

The real question is, when will the plan run out of money?  Assuming the plan can earn 8%, which may be an aggressive assumption in the current environment, the plan would run out of money in 2019.  However, NJ has increased its risk profile for the fund.  The state has moved 60% of its pension assets into riskier alternative investments, such as hedge funds and private equity.  Thus, there is a 25% chance the fund can run out of money as early as 2017.

The article concludes that NJ is not alone.  Connecticut, Indiana, Illinois and other states are due to run out of money before the end of the decade.  (See Bailout Nation Lives: Revisited, a Short Update).

Diageo

And while we are worried about risky funding strategies utilizing hedge funds and private equity, pension funding creativity reaches new heights with a plan by the Diageo Corporation. This beverage conglomerate intends to “fund” its plan with more than 2 million barrels of scotch whiskey.

Diageo said … it would transfer ownership of £430 million, or $645 million, worth of whiskey to a pension funding partnership. Diageo employees would not receive their pensions in whiskey rather than cash, but the move does give them a guarantee that they would not walk away empty-handed should the company default.

“A pension funding partnership will be formed, which will hold maturing whiskey spirit as assets,” ….

As part of the deal, Diageo agreed to pay the pension partnership £25 million a year as it sells the recently distilled whiskey once it matures after three years and replaces it with new stock. The agreement would expire after 15 years, at which point Diageo would buy back the whiskey, which comes from distilleries such [as] sic Oban on the west coast of Scotland. See Diageo Uses Scotch to Plug Gap in Pension Plan.

I personally love Diageo products.  Talisker, Lagavulin, Oban and others are some of the finest whiskies in the world.  See Tis’ the Season for Deflation and Update on Deflation. In my prior posts on Diageo, I pointed out that some of their premium products were in dramatic price decline.  Now it becomes clear that weak pricing power and pension underfunding for Diageo are connected.  If Diageo had pricing power, it would have sufficient profits to fund its pension plan with cash.  In a deflationary world, should their pension plan beneficiaries hope to count on the future price of scotch whiskey in order to receive their benefits?

GM, A Cautionary Tale

We have seen innovate funding techniques before.  In 1993, GM asked federal pension regulators to approve an innovative plan to meet a $24b pension deficit.

Under the plan announced today, GM would contribute shares of its class E common stock to the pension plan. The value of that stock is tied to the performance of a wholly owned subsidiary, Electronic Data Systems. Its closing price today on the New York Stock Exchange was $31; based on that price, the total value of the contribution would be $5.7 billion.  See G.M.Acts to Secure Pension Using Stock.

Regulators acceded to the GM request.  The rest is economic history:   GM recently went bankrupt, and the plans remain massively underfunded.

Poverty Follows Financial Innovation

In its time of pension deficit, Diageo is not the only creative funder. The UK is rife with new schemes:

The British supermarket chain J Sainsbury said earlier this year it would transfer property into a pension vehicle, while Whitbread agreed to hand over a share in its portfolio of restaurants and hotels. The investment firm Man Group moved some hedge fund assets into a trust as a security for its British pension plan in March.

“We’re seeing a huge growth in the use of non-cash funding,” Marc Hommel, leader of the pensions practice at PricewaterhouseCoopers in London, said. “There are big pension deficits and sponsors are cash-strapped. These mechanisms provide security for the pension plans in exchange for less cash.”  See Diageo Uses Scotch to Plug Gap in Pension Plan.

Mr. Hommel probably did not intend to be humorous, but one must ask whether these new methods of providing  “security” make the funds more or less secure.  I would submit that when one has to innovate and pull financial “rabbits out of the hat” both equity holders and pensioners of these companies face a lot more risk.  And so do we, the taxpayers and funders of our enormous public pension funds and guarantors of private pensions through the Pension Benefit Guaranty Corporation.

In this current age of funding gimmicks, maybe we should refer to pensions as a social insecurity system.

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8
Jul 10

The Tragedy of the Commons Part II: Modern Finance and BP

In Part I, we discussed the “tragedy of the commons” paradigm.   Financial excess in the housing market was a major factor leading us into the current financial crisis.  Finance is not the only area of concern.  Let’s turn our attention to BP.

BP, the Gulf of Mexico and the Eastern Seaboard

We are now approaching 80 days after the BP Deepwater Horizon oil rig spill.  Up to 100,000 barrels of oil are still spilling into the Gulf of Mexico.   The government now believes that by August 2010 there is an 80% chance that the spill will reach Miami coastal waters.  Once the oil slick starts moving up the Atlantic coast, some experts believe it will damage the fishing industries as far away as the Chesapeake Bay and even the Grand Banks off Newfoundland. See BP’s Crude Politics and the Looming Environmental Mega-Disaster

A dynamic tension exists among private profit, America’s need for oil, especially domestic oil, the government’s need for lease and tax revenue from the industry, and environmental concerns.  Despite campaigning against lax Bush Administration enforcement of oil drilling limits the Obama Administration ignored an environmental warning contained in a DC Court of Appeals decision.  Citing financial necessity, the Administration was able to overturn the ruling:

Less than four months after President Barack Obama took office, his new administration received a forceful warning about the dangers of offshore oil drilling.

The alarm was rung by a federal appeals court in Washington, D.C., which found that the government was unprepared for a major spill at sea, relying on an “irrational” environmental analysis of the risks of offshore drilling.

The April 2009 ruling stunned both the administration and the oil industry, and threatened to delay or cancel dozens of offshore projects in Alaska and the Gulf of Mexico.

Despite its pro-environment pledges, the Obama administration urged the court to revisit the decision. Politically, it needed to push ahead with conventional oil production while it expanded support for renewable energy. Obama Decried, Then Used Some Bush Drilling Policies.

The Risk of a Pro-Drilling Policy

A pro-drilling policy with minimal governmental supervision set the stage for the Deepwater Horizon tragedy.  Macondo History Before the Blowout provides a full analysis of the mistakes made at Deepwater Horizon.  First, Congressional investigators documented that BP took numerous short cuts: a cement log was not run, a lockdown sleeve was not used, they failed to circulate a sufficient quantity of mud, instead of a more sturdy liner they used a weaker production casing, and 6 rather than the recommended 21 centralizers were used.   While these shortcuts most likely contributed to the problem, the author focuses on human error.  The BP drilling engineer in charge ignored four major well events, referred to as “kicks” in the industry.  These are warning events.  One can surmise the engineer was trying to complete an over budget drilling project, quickly.  Drilling engineers are trained in mandatory safety courses to recognize “kicks” and take appropriate action.  Perhaps in a desire to expedite the project, he chose or was pressured to disregard obvious safety warnings.

Blowouts are a strong possibility when drilling. They are not rare events.  The author goes on to state “it is inexcusable that BP should have been so completely unprepared for the aftermath. BP should have had the containment built and tested ahead of time.”  By contrast, the Shell Corporation had a system on standby.

In pursuing its private interest in increasing shareholder value, BP despoiled a very large “commons.”  Avoiding an obvious extra expense, BP did not have a containment system on standby.  If the worst happens, BP will have fouled fishing grounds as far north as Newfoundland, and part of the Gulf region will become uninhabitable.  Of course, if BP goes bankrupt,taxpayers again will be asked to shoulder the clean up expense.

Private Interests, Public Policy and Protection of the Commons

The message and lesson of the Tragedy of the Commons is that there are dangerous activities requiring strict, intelligent and active regulation.  Neo liberal economists believe that regulation should not hinder the free market.  They assert that the free market will always self correct.  But in a technologically advanced and interconnected world, the stakes are far higher.  Unfettered capitalism can literally collapse the financial system as demonstrated by the recent financial crisis, or the eco system as demonstrated by the ongoing BP oil spill.

No one would question the right to limit private profit made through the sale of anthrax or nuclear materials.   We know that some activities are so inherently dangerous that the state should intervene and carefully control usage.   We are now learning that previously deemed “safe activities” can now have horrendous and unacceptable societal cost.

Nothing would please me more than for the financial industry to pursue whatever risky schemes they wish to engage in.  Just be prepared to bear your own losses.  Unfortunately, we learned that when it all explodes, we deem it a national crisis requiring domestic intervention to save the banks, insurance companies and industrial companies with finance arms (GE and GM).   In a parallel analogy, we have learned that an oil spill could paralyze an entire region of the country and perhaps the entire eastern seaboard.

We cannot afford too many more tragedies in our commons.  If we find ourselves privatizing profits and socializing losses, proactive and aggressive government regulation and intervention is going to be required.  At issue now is the viability of society itself, and that outweighs private gain anytime.

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7
Jul 10

The Tragedy of the Commons Part I: Modern Finance and BP

“Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.”
Alan Greenspan,  Senate Agriculture Committee testimony – July 30, 1998.

BP’s Hayward conceded that his giant oil company had been unprepared for this disaster.  “What is undoubtedly true,” he said, “is that we didn’t have the tools you would want in your toolkit.”  Tony Hayward, June 4, 2010 interview with the Financial Times

A powerful and controversial precept in economics is the “Tragedy of the Commons.”  University of California biology professor Garret Hardin introduced the concept in a 1968 paper published in Science:

The tragedy of the commons develops in this way. Picture a pasture open to all. It is to be expected that each herdsman will try to keep as many cattle as possible on the commons. Such an arrangement may work reasonably satisfactorily for centuries because tribal wars, poaching, and disease keep the numbers of both man and beast well below the carrying capacity of the land. Finally, however, comes the day of reckoning, that is, the day when the long-desired goal of social stability becomes a reality. At this point, the inherent logic of the commons remorselessly generates tragedy.

As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less consciously, he asks, “What is the utility to me of adding one more animal to my herd?”

The tragedy is overgrazing:

…the rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another; and another…. But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit–in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all.

We do not have a problem with herdsman.  Unfortunately, we have evolved to deadlier pursuits which threaten us all.  Let us examine the cases of the post-1999 financial world and the BP Deepwater Horizon tragedy.

The World of Modern Finance

Modern finance was born in 1999 with the passage of the Gramm Leach Bliley bill, ironically named the Financial Service Modernization Act, which repealed the Glass Steagall Act of 1933.  Glass Steagall among other reforms required a separation of commercial and investment banking activities.   Further, a commercial bank could not hold a brokerage firm.  With the passage of the Gramm bill the line between traditional and investment banking was obliterated and permitted  the merger of commercial and investment banks, brokerage and insurance firms.   The financial “commons” was now open for all to graze in.  The result:

-          Excessive use of leverage.

-          Large scale subprime lending.

-          Exotic mortgage products such as interest only, adjustable rates, and ALT-A.

-          Securitization of everything from mortgages to car loans to credit card debt.

-          Expansion of consumer lending facilities such as home equity line of credit, automobile leasing and mass issuance of credit cards to anyone who could fog a mirror.

-          Predatory private equity corporate takeovers amplifying leverage with “pick or pay” payment options.

-          Conflicts of interest between credit rating agencies and issuers and the ultimate purchasers of securities.

-          Credit derivatives wherein firms could bet on and simultaneously attempt to engineer the demise of other firms.

Before being distorted beyond their original purpose, these practices started from a rational base.  Take for example housing.   The reigning ideology supporting aggressive lending practices was that housing prices would always rise and homeowners would do everything possible to avoid foreclosure of their homes.  Banks armed with AAA ratings from the credit rating agencies and sophisticated models predicting default rates could bundle mortgages, create securities and sell them to “confident” investors.

The tragedy of this commons was that loose credit increased both real estate prices and supply to the point where incomes could not support repayment.  In turn, the packaged securitized mortgages did what no one unpredicted, failing at an alarming rate in excess of mathematical projections.  Soon the “housing commons” was littered with foreclosed homes, plunging prices, impaired bank balance sheets and the ultimate failures of Bear Stearns and Lehman.

Each participant: banker, builder, lender, appraiser, credit agency, and homeowner was merely pursuing his own economic interest.  If this was merely private participants losing money, it would create economic difficulties but not a financial crisis.  Unfortunately, two of the major players in the mortgage market were Fannie Mae and Freddie Mac, government sponsored enterprises with an implicit guarantee from the Treasury.  These entities are sporting losses which will exceed $1 trillion or more.  We the taxpayers through TARP and government guarantee programs are subsidizing these losses.  See Shredding the Social Fabric. We are still paying the price for this disaster with 8 million unemployed and countless millions more underemployed.

Part II will examine BP’s ill-fated sojourn into a “common” otherwise known as the Gulf of Mexico.

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27
Jun 10

Safety and Profits: Oil and Water?

Last Thursday was another opportunity to watch a corporate executive, Tony Hayward, BP CEO,  grilled before Congress.  Suddenly, our previously silent representatives sprang into action and demonstrated their new-found expertise in off shore drilling, cementing protocols, drill logs, blow out preventers and other esoteric elements of drilling and exploration.

How do these mishaps occur? Are other corporations really any better? What are the CEO’s like in these mammoth enterprises?

Risky Business

Industrial accidents occur in corporations.  It is a fact of corporate life.  People die at work every day, and the number is probably under reported.  A significant corporate mishap that reaches the popular press always shocks the public.   If there is a large enough loss of life or damage to the environment or economy, Congress jumps in to demonstrate that they are “on top” of events and protecting the public.

Some accidents are preventable, some are not.  Much of the outcome depends on corporate culture.

Safety, Environmental Compliance, and Corporate Culture

Enactment of Corporate Sentencing Guidelines drove corporations to compliance and ethic programs. Safety and environmental compliance were major parts of these programs. The first programs focused on formulaic policies and procedures and appointment of a chief compliance officer.  Understandably, prosecutors wanted managements to take compliance seriously.  Thus, in addition to compliance manuals, programs evolved to incorporate in-depth training, comprehensive investigations of wrongdoing, self disclosure and discipline of offenders.

Safety and environmental compliance are two particularly sensitive areas, as literally they can involve life and death.  Despite the best efforts of the corporation to establish robust compliance programs in these two critical areas, success still depends on corporate culture.   Does the corporation take compliance seriously? Are employees provided extensive training?  Does the compensation system support good practices? How will whistleblowers be treated?  How much of corporate resources are devoted to compliance?  Are violators punished?

Life in the Trenches

No one goes to work thinking that there is going to be a mishap.   Things happen in the trenches.  This is where corporate culture really plays the key role.

I am not an oil expert but we can imagine how a BP disaster could occur.  On June 14th, the House Committee sent a letter to Tony Hayward, CEO of British Petroleum, querying five areas of concern:

(1) the decision to use a well design with few barriers to gas flow; (2)  failure to use a sufficient number of “centralizers” to prevent channeling during the cement process; (3)  failure to run a cement bond log to evaluate the effectiveness of the cement job; (4)  failure to circulate potentially gas-bearing drilling mud out of the well; and (5)  failure to secure the wellhead with a lockdown sleeve before allowing pressure on the seal from below. The common feature of these five decisions is that every one was a trade-off between cost and safety.

The House focused on these areas, as each represented a trade off between cost and well safety.

A dynamic tension exists within corporate environments between cost and safest practice. The rig was 43 days overdue, meaning that BP was incurring $500,000 per day of incremental rental cost.   The project manager was under enormous pressure to bring the project in as close as possible to budget.  It does not take much creativity to conjure the conversations or attitudes at play on the rig when employees or contractors discussed safety issues:

Is (whatever) change really necessary?

-          How much is this going to cost?

-          Is everyone being a “team player?”

-          Are the contractors recommending this course of action so they can charge us more?

-          “Who wants to call London and explain a delay to top management?

-          Didn’t X Company do this safely without any problems?

-          Why a design change?

-          Do we really need to involve the government?

Each of these is a subtle intimidation intending to silence any naysayers standing in the way of “progress” and “profits.”

In most cases, the CEO of a mammoth corporation is detached from day to day operations.  Often, a CEO seeks plausible deniability. See Timothy Geithner and Plausible Deniability. While Mr. Hayward proclaimed that safety was a major BP concern, how did the rank and file personnel operationalize that concern?  CEO’s often send mixed messages and employees may have heard that while safety is important, the company is in the business of making profits for shareholders.  The true litmus test is behavior on the oil rig. From all accounts it appears that cost shortcuts trumped safety.

BP is Not Alone

Every day in corporate America companies make tradeoffs.  It is naïve to think that only BP is doing it.  Safety, compliance, and environmental controls are cost, not profit centers.  On the contrary, lots of companies exert subtle and not so subtle pressure on employees, subcontractors and even government officials.

If we are truly interested in preventing future avoidable accidents, we need to raise and enforce penalties on corporations and individuals.  The Corporate Sentencing Guidelines already provide a template.  Further, the government needs to intelligently enforce regulations on the books and promulgate new regulations when necessary.   Finally, corporate and environmental compliance needs to rise to the top of the corporate governance checklist.

Perhaps then we can avoid the “show” of the House of Representatives examining problems after the event.  We need to give prior thought to preventing calamities before they happen.  On so many levels, the cost of the aftermath is simply too great.

We have learned the hard way that balancing profits, safety and environmental concerns are like mixing oil and water.

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7
Jun 10

The Responsibility Index

Wall Street seems to manufacture measurement indices at the speed of light. Why not a “Responsibility Index” to track bad behavior?  Having one would force bad behavior into the spotlight, something that has been sadly lacking.

How to Be Responsibly Irresponsible

Unfortunately, irresponsible financial and business behavior is everywhere.  Moreover, offenders in search of exoneration have learned to “spin” their irresponsible actions.   Here is a short tour through a world of irresponsibility:

-          The Oracle of Omaha, Warren Buffet, testified before the Financial Crisis Inquiry Commission.  Buffet followed in a long line of CEOs such as Charles Prince who feigned ignorance about the housing crisis.   Buffet defended Moody’s lavish granting of AAA ratings to virtually all housing related bonds.

In Moody’s defense, Mr. Buffet pointed out that nearly all Americans were caught up in the housing bubble and very few market participants predicted a nationwide crash in housing prices. In addition, Mr. Buffet stated that he personally did not realize the extent of the bubble before it broke. See Was Buffet too easy on Moody’s in FCIC Testimony?.

Paraphrased another way, if no one could see the train wreck coming then no one was responsible.

-          The Deepwater Horizon oil disaster is a veritable case study on shirking responsibility.

a.  First we have the President informing the public that this is entirely BP’s responsibility.

b.  Then we have Ben Stein, a financial commentator and Yale Law School graduate, standing corporate law on its head with the following:

Look, I’m a stockholder of BP through mutual funds. You are, I’m sure, too. I’m sure most of your viewers are in their retirement fund. Why should we be punished? Why shouldn’t it be people who actually were there on the watch and made the mistake be put in prison if they did it criminally negligently? See CNN Transcript

When you buy stock in a corporation, you vote for the board of directors and as an equity holder you risk losing your entire investment.  The fact that BP stock is held in pension funds does not exonerate shareholders from financial responsibility.

c.  Finally,  in an interview with the Financial Times of London, Tony Hayward confessed that BP was ill-prepared for the disaster:

BP did not have all the equipment needed to stop the leak from its Macondo well in the Gulf of Mexico in the aftermath of the explosion on an oil rig six weeks ago, the UK company’s chief executive admitted.

Speaking to the Financial Times in Houston as engineers worked on their latest bid to trap the escaping oil, Hayward said BP was looking for new ways to manage “low-probability, high-impact” risks such as existed on the the Deepwater Horizon oil rig.

“What is undoubtedly true is that we did not have the tools you would want in your tool-kit,” Mr. Hayward said.  He accepted it was “an entirely fair criticism” to say the company had not been fully prepared for a deep-water oil leak. See BP CEO: We Were Unprepared for the Disaster

Thus, if you are BP, you should not be responsible for drilling in 5,000 feet of water through 13,000 feet of rock because a blow out is a low probability event?

-          We can draw an analogy in hometown America.  The New York Times highlighted the Pemberton family who have not paid their mortgage for two years.  However, with the extra money available, the Pembertons have funded their family business, gone out to dinners, fueled their air boat and visited casinos.  Their justification is emblematic of the age we live in:

Any moral qualms are overshadowed by a conviction that the  banks created the crisis by snookering homeowners with loans  that got them in over their heads.  See Owners Stop Paying Mortgages, and Stop Fretting.

The Pembertons therefore consider all the banks to be “crooks,” but not themselves for breaking their bank mortgage contract.

Personal Responsibility

We live in an age of moral relativity where we shirk responsibility as easily as we change shirts. Let’s summarize the shirking of responsibility:

-          Mr. Buffet and Moody’s are not responsible since no one could see the collapse in house prices.   Didn’t John Paulson and Goldman make billions in shorting the housing market?

-          Ben Stein does not want the BP shareholders to be punished.  Didn’t shareholders accept this risk when they purchased BP shares?  What if BP committed antitrust violations? Would Mr. Stein have the same opinion?

-          We should excuse BP since the spill was a low probability event? Haven’t spills occurred in Mexican and Australian off shore sites?  A $200 billion company did not have the proper tools in their “tool-kit”?

-          It is alright to default on a mortgage and live in a house rent free.   Didn’t the Pembertons sign a contract promising to repay all the monies they borrowed?  Is this behavior fair to their neighbors who diligently make their mortgage payments?

The Animal House Defense

In the classic comedy film Animal House, Otter, the fraternity president, argues against college expulsion on the following grounds:

But you can’t hold a whole fraternity responsible for the behavior of a few, sick twisted individuals. For if you do, then shouldn’t we blame the whole fraternity system? And if the whole fraternity system is guilty, then isn’t this an indictment of our educational institutions in general? I put it to you, Greg – isn’t this an indictment of our entire American society?  See Animal House Memorable Quotes.

We are perilously close to the Animal House defense that if we are all responsible, then no one is responsible.  We need to bring back individual responsibility and none too soon.  Otherwise,  seriously irresponsible people will be shorting the Responsibility Index.

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25
May 10

Less Leadership Than Meets the Eye

A ritual occurs yearly in major corporations:   the annual setting of management objectives.   This task has evolved to a high art form, with the goal being an objective that looks difficult to attain, but really isn’t.  A successful executive needs to master this skill to attain status among his peers, impress his superior, and thus earn a generous bonus.  To excel at this process the exec must:

1. Privately identify an objective that everyone else has missed.

2.  Keep that objective his little secret.

3.  Complete the objective singlehandedly.  Avoid teamwork; it gets in the way and diffuses credit.

4.  Trumpet the accomplishment to superiors just before bonuses are determined.

Excellent rewards then flow from this “extraordinary achievement.”   Said more colloquially, “Set the barn on fire surreptitiously, but be the guy who has the fire trucks strategically stationed just outside the barn.  Extinguish the fire.  And make sure you’re standing next to the grateful farmer.”

David Leonhardt, financial columnist for the New York Times, lauds the Obama Administration for its bold financial and health care reforms and economic stimulus legislation:

With the Senate’s passage of financial regulation, Congress and the White House have completed sixteen months of frenetic activity that rivals any other since the New Deal in scope or ambition. Like the Reagan Revolution or Lyndon Johnson’s Great Society, this new period of activity seems to be a paradigm shift in how Washington operates. See A Progressive Agenda to Remake Washington

These efforts are not beneficial to the country and appear like the objective setting exercise by our hypothetical executive.  My cynical suspicion is that in a world of sound bites, the Administration has created a formulaic check list of “reforms” to position the Democrats for the 2010 Congressional and 2012 Presidential elections. We have not “remade” anything.

Financial Reform

Since the final bill is not yet law, we can examine only its proposed parts.  The $5 trillion sink holes of Fannie Mae and Freddie Mac remain unchanged.    Instead of breaking up banks that deserve to disappear, the bill institutionalizes them as “too big to fail.”  Fair pricing remains elusive, as derivatives are not yet moved to the exchanges.  Leverage caps have not been reinstated, so the investment banks can leverage at ratios of 30 to 1 or greater.  The bill does not reinstate mark to market accounting. The Federal Reserve has ducked vigorous audit.   Rating agencies remain largely uncontrolled.

As the markets react to excessive debt in Europe, the collapse of the Euro and the possibility of sovereign debt default, it looks like the President has taken credit for “winning the past war,” instead of addressing the financial problems facing the country now.

Health Care Reform

The Administration has promised universal coverage but at what price?   Premiums for younger people will rise 17%, 4 million individuals will be subject to the $1000 penalty for not purchasing coverage, and small employers will incur at least $1000 of additional costs for employees.  Importantly, 15% of hospitals may be forced to close.  Where will doctors come from to staff this financially squeezed sector of the economy? See Obama’s Health Care Promises Already Busted

Deepwater Horizon Oil Spill

The oil rig explosion and spill occurred on April 20.  The President did not fly to the site until May 2.  This is ironic, as Obama campaigned against the Bush Administration’s lethargic response to Hurricane Katrina’s devastating impact on New Orleans and the Gulf region. The original estimate of a 5000 barrel per day spill is now believed by scientists to be 10 times as great.  BP and the government are blaming each other for misinformation about the original estimates, and we now have a bipartisan commission to examine it all.  What we do not have is expeditious candor from the beginning of this tragedy:  about its size, its scope, the ways to remedy it, what role the government will play and its potential effect on the Gulf and the Atlantic.  The Administration seems intent on avoiding responsibility and shifting any solution to BP.

Checking the Boxes

Robert Reich, former Clinton Labor Department Secretary, is scathingly critical of the timidity and lack of resolve in restructuring the finance and health care industries. He maintains that monster “regulatory” bills with huge loopholes favor these industries rather than reform them.  Worse, he predicts that these loopholes will result in later payoffs to those who benefited from them.  His damning conclusion:

So why has Obama consistently chosen regulation over restructuring? Because restructuring Wall Street or health care would surely elicit firestorms from these industries. Both are politically powerful, and Obama does not want to take them on directly. [emphasis in original article]

“A regulatory approach allows for more bargaining, not only in the legislative process but also, over time, in the rule-making process as legislation is put into effect. It’s always possible to placate an industry with a carefully-chosen loophole or vague legislative language that will allow the industry to continue as before.

And that’s precisely the problem.” See Robert Reich:  Why the Finance Bill Won’t Do Anything

Where is the Leadership?

There is an old saying that managers do things right, but leaders do the right thing.   The Obama Administration is checking all the correct political boxes: health care, financial reform, economic stimulus and crisis management.   Maybe they are doing things right politically, but I am not sure they are doing the right thing for the country.

Sudden crises like the Euro mishap and the Deepwater Horizon have a way of recurring and demanding true leadership.    What Obama may not realize is that the American public is skeptical and can see through his merely expedient responses to all these crises.  And if that is true, the recent primaries and special elections raise questions on the political longevity of this Administration.

Triumphant Rose Garden speeches will just not make up for lack of leadership.

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16
May 10

Surfing the Financial Crisis

I’ve been watching the financial crisis since it began in 2007.  Every so often it is good to step back and consider some of the anomalies. Thus, some disconnected thoughts:

-          The time between crises gets shorter.  It was seven years from the dot.com to the sub-prime crash.  It has taken us only one year from TARP and other alphabet soup US-based federal bailout programs to the European Commission trillion dollar bailout.  With the Euro plunging after the bailout, how long will it be to the next crisis?

-          If everything is really improving why have short-term US interest rates not risen? I am amazed that for over 2-years of regular Treasury auctions, 3 month bill rates have ranged between .1 – .2%.  Why does the Federal Reserve keep stating in its guidance that it intends to keep rates at zero for an extended period of time?

-          Why would anyone invest in the US equity markets?  The most active stocks each day are severely troubled, probably insolvent companies:  Citicorp, Fannie Mae, AIG, and Bank of America. More than sixty percent of every day’s volume is non-human, computerized, automated trading.  And what is worse, computers doing this trading are shaving cents off each transaction to the detriment of institutions and retail investors.   No one believes in long term investment value any more. Respected analysts believe the market is severely overvalued and should probably trade at the 850 S&P level.

-          How do Goldman Sachs and JP Morgan have perfect trading performance, that is, making money every day of the first quarter?  Karl Denninger has calculated the odds of achieving this feat at one in many trillions.  Have the SEC and other government regulators taken an extended holiday during the financial crisis? It sure seems that way.

-           The 1987 version of the SEC portrayed in the movie Wall Street was able to detect illegal activity in the fictional Blue Star Airlines and arrest the hapless Bud Fox.  Mary Schapiro and the current SEC staff can’t seem to find water with two hands if they fell out of a rowboat in the middle of the Atlantic.

-          Why do things keep getting more complicated and less clear? Yes, we live in a complex world.  But I have a deep suspicion that complexity is being used as a subterfuge to mask true intent.  Why do we need multi-thousand page financial and health reform legislation, customized credit default swap instruments and impenetrable corporate proxy statements? The answer: complexity is designed to disguise the essence of each issue.

-           Why is the Federal Reserve afraid of a full-fledged audit?   As taxpayers, we are the ultimate financiers for the various government bailout programs. What happened to sunshine as the best disinfectant in public matters?  This is an economic, not a national security matter. Or in the minds of the government, has everything become a national security matter, even the Fed’s purchase of the Red Roof Inn?

-          Why is Senator Chris Dodd, himself compromised with a Countrywide below market loan, allowed to lead financial reform?

-          With a Justice Department of 100,000 employees, why haven’t we indicted a major financial institution?

We live in dangerous times.  Perhaps some of our leaders should be thinking about some of these questions and issues.

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13
May 10

Lack of Skepticism and Imagination Can Be Harmful to Your Financial Health

Ron Geffner, a lawyer and hedge fund expert, was a recent guest on Bloomberg’s Hays Advantage.  He commented that one of the causes of the financial crisis was that investors were lulled into a false sense of security.  (See A False Sense of Security).  My corollary observation is the striking lack of investor imagination, skepticism or integrated thinking.

We have become a task focused society.  Much of the work in large corporations is task- or project-based.  Common business phrases reinforce this short sighted focus on immediate outcomes: “singular focus,” “eyes on the prize,” “mission critical” “pedal to the metal” and “full court press.”  These idioms reveal a true but unspoken agenda:  put blinders on and accomplish the task at hand.  Thus, in the interest of efficiency and rapid results, do not prioritize the long term, which takes much more imagination and thoughtfulness.  Let’s look at how a lack of imagination can be harmful not only to our personal net worth, but also to any notion of greater or societal good.

What Were They Thinking?

Group think can be a tourniquet around one’s mind, or if you will, intellectual tunnel vision.  Focused on outcome, we brush aside unintended or negative consequences, or worse we don’t even consider them. Let’s look at some of the group think that ushered in the current state of economic distress:

Exotic Securities – Without understanding what they were buying, why were investors involved with collateralized debt obligations, interest rate swaps, auction rate securities and other exotica?  Why were brokers and bankers selling these securities when even they did not understand them?  See e.g., Fabulous Fab’s s emails.

Counterparty Risk – When making a large bet, one wants to make sure the bookie can make good on the bet.  In the financial world, investors did not consider that counter parties (the bookie in the analogy) could be a bankrupt Northern Rock, Bear Stearns or Lehman.

Credit Agencies –When banks paid credit rating agencies and often worked with them to improve ratings, why were investors surprised that those ratings (AAA no less) were in fact false?  Today, NY Attorney General, Andrew Cuomo opened an investigation of bank fraud in obtaining ratings. Prosecutors Ask if 8 Banks Duped Rating Agencies.

Housing – When agencies pay mortgage brokers on the basis of dollar volume, why are we surprised that those brokers colluded with homeowners to qualify the unqualified?  When we created exotic mortgages such as interest only, no documentation loans, and option ARMs is it surprising that homeowners default in droves?  Why didn’t investors, brokers or homeowners ever question the prevailing assumption spouted by leading bankers and public figures that house prices always increase?

The FIRE Economy and Outsourced Jobs – Why did leading economists not question the viability of an economy based heavily on Finance, Insurance, and Real Estate?   Our economy has always been at its most prosperous based on strong domestic production of goods and services.  As we were outsourcing jobs and freezing wages for workers why did no economist raise the question of why a recession would not result from the decline in good paying US jobs?

Katrina and the Regulatory Environment – Katrina was a wakeup call that the laissez faire Bush Administration could lead to disastrous consequences.  Why did investment analysts, Congress and the media not question the ineffectiveness of key government regulators such as the Securities and Exchange Commission, Federal Deposit Insurance Corporation, the Federal Reserve and others?   Failure to enforce the laws and regulations on the books has had disastrous consequences for investors.

Private Equity – Corporations such as Chrysler and GMAC were deeply flawed before their failures.   Why did we not question how a private equity firm could improve on existing managements?

Programmed Trading – Why are we not surprised when 25 year olds put in charge of computer trading programs that trade against other computer programs can crash the market 1000 Dow points in several minutes?

Sovereign Debt – Why are we surprised that we now question the creditworthiness of nations such as Portugal, Ireland, Italy, and Greece, Spain and even the UK and US, when governments respond to the financial crisis by absorbing the private debt problems of the banks?

Human Nature

It is human nature to dislike hearing bad news.  Sometimes it takes a little imagination to conjure up negative consequences.  Maybe it is my legal training, but I tend to look at my downside risk before I look at the upside.  The public should have been a lot less trusting in some very flawed institutions: banks, brokers, mutual funds, traders, real estate agents, the SEC, the Federal Reserve and others.  Unfortunately, one consequence of an uncritical financial media is that presenting a cavalcade of financial “experts” without harsh questioning only reinforces misplaced trust and zero imagination.

We need to encourage some imagination and a whole lot of skepticism before we reach the other side of the Great Financial Crisis and try to stay there.

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25
Mar 10

Living in the Land of Pretend

I rarely have the radio on in the middle of the day. But yesterday on the Bloomberg Radio Hays Advantage, Kathleen’s guest was David M. Jones Sr.  Dr. Jones is a professional economist and consultant and the principal in DMJ Advisors. He holds a Masters and a PhD (presumably in economics) from the esteemed University of Pennsylvania.  He was speaking with Ms. Hays on the subject of financial reform and the role of the Federal Reserve.

Departures from Reality

Dr. Jones argued for the centrality of the Fed as chief financial regulator since they had garnered enormous expertise in banking practices in the current crisis. That is a pretty remarkable statement, as the Fed purportedly had a major bank regulatory role BEFORE the crisis. When events exploded, the Fed was clearly part of the problem.  They in fact had condoned shoddy lending practices and therefore contributed to the consequences we face now. (As examples, the Bear Stearns-J.P Morgan forced merger, the Lehman and AIG insolvencies).  On this issue, I guess we should all be glad if the Fed at least has learned that lesson.  But have they? Dr. Jones then lauded the government for the 2009 “stress tests” of the nineteen major banks.  These tests have purportedly restored confidence in our financial system.  Jones maintains that these “rigorous” tests demonstrate the reaffirmed solvency of the banks.

Stress Tests and Public Relations

Dr. Jones is wrong because the stress tests were not valid, but in fact were a public relations stunt.  Independent economists and bloggers such as Michael Shedlock, Karl Denninger and Martin Weiss felt the tests were at best deceptive and at worst fraudulent.  Instead of demonstrating the financial worthiness of the banks, the terms of the “stress tests” exposed fundamental weaknesses in these banks’ financial health.  Let’s look at some of the criteria, assumptions and methodologies the government utilized to assess solvency.

-          Worst case scenario too optimistic – The government assumed that at worst losses would not exceed $950b by the end of 2010. Projected bank losses far exceeded that worst case. The IMF projects a range of loss of 2.4 – $4.1 trillion; Karl Denninger projects residential mortgage losses at 2.5 trillion, and Nouriel Roubini’s loss estimates are in excess of $1.8 trillion.

-          The “Take Home Test” – Using two alternative macroeconomic scenarios, the government required the banks to estimate their potential losses on loans, securities and trading positions, as well as pre-provision net revenue and the resources available from the allowance for loan and lease losses.  Karl Denninger in The Scam of the “Stress Test” commented:

They asked the banks, they did not send in a team of examiners to look at the books independently.  So the base data that was ingested into this process in fact came from the banks themselves, not from independent, outside examination.  As a consequence it is fair to ask where the valuations came from and how they are supported, including the models and other information used to develop these figures.

This data is not disclosed.

Second, some of the data points and “expected losses” are comical.  For example, the banks are expected under the “more adverse” situation to believe that prime mortgage losses will not exceed 4%, and ALT-A (liar loans and Option ARMs) will not exceed 13%.  HELOC loss (most of which is unsecured!) is expected not to exceed 11%.

-          Bank Permission to Massage and Change Results – Some banks did not like the results, so they lobbied for methodology and outcome changes.  Karl Denninger again reports:

Some major banks managed to wrest concessions from the government in closed-door negotiations over their “stress tests” that helped them put the best face on their results, financial analysts, industry officials and sources said.

So in essence the entities being examined became the architects of their own examination.  In what universe do we do that?  Do we allow school students to write their own tests?  The resulting continued wave of residential delinquencies, foreclosures, losses on second mortgages (home equity lines) and commercial real estate demonstrate that the stress tests were flawed.  In fact, utilizing 2010 data from FDIC losses in bank seizures, Mr. Denninger estimated losses at just 4 major banks (Bank America, Wells Fargo, Citicorp and JP Morgan Chase) to be in the range of $1.5 to $3 trillion. See All You Need to Know About Bank Balance -Sheet Fraud

Sometimes the Truth Appears

Yesterday, Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, blasted the current large bank regulatory regime.  See Kansas City Fed’s Hoenig Endorses Volcker. The top 20 banks have a grossly unfair economic advantage by way of explicit government loan guarantees.  Without these guarantees the top 20 would need $210 billion more in new equity, or would need to shrink their lending activities by $3 trillion. How does this need for capital square with the confidence building stress tests?

Dr. Jones is a sad example of economists who slavishly follow the government line of thought.  Dr. Jones should be asking some tough questions: why do we need $23 trillion of government guarantees for our financial system to be solvent? Why are short term interest rates still set at zero for our top banks?  Why have we been in a state of financial emergency since 2008 if the economy is recovering?  Were the stress tests a scam to help the banks raise cheap capital? Given the Fed’s past poor regulatory performance why give them more plaudits and power?

Perhaps the Administration and the Federal Reserve have done a better job at capturing prominent economists and our news media than regulating the banks -  of course, all to the taxpayer’s detriment.

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2
Mar 10

Goldman and the Winner Take All Society

Finally, Goldman Sachs has gone too far.  In A Reputation as Good as Goldman?  Part I, we discussed Goldman’s selling of mortgage backed securities, and its role in the current Greek budget crisis.  These activities clearly contributed to its self-inflicted reputational damage.

Perhaps the hubris went further.   Does Goldman believe that its status as a favored Federal Reserve “too big to fail” firm will insulate it from government investigation? Last week Ben Bernanke put a dent in Goldman’s Teflon shield:

Ben S. Bernanke, the Federal Reserve chairman, told Congress Thursday that the Fed was ‘looking into a number of questions relating to Goldman Sachs and other companies and their derivatives arrangements with Greece.’

Mr. Bernanke said the Securities and Exchange Commission was also concerned about how derivatives — financial instruments that are largely unregulated and do not trade on public exchanges — have contributed to Greece’s problems. ‘Obviously, using these instruments in a way that intentionally destabilizes a company or a country is counterproductive,’ he said. See In Greece’s Crisis, Fed Studies Wall St.’s Activities.

In Is Goldman Finally About to Be Leashed and Collared? Yves Smith observes and analyzes Goldman’s corporate culture.  As a former employee, she reports on colleagues’ piggish and overly aggressive behavior. But in an otherwise excellent post, I believe she overlooks the role of current compensation systems.

Pay Practices and Reputation

In previously discussing the banking crisis, we pointed out a fundamental principal: you get what you incent.

Banks were interested in generating upfront fees. Incentives were predicated on “making the deal.”  The best way to make a deal was to ignore the creditworthiness of the borrower.  The banker who made the bad loan suffered no personal financial penalty.  There was no “skin in the game.” Why not write as many loans to poor credits as possible? See Hard Truths from the Banking Crisis.

The Goldman culture incents a “winner take all” mentality.  Since it is a public corporation rather than a partnership everyone is an employee.    A highly mobile employee rather than an owner is far less concerned about the firm’s long term reputation.  That employee wants to maximize current compensation; worrying about future consequences is for suckers.  Drawing on this paradigm, we are not shocked by headlines excoriating the firm for trading against its clients’ interests, shorting the municipal bonds it helped underwrite, skirting EU rules, or tanking the housing market.

Goldman operates in a larger Wall Street and indeed general culture that encourages greed at the expense of overall civic good:

  • Successful hedge funds report individual earnings in the hundreds of million dollars per employee.
  • Loyalty is dead.  Employees change firms. Highly paid athletes change teams without a second thought.
  • The media treats great wealth as reason for great celebrity.
  • Compensation validates individual worth.
  • Government backstops losses and allows gains to remain private.
  • The zeitgeist promotes: “I better grab as much as I can now before the economy implodes.”

Does It Have To Be This Way?

Any alert Board of Directors should be asking some difficult questions.  Why aren’t we concerned about the long-term firm reputation?  What do we want the corporate culture to be? Just because we can legally do a transaction should we be doing it?  How do we blend partnership-based personal accountability with a public corporation structure?   How do we get employees to care about the long-term view?  How do we meet the competitive threat of hedge funds and private equity without damaging corporate reputation? How does our compensation system comport with these concerns?

Yves Smith noted that it was as dangerous for anyone to get in the way of a Goldman employee and a profit making opportunity as it was to get between a predatory animal and its kill.  Goldman has managed to get itself between a very worried Obama Administration and a very angry public.  How ironic if the Goldman predatory lion becomes the Administration sacrificial lamb.

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