Prophet Without ProfitThinking Non-Linear

Captain Renault: I’m shocked, shocked to find that gambling is going on in here! Casablanca

The SEC awoke from its long slumber to file a civil complaint against Goldman Sachs.  Paragraph 3 outlines the case:

“In sum, GS&Co arranged a transaction at Paulson’s request [ed. note - Paulson &Co. is a hedge fund  firm unrelated to the former Treasury Secretary Henry Paulson] in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.”

Paulson helped Goldman shape a portfolio of mortgage-backed securities which were virtually guaranteed to fail.  The firm did not disclose Paulson’s influence or that he was shorting these securities.  Losses totaled a billion dollars.

On February 18^th, I described and criticized this and other Goldman transactions as not in their customers’ best interests.  See A Reputation as Good as Goldman Part I.

From an SEC perspective Goldman’s only failure was in failing to disclose Paulson’s influence and his role in shorting the securities.  That Goldman knowingly put together a collection of poor quality assets which immediately became worthless was not at issue.  So designing junk, destined to fail, is not an issue?

The Over-Financialized Economy and Fraud

But, notably, Goldman got caught.  The firm is the prime example in an over-financialized economy of an institution run amok wherein investors are nothing more than easy marks.  A look at headline stories over the last several weeks clearly and sadly illustrates the point:

• Merrill Committed Same Fraud as Goldman – Rabobank, a Dutch firm, claimed that Merrill Lynch committed a similar fraud in structuring a $1.5b CDO.
• Senate Panel Finds Major Fraud at Washington Mutual – A Senate investigation found that the Office of Thrift Supervision failed miserably in their oversight of WAMU.  In two top producing offices of the bank fraudulent loans exceed 58% and 8% of the loans written.  Senior WAMU executives were aware of the fraud.
• Big Banks Mask Risk Levels – Reminiscent of the notorious Lehman 105 strategy, The Wall Street reports that 18 major banks used strategies at the end of five straight quarters to lower their risk level 42%. The SEC is looking into this practice.
• GE Capital, Jack Welch and Jeff Immelt: A Tissue of Lies and Subterfuge – It is alleged that GE CEO Welch managed earnings through creative accounting in recognizing gains and losses at Capital.  It is further alleged that current CEO Immelt continued these practices. These practices were undertaken to enrich investors.
• Wall Street Real Estate Funds Lose Between 61% and 98% for Their Investors as They Continue to Rake in Fees! –(self explanatory)
• Ankle Bracelets for High-Frequency Traders – The SEC is struggling to control practices that give large Wall Street firms unfair advantage over the public.  The SEC is seeking to put limits on high-frequency trading, off-exchange dark pools and broker-sponsored access to the markets.

Beginning of the End?   Business as Usual?

Wall Street bemoans that volume in the current stock market rally is light and that the retail investor has not returned.  Why would any investor trust banks and Wall Street firms?  Synthesizing these headlines investors are exposed to the following risks:

-          An SEC too slow to take effective action

-          Complicit Office of Thrift Supervision

-          Fraud

-          Creation of near worthless securities

-          Taking an adverse interest to your own customers

-          Failure to Disclose

-          Excessive fees

-          Accounting Trickery

-          Excessive executive compensation flowing from accounting trickery

-          More protection is afforded to a used or new car buyer under state consumer protection laws.

The time has come for the casino operators masquerading as investment firms to stop viewing investors as “marks” ripe for fleecing.  These firms need to return to their historic roles as trusted investment advisers.  Maybe then investors can return to the markets with renewed confidence. Friday’s indictments were small ripples in a larger, very dirty pond.

“Act in haste, repent at leisure.”  – Source unknown

US Treasury Secretary, Timothy Geithner is in real trouble. The New York Times (Jan. 13) reports:

Representative Edolphus Towns of New York, said Wednesday that the committee had subpoenaed Mr. Geithner’s e-mails, phone logs and meeting notes from when he was president of the Federal Reserve Bank of New York in late 2008. The committee has already asked Mr. Geithner, now the Treasury secretary, to testify at a hearing next week about why the New York Fed told A.I.G. not to disclose that its trading partners were being paid 100 cents on the dollar to unwind tens of billions of dollars in derivatives.

Mr. Towns argued that A.I.G.’s counterparties would have received, at best, 30 to 40 cents on the dollar if the troubled insurance giant had filed for bankruptcy.

Mr. Geithner’s activities as Fed president drew additional scrutiny as he is suspected of encouraging, ordering or actually modifying AIG SEC-required disclosures to hide AIG’s payment of monies to its large bank counterparties.

It will take a Congressional investigation and maybe appointment of a special prosecutor to determine Mr. Geithner’s culpability.  Nevertheless, his behavior in crisis is instructive.

Lessons Learned from Crisis Management

After almost an entire career in a corporate environment, crises seemed to be an every day event to the point where I thought crisis was normal.   Crisis management yields valuable lessons and reveals the best and worst human behavior.  Some thoughts and advice:

• A former boss said “fifty percent of the facts told to a manager of a crisis are correct the first time, and seventy five percent are correct the second time.”  Keep sending your subordinates back for correct information until you are satisfied they have done their due diligence.
• The situation is never is bad as it looks.  One’s worst fears are rarely realized.
• The cool hand always wins.  Those who panic and predict doom are seldom correct.
• As a corollary, think more and react less.  At the inception of a crisis there is a lot of motion but, unless you have the skills of gurus like the ones described in Blink (Malcolm Gladwell), avoid “knee jerk” reactions.
• Every problem has a solution.  Applying logic and keeping a cool hand allows the crafting of a solution.  Everyone may not like it, but some sort of solution presents itself.
• Everything looks better the next day.   Every bad day ends. Every first day of a crisis is finite.  Putting some time and distance between the onset of a crisis and the arrival at a solution yields a better result.
• If you  are willing to give up credit you can move mountains.  If you are truly committed to solving a crisis do not worry about getting credit.  Letting your superiors take credit is great, even better is letting them think that they came up with the idea.
• Make the crisis a one day story. Own up publicly to the problem quickly and be as candid as possible.  Failure to do so will make the crisis a multi-day story. Avoid making the crisis a multiple day “Page One” story.
• Avoid acting it haste, as it will only end in tears.  Throwing prudence, deep thinking and obedience to the law out the window leads to a bad result and often later prosecution.

Paulson, Geithner and Bernanke – The Committee to Save the World

I knew the country was in trouble when Henry Paulson, then Treasury Secretary at the start of the financial crisis, got down on his knees to beg Nancy Pelosi to pass the $700b TARP plan.  The original plan had panic written all over it: massive give away of funds, unreviewable actions and virtually dictatorial powers.  Somehow hundreds of years of constitutional development and the rule of law went out the window because our banks had some serious problems. Eventually, Paulson, Bernanke and Geithner were viewed as the Committee that Saved the World. See Steve Rattner article.

Given the panic displayed by senior members of government at a time of financial crisis it is no surpise that Mr. Geithner is being questioned by Congressional Committees.  Going further, I  doubt that he incorporated any or all of  the above bullet points in his management style or action planning at the time he made these decisions.

Perhaps we should end with the maxim – - ” Act in haste, repent at leisure.”

America used to be different.  During World War II both blue collar men and the elite served in the military.  Everyone lived with rationing: sugar, butter, tires bicycles, automobiles, coffee and a host of other consumer items.  The tax rate in 1944 on incomes over $200,000 was raised from 93% to 94%.  Hardly anyone complained.

Labor journalist Sam Pizzigati argues that this shared sacrifice from the top down helped define the “Greatest Generation” and pulled the country—including the elites—together in wartime.  See Shared Sacrifice, Shared Glory.

Today we are mired in a global financial crisis and two wars on foreign soil, Iraq and Afghanistan.   But our prior generation’s shared sacrifice is noticeably absent. What happened?

“Buy an SUV”

Perhaps the defining change in our national character came after 9/11.  What was our response to this vicious attack?   We did not re-institute mandatory military (or even national) service. We did not raise taxes. We did not demand or undertake dramatic new energy savings initiatives.  Instead Americans were encouraged to keep shopping and buy SUVs.  In fact, Congress enacted large tax incentives in 2003 to buy SUVs.  In effect, we encouraged energy profligacy in light of deadly attacks by Saudi Arabian.  Did the always unstable Middle East (with the exception of Israel) suddenly become our greater ally by attacking us?

Greed is Good

The eminent (if fictional) philosopher Gordon Gekko insisted “greed is right, greed works.”  See Wall Street.  And we have become Mr. Gekko’s devout followers:

• The Petulance of Jamie Dimon – The United Kingdom proposed to tax banker bonuses above 25,000 GBP and require some bankers to defer bonuses for three years. In response, Jamie Dimon, CEO of JP Morgan Chase threatened to cancel a 1.5b GBP project in the Canary Wharf financial complex. See JP Morgan Plans in Doubt.
• The Blindness of Public Sector Unions – Cleveland public employee unions were given an ultimatum to accept a modest 4.17% wage reduction or face large layoffs.  See Showdown in Cleveland: Unions Refuse Nominal Pay Cuts.
• The Blindness of Private Sector Unions – Ford Motor Company proposed a concession package along the lines of the UAW agreements with Chrysler and GM management.  The UAW rejected these concessions.  While Ford has recently reported improved car sales, the company is saddled with debt, pension and health care obligations.See UAW Reject Ford Contract Concessions.
• Record Wall Street Payouts – As I previously chronicled, see What Went Wrong? Disconnecting Effort and Reward, Wall Street firms have reported record bonuses this year. In many cases they will be paying out more than 50% of revenue.

I Want it Now

Like the very spoiled Veruca Salt, our ethos has become:  I want it and “I want it now. What’s the matter with those twerps down there?”  See Willy Wonka & the Chocolate Factory.   Maybe we have become fatalistic and believe the end is nigh.  Should we grab as much as possible before the end?  Our two intractable wars are remote for most Americans.  With no universal draft, these conflicts are being fought by mercenaries.  This is virtually unprecedented in our history. Why should we care? We have the NFL playoffs, college bowl games and American Idol to look forward to.

So, as a nation we have come a long way from the Greatest Generation. Will future historians call us the Greediest Generation?

In the early 1990s Andy Grove, then CEO of Intel, addressed a management meeting which I attended.  Addressing the East Coast management meeting, he sat in his tiny California cubicle and streamed video to the attendees.   Before the advent of Google and the project to digitize books, Mr. Grove predicted that the internet would be like having the Library of Congress at your fingertips.  His prediction has come true.  We now have a torrent of information more voluminous than the Library of Congress.  What is lacking is wisdom to interpret this torrent.

Confusing Information, Knowledge and Wisdom

We confuse information with knowledge and knowledge with wisdom.  A short trip to the dictionary:

Information: the communication or reception of knowledge or intelligence

Knowledge: (1) the fact or condition of knowing something with familiarity gained through experience or association (2) acquaintance with or understanding of a science, art, or technique

Wisdom: a. accumulated philosophic or scientific learning b. ability to discern inner qualities and relationships

These words are sequential: information leads to knowledge, knowledge properly applied leads to wisdom. I submit that the internet supercharged by search engines does not move the meter past “information.”

CNBC creates an expectation that a glut of information conveyed through catchy sight and sound is meaningful.  Breathless announcers countdown to the 8:30 AM unemployment numbers, new home sales, the Case Shiller Home Price Index, the ADP Employment Report, the Consumer Price Index, the Baltic Dry Index, preliminary GDP results, retail sales, etc.  The Wall Street Journal website provides a myriad of national and global market indices.  Financial websites such as Yahoo, Marketwatch and Google only add to the economic information overload.  The media is capable of showcasing a wide variety of experts knowledgeable in their field, but displaying little, if any wisdom.

Commentators in both old and new media were happy for their fifteen minutes of fame.  But in the new media age, Andy Warhol’s fifteen minutes have been reduced to thirty second sound bites.

Wisdom and the 2008 Financial Crisis

A thoughtful observer of the 2008 financial crisis could have foreseen that there were major imbalances in the US and global economy.

• The US ran huge trade deficits.
• Manufacturing moved off shore to low wage countries
• Credit, on every level, was too easily available.
• Wall Street created fiendishly complex derivatives incapable of valuation.
• Congress and the administration outdid each other cutting taxes while increasing expenditures.
• Family incomes were stagnant.
• Interest rates remained at absurdly low levels.
• States ran deficits during boom times, lowered taxes and cut back on funding pension liabilities.

In other words, something was horribly wrong.

Despite the claims of many financial and political establishment leaders that “no one could see this coming,” many did.  Commentators such as Michael Shedlock, Bill Fleckenstein, Karl Denninger and a small band of others were able to connect the economic dots.  Why?  These commentators possessed wisdom.  They examined the entire economic picture, thought about the effect of the imbalances and extrapolated the economic harm from these imbalances.  To do so and achieve wisdom, certain traits are required: thoughtfulness, a coherent theoretical starting point, real world experience, integrity, humility, critical thinking, a willingness to go against conventional wisdom and mindfulness of the whole.  Wisdom often comes from being the lone voice in the wilderness.

Wisdom today is still in short supply.  We are again bombarded with the range of unemployment, CPI, retail sales, and GDP reports, but little time is spent in the media on putting this information into context or wider perspective.  Can you really rely on one month’s worth of numbers to declare a recession over?  What if unemployment is really not a lagging indicator, but a precursor of greater economic harm?  Why does it make a difference that unemployment dropped from 564,000 newly unemployed versus 550,000 unemployed when over 6 million people are out of work and the number climbing?  Why does the stock market rebound look suspiciously like the 1930 stock market rebound?

Why do We Lack Wisdom?

We lack wisdom in our leaders for a number of reasons.  We overvalue credentials, an Ivy League education, a Harvard MBA, a Yale law degree. We do not spend the same amount of time evaluating and training our workers with deliberation and care.  Critical thinking is absent in our school systems and universities.  We favor the business leader or politician who can deliver the quick answer and pithy sound bite. Mindfulness and humility are just not “cool.”

Before the next phase of the financial downturn hits, we should launch a financial Manhattan Project and hope that wise leaders emerge.