Sunday, March 30, 2008

Gretchen Morgenson's superficial rants

The New York Times business columnist Gretchen Morgenson inexplicably won a Pulitizer Prize five or six years ago which no doubt means that readers are stuck with her forever. Her skills as a journalist could be compared to those of the New York Times sports columnists who revelled in self righteousness as they covered the Duke lacrosse team case. Unfortunately there is no court of law that can exonerate the many constructive elements of the financial system as well as the whole concept of a free enterprise economy.

Today both lead articles in the Sunday Business section featured her byline.
---One, entitled "The Foreclosure Machine", moves to the point of the article in the second paragraph saying "Behind the scenes in these dramas, a small army of law firms and default servicing companies, who represent mortgage lenders, have been raking in mounting profits." A little later in the article she nails these companies that are "raking" it in, citing one company that had a 13% increase in revenues in 2007 vs. a 1% increase in 2006. The point of the article is to excruciate these firms for exploiting the mortgage market problems for their own benefit. For Crying Out Loud. If companies in this line of work don't have higher revenues in this market with so many foreclosures when would they? That's their job. Is it unethical to build a business that at times has cyclical revenue increases and therefore makes more money. It should be noted that Morgenson spends much of the article pointing out that some lawyers and firms in this business charge fees that are too high or at times do not follow the law. That is a totally separate issue from whether this type of firm has more business in this market. Those firms or attorneys that do bad things or break the law should be examined and held accountable. However, indicting an entire industry niche with the zeal of absolute certainty is either naive or maliciously self serving or both. Morgenson rarely makes an attempt to be balanced. She's too busy playing "gotcha" in a world that she only superficially understands.
---The second lead article is "If You Can't Sell, Good Luck" which focuses on the lack of liquidity in the auction-rate securities market. After an introductory paragraph, the second begins with "Everybody knows, though, that only big guys get bailouts". Man, is she insightful, once again encapsulating all truth before making any point whatsoever. There's really not much to say to someone with this kind of rigid agenda, but here are few thoughts.
First, the great majority of buyers in the auction-rate securities market are institutional investors looking for extra yield and high net worth investors being offered the same opportunity. They know, or should know, that added reward signifies some added risk. There is undoubtedly a portion of this market in the hands of individual investors who were accepting the guidance of their broker. The market had worked for more than twenty years and in this crisis it broke down. That is unfortunate but this will be worked out over time with minimal if any principal losses and some brokers will be under appropriate scrutiny.
Second, is Morgenson looking at the JPM/Bear Stearns transaction when she refers to bailouts. It certainly would be a normal assumption that she is, and yes bondholders of Bear will be fine and as a result the financial system of counterparties did not fall into a period of chaos that would have hurt everyone, big and small, if Bear had collapsed. However the shareholders of Bear, plenty of big guys there, were wasted, with their stock going from $80 to $2 and now $10 in two weeks. Bear Stearns executives and employees owned almost one third of the firm and their net worth has been shattered. Major institutions held significant positions. Everyone was not bailed out.

An April 13th, 2007 post here summarized the horrendous unbalanced reporting by the NYTimes sports pages in the Duke case, in particular that of Selena Roberts. Roberts hung on for awhile, but is nowhere to be found now in the paper of record. One can only wish.

Slow mo stock market crash?

Somehow there seems to be no middle ground in looking at the equity markets in the U.S. today. On the one hand, it is possible that the market is oversold and that the relative value to other capital market opportunities is heavily tilted towards a significant market rally. On the other hand, having only two hands, the thought lingers and just won't go away that we could be in a slow motion stock market crash, comparable to the U.S. dollar's collapse of 40% since 2001. Is it possible that through fits and starts, ups and downs, that by the end of 2009 we could look back and realize that the market took two years to accomplish what it did in one week in October 1987.

Saturday, March 29, 2008

NCAA basketball tournament notes

After not watching one college basketball game during the regular season, the inevitability of being drawn back in for tournament time is just that. The format has worked for the easily distracted in the pre-"Elite Eight" games as CBS has been able to switch back and forth between simultaneous games depending on the competitiveness of the action. Now is the real test, one game at a time for the rest of the way. A few brief comments on the tournament from this perspective follow:
---While watching only a few brief periods of the Texas vs. Stanford game, I felt as if I was lucky enough to see the turning point for Texas. It was a competitive contest and then in the second half sub Dexter Pittman, looking more like a giant NFL left tackle than a college hoops center, came in for Texas and put an end to the shenanigans of those, comparatively speaking, beanpole twins. Stanford was lifeless by the time Pittman hit the bench again. As an unrelated aside, it is interesting to see some politicos suggesting that the bulked up Al Gore play the same role at a brokered Democratic convention, if it comes to that.
---North Carolina and Louisville face each other today in both the men's and women's tournaments. That must be unusual. Despite going to summer school at Carolina years ago and viewing Chapel Hill as an attractive place to possibly live someday, in these contests I am 100% Louisville. Once having lived there, it was the best and most obsessive college basketball experience that a person could ever hope to have. In fact it was too much. In 1975 when Louisville blew a lead and lost by one point to UCLA in the NCAA semi-finals this fan was so down in the dumps that for two weeks he could hardly eat. That Louisville team was the one that either invented or, if not invented, made famous the ubiquitous high five that every one year old in the country is still taught by some stray uncle. That Louisville team was the one that befuddled opponents by speaking in pig Latin on the court---"ackbay oorday". That Louisville team had two stars, Murphy and Bridgeman, who would come out to the country to go fishing in a nearby pond with my friend Don who lived across the road. And then a couple of years later came the "Doctors of Dunk", led by the wiry 6'3" Darrell Griffith, who could almost fly from the foul line over entire teams. You get it. Louisville was implanted into my frontal lobe in the 1970's. Go Cards.
---What is amazing about Davidson is that they don't play like or look like an underdog. When Western Kentucky had its upsets, they actually seemed to be unlikely victories. When George Mason got to the Final Four two years ago, every game was a David and Goliath affair. Davidson appears to be no accident and Stephen Curry is of course beautiful to watch.

Wednesday, March 26, 2008

The Big New York Auto Show

This is the week for the annual New York International Auto Show at Javits Center. Having once attended twenty years ago I decided that it was time for a repeat visit. Obviously not a car aficionado, I could count the number of car magazines that I've bought in my life on one hand, if I could remember any of them. That said, I do like cars and here's what I saw.

Hands down my favorite exhibit was Hyundai. I entered a drawing to win a new Hyundai vehicle of my choice, an opportunity that I did not see elsewhere. The hosts and hostesses on the floor for all of the other car companies were either dressed in uniforms(the women) or suits or nice business casual for the men. On top of that they seemed mostly to be hired hands for the week. The guy I talked to at Hyundai had worked for the company for two years and was based in L.A. He was in his late 20's I guess, and was wearing casual pants with his shirttail out, had a soul patch and a three day growth, short messy west coast style hair. He knew absolutely everything about the cars, was relaxed and made eye contact, and was a real low key promoter---there was no one like the Hyundai reps anywhere else in the Center. The cars are mostly so so in appearance but they have been moving up the charts on safety and reliability big time. The Azeri looked good and was priced well. The big deal was the Genesis, due out in late summer I think, a new car that will really compete in the luxury sports sedan category. Looked good, great price for such an impressive seeming car, and this guy could lay out a sell rationale---"Hyundai can build great cars and undercut pricing of the competition because as a conglomerate they are vertically integrated, for example they have a shipping company so they control their costs there unlike any other car company(sounds like a cross subsidy so investors take care), these cars will be a bargain like Lexus in 1988 when very few people in the U.S. really thought that they could compete with Mercedes" etc. etc. All made sense to me, but what do I know.

And the others---Ford had some interesting looking new styles like the Flex Limited but they seemed to be just new covers for the same old stuff---same for Mercury except for one amazingly gaudy large wedge shaped sedan that was spinning slowly around on a pedestal. It was so self consciously "modern" and no doubt had had some interesting new features. It was getting some attention, wish I paid attention to its name---GM cars just look to me like GM cars have always looked, with the exception of the universally acclaimed Cadillac CTS. That is one handsome car inside and out---Acura was a big disappointment. I'm interested in those cars but they just had all of the familiar models on display and not even a picture of, much less a model of, the new Acura TL, coming out in September with a complete redesign---Chrysler cars are not faring well in the world of car ratings on most counts, and they seem to think that they can compensate by putting the most chrome, and impossibly shiny chrome, on the sides and into the grills and light frames of the cars. They are over the top in going for catchy design, a sort retro late '50's in some cases, that batmobile hearse look in others, that they just don't pull off in my book---Audi had an incredibly German display of cars all in a line, evenly spaced, all silver with black interior, they looked too perfect to drive---BMW, the take I had when I saw the new 1 series and its price is that it is essentially taking the 3 series pricing point and the entire line is moving up the pricing scale. Other than that surprisingly no surprises here. The display was just messy in its organization, the exact opposite of Audi---Mercedes, do they really need to put champagne bottles in the caddy between the two back seats to remind folks of their place in the car world, beautiful cars of course---Lexus, nothing unusual but I was interested the the 350 Hybrid, the first luxury hybrid that's really in full production that I'm aware of, with mid 30's gas mileage, not bad for someone who can afford it---Nissan, same old stuff too. Their Altima Hybrid was interesting for several reasons, not necessarily good. Altima Hybrid has a base price around $25,000 while the regular Altima sedan has a base of $20,000. The gas mileage on the hybrid is 35 in the city and 33 on the road while the gas mileage on the regular is 24 in the city and 33 on the road. Somehow that doesn't seem like an automatic yes on the green monitor, as in both environment and money---Toyota didn't have much new and the many hostesses in their matching dresses knew absolutely nothing about the cars. The little Prius with its 48mpg city and highway remains the hybrid standout and the Camry hybrid, large enough for me to sit in without getting cramps had the exact same specs as the Altima just discussed. Interestingly the base price on the Prius was $23,000, just $2000 less than the Camry---Honda generally didn't show much new either but there were some high points. The base Accord LX is just obviously one of the best buys there is with its nice redesign, Honda's perfect fit and finish, 171 horsepower, 21mpg city/31mpg highway, and Honda road feel. That's my opinion. I asked the uniformed but extremely well informed young Honda hostess whether there was an Accord Hybrid(there is a Civic Hybrid that is the same basic size as the Prius but the Prius still seems to be the better designed car and is the most efficient) and she explained that there was an Accord Hybrid but it was discontinued because the mileage was not that much better than the regular Accord and it cost quite a bit more. She explained that it was just not popular because of that. Having just had the same thought over at Nissan, I felt like I understood. Then she took me over to the new Honda FCX Clarity to be introduced in southern California this summer. What a stunning looking car, a wedge shaped midsized sedan that really seats two comfortably in the back and it was more low key stylish than anything I had seen during the day. And by the way, it has no emissions, zero. It was just beautiful. One problem though. It runs on hydrogen and apparently only southern California has some type of service station where you can refill your car with hydrogen. My last exhibit of the day, and I felt like I had seen the future.

Tuesday, March 25, 2008

Negative economic reports...yeah but what if?

---Housing starts declined again, which means fewer jobs in construction, more financed land lying fallow, and pressure on homebuilding companies. This is certainly not positive news but what if housing starts were rising while inventories of unsold homes are at the highest levels since the early '90's.
---Prices on houses sold declined again to over 10% since January '07, as price insensitive foreclosure sales grew in the lower end of the market. In the aggregate this leads to a decrease in household wealth and on the margin puts more mortgage holders in jeopardy of funding negative equity. But what if financial institutions were not actively clearing foreclosure inventories, taking charges to do so, and attracting investors at bargain prices to reinvest in neighborhoods.
---Consumer confidence numbers from the Conference Board are way down, in some respects at levels not seen since the 1970's. This may be unnerving but what if, considering the high levels of consumer debt and the negative savings rate, consumer confidence was staying steady or rising reflecting an intention to keep spending and charging at pre-downturn levels.
---Expectations of wage increases in the next six months fell to a level not seen in decades, but what if companies big and small were raising wages in the face of declining revenues and sticky pricing ability.

There's really no good news here but much of the bad news, if it doesn't get too dire, is necessary and ultimately constructive as a way to work out of this economic hole.

Hillary Clinton's valor under fire in Bosnia

"Of course," Signorina Elettra said, smiling herself, "I fear I must use that lovely expression that American politicians use when they're caught lying: I misspoke."
"Suffer the Little Children" page 80
Donna Leon, copyright 2007

Monday, March 24, 2008

JPM, Bear deal now certain

Renegotiation was underway and the results put to rest any speculation that this deal is not a certainty. A few thoughts:

---Today's agreement allows the merger to go forward, dissenters step aside. A crucial issue for any merger is quickly moving toward reassuring employees and this is especially important in an investment banking combination when, as they say, the most important assets ride the elevator out of the building every night.

---Jamie Dimon, according to press reports, had encountered considerable anger in approaching Bear employees. This new price allows the employees to at least feel that they were heard and that the forceful Dimon accomodated them in some manner.

---JPM and Bear have huge businesses with the investment management industry. They want to keep their clients. Again this deal shows some accomodation and willingness to listen, goodwill that may be helpful in the year ahead.

---In addition to raising their purchase price to approximately $10 a share, JPM agreed to take the first $1 billion of the $30 billion Fed loss guarantee. On the surface that's a big number for JPM and almost a certain added cost of the acquisition. The impact of this on the certainty of the deal, however, is huge. The Fed required a give up to change the transaction. This precedent says that any other change would require additional give up and cost any other bidder even more. It is just not worth any other bidder's time or effort to pursue this.

---The overall price that JPM is paying is still a huge bargain under most scenarios. There's the $2.4 billion value of the stock purchase, the probable $1 billion of loss protection, adding up to $3.4 billion. Subtract from that the minimal value of Bear's building of $1.1 billion and that's a $2.3 billion cost. The last time the market priced Bear, in a panic on Friday, March 14, the price was approx. $7.5 billion and the day before it was around $13 billion. And these market prices were without consideration of the backstop of what is now $29 billion of federal government loss protection. If this is not a good deal, JPM, the financial services industry broadly, and the U.S. economy have problems that will make any issues with this transaction seem insignificant.

---Is it possible that this was the game plan all along. Get the $2 share price purchase on the table to get everyone's attention and allow room for renegotiation to close the deal? If $10 had been put on the table last week, odds are the same anger and emotions would have emerged. Is Dimon that savvy?

Sunday, March 23, 2008

"But, first, stop the rot"

The title is the last sentence of the lead commentary in this week's issue of "The Economist". After reading much of the weekend press efforts to place blame, create anxiety, and pretend that hindsight is insight, it was a welcome sane suggestion in this financial crisis. We are in the midst of a problem that will take some time and, as "The Economist" is implying, we can't come up with the remedy to heal the victim unless we stop the bleeding first. One thing at a time. There are still a lot of good things going on in the economy, with corporate America, and with global economic growth, just not at the pace, in general, of 18 months ago. Financial firms need to get through the c's of confidence, credit and counterparties and speculators need to get discouraged. That's cleaning up the wound. Then we can again see that the patient is not near death and choose the best medicine(hopefully not too much).

One interesting bit of news, or subject of rumors, is that the price of Bear Stearns stock is not trading well above the JPM deal price because of the expectation that a better deal can actually be struck, despite the comments of that offshore Brit billionaire who willingly and knowingly invested in the declining Bear stock in the hopes of making a killing. Some say that Bear bondholders are buying the stock now so they can vote for the deal because any loss that they take on the stock is immaterial compared to what they would lose in a protracted restructuring or default. Possible, although who knows. Something's going on.

"Bridge of Sighs", Richard Russo

As I delved into Richard Russo's follow up to the Pulitzer Prize winning "Empire Falls", I had to remind myself that Russo is in the first instance a storyteller. His novels of small town America in decline and the everyday lives of people there are told at ground level. He introduces the reader to entire towns of people as well as the social landscape that they live in. He tells a thorough, multifaceted story.

I said remind myself of this because he is not in the tradition of others who have dealt insightfully with the everyday. Unlike Richard Yates, John Cheever, John Updike, more recently Jhumpa Lahiri, among others, his writing is not the key strength of his work. Magic paragraphs or sentences, descriptions that have nuance or insight that is completely unexpected, stories or chapters that wrap up in a way that is bracing, these are not Russo's trade. He uses writing to create a mosaic of experience and lets readers see if they are comfortable.

On pages 129 and 130 of the 528 page "Bridge of Sighs", he pretty much gives up the book like someone talking over the dining room table, setting the stage for everything to follow, and what follows are a few excerpts:

"Odd, how our view of human destiny changes over the course of a lifetime. In youth we believe what the young believe, that life is all choice. We stand before a hundred doors, choose to enter one, where we're faced with a hundred more, and then choose again. We choose not just what we'll do, but who we'll be... Even in the face of mounting evidence to the contrary we remain confident that when we emerge, with all of our choosing done, we'll have found not just our true destination but also its meaning...But at some point all of that changes. Doubt, born of disappointment and repetition, replaces curiosity. In our doubt we begin to sense the truth, that more doors have closed behind than remain ahead, and for the first time we're tempted to swing the telescope around and peer at the world through the wrong end...Larger patterns emerge, individual decisions receding into insignificance...To see a life back to front, as everyone begins to do in middle age, is to strip it of its mystery and wrap it in inevitability...And yet not all mystery is lost, nor all meaning...somehow Bobby actually managed to do what we all imagine we might back when we're young...Bobby alone invented both a self and a life to live it."

I still kept reading believe it or not, and despite knowing that Russo's greatest heroes are eventually not characters like "Bobby". Perhaps the small town milieu that Russo describes resonated clearly enough to keep me going, and eventually I of course wanted to know what happened. It has some staying power, which is good enough.

Wednesday, March 19, 2008

Costco cities

The Costco model is moving to cities.

Costco is the membership retail chain that is about the best by far at what it does. Anyone lucky enough to have one nearby knows that you pay an annual membership fee and then have access to great values. Granted many are just the same that you would have for free at WalMart or Best Buy, but there's much more. If you have a family of twelve(not required) you can get five pounds of Tilapia filets for $16.99, 18 red peppers for $7.99, 32 Dr. Peppers for $8.99, giant dill pickle jars big enough for a bar of New York sports fans $16.99, in other words if you want to buy in bulk, toilet paper, poland spring, paper towels, orange juice, etc... your membership is a bargain. Kirkland products, their label, are sensational in foods, like Kenmore appliances were and still are at Sears. But your Costco membership is checked at the door, at the check out counter, and at the exit. You must belong. And at that exit you can get a quarter pound kosher hot dog, mustard pickles kraut, and a 16oz Coke for $1.49. Can I belong to this club......

Could this concept be applied to cities. Seems to be the case.

In late January I spent some time in Lima, Peru. Arriving at the up to date airport I was in a familiar place, up to date, secure, organized. I met my driver, insisted upon by a friend because of the fear that I might be robbed, and we drove through a wild west scene for many miles(potholed roads, chaotic intersections, bars, neon signs galore, casinos, all kinds of girl clubs with the alluring signs, pawn shop type places, nightclubs and just an out of control but exciting atmosphere) before reaching the neighborhood of my hotel and near the hospital where my father was. That was relatively peaceful and orderly seeming area, like a U.S. city in some ways, except for the complete lack of people on the streets or in visible restaurants. That was my experience. Since returning, here's what I've learned---

The area that I staying in with the French owned Sofitel and the Clinica Anglo Americana where my father was staying is in a cordoned off zone where local Peruvians cannot go without permission. My wonderful waitress at my local diner, a Peruvian 20 years here and a U.S. citizen, said that she would not be allowed to go in that area if she were visiting. Apparently shopping malls, movie theaters, and entire areas of Lima are governed by identity cards, or membership cards, such that they are exclusive. Easy to justify at first, no Shining Path, radical Maoists, drug cartel terrorists, let the middle and upper class and visiting tourists have some sense of safety in a country with a less than reliable political system, but it was still a revelation. It was a Costco city, membership required. Safety was the benefit, the cost was unseen but...

Talking to my barber last week, he's from Uzbekistan, a Russian by nationality, from Tashkent, a great hair cutter and an opinionated guy who has been here for about 10 years, fled from his home country due to some sort of legal issues having to do with ethnic and class stuff, nice guy, fakes English well but hardly speaks it when you get to know him. He had some guests coming from Spain, Tashkent refugees like himself that went to high school with him, and he asked me where he should take them in New York City. I suggested a Greenwich Village to Soho to Little Italy to Chinatown walk, always a sure bet in my book for guests and even a joy for me. Eddie, my Uzbek barber, was repulsed by the idea. "They sell fish on the streets, it's dirty down there, it's too crowded on the sidewalks, how could I suggest that guests should go there?" His idea for New York---Disney should own parts of downtown New York and Coney Island in total and they should be theme parks with admission payments to clean places with entertainment, jugglers, magicians, bands and music, orderly "fun" places.

Costco is the coolest big box retail store that I know. Sorry for the comparison. I think that there is a concept here, however, that could be spreading and applied to much broader realms, spreading from the developing world and hopefully not to our world.

On the cusp of a massive U.S. equity rebound

If this is not the case we're in big trouble. Yeah I may be naive but look at what the alternatives are. If money wants to be totally safe it can go into 2 year US treasury bills at 1.4% or 10 treasury bonds at 3.4%, inflation adjusted value losing investments it seems. It can go into commodities that are through the roof over the last year, not that they can't go higher. Money can seek a safe harbor in other currencies but that may be an iffy bet at this point after the overwhelming devaluation of the currency of the world's largest economy. If any money is looking to go into higher yielding investments that are structured to insulate risk, that's over. Any yield seeking investment by public companies will be castrated by the regulators or accountants and private investment funds can't risk having the probable illiquidity if redemptions are required. Where can money go? Eventually it must go into the world's largest most regulated and transparent capital market and that's in the U.S.A. And now it must go into equities. The financial companies are stressed, no doubt about it, but that's priced in, if not God help us. Then there so many good solid large multinational commercial and industrial companies with strong balance sheets, dividends, and earnings(earnings even if they are lower than the prior year that produce value adding returns on equity) that they cannot be ignored. When the market turns it will turn big time, in a huge way that can't be traded, that's almost a certainty.

Please note that the U.S. economy can be down, global economic conditions can be negative as well, and U.S. equities can still go up, benefitting those that still have the wherewithal to stay the course.

Tomorrow, next week, after the first quarter earnings of most U.S. banks in mid April, or later, it will happen. If not, who could imagine, it's Wiemar wheelbarrow time? Optimistic, we prefer the sunny side of the street.

Tuesday, March 18, 2008

After Bear, is there a next firm?

Lehman was the focus. As Bear Stearns saw its support disappear the market focused on LEH with its fixed income prowess and deep involvement in the mortgage securities business. Wrong place to look it seems, at least for now. If there is a next significant victim of this market that requires some sort of rescue, however painful as BSC's was, it may not be a broker/dealer. It could be Washington Mutual. WM is significant as the seventh largest financial institution by assets in the country. It is the largest thrift. It has very little cushion now for more negative news. It would attract Fed attention.

On Friday its debt was downgraded by Moody's to Baa3, or one notch above junk. That's near death for a financial institution if anyone is paying attention. Standard and Poors, more lenient, moved WM down to BBB+ from A- several weeks ago, still two notches above Moody's. There have been rumors of capital infusions being sought or offered, from Goldman Sachs, or Warren Buffett, or a large U.K. hedge fund. It's more than a little concerning to remember that Buffett was rumored to be considering a significant capital advance to Bear Stearns just a few months ago.

If Alt A mortgage credits continue to deteriorate, and some of WM's pools seem to be, confidence may wane. A spokesperson for WM cited branch deposits and FHA access as sources of funding that were reliable if markets were not. That was not the best statement--- too defensive perhaps. With its new WhooHoo ad campaign, its statement that there will be 100 de novo branches opened in the next year, and the Board's heavily reported approach to executive compensation and continuity of employment(accountability issues here big time), Washington Mutual continues to push ahead with its never ending optimism. That may be their strength, maybe not.

The problem with mark to market accounting when there is no market

In 1993 the SEC ruled that all tradeable securities at public companies be marked to market. A boon to the accounting profession and a bane to the stability of earnings, there has been ongoing debate about the wisdom of the requirement but generally it has been seen as positive. In normal working markets, where price variations are a result of interest rate moves or credit rating changes, most observers concede that the rule makes sense even if they have issues with it. In the financial markets that exist today, there is a big problem.

For many securities today, and almost uniformly any with or backed by mortgage related assets, the markets are thin even for highly rated securities and almost non existent for others. The syndicated loan markets trading mechanism is working well only for the credit of companies who don't need loans. More complex securities like credit derivatives or the various short traded long maturity products may have no observable market trades of any consequence. In some markets the only sellers are distressed sellers, those that must take almost any price as a result of their own liquidity issues. They are not selling based on any calculation of the economic value of the security, only on their need for cash now. To mark to market on prices derived from this type of market is, to repeat, a big problem. It can lead to a downward spiral of reported values that is unrelated to economic value. While that may be just accounting as finance folks might say, that "just accounting" depletes capital such that regulators, counterparties and investors get anxious and therefore has real implications.

That gets back to the accountants. Their job is to follow the rules. If the rules are rigid and lead to overly conservative outcomes, that is not their call. To the extent there is some subjectivity there is always the question "Where is Arthur Anderson?" hanging over their heads, a reminder that a leading firm in their industry was wiped off the map over their approval of one firm's books(Enron). They are inclined to be as risk averse as humanly possible.

A number of financial firms that have reported significant writedowns have suggested that they expect, over time, to recover a large portion of these accounting losses. AIG made such comments, and has raised the issue again today. It is a legitimate issue. In markets that are not functioning normally, mark to market accounting as enforced today by regulators and implemented by accounting firms is creating more dysfunction than transparency.

Let's take a step back in time for a comparison. In 1990 a recession was underway and the commercial real estate market had fallen apart, impacting the balance sheets of many banks. The Fed regulated most large money center banks while the OCC was the regulator for regional banks. The Fed took a rational approach to balance sheet valuation. The OCC, on the other hand, took a draconian approach to writedowns required by banks against non-performing loans, real estate repossessed and held for sale, and lower graded loans that were still performing. Their actions most notably caused the bankruptcy of Bank of New England and, while the management there was far from stellar, many viewed the failure as something that could have been avoided. At banks like First Interstate and Wells Fargo huge reserves, or provisions, were required as well. First Interstate had a middling management and a franchise that was too spread out to have much competitive advantage and it barely averted bankruptcy. Wells Fargo had both excellent management and a strong franchise, and got through it with just a few very bad quarters. In both cases, however(and this is finally the point here), they had huge recoveries that lasted three to four years. The OCC had gone so overboard on the required writedowns that both firms had no, that's zero, credit costs until 1994 or 1995. Running a credit business, which was primarily what banks were doing 15 years ago, with no losses leads to significant earnings. Again that's just accounting the finance guys would say, but those high accounting earnings led to increased regulatory capital which allowed meaningful increases in cash dividends to investors and lower borrowing costs on the interbank market and with counterparties.

Today it's the accounting regs and the accountants that are forcing writedowns that are unlikely to be realistic. When the turn comes in this market, the stage could be set for a rapid return to material earnings growth for the surviving financial institutions.

(Addendum: and what could be the solution while maintaining mark to market in normal markets---no mathematician or accountant here, but in markets without a critical mass of trades, definition needed, there could be writedowns from historical prices, say prices over one year or any recent period. The write downs could be a deviation from the historic price of x for two months, y for four months, and z for six months and after six months just the observable price. This is not the answer, just an example of what an answer designed to alleviate this problem could look like)

Monday, March 17, 2008

$2 a share, $30 billion of protection

Who could have guessed these numbers. JPM is acquiring BSC for $2 a share when Bear's almost new 45 story headquarters just across the street is worth at least $8 a share. It doesn't take advanced math to see that without the building BSC's net assets and liabilities are being given a negative value. And this deal is backed up by a Fed guarantee of loss protection for JPM up to $30 billion. Talk about an emergency operation for the functioning of the financial system, nothing less. Counterparty chaos avoided for now.

There are lots of issues here:
---Will that $2 a share really stand up? This needs shareholder approval. For shareholders that owned stock a year ago trading at $130, two weeks ago at $70 and Friday at $30, what's their incentive to approve, or at least not try to sweeten the deal a little. One third of BSC shares are employee owned. Almost 10% is owned by an investor who today called the $2 price "derisory".
---The lawsuits are already being filed, as is usual in any event like this. Apparently, as the buyer of the whole firm and not just selected assets, JPM would assume any Bear liability. This could be a significant financial issue and perhaps was factored into the price. Is there any possibility that the Fed's $30 billion can be used for this contingency as well---sort of doubt it. The good news here for JPM is that there is seemingly no indication of anything fraudulent and it might be difficult to raise too much public ire in support of well paid New York investment bankers who lose their company investment value.
---Clearly BSC would have shut down today were it not for the takeover/bailout. As was stated here on Friday, Bear has some very good businesses and it had certainly over many years been viewed as a firm that knew its way around the fixed income markets. This is an alarming reminder that financial firms live on liquidity, and panic does not wait for things to work out.

Friday, March 14, 2008

Dramatic, but sort of obvious

Bear Stearns headed down the exit ramp today. There are some excellent businesses there, especially on the operating and clearing side, but the fixed income securities business in this traumatized environment has been its undoing. The "writing on the wall" came a little more than two months ago when Alan Schwartz, a relationship guy for heaven's sake, was named CEO of this firm based on fixed income trading, asset management clearing, and mortgage securities.

Time is running out and the Fed and JPM have stepped in. JPM, interestingly, seems to have no real skin in the game except for operational and executive management time, and may in the end pick off some valuable assets. Stay tuned.

Thursday, March 13, 2008

Walmart and Starbucks---Recession indicators?

Intrigued by a 3/10 article on entitled "Walmart/Starbucks - Red/Blue" that looked at political preferences as reflected in the density of Walmart's and Starbucks' market coverage state by state, I decided to look at these retail behemoths and see how their predictive powers look in this current economic environment. They are opposites, and on the surface they are significant.

Starbucks is startling. Over the last twelve months Starbucks stock is down 41% while the S&P 500 is down 3%. So what, one could say, there have been lots of company specific reasons for this and their growth has stalled. What if, however, the primary reason for Starbucks' poor perfomance has been that with its high priced beverages it became an easy first luxury to go as the credit crunch began to evolve and consumer spending was diverted more and more to price inflating necessities like fuel and food. Is it possible that the reason for their poor performance was not overexpanding and diluting the culture, not introducing breakfast egg sandwiches that conflicted with that coffee aroma, not doing away with the manual expresso machines and going to the push button ones, not bad management, but just the fact that Starbucks, with its national ubiquity and premium prices, was on the cutting edge as a barometer of a recession in the making. Did Howard Schultz come out of retirement to tilt at windmills.

Walmart is a shorter term story and just the opposite. Over the last six months Walmart stock is up 18% while the S&P 500 is down 10%. So what, one could say, Lee Scott has addressed some serious issues aggressively and for the moment successfully. Could that, however, really account for a 28% outperformance relative to the S&P in just six months. What if Walmart, with its low price leadership, became the beneficiary of relatively more retail customer traffic as a result of the pinch that consumers were feeling by the end of the summer. At some point as consumers stretch their dollars, who cares if Target is more upmarket in its style and fashion or if "name brand" retailers were yesterday's preference. Did Walmart's revival come from management efforts or was it primarily an economic event, with its demographic telling us six months ago that the economy was seriously slowing.

This may be a somewhat whimsical analysis done with the benefit of hindsight, but I still wish I'd thought of it earlier.

Wednesday, March 12, 2008

Financial market thoughts...

There has not been much inspiration here for comments since last Wednesday's post. Until yesterday the financial markets have been a directionless mess, and the reprieve is only that. The Democratic primary has gone from being mostly entertaining to almost uniformly unattractive. McCain's skin cancer history has received extensive press coverage as well as his not being friendly to a New York Times reporter. The Spitzer downfall - happening to anyone else it would have been the opportunity for a "what a tragedy" comment but this guy was so awful to other people and so experienced in deceit and blatant ego gratification before this that there's nothing that can be said. Still reeling from all of this here are, nevertheless, some comments on the financial markets.

---Yesterday's Fed action was effective at least for a day or two because it showed an awareness of the real issue which is the lack of almost any liquidity in some major financial market segments. Some analyst said, however, that it's like finally doing the right thing for a patient that's already three quarters dead. That doesn't matter. Nothing will solve this situation soon, but doing the right thing one day or week at a time will ultimately get the market through this.

---Which brings to mind scrolling market headlines during this day something like "Dollar falls to record low as Fed plan won't work" or "Stocks give up gains as credit losses will continue despite Fed move". Does anyone smart really think that there's any solution that will turn this situation around on a dime, like this week? We'll know when the turn comes six months after it happens when we watch market commentators scramble to demonstrate that they knew it all along.

---Want a radical idea for the Fed if this credit market illiquidity continues? It should coordinate with other regulators, Bush or whoever thinks for him, and leading financial folks in Congress to announce that the Federal government stands behind Fannie and Freddie and Sallie. It has been presumed to be the case for a generation if some last resort scenario came up. Why not do it now. They could set a time frame, say three years, for which the guarantee would absolutely be the case and then use that period to come up with business mandates and a system of governance that would work long term for these entities that pay like investment banks but have an implicit back up and chronically poor systems, controls and operating management. This action would at least put some floor under the housing market(that floor might still be in the basement but it would reassuringly be there) and it would create at least one major market related to the mortgage business that has absolute liquidity. Moral Hazard??, we could soon be long past the time to worry about that this time around. Naive and Complex considering all of the stakeholders??, complex for sure and perhaps eventually necessary.

---One thing that it appears might have been left out of all of the modeling financial institutions do is free will. The models for potential losses on mortgages at well run institutions have apparently not turned out to be too accurate. At less than well run institutions these models have been fatally flawed. Sub-prime has been the market most focused on. The biggest modeling mistake was obviously the presumption seemingly of the worst case scenario being stable home prices(no more growth), and from that it follows that one thing left out of the equation completely was that people with negative equity might face up to the facts and decide to start over rather than keep funding a losing investment . In a different way that's now turning out to be the case in the home equity loan market as well. Home equity loans actually have no access to collateral as long as the primary mortgage is being serviced. The majority of home equity loans stand behind a primary. Homeowners can be smart enough to keep servicing their primary and stop servicing their home equity. That puts home equity lenders and securities holders in a pickle to say the least. Might not have been in the model.

Tuesday, March 04, 2008

What is Bernanke thinking, or is he?

Is it possible that the Fed Chairman could call for banks and other mortgage lenders to write down their loans in some general way to give homeowners equity or more equity in their homes? Is it possible that he could do it in the middle of the market day with no foreshadowing?
Is it possible for investors in these companies to quantify in any way what this means? Unfortunately yes for question number 1, yes for number 2 and of course no for number 3. This seems mind-boggingly naive on Bernanke's part. Could this be a negative watershed event that over the next month pushes some heretofore viable but concentrated mortgage portfolios off the liquidity cliff? Yes it may be. It's definitely time for the honeymoon to be long over for the Fed chief. He is an academic with no business based capital markets experience and, it seems, limited observation of how valuations are derived. His voice quivers at each Congressional testimony. He is the opposite of savvy. He makes big mistakes and inspires little confidence. The fact that his intentions are certainly constructive and that he faces significant challenges are not at issue, his ability to grasp the magnitude of his job is.

Monday, March 03, 2008

Ohio, Texas, Gloria, Saturday Night Live, and Jesus

Comments about these up in the air Democratic primaries:

Ohio---If Clinton can't win this state her credibility is lost. Much of the state is white blue collar, or red white collar, almost like southerners without being in the south. That means that they might have a tendency to not like Obama and they also might not resent the strong woman Hillary as much as some real southerners do. Cincinnati and Columbus are very conservative towns while Cleveland should be Obama territory. Clinton must win here.

Texas---This seems to be completely unpredictable, and fascinating. Clinton has much of Democratic officialdom tied down. My guess is that Obama's chances depend on turnout. If it's really big he wins. If not, it's Clinton.

Gloria---Was this planned, to have Steinem dissing John McCain's POW experience and talking about how being trained to kill should not be a prerequisite for leadership. At this point who knows whether her words were out of context. In any event, was this meant as an all out charge for the female vote or was it a blunder in this state with so many military families. They could be anti-Iraq and still be insulted by her words if the press take is correct.

SNL---This high profile support just before these crucial primaries seems a bit strange. They claim it's just comedy calling it as it is, but two weeks in a row with the second having Hillary as a guest? Anyway one could guess that Clinton may be merely consolidating her support among the boomers that already support her as SNL may not be a magnet for the generations enthralled with Obama.

Jesus---Hillary says that "as far as she knows" Obama is not Muslim. Obama says he "prays to Jesus every night". This all seems a little over the top.

Sunday, March 02, 2008

Buffett's shareholder letter

Warren Buffett's 2007 Berkshire Hathaway shareholder letter was published Friday. It can be accessed by all on the firm's website and is pretty much required reading for practitioners and students of investing. This year's version was covered in the press this weekend, with the focus on his comments on corporate accounting, sovereign wealth funds, and the falling dollar. What follows are a few excerpts:

---"Our country's weakening currency is not the fault of OPEC, China etc. Other developed countries rely on imported oil and compete against Chinese imports just as we do. In developing a sensible trade policy, the U.S. should not single out countries to punish or industries to protect. Nor should we take actions likely to evoke retaliatory behavior that will reduce America's exports, true trade that benefits both our country and the rest of the world."

---Comment on Berkshire Hathway's four largest public equity investments---"In the strange world department, note that American Express and Wells Fargo were both organized by Henry Wells and William Fargo, Amex in 1850 and Wells in 1852. P&G and Coke began business in 1837 and 1886 respectively. Start-ups are not our game."

---On how he ended up being a huge player in the insurance business---"The best anecdote I've heard during the current presidential campaign came from Mitt Romney, who asked his wife Ann, "When we were young, did you ever in your wildest dreams think I might be president?" To which she replied, "Honey, you weren't in my wildest dreams."

---On a lucrative investment he made in Euro-denominated Amazon bonds---"Yes, Virginia, you can occasionally find markets that are ridiculously inefficient-or at least you can find them anywhere except at the finance departments of some of the leading business schools."

---On succession planning---"I've reluctantly discarded the notion of my continuing to manage the portfolio after my death-abandoning my hope to give new meaning to the term 'thinking outside the box'.

---On bad acquisitions---"A line from Bobby Bare's country song explains what too often happens with acquisitions: 'I've never gone to bed with an ugly woman, but I've sure woke up with a few'.

---"At Berkshire, we will attempt to further increase our stream of direct and indirect foreign earnings. Even if we are successful, however, our assets and earnings will always be concentrated in the U.S. Despite our country's many imperfections and unrelenting problems of one sort or another, America's rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever-growing prosperity for its citizens."

Saturday, March 01, 2008

Bush triggers huge market sell-off

When President Bush chose to assure us Thursday that we are not in a recession and that he does not expect one, it was one of those "oh brother" moments. It was a clear sell signal.

To put it politely, President Bush is viewed as a macro thinker. One may agree or disagree with his many actions or efforts(Afghanistan, Iraq, immigration reform, Medicare part D, no child left behind etc) but he is generally viewed as a cheerleader of ideas, some that he strongly believes in, and not an originator of ideas and certainly not one deep into the details. His standing as an authority on anything as multi-faceted and unpredictable as the economy is really about zero, which is still slightly above some of CNBC's anchors. The credit markets are on edge, experienced traders are shaking in their boots, and President Bush reassures.

There was once an equity securities analyst at a top five Wall Street investment bank, let's call him Hank, who had a senior position for at least ten years despite having a terrible track record of buy or sell opinions. He was an affable guy, well spoken when it came to grammatically correct sentences including any current cliches, but his analysis was light or just silly. At a dinner of major investors who would receive his work and meet with him, the question was raised as to how Hank continued to be employed. A portfolio manager at one of the largest mutual fund houses was quick to answer. "It's simple. He is almost the perfect contrarian indicator. He says sell, we do the analysis on the perfect point to buy. He says buy, we look at sell. On that basis his track record is phenomenal. We love Hank and will pay to be the first ones to have him in to discuss his recommendations."

That may have been the market's reaction to President Bush. Of course it was AIG's report, the reported continued decline in home prices, the ongoing decline in the dollar, the new oil price record, that's all the real stuff that led to Friday's sell-off. It all makes Bush's wide eyed pursed lip comments seem that much lighter, or silly.

That being said, let's hope he's right.