Intervention Follow On

Nice note by Frank Rich on the growing rage of Americans for the continuing parade of financial recklessness and fecklessness. He “retweets” a letter to the editor by Paulette Altmaier from Cupertino CA who elegantly pens the phrase, “President Obama may not realize it yet, but his Katrina moment has arrived.”

Brilliant. I think that Paulette has really captured the underlying issue– the administration’s legitimacy is on the line in how it deals with the issues of corporate irresponsibility.

And this is not just banking or high finance. The S&P500 lost about 38.5% of its value in CY2008. I would be very curious to see how shareholder value fared with respect to corporate executive compensation. While we need to be cautious and not grab  pitchforks and torches, it seems that there’s a real need to rationalize executive compensation. However, I advocate that executive compensation needs protection against abuse so that a free market is maintained, not because we are embarking upon a doomed path of economic class warfare. A small point, but important to me.

What we need is for efficient market action to purge ineffective companies and leadership and replace them with efficacious companies and leaders. (If this can be done without blowing up the global financial system and causing economic Armageddon next time, so much the better.) After all, market forces in unregulated markets should exorcise executives that enrich themselves at the expense of the business owners (equity holders, this means you.) If there are structural reasons this is not happening, then there is a regulatory gap that is distorting free market mechanisms that needs correcting.

The administration needs to walk a fine line between populism that degenerates into class squabbling and the “elephant in the living room” of failing to effectively address the issue. Either extreme will fail, albeit with different results. However, Frank Rich points out as I do in my Intervention note, that there is real concern that the regulators that we need to confront this complex problem may themselves be hopelessly compromised because of their personal past relationships with industry and financial services.

Perhaps Another Sort of Intervention is Required…

Just read the details on the Fed’s most recent intervention in the capital markets. Another trillion dollars + thrown after bad money. All in the name of “preserving the bonuses of fat cats capital markets.” (read the excellent Bloomberg piece here…) I especially like the image invoked by the writer of Ben Bernanke playing the financial equivalent of fictional renegade special operations warrior, Rambo. I bet he gets an even better hedge fund job after he leaves his post than his predecessor did. (See article on how Greenspan joins the  hedge fund that made billions shorting the bubble Alan denies he created here…) It seems that the news just keeps flowing and so do bonuses… and the person on Main Street that has been raised with the concept of “fairness” and manners and trying to be reasonably well behaved is mystified and left asking, “How is all this happening and why doesn’t our government stop it?”

Simply put, the government and financial services are caught up in their mutual addiction to each other in the form of government enabled liquidity. While many rationalizations can be made, a free market requires the government to ensure stable regulations, reasonable controls against unfair practices and a strong legal foundation for business.  In the current scenario, it appears to me that what has happened is that the financial services industry and government have gotten caught in a symbiotic relationship that prevents these real solutions from unfolding.

How has this happened? The markets are reasonably efficient. Therefore it is very difficult to make money in the market by investing prowess. So investors seek to change the market efficient landscape so that they can make money. The easiest way for that to happen is to lobby the government to make increasingly favorable policy actions that enable continued outrageous profits.

Government leadership seems to have an incentive that once they leave office, wealth awaits them by joining the financial community. Cases in point, much of the early leadership of the Carlyle Group, one of the world’s largest private equity funds, consisted of former government officials such as former President Bush, James Baker and John Major (former British Prime Minister). In fairness, many of these former politicians have retired from active service, but they nevertheless were there and current roles (if any) are non-public. Robert Rubin, former Secretary of Investment Banking Treasury in the Clinton administration joined the board of Citigroup for the years prior to its fall in stock price, Alan Greenspan, former Chairman of the Fed during the period the housing bubble occurred has joined a hedge fund that has profited billions in trading the housing bubble correctly. And according to the previously linked Reuters article dated in January 2008, former Treasury Secretaries Lawrence Summers and John Snow have been advisors to D.E. Shaw hedge fund and Cerberus.

I have concluded that intervention is exactly what is needed. However, it may not be the type that Ben Bernanke and the cabal of government, hedge fund, banking and high finance want.  When an addict is in denial, there is a tool that can be used to help them break that denial– it is called intervention. It is a process whereby an addict’s friends and family gather around them and confront them with the facts of their addiction in the hopes that they will come to their senses and realize the truth of their dire situation. Who should do it and how or even if such a thing could happen are all doubtful from where I sit. But one thing that is certain, without an intervention, an addict must hit bottom and then decide to get better. Let’s hope that we can avoid this path.

It’s not Personal, it’s Just Business

Needless to say- we are paying a lot of money for the follies of the banking oligarchs. I think there may a teensy argument regarding innovation, risk taking leading to economic growth, etc… compensating for the costs but it wilts quickly in light of the price tag that seems to rise with every news article.

However, I am cognizant that these folks have reaped billions of dollars in bonuses that ostensibly were performance related. So… now my question is what happens when the performance that the bonuses were based upon turns out to be vapor and in the worst case, fraudulent?

In order to investigate this, I have done a very quick study of the income and net profit of financial services for 20 quarters. The results are pretty interesting. A sample of 158 financial services firms over the period from March 2004 through December 2008 yielded Revenue net of interest expense of $3.5 trillion USD and net profits of $636.7 billion USD (data courtesy of Gridstone Research.)

In all fairness, in my study there are a number of quarters that I do not have data for so the results could be a bit larger. (I will endeavor to post the excel spreadsheet and the data once I figure out how to do so.) Even if I have an error of 20%, I think it is a fair statement that we have given corporate welfare in multiples of the total profit that the broader financial services industry has made in the past 5 years.

So all of the bonuses that have been reaped were ultimately based on phantom profits and some steep losses. What we are doing as side effect of trying to save the worldwide economy that these managers have run into the ground, is subsidizing their personal wealth. Now that is what I call pay for performance! Makes me wonder, what business schools did these managers attend?

Ethics at the Monsters Ball

I have always enjoyed watching the movie, “Miller’s Crossing.” It is a gangster era movie that opens with one mobster bemoaning the lack of ethics in his business as cronies look for an angle to make a profit on a boxing match that he has fixed. Yet as I watch the monster’s ball that the financial services industry has devolved into, I cannot help but remember that scene.

So why has ethics failures plagued financial services? And why does it seem so hard for this business to do the right things? Even recently in headlines, we have watched in dismay as bankers continue to enrich themselves, seemingly without a shred of awareness of why this is not a good idea at the moment.

I think that there are some good reasons that it has been hard for the industry to find its moral compass. One of the largest contributors to this vacuous ethical environment is the strict view that economics is a stand alone social science. The core premise of economics being the rational distribution and use of resources in a closed environment (i.e. limited resources.) And the corollary view that the most efficient mechanism to allocate resources is through unregulated markets.

Stemming from these two views is an implicit third perspective that economics is exclusively about resources and that there is no economic rationale to exercise ethical behavior. After all, what does impersonal market activity channeling resources to the most economically efficient agent have to do with church on Sunday? (or Saturday?)

This raises an interesting question of “how do we economically measure unethical behavior?” Because if we can measure its costs then we have economic relevance and ethics takes its rightful place among economic factors that must be consider by rational agents. And therein lies the crux of the issue. We can only measure the cost of ethical failures when it results in tangible losses- such as now.

Right about now as we dangle above the economic abyss, we can see that lack of transparency, due diligence and an arbitrage-based compensation system have been pretty expensive. There are many risks that we face that cannot be measured a priori and can only be measured ex post facto. Unfortunately ethics in finance appears to be in this class of challenges. You never know how economically inefficient the lack of ethics is until you have experienced a catastrophe- and then it is too late.

 

 

Grounded! Well, sort of…

When I was a kid- “Grounded!” was the worst news. No movies, no bike riding, no going out to visit friends, nothing. It was the ultimate punishment. And it was usually for some dire offense such as a broken window, failure to heed a parent or the super bad offense of trying out colorful language recently heard in the living room.

As far as I can tell, I never lied to people for umpteen years and stole $50 billion dollars. Nope. Not me. Yet, the NY Times and Bloomberg this morning are reporting that Bernie Madoff who is the central figure in the $50B fraud, is receiving house arrest (“grounded”) as part of exceedingly generous bail terms pending further legal proceedings.  THAT is a good deal for him. He even gets to go out (with electronic monitoring) but has a 7 pm curfew. Man- I never had it that good when I broke the living room window. This guy is GOOD.

If I had stole $50B when I was a kid, I would still be grounded. I bet ‘ol Bernie is catching up on his soaps on his big screen TV in his multi-million dollar apartment. This could be the best thing to ever happen to him! Imagine how good he will get on his video games. He can twitter to his heart’s content, work out with his Wii and really be a Facebook bavog. He can catch bargain matinees of new movies before 7 pm and even hit the gym. He doesn’t have the headaches of falsifying multiple businesses on a daily basis– that has GOT to be a hard job. Enjoy Bernie! This is probably the most carefree time of your life. Fortunately, you stole have enough money to really enjoy yourself.

Funny thing I have noticed about the American legal system and white collar crime. We sure do seem to love it. In fact, we can barely bring ourselves to punish these guys. But, god help you if you are hispanic (or african american) and mug a white, wealthy member of the community for $250 bucks. You may never see the light of day again. If it is your 3rd offense in California, you are simply done.  But if you are an amazingly good fraud and cheat, you get home arrest and a curfew. Yet I have to wonder at the amount of damage that a guy that allegedly steals $50B causes verses an alleged mugger of $250.  I mean, how many people’s lives and businesses are crushed by a guy that steals this much?

I would like to posit a new theory of market efficiency. I shall call it the “Cynical Theory of Market Efficiency.” The premise is that the market is efficient inasmuch as it discounts all information and takes the most cynical direction from among the many future possibilities. If you run into Bernie some afternoon at Central Park, ask him what he thinks.

All that glitters…

Just read the story about the allegations against Bernie Madoff.  $50B- wow. Stunning not only in the magnitude, but scope and time span that this seems to have occurred within. Some immediate thoughts that come to my mind regarding this:

  • It has got to hard to lose $50B (assuming that this number is accurate) without considerable help… I can only wonder what happened with firm compliance? Kinda makes me wonder if compliance was based in Nigeria… What about audits? Who were his investors and how often did they review due diligence?
  • It REALLY is hard to make money over the long term in the market. When you consider the caliber of investors experiencing significant losses this year, it reinforces how challenging the markets really are. Ask most VCs (which I consider essentially value investors), and they will tell you that their hit rates are low but returns on those high. And most returns in that industry are concentrated in relatively few firms. Even standard equity investors best hit rates are maybe 50%+. Making money in a long term systematic fashion is improbable in a reasonably efficient market. The alternatives? Cheat or create a structural advantage.
  • What else is lying around out there? Is this the first “cockroach” among many?
  • The investment industry is rife with poor business practices and this is an example of how it can play out. Given that the nature of returns are episodic and performance unmangeable (remember, “past perfomance is no guarantee of future performance…”), there is little advantage in scales of economy when you could go out of business next week. If you scale up to reduce your cost structure, then what happens if the unpredictable occurs? Also, there are considerable fixed costs in highly professional business practices- and in a business that has considerable performance risk, it makes perfect sense to keep fixed costs to a minimum. It must be terribly painful to pay for a professional audit that proves you were trounced by your benchmark.
  • There is nothing new under the sun. This financial business is so attractive that there will likely always be a new version of a “shortcut.” The lure of wealth appears to be the ultimate narcotic.