A loyal reader of this blog sent me today's press release from the Treasury Department, the introduction of which is below.
The reader posed two good questions to me:
Answer 1
Given the scarcity of capital in current markets, the general nervousness that surrounds the economy, the fact that we are seeing only a very few positive economic indicators, and the economic "upturn" could be a false signal, I would not have given the government back their money yet. Having to go back and ask the Treasury for a second capital injection in the future should definitely be a CEO career ending event.
Answer 2
The money was never really needed, except by Bear Stearns, Lehman Brothers and AIG. Only the later group had real cash flow problems. Almost everybody else had to take the money in order to increase confidence in the financial system.
As I have said before, a financial crisis is in large part a crisis of confidence. A crisis is of such consequence that most people immediately overreact, especially when it is the first financial crisis of their lifetime, government tenure or banking career. When the government gets involved significantly in the "turnaround" and all its aspects, we can be confident that the government will overspend, over regulate and generally focus on issues of no economic consequence. This is true regardless of political party.
The best thing the Obama administration could do would be to stop spending stimulus money and recognize that more normal market forces are now at work and will gradually right the U.S. economy. Maybe even in time for the 2012 presidential elections.
If the government continues stimulus spending and running huge deficits, government borrowing will crowd the private sector out of the capital markets and we will see interest rates not seen since 1980, when the Fed Funds rate was above 10 percent for almost the entire year and peaked at 19.44 percent. In the early 1980s government borrowing was to finally pay for the Vietnam War. (As an aside, someday the U.S. has to pay for the wars in Iraq and Afghanistan.)
The current Fed Funds rate is at an extremely low historical rate of approximately 19 basis points, .0019, in large part to provide economic stimulus. However, the U.S. Government can not borrow forever before bondholders demand higher returns to match the enormous supply of new bonds coming on the market each month. Then interest rates will move upward dramatically. Will they reach 1980 levels--hopefully not, but interest rates have to move much higher.
Today I am speaking at FIU in a workshop for non-profit organizations. My theme is how to sustain growth in these challenging economic times. I have spent my entire career in the for profit sector, in part because many of the non-profits I have encountered lack clear goals and objectives and the discipline to achieve them.
Every time that I speak on non-profit issues I become more strongly convinced that sound business practices are the best way to run a non-profit and that innovation in "business model" is a key to the success of a non-profit. Innovate in business model to sustain growth is today's speech. A great example of innovation in non-profit business model is Vittana. Visit the site to see what some very smart people (ex-Amazon--the booksellers, not the jungle) are doing to provide loans for education to children in the third world.
For further thoughts on non-profit business model innovation, read this post. Send me an email and I will send you today's Powerpoint deck.
Daniel Buenza, a Professor at Columbia University Business School (my alma mater), focuses his research on the social studies of finance. In a recent article he describes his research over the last three years on the derivatives trading desk of a major bank. The period examined included the recent financial crisis and the bank came through unscathed, i.e. no huge losses or need for a capital call. Before we get to Dr. Buenza's conclusions on why the bank avoided the errors of their peers, lets first examine this new concept of social studies of finance. At least it is new to me and hopefully of interest to you--my respected readers.
Basically the social studies of finance examines the role of technological artifacts and mental models in capital markets. Technological artifacts are artificial human constructs that provide knowledge. (More on this subject here.) Wikipedia defines a mental model as "an explanation of someone's thought process for how something works in the real world". In summary, the social studies of finance involves the study of the role of technology-based and "pure thinking" models in capital markets. Obviously the two types of models can interact on the same problem. In a simple Excel model, you change the assumptions and the company cash flow changes. This would be an example of the two models interacting. Program trading would be an example of technology-based modeling where the model basically trades the position. Playing Texas Hold'em would be an example of the pure thinking model.
The unscathed, unnamed bank that Buenza studied managed to avoid catastrophe by a principle called reflexivity. Reflexivity is nothing more than the ability to reconsider your position on an issue. In finance terms, it would be to reconsider your assumptions. In other words the mental model is reexamined, thereby leading to a change in the technology (computer model) which governed the trading strategy.
The particular bank in question had a very collegial atmosphere, free exchange of information between colleagues and no superstars to upset the flow. This culture allowed traders to gather much more data and to change their mental models more easily, thereby avoiding the current financial disaster. When trading model driven positions, there is a tendency to over rely on the model and be slow to realize the model is no longer trading profitably. Excessive positions and a slowness to realize that the trading models were no longer working properly is a large part of the cause of the current financial crisis.
Most of us do not trade derivatives, but Buenza's study of the bank points out the importance of maintaining a culture that is conducive to changing assumptions. Most air crashes are due to pilot error and in most of those cases the co-pilot remained silent while knowing the pilot was making a terrible mistake. It is not easy to maintain a culture where reflexivity is the practice, but it may help you avoid disaster in your business.
Venture capitalist confidence in the economy may be improving for the first time since 1st quarter 2007. As reported by Mark Cannice at the University of San Francisco:
The historic chart is below.
Perhaps another small piece of evidence to suggest an upturn in the economy.
Note:I found this information through a tweet by @briannorgard.
Atlantic, a monthly magazine, has a fascinating article this month in which they compare U.S. economic behavior over the last few years to the behavior of emerging markets. The basic premise is that the Wall Street elite have taken control of the government in much the same way that economic oligarchies in emerging markets control their governments. In the article the key question for the future of the U.S. economy is whether the government has the resolve to break the control of Wall Street over the economy.
The author of the story is Simon Johnson, the former chief economist at the IMF, which makes the analysis and the proposed solution more meaningful. I am not prepared to agree that Wall Street controls the U.S. economy, but the article is well worth reading.
Note: I found the story through a post by Umair Haique at HarvardBusiness.org.
I have always believed that an early indicator of the economy starting to improve would be a large acquisition by a Fortune 500 company or one of the large private equity firms.
Today the NYT and WSJ announced that IBM is in discussions to buy Sun Microsystems for a 100% premium to the current Sun stock price. The obvious strategic benefit to IBM is that it would strengthen their market position in servers.
Now, if CISCO, who announced last week that they are entering the server market, was to enter the bidding for Sun, that would be very encouraging. CISCO has a long history of acquisitions, which I discussed in this post.
Let's hope I am right and that this is an early indicator that the economy is turning up.
The New York Times reported Sunday that AIG will be paying bonuses of $165 million to executives in their derivatives unit and another $121 million to other executives in the insurance part of the company. Why is this happening after a government bailout of $170 billion? Supposedly, the answer is that AIG is contractually obligated to make the payments.
Now let's review a few facts:
Rather than pay a dime in bonuses, I would bring every criminal charge I could against management at AIG. The bonus agreement payouts would be staid until the "fruits of the criminal act" issues were resolved. With the DOJ proceeding deliberately, some of the executives would be bankrupted by legal fees and others might not see their bonuses for 5-10 years.
I have nothing against executive bonuses, but without the availability of the death penalty I would be bringing criminal charges as a way to stop bonus payments at AIG, Citi, BofA, etc. Such poor management does not deserve bonuses.
Image Credit: Cravens World
After reading 50 blog posts this morning about the end of the economic world being near, I have had enough. Time to propose a solution.
First we should restate the problem, which I have done as recently as last week. The current problems have been brought on by issues of liquidity, leverage, transparency....and confidence. The status of each factor is shown below.
Liquidity--the situation has improved significantly in the last few months
Leverage--improving, particularly as the government invests in the troubled companies and lenders become more conservative in their lending practices
Transparency--not likely to improve until the SEC stops thinking like lawyers (who have to win court cases) and starts to proactively investigate bums, con men and avaricious corporate types. However, at this point, transparency is the least of the problems except as it affects government bailouts, e.g. AIG. More on this below.
Confidence--there is none and therein lies the real problem. When Warren Buffett is confused, suffice it to say there is no confidence left in markets and particularly stock markets.
To understand the lack of confidence look at the 30 day volatility index, VIX, which is shown below. As you may recall from Finance 101, volatility is the measure of the standard deviation in the compounded returns of a financial instrument. As volatility increases, the risk increases and the price of the underlying financial instrument declines. The VIX is based on the S&P 500, so it is a measure of the volatility in equities for the next 30 days. The VIX 52 week trading range is 15.82--89.53 with a current price at about 50. Anything above 30 is considered unusually volatile. The last time it traded below 30 was September 2008. The last time it touched 40 was in January 2009 when the market rallied. Therein lies the first clue to how to get the economy back on track. Reduce perceived risk in the stock market.
The second factor that needs to be addressed is the short sellers, particularly in equities and equity indexes. Every pundit, expert and honest man has been on television or the Internet calling the bottom of the stock market ("buy") or saying the world is ending ('sell"). Nearly everybody advocating for a bottom, cheap stocks or some positive economic indicator is long equities, such as Mr. Buffett. Nearly everybody saying that the DJIA is going to 5000 is short equities (probably Soros). Logic would indicate that short positions are at an all time high (although it might be hard to prove given the low per share prices). So, the second clue we have is that we need to squeeze the shorts in order for the market to rebound and for some confidence to return. (When the shorts are squeezed they have to buy stocks to cover their position and prices go up.)
To summarize my argument so far, I think we need to see a rally in the stock market to restore confidence in the economy and we need to squeeze the short sellers in order to have a sustained rally.
Yes--I am saying rally the equity markets and that will restore confidence--and not restore confidence and the markets will rally. Therein lies the magic in my plan, which has two parts:
The benefits to the plan are as follows:
In pondering my outrageous idea I realize that everybody will hate it. The Republicans because it is another government stimulus but.... a lot of Republicans are still long equities. The Democrats will hate it because it does nothing for the foreclosure problem but....I think it would create jobs more quickly than infrastructure investment.
Unless Obama calls me this week while I am in Washington, I do not expect my idea to get much traction. However, I am reasonably certain that confidence in the markets is a key stumbling block to economic recovery and we need some new ideas for how to restore confidence. I am going to continue to think about the current problems but the next proposal will probably be equally outrageous. Maybe Mr. Buffett will come up with something in the mean time.
Enough fun for today. Back to work.
VIX chart credit: Yahoo Finance
EconomicPic is a blog devoted to pictorial presentation of economic data. It is a very informative blog particularly in these days of severe economic malaise.
The picture below comes from a post today and shows the loss in market capitalization of the major U.S. banks over the last 16 months or so. While the loss of nearly 1 trillion in capital is staggering, banks typically leverage their balance sheets at 20:1 or higher. So a loss of bank capital multiplied by 20 represents the potential contraction in liquidity in the U.S. financial system. The U.S. has lost as much as 20 trillion in capital due to the financial losses of the banks.
As Dean Light at HBS said about the current economic crisis, it's a matter of "liquidity, leverage and transparency". Yes-- and it may be a $20 trillion problem. Forget jobs, mortgages, healthcare and all the other issues Washington mentions. To turn around the economy we need to focus on re-building and re-capitalizing the banking system.
For a change of pace, instead of talking about a professor or paper from HBS, today I am going to discuss a blog post from Harvard Law School. The post is entitled The Case for Big Government. In a guest post Jeff Madrick argues that the expanding the role of government and economic growth are not inconsistent. He states:
"But, in truth, America when it worked best, in my view, America used government robustly to embed its social and political values but also to create a foundation and capacity for economic growth and prosperity. The case against big government has always been ahistorical. There is no wealthy nation in the world today that does not have a big government."
This is pure sophism. There is no wealthy nation in the world that does not have a large army, a good postal system and an income tax. Obviously none of these factors explain why a nation is wealthy and "big government" does not explain economic success.
We should not confuse the need for government intervention during the current financial crisis with a need for an expanded role for government. We could have avoided the current crisis simply through better regulation of financial institutions and by avoiding the unwarranted expansion of home ownership by the government.
The lessons learned from the stock market crash of 1929 and the Great Depression are:
All of the other features of government intervention during the Great Depression have had limited continuing value, if any.
The problems with "expanded government" are multiple:
In part the current crisis has been brought about by excessive self-interest and greed in the private sector. And, yes--we need to improve infrastructure, modernize schools and become energy independent. However, I think Washington is over reacting. Less government with money spent wisely will bring about a faster economic turn around. Trying to correct all the misdeeds of the past with a huge, wasteful government spending package will just bring on inflation and higher interest rates. I think we should all be sending the message to Washington to focus on the banking system and financial regulation and not try to make amends for every sin of the last 20-30 years.
The Constitution originally had a narrowly defined intent for the federal government. Such an approach worked remarkably well for many, many years. We should be very careful in forsaking the founding principle of a limited role for the federal government.
It seems like every day another large company in the U.S. announces layoffs of thousands of employees. Thousands of lives are totally disrupted (if not destroyed) by incompetent management.
There is considerable debate about whether the purpose of a corporation is to first serve the employees or the shareholders. Not surprisingly, Americans favor the shareholder and Europeans and Asians generally favor the employee. Good cases can be made for both positions, but what bothers me is that the two positions are not mutually exclusive.
If we look at most of the recent layoffs in the U.S., I do not believe they were caused by a drop in demand. Rather, senior management was lax in reviewing staffing requests during good times and when times got more difficult senior management did the easy thing and fired the excess staff. Simple, cowardly and incredibly painful to the workers who lose their jobs. I believe, in fact, most workers would opt for a pay cut if it allowed everybody to stay employed at a company (but at a lower salary). Of course, someone might criticize the U.S. company that it was being considerate of the employees--heaven forbid!
A better approach to staffing is as follows:
My approach creates a very lean organization of competent people who have a heavier workload, but this kind of organization does not lay off people. First, this type of organization is more profitable and second, every person is critical to the operations of the company.
I hate layoffs and I think they are proof of poor and cowardly management.
Enough idealism for one day.
Tom Nicholas, a Professor at HBS, has an interesting article in the McKinsey Quarterly today about the lessons in innovation to be learned from the Great Depression. Nicholas' area of expertise is economic history, a subject that should be required for every MBA degree. The major points from the article are:
A quote from the article is particularly noteworthy:
Great economic uncertainty creates a massive reallocation of resources in a free market. Assuming the government does not overstep its bounds, there should be a significant reallocation of resources this time and the consequent bounty of opportunities.
The current financial crisis is expected to be long and wide reaching. Every day there is new news and it all seems bad. Every media source appears to be trying to break new bad news. Most people have not been through such a crisis before. I, on the other hand, have been through such a crisis before when Southeast Asia melted down in 1997. Currencies dropped 80 percent in value in a matter of weeks, many banks collapsed, nearly every bank demanded loan repayment and unemployed people were eating tree leaves to stay alive. Some advice follows:
The Asian financial crisis was the single most significant business event in my career. I learned a lot about crisis management, people, courage and managing emotional energy. You will also learn a lot from the current financial crisis--but you have to survive it first.
Another part time CFO engagement is ending for me, which got me to thinking.
For companies looking to reduce costs in these difficult times, consider replacing full time positions with more experienced (and efficient) part time workers. Of course, you do not replace sales and product development people or the Controller, but the CFO, CIO, CTO, COO and senior marketing executive are all candidates to be downsized to part time. Target to spend 60 percent of the full time cost for the part time executive. An above average CEO is probably required to make this work and when in doubt do not do it.
Why would I be recommending such an aggressive strategy in tough times:
With the stock market in the dumpster I think a lot of retired executives will be coming out of retirement to make ends meet and a part-time executive position might be attractive to them.
Note: Anybody looking to downsize all of the senior executive positions in their company to a single executive (besides the CEO) or needing one of these executives part time, give me a call.(yes-once I even ran marketing.)
Over the weekend I did some blog housekeeping. I created a new category on the right hand side which includes all my posts on the financial crisis dating back to August 2007. 18 posts are included.
I do not arrange real estate financing, but this came in email yesterday. Looks like there is capital available. I do not know this fund so any interested party should do their own due diligence.
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2929 Arch Street Philadelphia, PA 19104-2868 PH: (215) 557-9600 FAX: (215) 557-9606 |
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This morning on NPR they interviewed three imminent economists, one from the Brookings Institute, one from the Heritage Foundation and Paul Krugman, the economics Nobel Prize winner from Princeton University. These world class economists made several good points:
The enjoyable part of this interview was that each of these economists went back to traditional economic theory and analysis to explain their views on the current situation. In my experience, in times of crisis traditional economic theory is the best guide for analysis and solutions.
Last night my wife, who I have mentioned before is much smarter than me, and I were discussing the current state of affairs in the financial markets. As she ran through the numbers related to the mortgage mess she constantly came back to the conclusion that the crisis was much less about the size of the sub-prime mortgage problem and much more of a "bank confidence" issue. In other words people panicked over the mortgage issue and created a real problem--a lack of confidence in the banking system. Yesterday's announcement that central banks are guaranteeing inter-bank borrowings and today's announcement that the U.S. government will invest $250 billion in basically the ten largest U.S. banks are directly related to restoring confidence in the banking system. Any ideologue who is concerned that such actions smack of socialism or bank nationalization is an idiot. If confidence is lost in the U.S. banking system, the world can all go back to living in caves and bartering for commerce.
Now if we took the approach that we have shored up the ten largest banks and the FDIC can sort out the remaining thousands of banks (if they have problems), then we might conclude that we do not need to spend the full $750 billion rescue package. This would be especially true now that we are properly focused on the real problem--confidence in the banking system--and not distracted by the politics of home ownership and presidential elections.
Of course, given the Bush administration record of rewarding campaign contributors and friends, I am sure they will squander at least another $250 billion before their term ends.
I think I was basically correct when I said we did not have a crisis until a major "bank" failed. So let me make another fearless forecast. I think the DJIA will trade in a band of 9,600-10,200 for the next 2-3 years.
Last week Sequoia Capital, one of the most highly regarded venture capital firms in the world, called in all their portfolio companies for a presentation on the current financial crisis. The presentation is here and well worth reviewing in detail. My take on the highlights of the Sequoia presentation are:
I found the Sequoia presentation thru Brad Feld's blog. Brad also referenced some other advice on the current situation that is worth reading.
