bizzXceleration: Performance, Value and Profit

In other words, as write-downs continue, we're arguing that most of the Finance Industry profits that were booked in the last several years will disappear. And that disappearnce is reflected in the poor outlooks for many of the major companies AND their need to re-capitalize. Taking these arguments and investigations all together it seems reasonable to argue that indeed to much money went into bad investment ideas, that capital was very inefficiently allocated and, as a result, the overall health of the economy will be badly damaged.

And, further, that the industry itself is going to have to re-think its' business models which increasingly appear to be badly....badly broken. The readings, links and excerpts on the continuation sustain this argument and extend it. But to anticipate what we think is happening is at least two things.

First, the industry needs to re-think and a new set of business models has yet to make an appearance. And second, as a consequence, despite all the folks who're starting to argue that all the catastrophes have been priced into the stocks of the Financials we're a long way from seeing a bottom grounded in fundamental realities. If and when we recover economically we're likely to see a major bounce in Financials based on that argument. In fact we're likely to see some bounced that will be trading opportunities before then. But not investing opportunities. Until the industry re-thinks itself it won't be well-grounded IMHO. The trick as an investor will be to watch the evolution of the reconstruction of the industry and then invest. 

We covered some of these points in an earlier readings collection on the Industry ("Interesting Times" for the Finance Industry: Readings & Resources) which is worth reviewing as well). One of the stories there that encapsulates the situation and provides a nice historical overview is this:

Wall Street doesn't want you After an era of innovation in financial services that benefited the middle class, The Street has abandoned individual investors in favor of big institutions and wealthy private traders. It's time for big changes. Wall Street doesn't care about the individual investor anymore. We're not profitable enough. Look at the billions the financial industry has made in recent years from trading, buying and packaging mortgages and credit cards, financing buyouts and selling ways to reduce risk. That kind of business drove operating income at Goldman Sachs) to $14.6 billion in 2006 from just $3.3 billion in 2002, a 340% increase, and at Merrill Lynch to $10.4 billion in 2006 from $2.3 billion in 2002, a 350% increase. Until they blew up, that is. It's not just that Wall Street's newest inventions -- collateralized debt obligations and asset-backed commercial paper and the like -- are irrelevant to the stuff we care about, like having enough for retirement. Wall Street's actions seem positively dangerous to our goals. It wasn't always this way. For 20 years, beginning in 1975, Wall Street produced a wave of innovation for middle-class investors that brought more and more people into the financial markets. The revolution began in 1975 with the invention of cash-management accounts at Merrill Lynch. From our position in time, it's hard to remember that there once was a day when all we had were savings and checking accounts, and that the two were so rigidly separated that you couldn't write a check from an account that paid interest

 If any of this makes sense to you it's a good opportunity to apply the thinking and tools for analyzing industry/company performance we sketched in another post as well:Winners & Loosers: Rubble Sorting

The bottomline - we're not anywhere near a bottom, the industry has broken itself, there are good operators who will get out of this mess and innovators who will come up with the next wave of ideas and business models. In other words there will be significant opportunities in the Finance Industry over the next several years but they ain't here yet. But it's never to late to start investigating and building a little shopping list for when things start to turnaround !

Good luck and good hunting ! Keep your powder dry for now.

READINGS 

Bubble Trouble First came the bursting of the tech-stock bubble, now the bursting of the housing bubble. The bursting of a bubble in finance -- and the pay of those who helped make the tech and housing bubbles possible -- can't be far behind. it might be good for the overall economy. Finance has had a remarkable run. It has been one of the fastest-growing industries in the U.S. (and Britain), and has attracted an increasing share of the country's, and the world's, talent. Today, roughly $1 in every $13 of employee compensation in the U.S. goes to those working in finance. The value added by finance -- a measure for calculating the industry's contribution to the economy -- rose to 4.4% of gross domestic product in 1977 from 2.3% in 1947... Its work force grew commensurately, with employees that were only slightly more educated than the typical American worker, and their compensation grew at roughly the same pace as that of other workers. After 1980, finance kept growing, reaching 7.7% of GDP by 2005. But the nature of the industry's work and work force changed. "From the 1980s onward, the financial sector grows by increasing the value added and compensation of its employees faster than in the rest of the economy," Mr. Philippon says. Workers in finance are increasingly highly skilled and educated.

Deal Fees Under Fire Amid Crisis At every level of the financial system, key players -- from deal makers on Wall Street and in the City of London to local brokers like Mr. Schmidt -- often get a cut of what a transaction is supposed to be worth when first structured, not what it actually delivers in the long term. Now, as the bond market wobbles, takeover deals unravel and mortgages sour, the situation is spurring a re-examination of how financiers get paid and whether the incentives the pay structure creates need to be modified. This week, Congress asked three prominent executives to testify about their pay packages. Upfront commissions and fees are well established on Wall Street. Investment banks get paid when billion-dollar mergers are inked. Firms that create complex new securities are paid a percentage off the top. Rating services assess the risk of a new bond in return for fees on the front end. Critics argue this system can give people a vested interest in closing a deal, regardless of whether it turns out to be a good idea over time. In various forms, a similar pay structure exists at the top of the financial world, where executives can reap lucrative pay packages, even if deals made on their watch later go south.

• Will Banks Drop Flashy Stuff? Merrill Lynch becomes the next bank to offer a confessional to investors today. As the parade of write-offs continues, it's time to ask what lies ahead for Wall Street after it cleans up its current mess.

What Does Goldman Know That We Idiots Don't?: Michael Lewis In retrospect, the most intriguing subplot in the collapse of the subprime mortgage market has been not the size of the losses but their distribution. Wall Street firms have a talent for getting themselves into trouble together. They all were long Internet stocks when Internet stocks collapsed and they'll all be long North Korean credit-default swaps whenever North Korea gets hot and then crashes. What's odd about the subprime crash is Goldman Sachs Group Inc. A single firm took a position contrary to the rest of Wall Street. Giant Wall Street firms are designed for many things, but not, typically, to express highly idiosyncratic views in the market. Enter two smart guys who trade Goldman's proprietary books to argue to the CEO and chief financial officer that the subprime market feels soft and that Goldman should short it. This they do, in such massive quantities that they more than offset the long positions in subprime held throughout the rest of the firm, leaving Goldman short the subprime market and in a position to make billions when it crashes. End of story. And it's a good story. But consider what it implies. Their own traders and salespeople in subprime mortgages and related securities had put Goldman in exactly the same position as every other Wall Street firm: long subprime mortgages. The only difference between Goldman and everyone else was that Goldman had, in effect, an entirely separate enterprise, sitting on top of the firm, with the power to reverse the judgment of its own supposed experts in various markets. They were able to do this, apparently, without ever saying a word about it to their own traders. Instead of telling the fools trading subprime mortgages that they are wrong, and that they should unwind their positions, they simply offset their trades.

Citi rediscovers the consumer As Citigroup revealed another big write-down and a cash infusion from overseas investors on Tuesday, the results of its troubled consumer business underscored the multiple challenges the bank will face in 2008. Weaker consumer credit and rising loan-loss provisions devastated its consumer division and ate up solid gains made by well-performing business units, and Citigroup said it's moving to set aside $5.1 billion to cover increasing loan losses and accelerating delinquencies on credit cards and auto loans. "We had losses in our U.S. consumer business, up over $4 billion, and these numbers completely overwhelmed record performance in many, many of our other large businesses," Chief Executive Vikram Pandit said on a conference call. Analysts, noting that Citigroup's bread-and-butter consumer business provides more than one-third of the firm's recent profits, said keeping that side of the company strong -- and its capital reserves healthy -- is a must if the bank has any hope of riding out current turmoil in the markets and the economy. "The reserve build signals that tougher times are ahead in the U.S. consumer channel, which has accounted for 30%-40% of Citi's recent profits," Goldman Sachs analyst William Tanona wrote in a research report. In step with that long-term philosophy, the firm said it will quickly divest itself of nonperforming assets in an attempt to shore up capital and limit its risk. It is a strategy that could be particularly welcome to many investors who are skittish after the bank's wild ride on Wall Street, as Citigroup shares dropped 7.3% to $26.94.