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Comes 'round, Goes 'round: Hastening Forward Slowly to Finance Reform

The Markets have been tanking most of this week and have given up most of mini-bubble beyond 1100, which if you recall was our upper resistance limit in previous posts. It's doing so because a bunch of things have come together, though semi-predictably there's a chorus of voices blaming the President's announcements of a major reform to restructure the Finance Industry and change what it's allowed to do and how it functions. Given the poor quality of earnings since last March, recent reports showing how weak the core businesses are and Industry behavior over the year with regard to reform that announcement was, at best, a trigger that crystallized an already saturated solution. What really saturated things and put them on the cusp point of teetering over an edge was a slew of disappointing earnings, an improved grasp on the real economic outlook and China's major changes in policy. ALL of which we've been discussing for months.

Rather than reviewing all that it's collected in the readings but we're going to use it as our fulcrum to focus on the salvo across the bow fired on reform, and ask you to start with investing eight minutes in listening the President's announcement. This is not just political theater, though there's some of that, it's to the point, substantive, grounded and a sensible reaction to being stone-walled by the industry for one year (bear in mind the Administration reached out to the Industry within days of taking office and has been trying to reach out for months).

Starting at the Top: Long-term Economic Performance vs. the Industry

Let's start at the top by looking at how the economy has performed when it's fueled by debt to encourage consumer spending and that's built on dissavings, leverage and the sacrifice of investment. An effective and efficient financial sector is necessary for economic growth and prosperity so the Industry argues that they are socially positive allocators of capital. The question is how have we done - not how they've done - as a result. Starting in the UL and working around clockwise we find that Industry profits grew cumulatively at rates that dwarf economic growth, wage growth and other industry profits. Further that the recent debacle destroyed almost a decade's worth of Industry profits but were better than half recovered this last year. Meanwhile (UR) we've experienced the worst economic crisis in many generations that will take a at least a decade to recover from and (LR) been dug into a hole where we're at least 12.2 million jobs in the hole. Worse we face a decade of poor job creation which means we're likely to stay in that hole for a very long time - so much for middle class dreams, eh? Then (LL) there's the long-term structural damage where a secular decline in Investment reduced Growth because of a drop in Savings, induced by un-regulated Finance and the growth of debt financing for consumer spending. We'd have to say the theory of effective capital allocation justifying the Industry as it is doesn't seem to have a very good business case behind it, based on simple, staight-forward data.

Earnings and Performance Outlook

In our post on the Pecora II hearings we borrowed some charts from one of the witnesses where he reviewed the structural shifts in the industry, the impacts on debt and the compensation comparisons which you might want to review. Here we'll take a complementary view on the same subjects and look at the nature of earnings and the implications going forward.

The President talked about reducing internal hedge and private equity investing AND eliminating proprietary trading for the Banks own accounts (bearing in mind that GS admitted last week that it trades against its clients and their interests - we'll be surprised if that doesn't result in some lawsuits). Some of the Financial Press heard part of the message and suggests (UR corner) that an elimination of proprietary trading will have a minor impact. If you'll look at what actually drove earnings this last year at the big banks it wasn't banking or client services (LL corner), it was trading. A few months ago McKinsey took a pass at projecting the future recovery of some of these alternative investment enterprises worldwide but, even with their optimistic estimates, the recovery was weak. Now that's dedicated firms not the big banks but nonetheless the impacts on alternative investment vehicles are likely to be significant (though there's a case to be made that eliminating it as a line of business from the big banks will help those who do it using their own money and take their own risks).

What's not being discussed is "Yield Curve" trading - which is where the banks made their money. With monetary policy keeping short-term rates near zero (ZIRP) and supporting Treasuries banks have been able to borrow at zero and then turn around and buy risk-free government assets. That's not a bad strategy for re-building capital bases and building up a cushion to fund the continuing losses from bad debt as well as re-structure the banks. Instead those profits went into bonuses - and guess who's money they're playing with? Bank profits in 2009 were entirely funded with OPM (other people's money) and you are the "Other People". In a hard-headed business world the folks who's capital is at risk should get the profits, not the folks who manage it. On their own terms, processes, business models and philosophies there's a very strong case to apply a windfall profit tax to the banks - on the order of 80-90% all things considered. After all, we want to be fair and compensate them for their management services at a fair rate, even 2 and 20! :)!!

Banks as Businesses and the Strategic Outlook

We want to finish up by revisiting a point we've been making off and on for over a year now by looking at banks as businesses. Now we've spent a bunch of time talking about how to assess business performance and even applied it to the Finance Industry as a whole. The result, by line of business vs. key operating functions, is encapsulated here.

If you map the last year, the charts above and the President's statements here they all match up perfectly. The Industry isn't making it's money by running effective businesses in the traditional areas but is doing it on trading and related activities, using public risk capital - not their own. (sorry for the teeny size but click to enlarge - we wanted to cover a bunch of ground here so...).

Aside from running good businesses the executive leadership of any firm is ALSO responsible for running their enterprises in a socially responsible manner which is measured by three criteria - earn a profit (which pays for jobs, investment, growth and cycle risks), do no harm and cooperate in fixing societies problems. Again, based on the evidence collected and presented above - not some arm-waving rabble-rousing,and judging the Industry's own standards by which it judges business performance - we end up with this assessment of performance as measured by these broader principles (and at the time we built this chart we were feeling generous - before a year of stonewalling). The Industry has a fundamental fiduciary responsibility to itself, its stakeholders and its investors to contribute constructively and positively to fixing the problems that nearly collapse the world economy. A responsibility that they don't appear, on the available evidence, appear to have met.

A third major line of criticism is that any business must add value, which in the case of an industry like Finance where the traditional lines of business have been subsisting on charges and maneuvers for years, means re-thinking value propositions, strategies, critical objectives and business models. If that were in fact going on and we were going to see a return of the value-creating innovation that benefited the economy in the 1980s in the early years of deregulation then the yield curve subsidy would have some justification. Instead we get this assessment.

Where's the Plan Wall Street?

Sadly, if you go back and listen to the President's announcement or read the prepared text, it seems to use that every single statement he made is not an allegation. It is in fact a simple statement of fact. But we've tried to provide sufficient evidence to let you judge for yourselves.

In the readings, just so we don't get to isolated but keep the bigger picture in mind, you'll find refreshed updates on the economy and markets as well as links to major previous posts and a complete set of links to our entire two years of work analyzing the industry and its performances. Finally you'll find some links and excerpts relating to the tornado that may have just appeared but has been building up since this time last year.

We'd also urge you to listen to the President's last several sentences - it may be political theatre but we think it's far more than that! And the Industry is about to reap the results of what it's been sowing - the results of which will be forced fundamental changes for which they are not prepared and are not preparing!

And one final point but perhaps the most important one - the Industry seems to be a terminal victim of self-inflicted organosclerosis yet the opportunity to innovate, create value and make money by providng the right kinds of products and services has never been better. Where are the real businesspeople and bankers?

Economy & Markets

Dealing With the New Normal: Economic Situation, Market Outlook and Business Performance We barely survived a very difficult downturn but are now facing a sustained period of sub-par growth, poor job creation, major changes in consumer demand and related challenges. Meanwhile Markets are over-valued and anticipating a return to the old normal - raising the risks of poor returns. At the same time businesses are struggling to catchup to the surprises of the downturn, improve performance and re-position themselves. Any stakeholder needs to under the relationships between the economy, markets and business performance and assess which ones are likely to well in this new environment compares to the many who will not. Whether your an investor, employee, executive, customer or business partner you will have to cope with these challenges and should consider adjusting your decisions in line with the situation we see emerging.

Smooth sailing now; icebergs ahead The odds that the U.S. stock market will win its current bet look daunting.Investors who've been pushing up stocks are betting that the U.S. economy will produce a big enough increase in earnings to keep stock prices headed higher and at the same time show enough signs of weakness to prevent the Federal Reserve from raising interest rates in 2010. Seems like trying to get a camel through the eye of a needle? Well, I think the odds are better than you might think -- for the first half of 2010. Then they get progressively worse until, by 2011, the chances that the stock market will get the precise balance it needs are almost nil. (This column is an update of my how to worry/when to worry post at JubakPicks.com.) The key to my relatively optimistic view for the first half of 2010? Timing. As stocks move further from the bottom in earnings at the end of 2008, year-to-year earnings growth slows because the year-earlier quarter was progressively less horrible. That makes spectacular earnings growth pretty easy to come by in the first half of 2010 while making earnings growth in the second half of the year look increasingly ordinary (especially if stocks have kept moving up in price quarter by quarter). So the odds that stocks will deliver the earnings needed to justify higher share prices look pretty good in the first half of 2010 and then decline as the second half progresses.

The coming economic crisis in China I think investors are worried about the wrong kind of crisis in China. Worry seems to focus on the possibility of an asset bubble and the chance that it will burst sometime in the next two to three months. I'm more concerned about a slide into a crisis that will be an extension of the Great Recession. That slide could begin, I estimate, sometime in the next 12 to 18 months. I understand the worry about the possibility of an asset bubble in China. After all, we've just been through two horrible asset bubbles -- and busts -- in the U.S. and global financial markets. And a Chinese bubble is a distinct possibility, one that should certainly figure into your investing strategy. But China's economy and political system are so different from ours in the U.S. and those in the rest of the developed world -- and its relationship to the global financial market so unique -- that I don't think we're headed toward any kind of replay of March 2000 or October 2007. A bigger worry is a long-term slide into a lower-growth or no-growth world in which nations strive to beggar their neighbors and all portfolios slump. As crises go, it's very different but ultimately just as painful for investors as the asset bubbles that draw all our attention now.

Business

The secrets of J.Crew's success This shouldn't come as a shock -- it's a bleak time for retailers. Stores have gone out of business, 70%-off sales are de rigueur and women are shopping in their closets rather than whipping out credits cards to spend on something new. But while most retailers have been suffering through the Great Recession, J.Crew is having its golden era. First lady Michelle Obama wore J.Crew while gabbing on Jay Leno's "Tonight Show" couch in 2008, and the first daughters wore clothes from Crewcuts, the company's children's line, to their father's inauguration. J.Crew's creative director, Jenna Lyons, has taken on fashion icon status, joining the likes of superstar designers Donna Karan and Miuccia Prada. The company's recent success is more than hype. J.Crew Group (JCG, news, msgs) reported 14% revenue growth in the third quarter and had strong holiday sales. The retailer has managed to provide fashion retailers with a glimmer of hope that women will shop, recession be damned. "J.Crew has become an expert in recasting timeless classics into current fashion must-haves," says Eric Beder, a retail analyst at Brean Murray Carret. Reflecting on J.Crew's success, Drexler told investors and analysts during a recent conference call: "It's about product, it's about quality, it's about design, it's about service, it's about creativity." Corporate speak, sure, but Drexler knows that his company's success doesn't depend on celebrity endorsements or the latest wash of jeans. It has to do with consistency. And therein lies the not-so-secret reason for J.Crew's success -- make clothes women want to buy and they will buy them

GE Earnings Drop 19% General Electric Co. posted a 19% slump in fourth-quarter profit as it was again dinged by a big drop in earnings at its finance arm and substantial weakness at its NBC Universal media unit. But the overall results topped Wall Street expectations, and the conglomerate heralded "encouraging signs" at its infrastructure divisions. New orders for big-ticket equipment and services came in at $22.1 billion in the fourth quarter. The figure was off 3% from about $22.8 billion in the year-ago period, but up from $18.4 billion in the third quarter and from $18 billion in the second quarter. Chief Executive Jeff Immelt previously has called the second quarter the potential low point for new orders amid the economic downturn. "GE's environment has improved, and we saw some encouraging signs at year-end," Mr. Immelt said in a prepared statement Friday. He said the Fairfield, Conn., conglomerate is on track to achieve the broad financial forecast it unveiled at its annual outlook meeting last month, which essentially called for flat overall 2010 results followed by "solid growth" in 2011.

Banking Business vs. Reform and Social Responsibilities

The Corporation vs. Society: Performance, Social Responsibility and the Win-Win The focus of the Finance Industry on short-term financial reform and bonuses led us all to the brink of disaster in 2008 and has caused a wave of anger in the citizenry, most business folk and even much of the industry itself. At least those portions that were badly damaged by the mis-behaviors the caused them to almost be driven out of business themselves. While that anger is obviously justified much of the discussion has centered on emotional judgments. Here we would like to consider the case for reform from two more hard-headed, analytical if you like, perspectives. One is from the point of view of Society and the Industry as members of that society. The other from a “business case” perspective. Either alone justifies significant regulatory reform. Taken together we consider the case to be overwhelming. No business or other organization exists solely for the sake of existence. It exists to create a value for society, whether that’s measured in profit terms or not. Overall then a business, as a business, has three strategic goals. First, it must deliver value. In this case profits. But those profits should be based on contribution and not financial engineering. Second, in its own long-term interest, it needs to be a productive workplace where the worker is made effective. People are social animals and the more comfortable they are in their environment then the more they will contribute to the health and performance of the organization. Third, an organization or business must be socially responsible.

Banks As Businesses: Performance, Reform and Blindsidedness Now that the smoldering re-regulation fires are beginning to burst back into flames the Finance Industry seems to be doing just the opposite. Despite repeated attempts on the part of the Administration since the beginning to reach out and work with them constructively they have been lobbying behind the scenes as hard as they can to limit and reduce the various reform legislation packages. Along the way they have repeatedly treated the political establishment, the Administration and the various regulatory agencies and the President with disdain and disrespect. Worse, they have treated the Public with disdain and disrespect by announcing record bonuses, arguing that those bonuses were the result of their own performance instead of government funding and support and reacted in a tone-deaf and disdainful fashion to the widespread distress in the economy that most people are suffering thru. The core of their argument is that what they do is good for the economy and the country and their bonuses are earned and necessary to the efficient and effective functioning of their businesses. Sadly all the evidence is against them on that score.

Pecora 2 Hearings, Malfeasances, Your Future & Cusp Points The Financial Crisis Inquiry Commission (FCIC), or Pecora 2, kicked off its hearings this morning with quick statements from the chair and vice, testimony from the heads of 4 of 5 of the big banks, a second panel from several investment banker/analysts with strong criticisms and an afternoon panel from four banking/economic/housing experts. Frankly the hearings so far are stunning - intelligent, polite, informed, limited axe-grinding by the commissioners (with some exceptions), almost no ideology and a strong bi-partisan spirit of inquiry, digging into the data and understanding.

Renewing the Enterprise 2: Governance, Measurement & Performance The fundamental messages we've been trying to drive home are that the next decade will be one of the most challenging in at least four, if not since the Great Depression, that the new realities have not sunk into investors, management and stakeholder consciousness and the single biggest challenge will be to improve enterprise performance. Performance improvement will either be led by the enterprises or imposed from the outside, less effectively, by a high level of distrust and justified anger at near-disasters brought on by malfeasance. And this is not just restricted to the Finance Industry. It is in enterprises own best interests to improve their governance, management systems and performance to make sure it's done well, adapted to their needs and, most importantly, they actually improve their performance

Banks, Finance Industry and Reform

Prudence Pays Off for Jefferies—and Its Workers While employees at the likes of Goldman Sachs Group Inc. and J.P. Morgan Chase & Co. quiver at pronouncements from Washington, the bankers and traders of Jefferies Group Inc. are happily avoiding the fray.Complicated stock clawbacks? Not at Jefferies. The New York securities firm has no plans to take back shares from rank-and-file employees. Chief Executive Richard Handler also isn't giving up a potential $12 million bonus this year. His target compensation for 2010 is $26 million depending on whether he can achieve certain performance goals and whether the board signs off on it. Jefferies, which specializes in trading debt and stocks, didn't take government rescue funds. Nor does it handle consumer bank deposits. During the crisis, it kept a clean balance sheet and relatively low leverage. Its size—revenue about one-tenth that of Morgan Stanley—has also helped it fly below the radar. Jefferies has a reputation as a scrapper, willing to take on difficult clients such as financier Carl Icahn. The firm is sensitive about its reputation, asking via email that certain terms not be used to describe it, such as "small" and "boutique." Mr. Handler declined to be photographed for this article. But now its perch outside the Wall Street pecking order is something of an advantage in the market for financial-industry talent. The question for the 47-year-old firm is whether that is just short term, or can be used to build something more lasting. "We can pay our people what they deserve to be paid," Mr. Handler said in an interview from his sparse New York office overlooking Jefferies's trading floor. "We are only beholden to our shareholders." Such a notion sounds almost quaint these days on Wall Street, where large firms have been trying to douse a political firestorm over bonuses

Obama hits Wall Street, pushes for bank limits Embracing Depression-era policy and populist politics, a combative President Barack Obama chastised big Wall Street banks Thursday and urgently called for limits on their size and investments to stave off a new economic meltdown. Investors responded by dumping bank stock. Obama's rhetoric covered the whole financial industry, but the key changes will affect only a few high-profile players, including JPMorgan Chase & Co., while sparing investment banks like Goldman Sachs Group Inc. The move could undercut Treasury Secretary Timothy Geithner's strategy of maintaining close ties with the financial industry as part of the administration's overhaul efforts. Obama's announcement included changes that have been advocated for over a year by former Federal Reserve Chairman Paul Volcker -- who appeared with the president at the White House -- particularly by endorsing Volcker's proposal to ban banks that take deposits from also trading stocks for their own profit. The change would separate commercial banks from investment banks, a line that was blurred a decade ago by the repeal of the Depression-era Glass-Steagall Act.

Proposal to Rein In Banks Sinks Stocks President Barack Obama proposed new limits on the size and activities of the nation's largest banks, pushing a more muscular approach toward regulation that yanked down bank stocks and raised the stakes in his campaign to show he's tough on Wall Street. With former Federal Reserve Chairman Paul Volcker at his side, Mr. Obama said he wanted to toughen existing limits on the size of financial firms and force them to choose between the protection of the government's safety net and the often-lucrative business of trading for their own accounts or owning hedge funds or private-equity funds. Mr. Volcker has been an outspoken advocate of such rules; until recently Mr. Obama's top economic advisers, including Treasury Secretary Timothy Geithner and Lawrence Summers, were less than enthusiastic. Big banks and their trade groups attacked the Obama proposals as unnecessary and unwise. "If people are focused on things that caused or were real contributors to the financial crisis, it wasn't trading," said David Viniar, chief financial officer at Goldman Sachs. Over the past several years, banks have bulked up their profits in areas far beyond taking deposits, making loans and trading stocks and bonds on behalf of customers. Some have bought or sponsored hedge funds. Others have moved to invest their own money in the markets. After the collapse of Lehman Brothers and the rescue of American International Group in the fall of 2008, investment banks Goldman Sachs and Morgan Stanley formally became banks—giving them access to Fed loans and federal guarantees of their borrowing in financial markets. When the crisis ebbed, Goldman and some other banks were able to borrow at low rates and turn profits trading for their own accounts. This gave Mr. Volcker and his allies, who include Vice President Joe Biden, new fuel for their argument that government-backed banks should be prevented from taking big trading risks.

Policy Pivot Followed Months of Wrangling For nearly a year, President Barack Obama's economic team resisted measures to restrict the size and activities of the biggest U.S. banks. Two days after Democrats suffered a devastating election loss in Massachusetts, the White House rolled out a proposal to do just that. The policy's evolution took months, according to congressional and administration officials. Prompted by the cajoling of former Federal Reserve Chairman Paul Volcker and other respected voices, dissenters in the administration—notably Treasury Secretary Timothy Geithner and White House economics chief Lawrence Summers—gradually dropped their opposition. On Jan. 13, Messrs. Geithner and Summers locked down the final regulatory proposals into a memo to the president that they said was unanimous.

They Brought it Upon Themselves U.S. investors spent a second consecutive day reacquainting themselves with the term “risk”. Since the past few months have mostly been tranquil, this renewed volatility might require an adjustment period, with most of the adjusting taking the form of lower securities prices. And while yesterday’s big concern was a potential cooling of the Chinese economy, today’s culprit was political heat on our nation’s largest financial institutions. President Obama proposed sweeping new regulations for the banking sector, including caps on deposit size, and bans on activities like proprietary trading and owning alternative asset managers. Financial shares slumped in response to this latest salvo directed at Wall Street, the timing and ferocity of which may not entirely be coincidental to Tuesday’s election results in Massachusetts. Predictably, there was considerable gnashing of teeth in the executive suites up and down Wall Street, but I believe top management brought these latest proposals upon themselves. Executives at our nation’s largest financial firms reacted with shock and dismay this afternoon, but they brought these policy proposals on themselves. They’ve successfully gamed the legislative and regulatory systems so well and for so long that they literally cannot understand why so many people are angry enough to side with the President on this issue. Maybe their memories are a little foggy, so let me try to list just some of the change Wall Street firms themselves were able to effect during the past 15 years. It’s a Top 10 checklist of memorable achievements only a bank executive could love:

Posted by dblwyo on January 22, 2010 10:15 AM |

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