The Arrogance of Wall St.

Goldman Sachs is a smart firm...very smart. But their recent position on the re-purchase of warrants from the Treasury has me a little perplexed. Allow me to explain. Goldman took over $10 billion in TARP money from the Treasury to insure against insolvency. In exchange for the $10 billion or so of cash from the Treasury Goldman issued warrants to the Treasury (read: taxpayers). Warrants give one the right, but not the obligation, to purchase shares of a company's stock at a certain price. It's very similar to an "option" with the key difference being the length of time one has to exercise the warrant (the life of a warrant is typically 5-10 years while an option is generally shorter than that, sometimes only months). Here's an example using the Goldman case (I'm too lazy to look up the exact numbers but I think an approximation will suffice).

The treasury receives twelve(12) million warrants that allow them to buy Goldman stock at $122/share. Last I knew, Goldman was trading at $150 (or thereabouts). If the Treasury exercises its right to buy the shares, it would buy them at $122/share and sell them for $150/share, making a tidy profit of $372,000,000. By my rough calculations, that's about a 5% internal rate of return. Not bad for 12 months. But, it's not quite that easy. The contract Goldman signed with the Treasury allowed them to buy these warrants back from the Treasury. But price is negotiable. So what should Goldman pay? Whatever the Treasury wants. I'm guessing the Treasury won't give up their warrants for the $372,000,000 because of the tremendous long-term potential they see in Goldman. Remember, as Goldman's stock increases, so does the Treasury's profit. Since Goldman is one of the first to pay pack their loan, I would bet the treasury is eager to show the taxpayer what a good deal the TARP is for them and is asking for a little premium on their warrants. In other words, more than $372,000,000 and more than Goldman is willing to pay. If I'm the Treasury (and it's a good thing I'm not), then I would NOT let go of those warrants for any less than $750,000,000, yielding an attractive 10% IRR. That's a nice double digit number. It's O.K. for Goldman to 'stick it to the man' as long as the "man" is not the Treasury/tax payer/life saver.

If somebody saves your life, you take what they give you. I'm firmly rooting for the Treasury on this one!

Thoughts on Obama's Plan for Restructuring Financial Services

Last week, Tim Geitner laid out a plan to restructure regulation within the financial services industry. The net result was an additional three government regulatory agencies with clearly defined mandates, which, among other responsibilities include monitoring banks, hedge funds, and consumer protection. One can easily find Mr. Geitner's testimony online (which I will find and post) but, in essence, it boiled down to 1) require banks to hold more reserves and keeping a close eye on banks that are "too big to fail" 2) require certain private investment vehicles to register with the SEC and 3) create a new division whose sole responsibility is to protect consumers. Here are a couple of thoughts. But before I share those, I should disclose (lest there be some agregious misconception that I know what I'm talking about) that I have no idea how to fix the problem. If I did, I would be there...fixing it (and making a lot more money). While I'm generally opposed to creating more governement agencies, I'm sure Mr. Geitner and the entire administration were thoughtful in their proposal, and it is certianly better than anything I would have come up with.

1) I don't think more "regulation" is THE solution, nor was lack of regulation the problem. On the face of it, it would seem Mr. Geitner does think regulation was the problem. I get it, that's what he does, he exchanged a multi-million dollar private contract for a multi-million dollar public contract and his party line is, by necessity, "Re-establish confidence in the banking sector via broader regulation." But this is a faux-solution that is only optical in nature. Nope, more regulators won't work because employees working at Hedge Funds, Investment Banks, and other Financial Institutions are smarter than regulators. These firms made billions of dollars maneuvering through the OTC, FDIC, SEC, Treasury, FED, and the office of Thrift Supervision (just to name a few).

2) I think there is a misalignment of interest between banks that are too big to fail, the shareholders, and the public. If a bank is too big to fail, then the purpose of that bank should NOT be to maximize shareholder wealth. Since maximizing shareholder wealth requires banks (because it is economically rational) to circumvent regulation and shoot for the moon. In other words, pushing the price of the stock higher and higher sometimes means you take more "risks" (that, in theory, you are compensated for). In the end, you have a limited liability since many of your liabilities (deposits) are insured by the state. However, if you are deemed systemically relevant (a very slippery definition) then you should have the public interest as a primary objective with shareholder value subordinate to that of the public. So this position, I think, creates a lot of philisophical problems for capitalism.

Regulation may not be THE solution, but PART of the solution. What I believe we are grappling with are the incentives of capitalism. One tenent of capitalism is constant innovation and efficiency which result from risk taking at some level. Unfortunately, the higher the climb, the steeper the fall.

Investing in the New Economic Paradigm

Image by ocean.flynn via Flickr

I'll continue with the sparse summer posting. It seems these days my time is spent passed out on the couch from overconsumption of otter-pops.

There's little doubt the last two years have changed the rules for investing and managing risk. Constructing your investments based on historical information worked as long as financial markets dealt the same types of risks (though the timing around the manifestations of those risks were completely random). In short, we all learned that when dealing with models, garbage in equals garbage out. Yes, models are helpful and they help crystallize your thinking, but it should not be a substitute for a good deal of independent critical thinking. So with all the uncertainty surrounding where the market is headed over the next 1,3,5, or 10 years I thought I would share a couple of thoughts. Perhaps they will be of some benefit (but probably not).

1) The current recovery may be little more than a "Dead Cat Bounce". Perception is reality. Based solely on the number of editorials, articles, and reports I've seen over the last few weeks, I conclude the majority of US citizens assume the worst is behind us. Which is extremely curious. Based on fundamental information only, there is no justification of a recovery. In fact, less than 15% of all the stimulus has been deployed. Although this is curious, its not surprising. In a previous post I noted Mordecai Kurtz's (Stanford) research on behavioral economics. Kurtz concludes fully four-fifths (80%)of the movement of a stock price is based on behavioral factors, not technical. Markets move up when the majority of investors hold optimistic expectations of the economy and down when the collective view is pessimistic. To me, this conclusion means the American psyche could be in for a huge disappointment. Banks and Insurance companies still have a tremendous amount of exposure to commercial mortgage backed securities, which, by the way, have yet to correct for pricing. If this happens, unemployment could easily reach 15% which, I imagine, will have a devastating affect on investors who assumed the worst was behind us.

2) If traditional asset allocation, modern portfolio theory doesn't work, what does? Perhaps a prudent way to evaluate investments is with three scenarios in mind; growth, depression, inflation. This allows one to be less rigid in their approach and forces investors to consider the macro environment before making a decision, instead of blindly following an allocation model. How much you allocate to each is based on your personal macroeconomic perspective. True diversification is a moving target. Writing in broad generalities, in the growth bucket you would target public stock, high-yield bonds, Real Estate, and avoid T-bills and some commodities. In the Depression bucket you would focus on holding T-bills, Gold, Foreign Reserve Currencies, and short duration government bonds but avoid exposure in US stocks or high-yield bonds. Inflation warrants investment in Commodities, Infrastructure (like toll roads, power, hospitals, etc.)and international markets. You might allocate a third of your resources to each bucket (growth, depression, and inflation) and tilt the allocation one way or the other based on your outlook. One note, exercise prudence when purchasing or selling securities to avoid buying at the height of the market. You could either dollar-cost average (purchase $200 of XYZ security every month/week/etc.) or use some light market timing. An example of "light" market timing would be waiting to buy gold. Gold is trading at historically high levels. Rather than wait for it to return to "normal prices", which may not happen for a few years, you would wait for it to come down, say 10%, and then make your purchase. In other words, you're simply being more opportunistic when you make your purchases. Unless you have a good understanding of a sector, its probably best to dollar-cost average.

Anyway, I'm not providing specific advice, nor am I providing any advice for a fee (now you can't sue me). Rather, I'm simply introducing a couple of ideas that readers might find helpful and would like to study in more detail (on their own).

The New York Common Fund Scandal

Thanks for bearing with me throughout the hiatus. Truthfully, aside from the Chrysler bankruptcy, there wasn't a whole lot going on. However, if you've been reading the financial times or the wall street journal you'll have come across several stories regarding Cuomo's latest smackdown involving one of New York's largest pension plans. Why should you care about this? Because some of the underlying details actually get to the problem with decision making in the institutional world that is equally applicable at the individual level.

Here's what happened. The New York Common Fund is a public pension fund, one of the largest in the world. The fund is being investigated for allocating funds to money managers who made political/personal contributions. That's basically it. Most public pension funds have a Board of Directors acting as a check and balance on what the internal investment team is doing to avoid conflicts such as these. However, at the New York Common fund, they have a sole decision maker, the Comptroller. This Comptroller allegedly allocated money to several external money managers who investigators say also contributed heavily to the local political party. These "contributions", ahem...bribes were made by investment managers directly (think hedge funds and private equity funds) and also by placement agents. Placement agents are basically hired by hedge/private equity funds to help them raise money. They are paid a commission on any money they bring in. Cuomo says these placement agents paid fees to the comptroller, or his party, in exchange for several millions of dollars worth of commitments. Also, the NY Common fund hired consultants that almost had discretionary authority and approved several of these allocations. It's messy. Of course now it's turned into a massive witch hunt that will ripple across the institutional universe. I'm not to naive to think this doesn't go on elsewhere.

There are obvious lessons here, but a couple I think we can apply personally. The first mistake is having a sole decision maker. It's a stupid idea for institutional investors and it's a stupid idea for individuals. You should never make a major money decision without a second opinion. You need someone else to help you think through the idea and help you discover if perhaps you are seeing something that simply isn't there. Second, many pension funds rely on consultants for opinions. This might seem like a good idea. But not taking any action unless a consultant approves such action is essentially giving de facto discretionary authority. This can be equally damaging. So if you don't want to make decisions on your own, and you don't want to rely too heavily on a consultant (or perceived "expert"), what do you do? Something in the middle. Make sure you listen to others but use some good judgment. Ask yourself, why would this individual be considered an expert in a certain field? What are his motives? Are they aware of other opportunities? Are they on the hook for the decision? Do they have money at stake (in other words, if I lose, do they lose?)?

Being honest of ones intellectual and behavioral limitations could save thousands of dollars. It's not enough to be right or wrong, but to be right or wrong for the right reasons (or something like that). Good luck.

Double Standard for Auto Industry

I'm going to field this question as I walk out the door because I don't think it's too difficult. Many are wondering why the Obama administration is taking such a hard line with the auto manufacturers while being so tolerant to the banks. Here are five reasons, in no particular order.

1. Banks pose greater systemic risks than the auto manufacturers. Although the effects of auto manufacturers going bankrupt would be immense, it would be worse to let the banks fail.
2. Banks are operationally solvent. Meaning, they have enough money to pay their bills and have only taken money from the Government to comply with regulation. Auto manufacturers can't even pay their bills, which is mostly due to their high labor costs.
3. Auto makers have been losing market share for the last ten years or so. Up until last year, banks have made money every year.
4. The White House is teaming with former Wall Street executives, which may account for why they understand the wall street funk.
5. The automobile industry has a lot more long-term uncertainty surrounding their business model (i.e. cars that run on alternative fuels, etc.). On the other hand, the low interest rate environment has actually helped banks this year as the spread between what they pay the depositors and what they lend is relatively wide. The majority of banks will be profitable this year (by profitable, I mean in a healthy way).

Insights from PE Conference Part II

More of the same doom and gloom scenarios with some interesting comments from the former head of the EBRD (European Bank for Reconstruction and Development).

-There are major issues with banks in Europe since it is not uncommon for a bank's subsidiary, which functions entirely separately from its parent, to need additional capital to prevent a failure. Here's the problem, the parent bank is located in a different country. So XYZ bank is headquartered in Poland and has an Italian subsidiary that needs additional capital. Taxpayers in Poland have to put up the money to save an ostensibly Italian bank. That's caused some contention.

-Eastern and Central European consumers are more reselient than U.S. consumers because they are not as demanding. Most Europeans in the developing regions are more resourceful and use to living on meager incomes. So it's unlikely the consumer will be as distressed in those areas as they are in other developing regions.

-Lots of talk regarding the deleveraging of the U.S. consumer. That's a fancy way of saying americans are going to save more. According to a brand new study by McKinsey, every percentage point gained in the personal savings rate translates into $100 Billion of decreased spending, which can be a major drag on the economy. This of course, assumes income growth remains stagnate (which it has since 2000). If incomes increase, then spending can increase and savings can grow.

Insights

For the next two days I'll be at the Thunderbird Global Private Equity Conference. The first couple of presentations have been interesting. Here are some tidbits.


Regarding TARP Money. An executive from a large bank that took money from the TARP had to rescind job offers to several candidates because he was informed that banks who recieve money from TARP can't hire non-U.S. citizens. Ouch. Can you say talent flight?

On the Treasury's new plan. Seems like consensus is that the new proposed partnerships (I know, I promised a post on this and will complete it soon) between the governement, banks, and private money, is a logistical nightmare. I can't say I'm surprised. You have three separate parties trying to establish a "fair" price. And everyone has a different agenda.

More shoes to drop. Not to go into detail, but bond spreads are predicting defaults to go from approximately 5% to 15%. That's not great news for employment, and, by extension, GDP.

China's political backlash. Earlier this week China said it was worried about the solvency of the U.S. That should scare most people. China is the largest holder of U.S. treasuries. If China decides to dump them for a safer investment, we would have massive hyperinlation (I know, that's redundant). I don't think that will happen for two reasons. First, there really aren't any other currencies I can think of that are safer and second, they'd be shooting themselves in the foot. China's GDP is like 50% exported and the U.S. is the largest net buyer. Guess what happens if we can't afford their goods due to our hyperinflation?

More to come.