Pay Regulation To Creep Into Wall Street

You cannot take their money and expect they won't have something to say about how you run your business. Well, Congress does have something to say, and today's something regarding executive pay is: Are You Kidding Me!

In an election year, when the government has allocated $860 billion to a bailout, given $250 billion already to the banks, given almost $40 billion to AIG, back stopped deposits in excess of FDIC insurance, and forced the takeover of Bear and Merrill and WaaMu and Wachovia, the executive pay of these same firms is an easy target. So Congress is taking aim.

http://www.reuters.com/article/ousiv/idUSTRE49R7WC20081028

Congressman Waxman has requested a break down of compensation from banks receiving half the bailout money. Don't worry you other half, a similar document should be in a Fed-ex pouch very soon.

Wall Street has always argued that it is a meritocracy, in a meritocracy pay for performance is fair, and that there should not be a cap on it.

This may be true, it may not be. In the old days, when Wall Street rarely committed capital, when it made its money on expertise and execution rather than prop trading, this was probably true. Now, when it makes its money on allocating capital, making directional bets, and competing with its customers with seemingly limitless funds, perhaps not. Profit derived exclusively from your wits is one thing, profit requiring the use of investor capital quite something else, irrespective of the brilliance.

Congress is questioning how much pay is merited while trillions of investor and taxpayer dollars are lost.

Wall Street has also always warned that capping pay would lead to a brain drain: that all those clever MBAs will go elsewhere; and that experienced deal makers and rocket scientist product guys won't have enough incentive to stick around. I for one think most guys still show up to work earning $1 million - $5 million instead of $10 million to $50 million, but thats just my opinion.

In any case, we are soon to find out.

The Economy: Does Either Candidate Get It?

Watching the final Presidential debate Wednesday evening, my undergrad classmate Mike Markowitz blogged " Must Kill... Joe the Plumber... Must Kill..."

I am significantly less clever, so my thoughts went to Winston Churchill: "Those who fail to learn from history are doomed to repeat it."

Sen. McCain's failing: Mistakenly placing the blame for our failing economy on the sub prime market.

Sen. Obama's failing: No proposal to get the liquidity into our markets.

Both candidates spent more time arguing that their proposals would lower taxes for Joe the Plumber. Meanwhile neither is really addressing ways to generate sustained growth of our economy, and therefore either one is likely to kill Joe the Plumber - at least financially.

I have said it in previous posts, and its important, so lets repeat it: Sub prime lending did not cause our economic downturn.

If it had, then the actions taken which have eliminated sub-prime lending would have corrected the problem. We wish it were that simple, but of course it is not; so McCain, the press, and everyone else needs to stop banging that sub prime drum, because that instrument is out of tune with the music of our economy and markets.

If sub-prime lending was not the culprit, what was?

A lack of economic growth outside of the real estate industry, and an abrupt termination of liquidity, including and specifically sub prime lending, but also leveraged lending.

The 1990s were a time of information technology development that literally changed the way everyone of you reading this post does business. Companies such as Amazon, Ebay, Google and Yahoo came into being, and modest size companies such as Microsoft, Cisco, Oracle, and Intel became the behemoths that they are today. Information technology was a key driver of the productivity gains in the US from 1995-2000.

The current decade has seen no such transformational development, and no such productivity gains. We need to change that if the economy is to improve.

How?

Stop the bleeding. The candidates talked about a short term moratorium on foreclosures, which ultimately doesn't address the problem. Instead, they should implement an 18 month freeze on mortgage rate resets. Make it retroactive for six months, and waive accrued fees, so folks that are in default due to resets can get current. This will allow people to stay in their homes, while giving the real estate market time to firm. In 12 months the freeze should be reviewed for a possible one year extension.

Increase liquidity - lower short term rates - a lot. This allows banks to keep rates low and still make a profit, getting them healthy in a hurry. One month Libor is roughly 4.40%. It needs to be 200 basis points lower and needs to stay there for awhile.

Increase liquidity - encourage mortgage lending including sub prime - but not mortgages with short term rate resets. Why do we care if a home owner borrows 50% or 100% of the home price provided he/she can AFFORD THE PAYMENTS!!!! Fannie Mae and Freddie Mac are a catastrophe, so start a new entity to buy mortgages from banks. In a previous post we named that entity Billie-Mike after Bill Gross and yours truly - I think its kinda catchy.

Now, onto industrial growth.

Develop non-polluting energy resources. OK, this isn't new, but lets put some numbers on this:

Exxon-Mobil and Chevron, the nation's largest oil companies, earned record profits this year of $40.6 billion and $18.7 billion, respectively. Yet the industry devotes annually less than 1/2% of their revenue to R&D. For Exxon-Mobil that’s roughly $2 billion, and for Chevron thats roughly $1 billion for total R&D that includes but is not exclusive to renewable energy. It is simply not enough. We need to devote 20x that amount solely to renewables if we really hope to make any meaningful progress.

The benefits? Reduce payments for foreign oil. Reduce demand for oil which should reduce the price, which should reduce corporate energy costs. Reduce emissions, which lead to pollution and global warming. And most importantly, create new companies and hundreds of thousands of new jobs! But without order of magnitude increases in investment this will be nothing more than a pet project for a few engineers for the foreseeable future.

Encourage auto lending, particularly for hybrids and battery powered cars. Previously 90+% of auto loan applications were approved, currently its down to 60%. Meanwhile the auto industry has declined from selling 17 million new autos per year to 12 million. That’s a whole lot of lost GDP and a bunch of lost jobs. Hybrids are $5000 - $8000 more than their polluting alternatives. GM's Volt, to be released in 2-3 years, is estimated to cost $43000, or about $20k more than its current comparable gas powered autos. We need to subsidize these costs through loan programs and tax credits to get more of these in the hands of consumers quickly and drive job growth (pun intended).

Contain medical costs. Extend basic coverage to those without care. Create a system of free clinics so that pregnant women get pre-natal care, and mothers get basic care for their kids. Create trauma centers so people can get treated for injuries. Staff both with doctors and nurses who will get college loans waived in exchange for serving in these facilities for three years after leaving med school. Use technology to allow for remote chart and test reading by specialists. Create a payor system that reimburses providers, therefore cutting insurance rates for the rest of us.

These changes will reduce the cost of providing health insurance to employees, which should lead to a healthier workforce with less worker down time - ie increased productivity.

Invest in medical technologies, whether adult stem cell, nanotechnology, or other research approaches. In addition to longevity and quality of life benefits, this will create jobs!

Finance start-up businesses. Where can a start-up get financed today, particularly with the IPO window closed? Without start-ups, where will the next Google come from? Fund the Small Business Administration, and restart SBIC venture and buyout programs.

So? By following these recommendations, we will get liquidity into our markets and fund new industries, thereby creating GDP growth and jobs.

And maybe we won't actually kill Joe the Plumber......

Why Isn't Our Economy and Stock Market Behaving Like the 1990s?

In the 1990s our economy and stock market grew due to the following fundamentals:

1) Productivity Expansion due to
- implementation of computing and related technologies,
- outsourcing - ie lower costs for same or even better work product
- declining (in real dollars) energy costs and increasing energy efficiency

Today, we lag behind the other developed nations in productivity growth. Our technology adoption rate has slowed, the benefit of outsourcing already realized (in fact outsourcing costs are rising due to inflation in China, India, and Mexico), and energy costs are much higher, not just for gasoline but also for natural gas.

2) Historically Low Interest Rates allowed banks and investors to realize outsized ROE's from moderate nominal returns on investment.

In November 1990 one-month LIBOR (the base index for corporate loans) stood at 9.125%, and the 10-year treasury yield was 8.39%. Through the rest of the 1990s both rates averaged roughly 1/2 those levels, allowing companies to access debt markets cheaply.

3) Massive Increases in Market Liquidity drove stock prices. In-flows came from:
- Companies switching from defined benefit retirement programs to defined contribution (eg 401k) plans.
- Increases in leveraged lending fueled by the development of the syndicated lending and the participation of non-bank lenders (ie increased demand for bank product); and
- meteoric increases in high yield bond issuance, which together with bank syndication drove a huge spike in M+A activity, which in turn drove stock valuations.

From 1990 - 1999 investment in IRAs and 401k programs tripled from $4 trillion to $12 trillion. From virtually $0 issuance in 1990, high yield bond issuance exceeded $140 billion in both 1998 and 1999, and averaged almost $100 billion per year from 1993 through 1999. Leveraged bank lending over the same period was 3x - 4x the bond issuance levels (my estimate).

The net effect on stocks? From December 1990 to December 1999 the Dow and S+P 500 grew in value over 4x (Dow 2633 to 11470, S+P from 330 to 1469). The tech heavy NASDAQ composite over the same period grew almost 11x, from 374 to 4069.

More telling, S+P PE ratios increased from roughly 12.5x in 1990 to roughly 35x in 1999. In other words, in relative terms investors were paying almost three times as much for stocks.

The bottom line: Market Liquidity Matters!

What is different now?

We talked about productivity - it has slowed and some argue that we have not had any real increase in productivity since 2000. Our energy costs are much higher. The growth of IRAs and 401Ks has slowed, and the credit markets are dead, so liquidity is down.

Rather than productivity, our economy has been dependent over the last 8 years on real estate and related industries (construction, raw materials, furnishings). As we all know, real estate has been neutered.

With no fundamental industrial growth, and no market inflows to drive stock demand, and a deflating real estate market, there is nothing in our economy to drag us out of the mire.

The Bailout Passed: So Why Do Stocks Continue to Fall?

To no one's surprise, after a slight delay and an extended drum roll, the $700 billion "bailout" package was approved last week. Also not surprisingly, after a one day stabilization, markets continued their free fall as we had said they would.

Why?

Because "$700 billion bailout" is a headline, not a plan. It passed without determining: exactly what was to be acquired; from whom; who was going to actually make the purchases: at what price; and how that price would be determined.

It didn't address the real issue: A lack of confidence in our financial institutions based on not knowing what is in their portfolios. In short, we worry, "is the situation even worse than we realize?"

How could our House of Representatives pass such an extraordinary measure with such little information? Confidence that President Bush got it right? Treasury Secretary Paulson? Fed Chairman Bernanke?

Nope. Because Warren Buffet said so.

It went something like this:

Warren: "Golly gee, Republican Congressmen, 60% of you objected to this bailout. If I had known that I would never have purchased $5 billion of Goldman Sachs stock at a huge discount and with a previously unheard of 10% dividend. And with an option for $5 billion more. Boys and girls, you better rethink this, because Goldman only has a $50 billion war chest, and we need the government to buy all the illiquid, unpriced crap on Goldman's books (at prices we will be happy to establish) so Goldman is free to purchase all the banks assets that the Fed is going to foreclose upon and sell at a discount in the next 12 months." (More on that later.)

What Republican politician can resist Warren Buffet? It is un-American to deny this guy a 20%+ return on his capital year after year. Somewhere it is written that the world's richest man must be the one to capitalize on the downfall of the American financial markets, and Congress had better buck up and make it so, even if his argument is self serving and has no logical rationale. Hey, this is Warren freaking Buffet we are talking about here!

So now the bill has passed and somebody, not sure exactly who, is sitting on a real big pile of cash, and at least the "from whom?" question is partially answered: Goldman Sachs.

What has this done and what will it do for our markets? To date, absolutely nothing. We have suffered a 2000 point drop in the DJIA since its passage. The smart folks on Wall Street (I prefer Rob Rubin, the former head of Goldman, to Warren Buffet, when it comes to matters of financial firms) knew this would be the case.

So what should we do next? What are the "smart guys" clamoring for?

Suspension or elimination of FASB 115, the so-called "Mark to Market Accounting" rule, and its recent follow-on FASB 157, the "Fair Value Measurement" rule, which they believe is the real cause of our financial crisis.

I can hear your resounding: "Huh?... What the heck are these FASBs? Mike, explain."

My pleasure.

FASB 115 and 157 contain the seemingly common sense rule that financial firms need to account for (or "mark") their assets (stocks, bonds, loans, etc ) at their current market price, rather than simply leaving them at the price paid for them. If the prices of these assets decline, then firms needs to mark them down, not unlike a retailer marking down its spring stock once summer rolls around.

"Mike, What is wrong with that? Sounds like common sense!" you say.

Well, it seemed that way for a long time, so much so that the assets to which FASB 115 applied continued to expand. And in "normal" markets, which I will define as one with both a "bid" (offer to purchase) and and an "ask" (offer to sell), it works fine. But what about when you do not have a bid? Or when the bid-ask spread (the difference between offers to purchase and to sell) is exceedingly wide? What is the market price then? And does this reflect "true value?"

Lets make a simplified example:

Suppose a financial institution owns a sub prime loan, which in this example we will define as a mortgage with zero money down (100% loan) to a credit worthy borrower. That borrower continues to make payments on time. Lets further suppose that a home in the same neighborhood, with the same layout and built by the same builder at the same time, recently sold in a foreclosure sale at a 40% discount to the face amount of our financial institution's loan amount. Now, where should we "mark" our loan, i.e. what is its market value?

There are three possible answers:
1) Par. After all, the borrower continues to perform on his obligation and is expected to continue to do so.
2) 60% of par; reflecting the 40% discount in market value of homes in that neighborhood.
3) Something less than 60%, reflecting the fact that if a financial buyer was to purchase the loan it would be at a discount to the market value of the home.

Now, repeat this example several million times, and throw in millions more derivative instruments based on these underlying mortgages, and you will start to understand the magnitude of what Wall Street is calling the "Mark to Market Problem."

There are roughly 8500 banks in the US, and thousands of fund managers, and they all are to some degree facing this dilemma. If they all were to mark the assets in their portfolio to the bid price (or implied bid price) for those assets, in almost every case their capital base would wiped out, despite in many cases only a negligible effect on their cash flow.

Simplistically, this is what led to the failure of both Bear Sterns and Lehman Brothers. Because there was a perception that their assets had drastically declined in value, Bear and Lehman were unable to get the short term financing that financial institutions rely upon, thus forcing them (in Bear's case) to sell for next to nothing or (in Lehman's case) declare bankruptcy where they are currently selling themselves for even less.

Turnaround/Vulture investor Wilbur Ross recently predicted that 1000 banks will be forced to close within the next year or so (and he has raised a fund to buy a bunch of assets). History suggests that his claim is modest. In its existence, the Fed has closed 3,286 banks. 82% of these, or roughly 2600, were closed or forcibly sold in 1990-1992, the last time the government stepped in to help us out of a financial mess with an imbecilic strategy. (Check out the companion post "Legislative Idiocy - Its Like Deja Vu All Over Again" to rehash that government imposed debacle.) Goldman, Buffet, Ross and others are counting on this happening again, and are well positioned to acquire cheaply assets when they come up for sale.

Back to our current issue: Would a change to the mark-to-market rules solve our problem?

Wall Street argues that marking illiquid assets to market does not reflect their true value, and that marking them down will only damage the firms rather than impart the intent of FASB 115 - to reflect "impairment." In other words, the losses incurred from writing these assets down are imaginary, not real.

What is real is what can and has happened after these writedowns occur - the firms' capital bases are diminished, on paper, so that they are out of compliance with required regulatory capital causing:
1) investor panic which leads to a stock price freefall;
2) depositor panic which leads to deposit outflows;
3) trading partner panic which leads to elimination of trading lines and short term loans.

A precipitous stock drop is bad. Losing deposits and lines of credit eliminates liquidity and causes firms to shut the doors, ala Bear, Lehman, Indy Mac, and WaMu.

So will suspension of Mark-to-Market rules stop this trend? No. and, Yes.

No, in that I am not so sure that if previously written down assets were to be written back up, that the stocks and liquidity would suddenly return to previous levels. The cat is out of the bag, ie investors and analysts would be skeptical of capital bases suddenly inflated by an 180 degree turn on this issue.

Yes, however, it should help in respect to additional writedowns. Financial firms have not written down all their assets to the extent that they truly reflect the price at which they would trade, or that would reflect their value in today's world. This is particularly true in that prices keep dropping every day. It is an impossible task, and it largely depends upon assumptions of supply - what assets are assumed to be traded and how much at any one time.

So what to do? Certainly, we need to do SOMETHING!

So I yield to Wall Street: Lets temporarily suspend FASB 115 and FASB 157. But we need to make sure that this isn't an opportunity for weak institutions to mask their problems.

In Japan's economic crisis of the late 1980s through the 1990's, the banks did not write down assets to reflect true losses due collusion with government officials. Instead the government lowered interest rates to 0% in order to stimulate the economy. This lack of recognition delayed banking reform and caused Japan's financial markets to be stagnant for almost 15 years.

This could certainly happen in the US.

So, instead of writing down assets per the Mark-to-Market rules, financial institutions would identify with much more specificity the assets affected. How much real estate backed bonds and related derivatives do they have? How much in direct loans? How much in credit default swaps? What are their lines to other financial institutions? How much of each asset type are in default?

Clearer information about the portfolios would allow investors and lenders to make better decisions about which financial institutions are healthy, and which need help.
Also, since writedowns are subjective, this approach would not penalize or reward firms for being conservative or aggressive with their valuations.

However, do not think that this will suddenly float our markets. That will take time, more capital, and an economy not solely driven by real estate.

Subjects for future posts.

Legislative Idiocy - Its Like Deja Vu All Over Again

Turnaround/Vulture investor Wilbur Ross recently predicted that 1000 banks will be forced to close within the next year or so (and he has raised a fund to buy a bunch of assets). History suggests that his claim is modest. In its existence, the Fed has closed 3,286 banks. 82% of these, or roughly 2600, were closed in 1990-1992, the last time the government stepped in to help us out of a financial mess with an imbecilic strategy. The centerpiece of that strategy was the Resolution Trust Corporation, or the RTC as it became known.

In that sterling example of clouded thinking, our government legislated against banks making leveraged loans (Highly Leveraged Transactions or HLTs) which limited borrowers' ability to refinance. The government then forced the closure of the Drexel Burnham (basically because some guy named Milken made $410 million one year), a firm that at the time controlled over 80% of the leveraged bond market. In two seemingly unrelated actions our government utterly closed the refinancing market. Corporate borrowers therefore defaulted, and the prices of bonds fell from par to roughly 33% of par. Nice job.

Why did the government do that? LBOs and their companion junk bonds had gotten lots of bad press as Uncle Wally and Aunt Millie lost their jobs to corporate restructuring. Junk bonds and LBOs were deemed "bad", and the government in its infinite wisdom wasn't going to stand around and let it continue willy-nilly.

The problem? Lots of insurance companies and savings & loans held these bonds as assets. So the value of their holdings fell, wiping out their equity to the extent that they no longer had the required regulatory capital. The Fed stepped in, took over a bunch of banks and S&Ls, and handed their assets over to the RTC. With the closure of banks and S&L's and coincident recession these actions caused, the housing market had little liquidity, causing a downdraft in real estate prices, leading to real estate loan defaults, which led to more bank and S&L failures.

The RTC proceeded to hold an unprecedented gi-normous and hasty liquidation. California did its part - foreclosing on three huge insurance companies (Executive Life anyone?) and itself hosting a bulk sale of their assets. Predictably, asset prices were low; real low. Buyers of these assets made out like bandits (within twelve months the buyers of the Executive Life bond portfolio tripled their money); the American taxpayers, including Uncle Wally and Aunt Millie, were stuck with a $1 trillion bill.

Notice any parallels with our situation today? We have to a degree a government induced reduction of liquidity (sub prime loans, like junk bonds, are "bad"). We have a huge government agency acting to take on lots of illiquid assets. We have structural weakness in our financial institutions, and we have lots of cash waiting on the sidelines (Buffet/Goldman, Wilbur Ross and others) to take advantage of illogical pricing to make a fortune. And we have the American taxpayer who is resigned to picking up the tab once again.

At least in 1991 the surviving financial institutions were in a position to get back to the business of moving money around. That's because largely the commercial banks (if you ignore Bank of New England) and the investment banks (excluding Kidder Peabody) had not been caught up in holding these assets, and the talent from Drexel became disbursed across Wall Street to create a vibrant bond market - renamed from "Junk Bonds" to the more politically acceptable "High Yield" bonds.

Just as importantly, in 1991 the US was on the cusp an 8 year increase productivity, led by the widespread adoption of the PC in the work place, the lowering of interest rates, and some would argue to the revival of the LBO. These productivity gains drove our economy to unprecedented heights.

Today, virtually all of our financial institutions are tainted by our financial mess, and our economy has not seen material productivity gains since 2001. One year after 1991 the US began an eight year period of expansion. Unfortunately, current conditions do not suggest a repeat of that history.