Follow Up: What Type of Investors are SWFs

Well, if Nicky Sarkozy gets his way, they'll be the worst kind. Apparently he has fallen off the wagon along with the rest of our world leaders. He wants a Europe-wide SWF which has the following stated goal:

"buy stakes in companies with low share prices and protect them from foreign predators"

Strange, back in those naive, silly days of capitalism, a low share price indicated that the company had poor prospects and thus was not a good investment. Back then, the share prices suggested that these companies faced quaint capitalist problems like overbearing competition, bad management, too much debt, bad products, or litigation.

Thankfully, the New World Order has seen the light. They've finally recognized that economies following Marx, Engels, Lenin, and Stallin have always been so wildly successful and stable precisely because they outlawed those nuisances above. Just like the pickled corpse of Lenin in Red Square, they insisted on preserving their rotting businesses at the expense of focusing money and effort on fresh, vital ones.

Yuck.

At the Risk of Stating the Obvious: Too Much is ... Well ... Too Much

I'm declaring an end to my blog-strike protest, but I'm certainly not getting over it's original cause. The floodgates are open. Bad, inefficient, uncompetitive, loss-making businesses are being propped up rather than forced to release their capital and get out of the way for someone who can actually make money with it. Return on capital is so '80's. Terribly capital inefficient projects are being brought out of governmental garbage heaps by heavy Keynesian hands. People who paid too much and made too little for their McMansion and Merc are going to be "rescued" from themselves (no matter who becomes president).

Anyone who is currently faced with a "cut your losses" prospect is highly incentivised to wait a while, maybe even make their situation a little more dire, and then scream for a rescue. As Ayn Rand feared, the notion of "from each according to ability, to each according to need" is fast becoming a reality.

Governments globally are assuming the role of [incompetent] banks by assuming bad debt and making foolish loans. Counterparty, market, and credit default risks are being glibly transferred to sovereign risks.

It's always tempting to throw good money after bad. Temptation has finally won. If I were a religious man, that statement might give me cause for concern.

As an economics man, it gives me horror. Without solving the root of the current crisis, we've sewn the seeds of the next.

It will be a doozy. With each crisis, our helpful nanny-leaders grow more sure that we, the lowly citizens cannot be trusted with ourselves but must be kept on tight choke collars. More regulations. More taxes. More reallocation of the money we earn. It's for our own good, they keep telling us as they encroach ever further into our ability to progress (personally and as a society). Times are different, they say. This is unprecedented, they say.

They are not, and this is not. We've had many a crisis before, and unfortunately with mixed outcomes. The stronger the pain, the more severe the whiplash response ... and the more unpredictable.

I'll return to my mantra (and notice I am unable to channel Keynes). No one can live beyond their means for long. Temporary rescues just forestall the fall.

Follow Up 2: Idle Shareholders

Jinx!

Apparently, at the exact same time I was blogging about irresponsible boards, Carl Icahn was on Fast Money echoing my comments, right down to my "fox in the henhouse" allusion. The video is here. For the record, I first said this about corporate execs back in July. Also for the record, I'm sure he's been saying it since before I was born. It's just nice to be in good company!

In a nutshell, Icahn doesn’t feel corporate management is properly held accountable for their actions. And going forward, he’s determined to see that they are. "It's like asking the proverbial fox to guard the henhouse," he said. Ichan said he is starting a cause called the United Shareholders of America to fight in Washington to change the rules on how corporate management in America operates.
- Unintended Consequences, Recap of CNBC's Fast Money, Seeking Alpha Blog 10/6/08

Follow Up: Idle Shareholders

Way back in July when the financial crisis was just a dull, irritating hum, I wrote a blog to explain the biggest reason why big corporations go afoul. In short, I argued that CEO foxes are left to guard the corporate hen house by absentee owners (shareholders) and their surrogates (fund managers).

I promised to be back with some suggested cures for this corporate cancer. So here I am ... with a new buddy.

Governance Guru Nell Minow talked to Congress about Lehman today. After watching the proceedings, I'm certain they brought her in to lend a sliver of credibility to their populist attack on executive compensation, but she slyly took the opportunity to point the finger a different direction:

the board was too old, had served too long, was too out of touch with massive changes in the industry, had too little of their own net worth at risk, and was too compromised for rigorous independent oversight

I couldn't have told the story better myself. Therein lies the problem and the cure for the cancer. The Board are the ultimate representatives of shareholders, and they are just as guilty of negligence as absentee shareholders. If leverage over CEOs can be had, the Board is the vehicle. The trick is to fix their incentives in order to align with shareholders at large.

A Board seat is a position of honor and prestige. Unfortunately, some members are after these alone, and only grudgingly accept the duties of representing shareholders. Some don't even bother to pretend they care. They usually get nominated because they are famous or connected, not because they are qualified. To align the Board's interests with the interests of us shareholders, we must flex our public opinion muscle by pressuring ALL corporations to implement some game rules.

• Corporations must finally figure out what Governance really means. I'll devote an upcoming blog to this one soon. As an amuse-bouche, I offer the Washington Post's 2006 corporate governance primer.
  
• Boards must meet monthly. Each committee must meet twice monthly or more. Repeated truancy must be rewarded with expulsion. If this is too burdensome to fit into one's social calendar ... well, board seats are not for everyone.
  
• Executives must not sit on their own boards. Period. They can submit proposals. They can submit reports. They can visit when invited.
  
• In the interest of combatting boardroom ADHD, board members should focus on one organization in most cases.
  
• Board members must "buy in" just like a poker table. And the stakes must be enough to make it interesting to them. Explicitly, shareholders must invest a significant share (25% might be a good guideline) of their net worth in the company's common stock or unsecured debt. Furthermore, they must agree to sell deeply underwater puts with expiry at least 5 years out. These must be rolled each year they are on the board, such that they continue to be in force for 5 years after departure from the board. Again, if this sounds too harsh ... NEXT. I can already hear people calling me elitist, "if seats are bought, only the rich will have them." To that I counter that anyone should be able to get on the board if enough shareholders are willing to "sponsor" them. But then it's up to those shareholders to actively police their representative.
  
• Board members must be able to demonstrate a germane area of expertise. For some it might be accounting, for others economics, for others management, for others past experience in the industry. If their only claims to fame are money and ... well ... fame ... NEXT. This should be policed by the owners. Here's a million dollar idea for someone: set up a board member rating agency. Nell's group The Company Library is a good start, but focuses on the enterprise as a whole, not specific board members. Additionally, their soup-to-nuts prosaic appoach is a bit much. My advice (to them or their start-up challengers): keep it simple: A through F based on pre-determined and public criteria.

This is just a starter kit. I'm sure Nell and the other Governance-ators have their own hats to throw in the ring. Go ahead, new buddies-o-mine!

What Will Tomorrow Bring: the TARP Bonanza

To my chagrin, TARP passed without consideration of other options ... and with a disgusting dose of pork which had NOTHING to do with our current financial situation. The worst of Washington yet again.

So what will Wall Street do in response to this shiny new program?

• A number of banks will take this opportunity to PASS. They will recognize that doing so will put them at a strategic long-term advantage over competitors who will be hamstrung by the plan's restrictions. They'll be able to spin this to their PR advantage as they swagger that they're too strong to need such handouts.


• Accontability will be a joke, as will the valuations used. Nobody except the sellers will do enough due dilligence to understand what goes on.


• There has already begun a feeding frenzy of asset managers and prime brokers pining to become "financial agents of the Federal Government" (as they're called in the text of the act). Those cozy enough with their regulators and the Treasury will win these noncompetitive contracts will help Hank blow his new riches. These will be the biggest winners of the whole event. I don't like to drop names, but ... cough, cough, Goldman, Chase, cough.


• US Debt will march north. It will get more and more expensive to find lenders. Thus, treasury yields will go up. This means the cost of serving the national debt will go up. This means the government will have less to spend on other things ... OR they'll just continue to borrow. One of the "sweeteners" in the final TARP was to raise the national debt ceiling got raised to an unfathomable $11,315,000,000,000.00. Oh, and "any amounts provided in this Act shall not be counted for purposes of budget enforcement." At some point, we pass the number we'll ever be able to repay. The country becomes that downtrodden dude who will take 137 years to pay off his credit card (at the minimum payment) ... but with several score more zeros. Then the choice is:
• Undertake a painful, suicidal "fiscal austerity" program like we've imposed on many a Banana Republic
• Default on the debt
• Inflate the currency until all those zeros aren't so daunting to pay off


• My prediction: Inflation will march north along with the debt. This will throttle both savings and borrowing in the US. It will depress the value of the Dollar. It will shave points off growth. It will eat away asset values of ordinary Americans and provide a disincentive to save.
  
• On a brighter note, Europe, Southeast Asia, India, and South America will experience 1.5x the pain we do here in the US.

Federal "Stay in Your Home" Insurance

Never thought I'd be happy about Congressional ineffectiveness, but in this case I'll make an exception.

Their inability to get anything done properly has given us a (few) breathless seconds to think about alternative steps to help soften our inevitably bumpy return to Earth from our debt-propelled cruise through the stratusphere.

I'll stay within the conceptual confines of "big government action" that apparently everyone is hungry for right now. How about ....

A new Federal "stay in your home" insurance program. Here's how it might work: Anyone with a mortgage on their primary residence can sign up for a Federal plan which allows them to opt for a renegotiation as an alternative to foreclosure if they have permanent trouble making payments. Eligibility criteria might look at the ratio of monthly mortgage payment to average monthly household income. The terms of the renegotiation should be standardized: either lower payments by extending the lifespan of the loan at the same rate ...

... OR lower payments by swapping with the Federal government a portion of the loan balance for a portion of the home's appreciation when the house is sold (or when it is paid off or refinanced, whichever comes first).

Tactically speaking, on the front-end, the insurance program would cut a one-time check to the lender for that portion of the loan, and the payments would be re-calculated based on the new balance and the original loan lifespan. On the tail end, the house sale would be subject to an additional "swap tax" which would be the greater of the amount originally "swapped" or a percentage of the capital gains large. The percentage would be set at re-negotiation based on the ratio of initial loan value to "swap" amount. For example:

If the borrower STILL fails to live up to their new, lowered, expectations, they might choose to swap again if there's enough home equity ... or the lender would proceed with foreclosure.

Clearly negative-ammortizations and HELOCs above 100% of equity would not be eligible. I'm sure realtors and mortgage bankers can think of other sensible clauses to ensure the homeowner doesn't simply let the house go to shambles. On the other side of the moral hazard coin, we'd have to figure out how to guard against abuse of the program or artificial manipulation of sale price.

The free marketeer in me would like to see these programs offered by the financial industry, not the Feds in the interests of overally efficiency for the macro economy, but I present this idea as a government plan to demonstrate that it could be run with minimal risk to taxpayers. A big buzz-concept in the coming years will be public/private cooperation. Applying that to my idea would be as simple as allowing the government turn around and sell these swaps in the open market in order to ensure market pricing.

Chalk One Up for Democracy

Has the Paulson Plan finally awakened the sleeping giant again?

Representative democracy seems to be working today, as US citizens have put a (finally) irresistable tidal wave of pressure on their elected officials NOT to sell our childrens' financial futures down the river.

Evidence: the government's internet servers for websites including http://www.house.gov/ have been entirely overloaded all day with citizens logging in to express themselves to their elected officials. Mark my words: they'll report a record number of hits over the last 24 hours.

How About a Plan That DOESN'T Bankrupt the Country

By now I've made clear my disapproval of the socialist programme Paulson proposed. What a disappointing liberal in conservative clothing. I'm slightly softer on Bernanke, who's still trying to recover from his delivery from the womb of academia into the real world where execution is the bugbear of pristine theory.

I understand that "everyone" (read: those loud enough to get Washington's attention; read again: whomever can wield the most bucks and/or votes for the politicians) is in a hot lather to secure their place in history by putting their fake-smiling face on something impressive.

Guys, what would impress ME is something WORKABLE, SIMPLE, TRANSPARENT, SUSTAINABLE, FISCALLY SOUND, PRO-LONG TERM GROWTH (as opposed to pro-short term bubble, leading to long-term crash), PRO-CAPITALIST, PRO-GDP.

I do NOT believe ... in fact it's just asinine and insulting to think we would believe ... that credit has flatly "siezed up" and the only answer is a bail-out. Perhaps the borrowers don't like the current rates, but there is ALWAYS money available to be lent if the rate is high enough. Yes, it will hit their profit and thus their stock price and thus their bonus. Deal with it or get out!

Same goes for equity issuance: if the firm is, indeed, a going concern with a simple liquidity problem, there are ALWAYS investors available to buy in if the value is good enough. As we saw this week with Buffett and Goldman, a true value investor sees through the temporary assyncronicities and depressed market valuations created by the "fire sale" prices at which the so-called "toxic" assets are currently trading ... and the mark-to-market rules which are launching these depressed asset prices like cannonballs into the accounting hulls of these financial ships.

But I'm not just here to carp about others' plans ;-)

Without further ado, I offer my own rescue plan:

1. Central banks manage market liquidity and interest rates via open-market operations ... as they've been doing all along
2. Central banks act as lenders of last resort ... as they've been doing all along. They must, however, lend at market-equivalent (risk-compensating) rates, not politicized giveaway rates. If the (true, non-hyped) size of the crisis merits, these central banks should be allowed to lend at longer maturities (30 days up to 2 years) in order to provide some financial stability for borrowers. Collateral requirements must NOT be softened.
3. Congress must immediately cancel their winter hibernation. They can go on vacation once they've balanced the ENTIRE Federal budget, not a day before. If they can't do it before the election, they should be replaced by the voters. I don't care what it takes, we have to stop living on credit, and Washington is the best place to start.
4. Insolvent companies must go bankrupt. Period. Using the money available via points 1 and 2 above, new entrepreneurs will have a spectacular opportunity to take over businesses and run them better.
5. Insolvent households must go bankrupt. Period. They don't have to lose their jobs. They don't even have to lose their roofs (they can rent their McMansion from the new owner or they can negotiate a new lending arrangement via mandatory bankruptcy arbitration). But the Escalade must go. The European trip must go. The morning Starbucks must go. The 52-inch flat screen must go ... which means the digital cable can go too. Groceries must come from Costco, not Whole Foods. Yes, I love these things too, but those who have put themselves in a financial pinch must now do whatever it takes to get current expenses below current income so they can start paying down debt or building up savings. Period.
6. Incompetent politicians, bankers, and executives must be demoted. Just one notch. There's never been clearer vindication of the existence of the Peter Principle of promoting people until their job is beyond their capabilities.
7. The mark-to-market rule must go. Accountants and regulators over-reacted to earlier problems by creating opposite but bigger problems. Something better must be found in short order, but for now it's just causing unnecessary liquidity crunches and extreme volatility. Next time: try matching asset valuation to it's NPV based on expected length of holding, not frenetic current market price.

If I have to concede a point it is this: If the US government MUST take on assets, they should be placed in a new US SWF. For expediency, this SWF can initially be managed using the governance and by-laws of Temsek (a long-standing Singapore SWF). Everything must be transparent and done at market rates. The fund should be managed for profit by a set of (private, contracted) fund managers using the afore-mentioned Temsek goals on profitability and long-term stability. Period.

I'll be back with a post about longer-term steps...

... Suffice it to say banking regulation must be revised, not to increase the presence of government, but to bring it up to the 21st century and to set capital free to seek the proper balance between maximized returns and minimized risk without economic/financial/business novices in the government meddling.

... Suffice it to say bankruptcy regulation must be more expedient and cooperative without economic/financial/business novices in the courts and law firms meddling.

... Suffice it to say we need an entirely new take on government accountability.

... I'll be back!

What Will Tomorrow Bring: Black Ink for Everyone!

Putting my conspiracist hat on...

Isn't RTC2 (aka TARP) shaping up like a back-door SWF ... only on borrowed money, since that's the new American way?
Aww, you shouldn't have. I always wanted the US to have a SWF! And this one's a bee-ute!

Perhaps this is just a big surprise present to future generations ... kinda like how High School seniors give the school a parting gift before graduation. Just think ... Paulson, in all his wisdom, and with his near-zero cost of capital, buys up major chunks of US assets.

He lets them ripen.

He sells them for twice the purchase price. He pays off the national debt, puts Social Security on sound footing, and even has left-overs for Obama's gazillion-dollar social and healthcare programs.


Merry Christmas, 2058!

Dear Hank

To Hank with love ... I'd like to offer you a gift. Out of my own pocket, I want to buy you a nice long vacation. I'm serious. Anywhere you wanna go, any price, any number of weeks. Anything you ask. You need to get away for a while. You've done quite enough here, thank you.

Yes, I'm breaking up with you. It's not you, and it's not me. We've just grown apart. Well, to be frank, your deal-making addiction and shop-a-holism just leaves no room in your life for me. Don't feel ashamed. You're not alone ... and it wasn't your fault. The peer pressure from those rowdy new buddies of yours down in Washington must have been just too much. I care enough about you to say this: seek help. Really. You'll thank me someday.

Honestly, warts and all, I'd keep ya ... but it would never last. I just can't afford the kind of lifestyle you require. If I was made of money, I promise, I'd have bought you the auto industry like you asked last Christmas. I kept working weekends saving up for that "Brazil" place you said would make you my best friend forever ... but darn the luck, I put everything I ever had in the markets, and well, you may have heard they're gone.

I did the math and it turns out I can't even pay the minimum balance on that credit card you used to buy 10% of America's home loans for a trillion bucks. I think you probably could have gotten that cheaper if you had looked online. I know you like to shop, but I think you need to take this one back to the store. It's just over the top. Garish. Gaudy. You don't want to be gaudy, do you?

No, I'm going it alone ol' chap. Probably won't be emotionally ready for another Trust Me Treasury Secretary for a long time. You'd best return some of the stuff you bought or find yourself 300 million new sugar daddies and mommies before the next installment payment comes. Try Russia or China. I hear they have some extra ones.

May God bless and keep you far away from us,

Your most humble, loyal servant for the forseeably indebted future,

n.b.dubya