Greed Gone Wild

I leave this here for public domain, if it has not already been coined.

This ought to be the title of the book.

Hank Paulson & Co.: World’s largest hedge fund

How do you bail out a global financial crisis, born of wild speculation, financial engineering, fear, greed, ignorance and massive leverage?

Well dummy, of course there is only one way.  Lever up one of the world’s largest balance sheets and simply start your own trillion dollar hedge fund to prop up markets and to make an stratospheric return.  What more would you expect from the former CEO and Chairman of Goldman Sachs.

Just consider the terms of the AIG deal.  $85 billion loan at 850bps over 3-month libor or approximately 12% or $10.2B/year in interest payments plus79.9% of all of the equity at a share price of approximately $2 or a market cap of approximately $5.5B on a company that one year ago was trading at $60.

I realize that with the recent and pending write downs that those losses go to equity holders first and as such it may not be entirely fair to compare $2 today to $60 a year ago, but it is also not fair to recognize that the AIG’s, FRE’s and FNM’s are not going away.  They own massive pools of assets that pay them perpetual royalties.  Add to that the fact that some of the greatest value investors have long-term investment horizons, look for companies with monopolistic characteristics, strong consistent cash flows, and great brand recognition.

With the news on Friday that shareholders may attempt to block the hostile takeover of AIG by Hank Paulson & Co., it only adds one more layer the idea that this looks more and more like hostile active investment by a large hedge fund.  When H. Paulson & Co. starts buying private firms we can give him the dubious affirmation of being a private equity investor.

Given that the Freddie and Fannie deals were structured similarly, and given the sheer size and cash flows associated with these firms who’s core revenue streams are annuities in the form of mortgage payments and policy payments, I can’t help but wonder if these savvy investments now being labeled as bailouts, are not infact the tail wagging the dog.

It’s only a matter of time before Paulson sees the short treasury trade.

Corporate Governance: Redefining Independence

In the wake of Enron and Worldcom many of us assumed corporate reform was complete after the last recession ended.  After all, even Yahoo Finance began publishing CGQ (Corporate Governance Quotient) scores as compiled by ISS to their company profile pages.

As I began writing this, I was lucky to find the summary page from Yahoo on Lehman (Ticker: LEH).  Since Lehman has filed for bankruptcy and subsequently delisted during the week, you can no longer find it on Yahoo; however with the magic of Google I was able to access the information via a cached page from a few days before Lehman was delisted.  In fact at the time the page was cached, the stock was still trading at $4.5599.

Lehman Brothers Holdings Inc.’s Corporate Governance Quotient (CGQ®) as of 1-Sep-08 is better than 41% of S&P 500 companies and 87.6% of Diversified Financials companies.

A company’s CGQ is compiled by scoring each firm across 8 metrics.  These include, as noted from an ISS website about the ratings:

Eight core topics comprise the [CGQ] rating: (1) board structure and composition, (2) audit issues, (3) charter and bylaw provisions, (4) laws of the state of incorporation, (5) executive and director compensation, (6) qualitative factors (7) D&O stock ownership, and (8) director education. The score for each core topic reflects a set of key governance variables. The current list comprises 61 of these sub issues. In addition, some variables are analyzed in combination with other provisions. For example, a board with a majority of independent directors and all-independent key board panels (audit, nominating and compensation) receives a higher rating for each of these attributes than it would if it had either one of them in isolation.

How could a company who’s CGQ score outperformed its peers by 87% be the first and only thus far not to find a way out insolvency?  Of course, the fact that it scores so high relative to peers does not address why the pack of diversified financials falls into the bottom of the broader comparison to the S&P 500.  That is a separate discussion of what we expect and accept as risks to the financial system.

As I posted recently with regard to Freddie and Fannie, at least part of the outcomes we are seeing in the markets and will continue to see are driven by the most human of factors, people.  The remaining blame will fall on the system itself as the rules of the game will need to change along with many of the players.

Although, one would assume (and probably did) with a relative ranking of governance as high as Lehman had to its peers, that the board of directors would have had both the information, structure and ability to intervene at one of the half dozen offers Dick Fuld turned down in the weeks leading up to the firm filing for bankruptcy.  Whether the aptly named Dick could have sold the entire firm at $40, $33, $27, $17, $12, or even at $6.50–which was recently reported as the final offer Mr. Fuld refused from the Korean Development Bank–is now a moot point.  The question now is why didn’t or couldn’t the board intervene to force the brass-balled CEO to take a deal?

I don’t know that I have the real insight on that question, but based on publicly available information, one can look at the board to at least see if it maintained a level of diversity concurrent with a best-in-class among peers ranking.

Below is a list of the directors of Lehman Brothers as reported on their website (for as long as that lasts).

Richard S. Fuld, Jr.
Director
Chairman and Chief Executive Officer

Michael L. Ainslie
Director
Private Investor and Former President and Chief Executive Officer of Sotheby’s Holdings.  Mr. Ainslie has been a director of Lehman Brothers Holdings Inc. since 1996, and serves as a member of the Audit Committee.

John F. Akers
Director
Retired Chairman of International Business Machines Corporation. Mr. Akers has been a director of Lehman Brothers Holdings Inc. since 1996. He serves as the chairman of the Compensation and Benefits Committee and as a member of the Finance and Risk Committee.

Roger S. Berlind
Director
Theatrical Producer. Mr. Berlind has been a director of Lehman Brothers Holdings Inc. since 1985. He serves as a member of the Audit Committee and the Finance and Risk Committee.

Thomas H. Cruikshank
Director
Retired Chairman and Chief Executive Officer of Halliburton Company. Mr. Cruikshank has been a director of Lehman Brothers Holdings Inc. since 1996 and serves as the chairman of the Audit Committee and as a member of the Nominating and Corporate Governance Committee.

Marsha Johnson Evans
Director
Rear Admiral, United States Navy (Retired). Ms. Evans has been a director of Lehman Brothers Holdings Inc. since 2004. She serves as the chairman of the Nominating and Corporate Governance Committee and as a member of the Compensation and Benefits Committee and the Finance and Risk Committee.

Sir Christopher Gent
Director
Non-Executive Chairman of GlaxoSmithKline plc. Sir Christopher has been a director of Lehman Brothers Holdings Inc. since 2003. He serves as a member of the Audit Committee and the Compensation and Benefits Committee.

Jerry A. Grundhofer
Director
Chairman Emeritus and Retired Chief Executive Officer of U.S. Bancorp

Roland A. Hernandez
Director
Retired Chairman and Chief Executive Officer of Telemundo Group, Inc.. Mr. Hernandez has been a director of Lehman Brothers Holdings Inc. since 2005. He serves as a member of the Finance and Risk Committee.

Henry Kaufman
Director
President of Henry Kaufman & Company, Inc.. Dr. Kaufman has been a director of Lehman Brothers Holdings Inc. since 1995. Dr. Kaufman serves as the chairman of the Finance and Risk Committee.

John D. Macomber
Director
Principal of JDM Investment Group. Mr. Macomber has been a director of Lehman Brothers Holdings Inc. since 1994. He serves as a member of the Compensation and Benefits Committee, the Executive Committee, and the Nominating and Corporate Governance Committee.

What is striking is how the board passed the diversity screen.  While on first glance we see a broad cross section of directors from different industries, note that aside from two, all of them have lead major corporations.  Four of the eleven have experience running large financial institutions, seven of eleven have been in a senior leadership post at a major public U.S. corporation, and two truly external board members have little experience in either running a major corporation or with financial markets in general–but both of them made it on the Risk Committee.  Furthermore and most importantly, seven of the eleven directors, including Dick have been together for over 12 years.

Now ask yourself how if convened in a room together, how the chemistry of the cast of characters could possibly have lead to a coup to save the firm from Dick’s massive game of chicken between suitors and the fed.  I’ve been in enough meeting rooms to know that I certainly would have had a hard time, and I’m sure this was not an intellectual conversation, convincing a majority of them to ask Dick to step down.  This board was architected to meet the perception of propriety, not propriety itself.

There were a lot of failures last week in America, many of which were inescapable.  Some of them are human errors, some errors of omission, deception and fraud.  Some of the mistakes were systemic, created by antiquated legislation and oversight in a modern financial system.  Leadership in all its forms have been scarce at all levels.  Greed, fear and ignorance abound in a marketplace with so many faults removes the actual ability of self preservation.  Just think of the many people whose money market funds broke the buck and the fact that the fed had to step in to guarantee that this would not be allowed to happen again at taxpayer’s expense.

Among the many areas of reform we must reconsider, if our system is to regain both solid footing and long term trust, is going to be how we measure good corporate governance.  While we decided five years ago that good governance was important to the safety of the system, this lever like many of the others we had in place, has failed us.  I provoke that it is not just the transparency of good governance that matters today, when combined with the perverse incentive systems we have created, it will be how we measure the data we have begun to collect.

The leaders and governing bodies among us will be working to stem the crisis in the weeks ahead.  However, in the months and years ahead we are going to need to do a better job of measurement.  Measurement of risk (financial and social), and of governance.

John Mauldin’s Thoughts from the Frontline

Mainstream media is something I have lost my taste for, mostly since 9/11 but more so over the last year.  The realization that the sale of eyeballs or click-throughs is what drives the creation and distribution of “news” is sobering.  A good case and point was the zeitgeist of stories around Lehman Brothers up until its filing for bankruptcy last Monday.  Up until then, Gasparino, Bartiromo and a host of other aspiring Tom Brokaw’s latched on to, and puffed up stories, mostly based on rumors, about the venerable institution.  When I learned that David Einhorn’s wife once works for Barron’s, before she was fired, I only confirmed my conspiratorial aspirations that the global media might actually be in bed with the short community.

That said, when Lehman Brothers, the name that sold so many papers, and drove millions, if not billions, of click-throughs for months finally went bankrupt, I did not find a single story that actually dug further than the surface to report that (at the time) many parts of Lehman were still operating.  If I only judged by the numbers of email and phone calls from people who thought I was out of a job, having worked in the Private Investment Management Division, I would have said that not one reporter did an ounce of due diligence.

A colleague of mine, who is an attorney, brought a copy of the bankruptcy filing to work the next day.  Very simply, the filing was for LBHI.  We were, at the time, working for LBI.  Neuberger Berman of course is incorporated as NBI.  And there are a host of other wholly owned subsidiaries under the parent LBHI.  However, I suppose the words “Bankrup” and “Lehman Brothers” in the same sentence were way to valuable to concern a “reporter” or an “editor” with the truth, which if they had dug deep enough was even more interesting, so much so, I cannot scribe the real story here

That said, these days there are few authors whose opinions I feel merit consistent attention.  With most computers being used to profit by the keystroke, it is rare to find research and insight that penetrates to depth without concern for ink, paper, eyeballs, click-throughs or profits.  I posted just two days ago a blurb on mark to market accounting that afterwards I wish I had elaborated more on, and in all honesty had more time to elaborate on.  Now, just two days later, my favorite newsletter arrived in my inbox.  This is the only email that I read anywhere and at any time I get it.

In any event, I implore and encourage any lonely straggler who stumbles on this blog to redirect your efforts to John Mauldin’s Thoughts from the Frontline.  If there ever was someone with a crystal ball, who’s comments avoid the prophetic but border more on the wisdom, insight and vision of a parent, John is it.

The newsletter, distributed today, I felt was of particular brilliance.  I only hope it makes its way to the fed this weekend before they finalize the terms of the RTC -Resolution Trust Company to buy all the stinky assets from America’s shortsighted financial institutions who were over reliant, as Nassim Taleb said, on Gaussian risk management techniques.

Please take the time to read John’s newsletter from today.  In it is a wonderful overview of how we got here, and a real detailed and actionable plan for how we can get out.  He does not ignore the pain we will feel for generations.  And his conservative estimate of $500 billion to solve this crisis I think to be at least half of what is needed.  What he misses here, which I look forward to hearing about in the future, is the implications for inflation with a Treasury in need of printing a trillion extra greenbacks.

You can access the article by clicking here.  Or by visiting: http://www.frontlinethoughts.com/article.asp?id=mwo091908

Just a reminder: Buffett warns on investment ‘time bomb’ (2003)

Tuesday, 4 March, 2003, 13:32 GMT

The rapidly growing trade in derivatives poses a “mega-catastrophic risk” for the economy and most shares are still “too expensive”, legendary investor Warren Buffett has warned.

The world’s second-richest man made the comments in his famous and plain-spoken “annual letter to shareholders”, excerpts of which have been published by Fortune magazine.

The derivatives market has exploded in recent years, with investment banks selling billions of dollars worth of these investments to clients as a way to off-load or manage market risk.

But Mr Buffett argues that such highly complex financial instruments are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.

http://news.bbc.co.uk/2/hi/business/2817995.stm

Hubris & Crimes Against Humanity

How does one measure the loss of life?  Does a life have to have actually passed on to the next to be counted as lost?  Or can one argue that loss of life includes loss of life as we know it, individually or collectively?  Having lost multiple loved ones in my life, I do not want to minimize the permanence of death, but sometimes for the living, the emotions around the loss of continuity can be equally or more devastating than the emotions we face when we lose a loved one.  Logically or not.

As a friend of mine noted, comparing the actions of the Lehman Brothers executive committee and board to that of the Third Reich might be inspired more by anger than intellectual logic.  That is of course because Hitler was at least intelligent and unobscured.  Slobodan Milosevic, however, might be a better example of attaching slander to anger over the hubris that took down Lehman Brothers.

Should we continue to attach a separate value on those who take biological life from those whose damage can be separately but equally devastating?  Is being alive enough of a consolation prize that the rules in place to punish corporate hubris negates options that we impose on those who force a  last breath of others?

Anger is certainly rearing its ugly head, and the anger is only bound to grow as more of Wall Street collapses.  Those who were responsible for this collapse, all of them, need to be brought to justice.  I don’t know if America will settle this time for a punishment that results only in those people selling one or two of their five homes, and selling their commodity exposure, a small portion of their investment portfolio, to pay fines equal to more money than most Americans earn in a lifetime.

To allow the greed and hubris of the last decade result in anything less than criminal prosecution for the loss of a great number of “lives” of the living would be the largest crime of all.

While the great divide between Wall Street and Main Street at the moment may be insulating “normal” American’s from the shocks of the last few days, it is my opinion that the collective anger will grow.  2008 is supposed to be the dawn of Aquarius.  Maybe this anger will inspire the revolution.  Or maybe the dawn of the new age has begun.

Vulnerability

I wrote this somewhat provocative and easily perceived as overly fearful blurb last night as part of another post.  After a good friend offered some thoughts, I made a few slight changes, separated it and am re-posting it here.

My larger fear is that this [current market crisis] leaves us vulnerable in ways we have not yet begun to imagine.  Around the world rouge groups have apocalyptic dreams of wiping capitalism from the planet.  While that most likely would never happen, the current economic crisis affords them a window in their mind to try again, much like the window created by the dot-com collapse and corporate scandals prior to 9/11.  Please don’t underestimate the intelligence of our enemies and please understand that there is more at stake here than a few wall street CEO’s, investment bankers, and even more than middle America.  Our national security, in a world filled with rogue states, is now terribly compromised.

As I arrived at work this morning and checked the news, there was a top story on Bloomberg about Ahmadinejad once again stirring the pot from the desert across the pond.  At this point I hope the Federal Reserve is in constant communication with intelligence agencies, the National Guard and the Pentagon.

Aged 158 years

If the marquee sign of Lehman Brothers itself was to be buried at Trinity Church–the storied church that resides in concert with a cemetery karmically placed at the end of Wall Street–in memorium of the once venerable Wall Street investment bank’s rapid and tragic collapse, it would have a tombstone that read, at least in part, “aged 158 years.”

At least that is the thought that passed through my head while I was exiting a client meeting the day after my firm filed for bankruptcy.  Despite growing up in Manhattan, and passing Trinity Church more times than I care to remember, even before my Wall Street job, for some reason that day (yesterday) was the first time I noticed how charming and peaceful the church and adjoining cemetery really were.

The irony of the fact that Wall Street dead-ends at a church and a cemetery struck my friend and colleague with divine inspiration.  However, my laughter was muted as I began to read some of the inscriptions on the tombstones.

The care for which the tombstones were written and most likely hand carved, juxtaposed to the now seeming triviality of having just seen one more US financial institution fail, hit me particularly hard.  After all, I had just sat at a conference on investing a week earlier where one of the speakers ended his diatribe with a trite reference to the legacy we are each remembered for as referenced on our own tombstones.  Admittedly I have not spent much time in cemeteries, but I quickly felt that the words on those stones were penned in a time filled with much greater humanity and intelligence than we are afforded today.

Is capitalism fated to lead to socialism?

Dear Federal Reserve Board,

Why can’t we stem this crisis by working with FASB, the SEC, FINRA and others to change US Accounting laws?  It would solve much of the death spiral we are in and it would save the treasury trillions that it is going to have to print to keep the system afloat.  Seems to work OK in Europe, and it might even give US corporations even footing in a global economy.

After the brokers, then we’ll see large hedge fund failures, more bank failures, auto, airlines…etc.  The end of capitalism ought not be socialism as the US Treasury buys American companies, selectively.  Or from another point of view, should the US Treasury become the world’s largest hedge fund?  We need to find a more social set of economics that protects us from ourselves.  I think removing mark to market accounting will seriously challenge the current death spiral we are in, if done appropriately.  Mark to market is backfiring, furiously.  While intended to protect shareholders, it is now having the opposite effect.  I understand that part of this is resulting from the fact that the global economy has been overcapitalized for too long, however leverage, in moderation is healthy.  The massive global unwind underway is only going to lead to massive under capitalization that will cause pain that will be felt for generations.

Under the circumstances I think uncle Ben has done an excellent job navigating the unknown.  But what was unknown a year ago is now clearer than ever.  This is not a crisis of capital, it is now a crisis of confidence.  You can’t keep throwing money at a crisis of confidence and expect it to go away.  The problem with the system is no longer capital, it is in fact the system itself, or said more specifically, the rules that govern it.  They no longer work, the system has failed.  The treasury needs to collaborate with regulators and the private sector to help engineer a more modern system for the 21st century.

If not Uncle Ben’s life long journey to understand the Great Depression will have been more prophetic than practical.

What can you do to help the US Economy Recover?

The following link will take you to a page on how each of your Representatives voted on a bill that included Renewable Energy Tax Credit legislation back in July.  The legislation was not passed, again.

The tax credit (or shall I say the fact that it may disappear at the end of the year) is largely responsible for freezing investment in siting and building new projects which is crimping the pipeline for solar, wind and other alternative energy firms.  If you want to help create Green Collar Jobs, stop the US from bleeding oil dollars to our enemies, and the help build a more reliable and modern energy infrastructure, please diagnose who your own Representative(s) is/are and implore those who have been blinded by lobbyists, campaign financiers, or simple ignorance to reconsider their vote as this legislation comes back for another vote in the days or weeks ahead.

http://www.senate.gov/legislative/LIS/roll_call_lists/roll_call_vote_cfm.cfm?congress=110&session=2&vote=00192

States that don’t get on the front end of this wave are ultimately costing their states enormous tax revenue, job creation, and tax breaks to their constituency in the form of cheaper, cleaner energy alternatives in the long run.

Alternative energy can be one of a number of industries that can help us rebuild and revive America, we the people still have the faith of a global population.  It’s time we take back government and reestablish what democracy was intended for: we the people.