Economics

• If you look in the back, it seems that there were 58 respondents. From page 13: Methodology & Panel Selection Invi… http://t.co/p8sVZl9g Feb 06, 2012
• Will the great interest rate gamble pay off? http://t.co/hgj5XSKc People want to believe that you can get something for nothing; ain’t true. Feb 05, 2012
• Central Planning at the Federal Reserve http://t.co/X8qmqU6C Fed: we can create prosperity by holding interest rates down, right? $$ #wishes Feb 05, 2012
• Labor Force Participation Rate: 28-year Low http://t.co/kLgQ61iK Everyone still happy about the lower unemployment rate? $$ Feb 05, 2012
• Bill Gross: Free Money Ain’t Really Free http://t.co/LXWxpxp5 It will lead to stagflation, IMO, depending on what fiscal policy does $$ Feb 05, 2012
• Life & Death Proposition http://t.co/XuZS5Snn Where does credit go when it dies? Back where it came. It delevers, slows & inhibits ec growth Feb 02, 2012
• US unemployment “progress” http://t.co/WoIVZPGp If you add back the discoraged workers, all of the improvement in U-3 goes away $$ Feb 02, 2012
• The Perniciousness of ZIRP http://t.co/dYlFMbLe Gonzalo Lira on how ZIRP loses effectiveness b/c people think it’ll b there a long time $$ Feb 01, 2012
• Why Neoclassical Economics Doesn’t Work In The Age Of Deleveraging http://t.co/D3IAhTyv Steve Keen explains y Krugman & others r wrong $$ Feb 01, 2012
• Warning: Goat Rodeo http://t.co/JQ2FV9LS Hussman makes his case that equities are overvalued and could pull back 25% $$ Feb 01, 2012
• Who Owns World’s Financial Assets? & Why R US Households So Fascinated W/Stocks? http://t.co/5rp52OM4 American Exceptionalism in investing Feb 01, 2012
• As an aside, that is one reason why the US net foreign debt hasn’t spiraled up. We own equities abroad & they own our debt. $$ declines + Feb 01, 2012
• $$ declines reduce the value of our debts, but not the value of r foreign holdings. I think the US will come out of this crisis rel well $$ Feb 01, 2012

Housing

• Home Prices Tumble http://t.co/N1gdNslr No surprise here with all of the dark supply; houses come onto mkt when ppl can bear loss $$ Feb 01, 2012
• Too lazy to be knowns http://t.co/flXRR6fM I know many who understood what would happen if home RE prices fell, but none who got the size $$ Feb 01, 2012
• Freddie Mac’s “inverse floater” allowed more loan origination http://t.co/5devKZ17 Other side to the Propublica story http://t.co/KjXJHU1x Feb 01, 2012
• I’m no fan of the GSEs; I think they should be abolished, but the GSEs have always made a variety of bets on prepayment over time. $$ Feb 01, 2012

International

• On China, Henry Kissinger and Fareed Zakaria see Domestic Tension and Risk of Geopolitical Conflict http://t.co/1bhvrI3U Ferguson is wrong. Feb 05, 2012
• Tightening lending standards vary materially across the Eurozone http://t.co/ciWUK9cm Conditions tight in Italy & France, but not Germany $$ Feb 02, 2012
• Japan Auto Sales Notch Record Jump http://t.co/0VzF4WST Another small bright spot. Of course, bouncing back from a low level $$ Feb 02, 2012
• Socialist Hollande, Who Wants Full European Treaty Renegotiation, Increases Lead Over Sarkozy http://t.co/J3qCpZZ3 Eurozone Wild Card $$ Feb 01, 2012
• Hong Kong Homes Face 25% Drop as Loans Fall in Year of Dragon http://t.co/ifg1146H And this is with wealthy mainlanders fleeing China. $$ Feb 01, 2012

Markets

• RBC Takes On High Frequency Predators http://t.co/MfA5qdxm Where there is offense, there will b defense; nothing goes unanswered in the mkts Feb 05, 2012
• Global Strategists Abandoning Bearish Views http://t.co/dOXCUMA7 Makes me think we r getting close to a turning point. Feb 02, 2012
• Dividend stocks: Buyer beware http://t.co/SvMCHtCj Makes the valid & missed point: high qual div paying stocks r stocks & can lose $$ #yeah Feb 01, 2012

Credit

• 6 High-Yield Canaries-in-the-Coalmine http://t.co/4pz6SSQc 6 reasons y high yield is overheated http://t.co/fKnHmBqD & http://t.co/UPVev0iD Feb 02, 2012
• QOTD: Regulators Watching Aggressive Yield Chasing http://t.co/iWimo3eg FINRA warns of undue risk in income seeking. Advisors take note $$ Feb 02, 2012
• Contra: The Safest 7% Yield in America http://t.co/VrXoLEFH Poor analysis does not take into account the highish leverage on mtge repo $$ Feb 02, 2012
• Shipping Loans Go Bad for European Banks http://t.co/y5Z0wt3R Highly glutted area w/many dead firms walking; how far down will the losses go Feb 02, 2012

Politics

• Group lists top stock investments by members of Congress http://t.co/CarxUCjS Top 50 hldgs -> in top 100 cos by mkt cap. Hard2manipulate $$ Feb 05, 2012
• Obama Re-Election Odds Versus the Stock Market http://t.co/F5EETcve Example of 2 variables that r correlated b/c they anticipate GDP changes Feb 05, 2012
• RE: @abnormalreturns Gold is mostly political philosophy. How much control do you want the government to have over mo… http://t.co/hRxIkaoo Feb 03, 2012
• Getting back to the gold standard http://t.co/pCk8Ij6j Gingrich & Ron Paul have said they would like to appoint James Grant as Fed Chairman Feb 02, 2012

Companies

• Carlyle’s proposed IPO disaster http://t.co/OqGke8eN So there’s no board. Most boards don’t do much. Mgmt will have no board 2 shield them Feb 05, 2012
• For These Fans, a Day With Buffett Offers Wealth of Photo Opportunities http://t.co/UpcwVKe7 I think Buffett is enjoying life more now. Feb 05, 2012
• Buffett Railroad Boosts Capital Plan to $3.9B http://t.co/9XEw2gyT Buffett changes; organic investment in capital-intensive biz $$ #olddog Feb 01, 2012
• Pep Boys Seen Gaining 27% as Cheapest Value Lures Bids http://t.co/GyfH7qRL Could a bidding war start? Company is undermanaged $$ Feb 01, 2012
• Jefferies Allows Bonus Recipients to Swap Stock 4 Cash With 25% Discount http://t.co/pfGB3Vmc Fair way2 let employees disconnect from $JEF Feb 01, 2012

Financial Services

• I’ve just started “Acts of God and Man,” by Michael Powers. In the intro, he goes through the various meanings of th… http://t.co/tX7uAlWl Feb 05, 2012
• When evaluating Investment Funds, use Dollar-weighted Returns http://t.co/N5g7PI0d This is a neglcted concept that is enjoying a rebirth $$ Feb 02, 2012
• After a Delay, MF Global’s Missing Money Is Traced http://t.co/4s6U8yOe Investigation moves to how to recover the $$ and who is at fault. Feb 01, 2012
• http://t.co/wBbJTe3D FINRA Alert: Do you use complex products? What additional work do you do 2 assure that they are being used properly? $$ Feb 01, 2012
• Banks Need Higher Interest Rates to Start Making Money http://t.co/SneRACCi Flat front end of yield curve squishes bank interest margins $$ Feb 01, 2012
• 401(k) Plans Step Into the Sunshine http://t.co/fvKeup2L But as with DB plans, as costs rise, companies will offer them less. $$ Jan 31, 2012

Value Investing

• The SEC’s “90% Convergence” Fantasy http://t.co/bkWaAS5S US GAAP has many flaws, but we know them. IFRS will introduce abusable flexibility Feb 02, 2012
• But on the bright side, value investors may do relatively better as financials become less trustworthy; the accruals anomaly will sing $$ Feb 02, 2012
• Need to consider (Cost of goods sold)/user $$ RT @ErikSchatzker: Facebook gets $4.39/yr of revenue per user. ESPN gets $4.69/mo. Feb 02, 2012
• Berkowitz: Fund Plunge ‘Makes Little Sense’ http://t.co/pcoPLahW BB, appoint someone in your group 2 seek out opinions contrary 2 yours $$ Feb 01, 2012
• @ADayforRabbit I have argued in the past that BB is not paying attention to the delevering, which is a real headwind for the banks. $$ Feb 02, 2012
• New Fund Hopes to Prove Outspoken Analyst’s Thesis http://t.co/cuVpRzvO I bet @rcwhalen does well like my friends @ Hovde or M3 Partners $$ Feb 01, 2012

Hedge Funds

• Are Hedge Funds Worthwhile Investments? http://t.co/Lw2EhRPr Yet another “Hedge Fund Mirage” citation; the book is having a lot of influence Feb 02, 2012
• Are the hedge fund and private equity boys pulling a fast one? http://t.co/TNXFJo62 Beginning 2c the args of “Hedge Fund Mirage” everywhere Feb 02, 2012
• Did Hedge Funds Trigger the Financial Crisis? http://t.co/lNIb2dgF Secured asset classes can be overlevered; when they collapse, big mess $$ Feb 01, 2012

Miscellaneous

• Do the Job You’re Meant to Do http://t.co/wR3OX20N LIfe is too short to work with people you don’t respect, or tasks unfit for you $$ Feb 02, 2012
• Millionaire adopts girlfriend as daughter http://t.co/zffGCWbu Asset shelter. Does incest rely on consanguinity or on legal relationship? Feb 02, 2012
• Charles Murray Reiterates Willpower http://t.co/smeXZKNh Lack of self-control can destroy relationships, jobs, firms & lives $$ Feb 02, 2012
• I ran into @twitalyzer today. Lots of interesting analytics for tweeting. Here are some for me: http://t.co/HDdcFYaU & http://t.co/8uFFOMuP Feb 01, 2012
• At the first blogger summit at the UST, I recommended to the powers that be that they issue floaters. I also recommen… http://t.co/R3U8OHSi Feb 01, 2012
• California Faces Cash Shortfall by March on Low Receipts, Controller Says http://t.co/QxH1a6Re Could be interesting given the elections $$ Feb 01, 2012

But there is a limit to that, and more so when many companies build up large slack cash balances.  Think of the converse: only one really intelligent company has a lot of slack cash.  That company starts buying up other companies like a clever private equity buyer, but taking account of synergies with existing companies in the process.

Such a buyer would understand the value of each company purchased, and how much fat could be cut out, synergies realized, etc.  But even as that one company acted, valuations would rise with each purchase, until the “intelligent company” stopped buying, because it was no longer reasonable to buy at the higher valuations.

If this is true with one clever buyer, it is true with many not-so-clever-buyers, but it takes longer, and there will be errors, failures even, and more.

It is hard to deploy cash effectively as a corporation, aside from the simple routes of dividends and buybacks.   But companies that are good at doing small acquisitions that improve organic prospects can do far better than companies that blindly acquire for reasons of scale.

The company with a lot of cash will look for a scale acquisition, and will overpay, or, will overpay for an acquisition in an unrelated industry, creating a conglomerate that is hard to manage.

It would be far better to pay it out as a dividend, or buy stock back.  The shareholders as a group have a better idea of what is valuable in the public markets than the management team does, particularly aas public valuations get high.

Thus, I agree with Michael Santoli of Barron’s in his recent article.  The additional cash in the hands of many growth companies is depressing valuation measures, and should be paid out as dividends, or with an eye to the price, buy back stock.

And, I disagree with the fellow who wrote this article, that large corporate cash hoards are a reason to buy equities.  That might make sense if one knew what companies would get bought  out, but no one knows that.  In general, it is hard to pick acquisition targets profitably.  If major corporations can’t do it, odds are you can’t do it either.

For one more point on corporate cash generally, don’t pay much attention to it, because corporate cash often serves as collateral for futures positions, and other derivatives.  Cash on the balance sheet is often encumbered.  Maybe accounting standards should be modified to reflect that, because knowing the true liquidity of a company is valuable.

But in another sense, they are very much to blame.  Why?  As Buffett has said, he thinks about the things others say “can’t happen.”  Secured lending fits into another aspect of the “net capital rule,” an aspect less noticed.  That can be geared up 50 times, not the 12 times commonly considered.  Who would have thought that secured lending would be so overlent that it would push up asset prices, and that so many would rely on holding assets via short-term loans via repo?

Well, I fingered some of it at the time, but not all of it.  So the argument shifts — the SEC was not wrong for shifting its standards in 2004, which had little impact — it was wrong long before then with the net capital rule 15c3-1 by being too lenient with secured lending.

Secured lending often fails colossally, because lenders think the current value of the asset is a guarantee, when it is really subject to the conditions of the market.  When many lenders rely heavily on collateral, it proves to be less than valuable.  Also, secured lending tends to be done by leveraged entities, who think they can do it because it is safer.  When it fails, it can be like a string of dominoes.

We need to abandon the idea that the SEC made some grand shift in 2004, and rather, take up the idea that the SEC had the net capital rule wrong in the first place — it should have been tighter with respect to secured lending.   Given the short-term nature of the repo markets, and the correlated nature of changes in repo haircuts, maybe the SEC should ban investment banks from using repo financing.  Yes, it will kill profits, but no regulator should care about that.  Regulators should care about solvency under all scenarios.

Short-dated financing of long-term assets is at the root of most financial crises.  Let the regulators move to a strict asset-liability matching framework for regulating the investment and commercial banks, where they look through the financing arrangement to the ultimate asset being financed.  Long assets deserve long financing.

T+1 will raise volatility.  Often increases in the technical efficiency of information or trading systems increase volatility, because people can act precipitously on information, all at the same time.

There was an effort in the early 2000s to make almost all securities settle as a rule in one day.  Three days was the rule for most markets then, as it is now.  Government bonds settle differently, and some other securities as well.  The effort to settle transactions more quickly failed, and we still settle trades in three days.

I was glad when the move to T+1 failed.  There were efforts to move to T+0 behind it.  Not that I had many trades that I needed to break as a bond manager (I had one, the phone call to do so made me ill), but I knew there were settlement failures even at T+3, and the stress on the back office would be considerable.  Better to go slower, and have fewer failures.

I prefer stability over efficiency.  Efficient systems tend to require high attention.  Stable systems have redundancy.  Not everything has to go right for the system to work.  In my example above, T+1 required a lot more accuracy, and T+0 would be unimaginable.  We would need angels to clear trades.

That’s one reason why I am not crazy about market efficiency.  Yes, efficiency is a good thing as far as it goes, but when it begins to impact stability I part ways with efficiency.

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It is inefficient to have a balance sheet.  All of the slack capital that you don’t need all of the time.  Far better to be a trader with no significant balance sheet, the profits will be greater.

I disagree.  Though this is an extreme example, look at Buffett with his purchase of Bank of America preferred stock with warrants.  In a single stroke, he protected the downside, and allowed for the participation in the upside.  He probably understands that his credibility can move markets.  The preferred stock can be stuffed inside an insurance entity with little capital cost, while the warrants can be held at the holding company.

Bank of America entered into expensive financing with Buffett who had cash at a critical moment.  Give the Buffster props for his cleverness in the tub — he understood their need of capital, and gave it to them in away where they could deny the need for new capital.  Brilliance.

Brilliance, so long as the losses never reach down into the preferred equity portion of their balance sheet.

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Having a balance sheet allows for modest losses to occur and the system does not fail.  But it means that some capital is not deployed; it is there in reserve for disasters.

That is why financial systems with excess capital survive better.  Yes, it is inefficient to carry capital that does not earn much, but it is more inefficient to fail.  Think of the Baumol model, where there is an economic order quantity.  The same can be applied to finance, where the is a level of efficiency below which we should not go, because of ordinary volatility.

Volatile markets require intermediaries, or at least, systems that slow settlement.   Slack in the system is not wasted, but is there to protect against catastrophes.  That is a benefit to all, even those that seek to make markets more efficient.

This book was surprisingly good, and ambitious.  It takes on the short-term nature of our business culture in many areas:

1. The nature of the problem is that the owners no longer work for the corporations, and so managers run companies for shorter term objectives.  Owners would care more about the survival and long run profitability of the firm.
2. Much of the financial crisis stemmed from managing for the short-term, as financial institutions moved from a originate-to-hold to an originate-to-sell model.
3. Corporations focused on meeting quarterly earnings estimates, possibly to the exclusion of longer-term profitability improvements.
4. Investment managers manage for the short run as they try to beat indexes in the short run rather than over the long term.  Investors pulling money in the short term influences that.

The book then takes on these problems, and proposes solutions:

1. Create the proper long-term incentives for all parties: Executives, Line managers, and Employees.  I think he gets it right.  Make them long-term, and relative to a proper market index.  Or do it on a book basis, but make the hurdles reflect the cost of capital.
2. Communicate to the external world that you are no longer going to play the short-term game, like Berkshire Hathaway.  No more earnings guidance, and no more pseudo-earnings guidance where the analysts get enough to publish their estimates.
3. Most boldly: adopt new accounting principles that revolve around free cash flow, not earnings.  Make balance sheets probabilistic.  (even as an actuary, I don’t think we are ready for that, good as it would be)
4. Incent investment managers properly.  This is probably the weakest part of the book, because the problem of incenting investment managers properly is probably impossible.
5. Finally, how to make money.  Concentrate your investments, and if you are a good investor, you will make money over the index.

Now, some of these insights are truisms: sure concentrate your investments, and if you have good insights, you will do well.  Duh.  Most professional managers don’t have good insights, but they aren’t dropping out, and their investors are sticky enough.  That will be hard to change.

But creating longer term incentives for managers and realizable goals for workers are significant ideas.  I have argued for these for some time.  At my fellowship admissions course for the Society of Actuaries, I remember arguing with a consultant over these ideas, where she told me that longer-term incentives were unrealistic.

In a similar vein much of the book argues that you should think like a life actuary (my words, not the author’s).  Discount over the long term, taking into account interest rates and likelihood of the cash flows occurring.  I can heartily back that idea, though I wonder how well the average professional would deal with the concept.  Imagine a new income statement that has a pessimistic, realistic, and optimistic scenarios, and has ranges for accrual items off of that.  I would enjoy that, but the average investor would blanch at the complexity.

Average professionals, much less investors, don’t do well with probability  They want a point estimate and that is human nature.  Are we trying to create the NEW CAPITALIST MAN here?

Maybe, and I actually like the effort, though I think it won’t amount to much. Eliminating self-interest is very difficult; channeling it is another matter.

Quibbles

The book uses the exact same quote from Peter Bernstein on pages 54 & 130… come on, you can do better than that.  Where is the editor?

Beyond that, if you are going to rework the income statement, then differentiate between investment capital expenditures, and maintenance capital expenditures.

I think the proposed excess return versus shortfall ratio is flawed.  Under your definition, a manager who beats once by a lot, and loses often by a little, but loses versus the index overall would look good.  I think it is better to just look at long term returns versus the index, and consider Buffett’s dictum, “I would rather have a noisy 15% than a smooth 12%.”

Who would benefit from this book: Those who want to see a better capitalist economy built could benefit from this book.  If you want to, you can buy it here: Saving Capitalism From Short-Termism: How to Build Long-Term Value and Take Back Our Financial Future.

Full disclosure: The publisher sent me a copy of the book for free.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

But that doesn’t mean I can’t keep going.  I backed up all of my files on Saturday, and I have my most commonly used files backed up in real time by Microsoft Live Mesh.  It’s inconvenient, but the data is safe, and I can keep working and serving clients.

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Almost everyone argues their interests on tax reform, excluding me, but including Buffett.  Buffett is in favor of increasing taxes that he doesn’t pay.  Estate tax?  Buffett isn’t paying it, he’s giving his fortune away to the Gates foundation, largely.  Income tax?  Relative to the increase in his net worth, Buffett pays almost nothing in taxes because we don’t tax stocks until a dividend is paid, or until some stock is sold.  What’s more, BRK has a $38 billion deferred tax liability, which measures taxes that would have been paid on GAAP income, but weren’t paid because taxable income was lower for reasons that may revert, someday.

Thus, I say Buffett is a hypocrite on taxes.  Let him argue for the following:

• Unrealized gains on assets should be taxed each year, for corporations, partnerships, and individuals.  Losses should receive deductions.
• Eliminate deductions/credits from the personal and corporate tax codes.  We could eliminate the deficit instantly with that one simple change.  Don’t use the tax code for social engineering.  Much as I favor a Balanced Budget Amendment, perhaps a “No Social Engineering” Amendment would be better.  Or an amendment that incorporates my anti-gerrymandering idea.
• Tax corporations on their GAAP income, or better, whatever they represent to investors as the true increase in period-to-period net worth.
• Add in an EBITDA tax on private equity, and everything like it, such that we assume a 15% ROE for tax purposes that trues up when the partnership closes.  Everywhere, make the tax basis equal to GAAP, or modifed GAAP, where it exists.  Where it doesn’t exist, make the taxes punitive enough that adopting GAAP is preferable.

With the present tax rates, implementing all of these would put the budget in a decided surplus, WITHOUT RAISING RATES.  You would even eliminate the estate tax, because estates would finally be taxed year-by-year.  The tax code would then be close to fair, like it was with TRA ’86.

But there is one place where I agree with Buffett entirely:

People invest to make money, and potential taxes have never scared them off. And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs were added between 1980 and 2000. You know what’s happened since then: lower tax rates and far lower job creation.

Taxes affect business decisions when the definition of taxable income gets changed or credits get offered.  I’ve seen it working on section 42 housing credits, and in insurance company accounting.  I’ve seen it with private equity; I’ve seen with clever investors that max out debt while growing net worth.

In that sense, the definition of income, and the offering of credits make a huge difference in the behavior of those taxed.  But within reason, tax rates don’t make that much difference.  Yes, up 10%, there will be some effect on economic activity.  The bigger changes come from deductions and credits.

You want a pro-growth tax code?  Eliminate the deductions, credits, and deferrals.  Tax us year-by year on an estimate of our increase in income including unrealized capital gains and losses.

Yes, there will be unemployed accountants, actuaries, attorneys and administrators.  But the system as a whole will be better off, and for once, who will argue in favor of preserving the nation, and ignoring special interests?

What Buffett suggests will get little in the way of results.  A focus on defining income properly will bring in more than sufficient taxes, and especially from Mr. Buffett, one of the least taxed relative to the increase in his net worth.

Now economically rational could mean two things:

• He is economically rational for the company, and thinks like an owner.
• He is economically rational for himself, and thinks like a worker.

When we/I used the phrase, we meant the former, not the latter.  It implies a very different standard of behavior than merely trying to get the best for yourself — you are trying to faithfully serve the company that employs you.

Insurance is the most complex industry in accounting terms.  In simple terms, that is because when a sale is made, you have little idea what the “cost of goods sold” is.  The cost varies in time and severity.  That complexity meant that there were a lot more games that could be played with the accounting, and the games could go on for a long time.

If you were out for the good of the company, you would aim for organic growth where it made sense, but close down lines of business where it did not make sense.  Now, when you are trying to close down another person’s line of business because it does not earn enough, you might run into some opposition.  And so I did, several times on flawed business that had been, and was being written by the domestic life companies.

It may seem lousy to shut businesses down, but when the underwriting is losing large amounts of money, it is a mercy to the company and its shareholders.

I have known many people in insurance that talk a good game, but in reality, they aren’t doing much.  They may play with the accounting to make things look good.  They may cram sales out the door in the short run, but the quality is bad.  They may boast of big sales in the past, but they don’t deliver when you hire them.  They claim to be a good claims manager, and they settle a lot of claims, but then you find that all the tough cases are stagnating in their bottom left hand drawer.

But the worst is when it reaches to a CFO or a CEO.  The Peter Principle propelled him into office, and the CFO manipulates the earnings, or the CEO takes actions to make it look like he is doing something, when it is not adding to value.  Worse is when the incentives are misaligned, and they sacrifice real profitability to meet incentive targets.

That’s why I believe that pay incentives should be based on growth in book value plus dividends over 3-5 years, with book value being “old style” book, not taking in market value elements.  It has to be long enough to take in a full economic cycle.

Now the phrase “economically rational” does have utility in this respect — the first definition would mean the same thing for everyone — acting like an owner.  The second definition is every man for himself.

I ran into the same situation at companies I served before and later.  Were financials being managed for the good of the owners, of the good of the leading managers?  Sometimes it was owners, sometimes it was managers, and sometimes it was greedy managers.  I remember being disillusioned when the guy who hired me for my first job had used me to tweak earnings higher (I didn’t get it until a years later).  He had left to start something new.  I never saw him again.

I liked my work most when we were acting like owners.  It forced us to be more creative, and take prudent risks.  On imprudent risks, I remember a boss praising me for not putting the company at risk on floating rate Guaranteed Investment Contracts, when I proved it was too risky.  When several of my competitors failed shortly thereafter, I was vindicated.  But being a good businessman, I called those who would want floating rate GICs but no one was willing to lower their yield demands for the contracts.  They weren’t economically rational, and we abandoned the market.

At another company, a chief actuary who would eventually be shown the door for malfeasance, said to me, “We are losing business to these five companies.  Why can’t the investment department make money like they do!?”

I did heavy due diligence.  It was a perfect question to ask me, because my skills on both sides of the balance sheet were significant.  I came back to him and said, “Four of the companies are taking risks far beyond what anyone else in the industry is taking.  In a bear market, they will die.  The last one has a weird holding company structure that allows them to lever up more.  If you want the ask [the parent company] for a similar deal.

Within one year, two of the competitors died, and my explanation of it put me on Jim Cramer’s radar; he even posted what I wrote. Within three years, another had died, and one merged into another entity.  After seven years, the last merged into another entity.  They all were gone.

So what is the value of all this?  I think of it as training to understand managements — see if they act like owners maximizing long-term profits, or as workers aiming to maximize their pay packets.  You will earn more with companies that think like owners.

Now after all of this, it’s not so much a question of rationality but ethics.  Who will do the right thing for the one he ultimately serves?  Working for those people is a joy, and is beneficial to those that own. Doing right does well for many.

I guess I made some of the wounds obvious enough.  I don’t believe in “payback,” I believe in “Love your enemies,” and “Be honest.”  Thus I find it odd that I am being ever more sought out by reporters on any AIG news.

Granted, I’ve written on underreserving by AIG, the problems they had at their operating insurance subsidiaries during the financial crisis, which got picked up by SIGTARP.

What has prompted recent inquiries, is the sale of stock at $29/share,  at only a 1.6% discount to the prior closing price.  That price was a hodgepodge between what the market would bear, and what would give the government a “profit.”  Bad idea in my opinion; it would have been better to price the deal lower, say $28.50, where the government took a loss, but where the market might have driven the price up.  A 1.6% gap is marginal and would invite sellers. $28.50 would be over 3% and would invite buyers.

Now, some sympathy for Bruce Berkowitz — He saw book value decline by almost $1 today, from $47.32 to $46.35.  I don’t know if he was buying as the largest private shareholder of AIG, but he was certainly disappointed by the company offering shares.  Why offer shares at less than 2/3rds of book?

Easy, because AIG can’t borrow or issue any other security.  But that is a signal to what the company is worth.  I mean at worst, AIG could have procured a secured loan to  provide $3 billion, offering a valuable subsidiary as collateral.  They chose to dilute, which tells you what the stock is likely worth.

Also, with such a large fall in price after the offering the next offering should come at a larger discount to the recent market price.  Those that were burned in this offering will be less willing to step up and take immediate losses.

Now, AIG has two other ways to improve their stock price.  Improve transparency, and improve Return on Equity.  The first of those means eliminate the sense that there could be negative surprises in the future.  That means that reserves have to be modestly conservative, unlike they have been in the past.  That means taking one last reserve strengthening to do so, if needed, even if it temporarily hurts the stock price because of the loss.

But if it can be shown that the loss is likely the last of such losses, and that AIG isn’t going to use its reserves to manipulate earnings any more, the loss in the stock price should be minimal.  After all, a lot of that is buried in the discount to book anyway.

Then comes improving ROE. The CFO Peter Hancock has said, ‘“We are moving away from any kind of top-line targeting,” Hancock said in a call with analysts. “We think that leads you to do business at the margin, which is unattractive.”’

That’s some of the best news I have heard on AIG in some time.  If AIG limits its underwriting, and focuses on profitability, it has a lot of potential for upside, but that would mean:

• Reducing overhead expenses
• Compensating line managers on underwriting profitability, conservatively estimated.  Tie their long-term bonuses to aggregate underwriting profits.
• Eliminating marginal lines of business, including selling off lines where AIG has no sustainable competitive advantage, like investment management, consumer finance, aircraft leasing, and domestic life insurance.  The last of those is the most controversial — I would sell off the domestic life insurers to the highest bidder.  I suspect there would be willing buyers among the big players of the life insurance industry.  Use the proceeds to buy back stock from the government, or to reduce debt.

AIG would do best if it were a pure play P&C insurer.  As I have argued since long before the crisis, the size and complexity of AIG make it unmanageable.  Better management will come through creating a more focused company that does not require having a “superman” like Maurice Greenberg to manage it.

Disclosure: I don’t own any AIG, nor am I short.  The same for my clients.

Me: So, DX, how did you make out this tax season?

DX: What do you think my federal tax rate was?

Me: Uh, 25%.  You’re a successful guy.

DX: Try again. Lower.

Me: 15%?

DX: Lower.

Me: 10%?

DX: I said LOWER.

Me: Uh, yeah… 3%?

DX: It’s lower.

Me: 1%?

DX: I’m sorry, LO-wer.

Me: O%, you paid nothing?

DX: I’m SORRY, lower.

Me: Wait, the government paid you?

DX: That’s one way to put it.

Me: Then I am clueless.  I have no idea what to do with someone like you who earns a lot, but pays no taxes.

DX: Negative 3%.

Me: How does that happen?  Why aren’t you caught by the AMT?

DX: Many deductions, and many children, with some in college, like you my friend.  Aside from that there is the swiss-cheese post-AMT that wipes out taxes.

Me: Wow.  Why would the government allow this to happen?

DX: Beats me, but I am happy to be wealthy and pay no federal taxes.  That’s been largely true for the prior two years as well.  It genuinely helps if most of your income is coming from sources of investments, and businesses that benefit from certain tax credits.

Me: This is ridiculous.  Why should you get off paying no taxes when our government is running huge deficits?

DX: That’s the fault of the government favoring certain actions.  As long as the tax code is a policy tool, there will be some that take advantage of it.  As for me, I made few active actions to take advantage of it, but also, the way that I do things paid off because I have a certain configuration of income that is presently favored, and a family structure and deductions that are favored.  It may not always be that way — look at the code from the Depression through the 70s; it would be the opposite for me.

Something in-between the two would probably be optimal, including taxing all income at the same rate, and limiting deductions severely.  Stop the games, and fairness becomes a  possibility.  Otherwise, you will have some well-off that pay virtually nothing, like me for the past three years.

Me: Indeed, DX.  You are the man, and have triumphed over the federal government. But what are the common men supposed to do?

DX: Do what I do, or, pay taxes.

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Dr. X is a bit of a “piece of work,” but he’s no Leona Helmsley.  (“We don’t pay taxes. Only the little people pay taxes.”)  Much of the reason for his low taxes stems from charitable giving, including donating appreciated stock.

But this helps to point out my point for what I call “true tax reform,” which I don’t think either side in DC would favor today.  Here’s the simple version of it:

• Flatten out the tax rates, and apply the rates uniformly to all income.
• Eliminate all tax preferences, and eliminate the estate tax.  Get people focused on growing the economy rather than employing clever people to eliminate taxation.
• Tax all income, including capital gains/losses, whether realized or not.  For illiquid investments, where there are no prices, assume a 12% return on equity for taxation purposes, and true it up when the investment is sold.  In other words, tax everyone as if they were traders, and develop fair market value accounting to do this.
• Tax corporations on GAAP income, which solves the problem on overseas subsidiaries.  If they act like private equity firms, then disallow the deduction for interest, or assume a 12% return on equity for taxation purposes.
• Eliminate all ability to defer taxation.  No more IRAs, or anything like them.  Tax the pension earnings inside corporations, etc.

My main point here is that the discussion on taxation should shift from rates to the definition of income.  You can tax wealthy people as much as you like, but if the definition of income is loose, you can bet that the wealthy will take advantage of it in ways that those less well-off can’t.

My proposal will make the clever wealthy pay.  It will make the poor pay.  We all will pay.  And that is fair.  Even Dr. X would agree with that.  And it will lead to a growing economy, because we will release many clever people who spent time trying to reduce taxes into trying to be productive.

Full disclosure: This book was sent to me by the author, unsolicited.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

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1) What impressed you most about your interview(s) with M. R. Greenberg?

To begin, his utter and consuming passion for AIG. He does not distinguish between AIG and himself, at least in any appreciable sense. What happened to AIG thus happened to him and vice versa. He will never forget anything and he will never forgive anything. Nor, for that matter, will he concede very much. The other issue is that per David Schiff’s observation, Greenberg never stops, he is “Always running.” Since his obsession is work, then everything else in his life can be elegantly understood: The foreign policy stuff, bringing his sons into the business, the travel schedule of a foreign diplomat, the boards and foundations. Since AIG was everywhere and doing everything so was Greenberg.

2) If you could have gotten others to talk with you, who would they be, and what questions would you want them to answer?

It’s a tie between Win Neuger and Martin Sullivan. I’d want to ask Sullivan if he really saw events per his Congressional testimony on the fall of 2008, where he laid much blame for the collapse at the feet of mark-to-market accounting. This is akin to Morgan Stanley’s John Mack complaining about short-sellers at the same time–a complete abdication of all intellectual responsibility. I’m guessing Sullivan has a lot more to say than just stuff about accounting. Regardless, no one at AIG had much to say about mark-to-market accounting in 2005-2007, when they had billions of dollars in unrealized gains from their sundry portfolios.

With Neuger, I would want to start at the very beginning of the expansion of the securities lending portfolio, which tracks to around the very minute of Greenberg’s departure. It’s easy to take shots after a crash but I wouldn’t do that; I’d want to know how he thought AIG was going to have a different end than the number of other securities lending portfolios that extended duration during low rate cycles and modest volatility. I’d also want to know when HE realized there was trouble, that you can’t always unload $150 million worth of mortgage-credit paper on the bid side. That conversation might get interesting.

3) AIG Financial Products had three eras, with three different managements, strategies, and interactions with AIG parent company.  Why wasn’t AIG able to manage AIGFP to keep it sound?

In a word: competition. In 1987 the only limits to what FP could do was what they could dream up. They dominated the landscape with a virtual monopoly. Come 1996, every I-bank and commercial bank was in rate swaps in a big way and, in the case of Gen Re and Credit Suisse, had their own Financial Product units seeking to do “bespoke” transactions. By 1999, Goldman was actively leveraging its corporate finance relationships to do custom transactions. Hedge funds, by the early parts of last decade, are competing with them on the asset finance side and on every sort of complex short-term trade FP entered, they were competing against the prop desks of Goldman, Merrill, J.P.Morgan and the like.

There is also the intellectual drift common to every enterprise. A founder comes in and designs a business in a certain fashion; By the second or third generation of management, it’s highly unusual to have the same rigid adherence to the founder’s goals. For an (extreme) example, look at the Ford Foundation and its role within the Liberal firmament and then look at who Henry Ford was. The divergence of mission usually occurs obliquely. For instance, Joe Cassano would have looked askance at a speculative bet directly on the mortgage market via Freddie or Fannie passthroughs. Instead, FP wound up long the mortgage market via writing insurance coverage they were told would never be impaired.

4) Are there any areas/subsidiaries inside AIG that you would want to look more closely at after writing Fatal Risk?

Not really.

5) What do you think the last moment was that AIG still had control of its own destiny was?

Maybe late 2006 or early 2007. Assuming some visionary philosopher King rode in with a mandate to hedge all risk, with total operational control and the budget to see it through, they would have had the ability to go out and buy a fair amount of coverage in the ABX indices for FP (and maybe structure some custom swap with a large bank) and begin an immediate “run-off” at the Securities Lending portfolio. It would have cost them billions of dollars and they still would have taken some bitter losses in the autumn of 2008. Still, I can see a $10 billion “investment” across FP and Securities Lending going a long way to preserving autonomy. It should be noted that I asked this question at every interview and no one said anything like it was even considered. FP executives say they never considered buying CDS on the CDS they were writing since it would have completely eliminated the “profits” from premiums. Go figure.

6) What would it have taken for AIG to be properly managed after Greenberg’s departure?

There was a massive gap in the knowledge base of the men who stepped in after the departure of Greenberg, Ed Matthews and Howie Smith; Martin Sullivan and (CFO) Steve Bensinger knew enough to run AIG in a bull-market. Their greatest weakness was in not having a suitable understanding of the downstream, or long tail, risk of derivatives, particularly in the reference securities. They were almost childlike in their trust in systems and processes: If PWC or a big law firm looked at something, that was good enough. The problem was that it isn’t. This isn’t to indict them: A guy like Steve Bensinger was a solid Treasurer but the CFO job at AIG required the ability to be an accounting whiz plus having equals parts risk guru and legal eagle–I’m thinking of a David Viniar sort–and he wasn’t any of those things.

Part of this problem has to do with the fact Greenberg/Matthews/Smith had seemingly been there forever and so a bright, truly talented next generation CFO or COO never bloomed. How could it have? Any ambitious 40 something would conclude that the AIG executive suites were permanently closed. So there was no backbench to hand and as I explain in the book, a post-Greenberg transition plan was not something Hank thought much of as a concept. Practically speaking, Sullivan was never remotely suited for the role since he had zero financial management experience. Moreover, his trusting, amiable disposition insured that when his former peers like Joe Cassano ran into hot water, he didn’t have a skeptical or questioning bone in his body. That’s a big risk to run when you have a Financial Services unit embedded in your company that is larger than Lehman Brothers and many times as complex. Greenberg, on the other hand, had little fear of conflict and had a track record of asserting himself over his trading desks.

7) Did AIG management err in moving so aggressively into areas that exposed them to the credit cycle and equity markets?  Do you think Greenberg could have been happy running a smaller insurance enterprise that would have a hard time growing profitably with moderate risk?

Part one: That’s the core challenge of AIG’s entrance into “The Kingdom of Money” as I put it. As conceived, its financial units were never supposed to have this risk; that was what the asset management units were for. Per question #3 however, FP inevitably had its advantages competed away and was forced to seek profits in areas that had long been frowned upon, like getting long fixed income risk.

Part two: No. Handsome and steady profits were attractive to Greenberg but growing them were what he was all about.

8 ) What were the shortcomings from Greenberg being an autocrat at AIG, even if he was one of the most talented CEOs ever?

In AIG under Greenberg the single-minded focus on profits, new opportunities and growth that he instilled obviously facilitated a period of expansion and wealth creation that has a bare handful of rivals in history. However, given time and the law of averages, profit opportunities began to fade (the returns on assets tell this story) so they had to go farther out on the risk curve to sustain income growth. There is the same end to this story every time. Secondly, autocratic organizations tend to have weak leadership benches. At the unit level, AIG was shot through with talented people from top to bottom. The person who could run the company post-Greenberg, however, arguably didn’t exist at the company. For a talented executive, in retrospect, AIG was a company that you either came to understand that you were never going to go any farther than where Greenberg saw you going or you left. A lot of people chose the latter but over time, many of them “went along,” and didn’t speak up at key junctures. For instance, in the securities lending debacle, the global investment unit’s senior leadership seemed fine with things but it was a pair of rank-and-file portfolio managers, Mike Rieger and another guy, who spoke up. They were roundly ignored.

9) What aspects of AIG’s culture overall helped lead to the eventual failure?

A problematic trust in process over actual insight and investigation. Time after time, “A law firm signed off on it” was considered actual risk management; it’s not. There was also just abysmal risk management, not only in the obvious things like writing $73 billion of super-senior CDO tranche protection and the Securities Lending debacle, but in the minutiae. It appears no one even looked at the credit support annexes, which were standard in all swaps. Moreover, FPs valuation systems were completely inadequate in getting real market prices for the underlying CDOs. There is an element of the “The Wizard of Oz” to AIG–”So that’s what is behind the curtain?”

10) Do you think AIG got sloppy in the early 2000s as business got more complex, and the need to meet earnings estimates grew more difficult?  (Gen Re, PNC, Brightpoint, etc.)

Yes. They were all very different transactions but yes. Gen Re should have been caught by a mid-level risk analyst or lawyer in the general counsel’s office around the second week it was under construction. Brightpoint and PNC were separate but had at their core the manipulation of earnings. The odd thing is that the PNC transactions had been done several times in Japan with the same ill intent and were thoroughly blessed by regulators there, who were apparently happy to do anything to suggest that the nightmarish balance sheets of Japanese banks were improving. They had not a concern in the world that the deals were totally abusive to the investor.

11) At the end, AIG had subprime risk in their life insurers (through securities lending), mortgage insurers, at American General Finance, and at AIGFP.  Was it a mere coincidence that they had it everywhere?

No. AIG was a corporation whose ethos was a ceaseless hunt for earnings. When you are a AAA, or AA+ and fund at Fannie/Freddie levels, the carry trade is a very obvious place to capture some seemingly risk free spread. Given that AIG’s risk management was highly passive–relying on what others said about risk (as opposed to doing their own work)–trusting the rating agencies to get it right came easy. What was interesting is that Securities Lending and the mortgage insurance company continued to add exposure months after the market started to turn but American General Finance and FP examined the market in-depth, had a heart attack and immediately ceased those lines of business. The best thing? No one said a word to each other. AIG, in this sense, resembles a large and dysfunctional family, where no one shared anything with anyone, even Mom and Dad. Under Greenberg, big decisions like that invariably resulted in long, detailed phone calls where the decision was hashed out with Greenberg and Matthews. They would abide the decision but would want to know every reason why it was made.

12) Did it ever dawn on anyone at AIGFP that they were the big patsies insuring subprime securitizations prior to them stopping the practice in entire in 2005?  Or that the Street were patsies for relying on one insurer? (Forget that the US bailed them out in the bailout of AIG.)

Not as laid out in your question, no. An FP executive named Gene Park has become a minor celebrity because of media accounts that have him as a “Voice in the Wilderness,” decrying abusively structured mortgage credit. Park certainly hated the sector and let it be known but his effect was limited in that Cassano disliked him with varying degrees of intensity. A guy named Andrew Forster, who ran the asset-finance group out of London and had ultimate authority over the swaps, was much more methodical and cautious. Park certainly communicated his dislike to him but Forster took months to flesh out his concerns. It doesn’t appear that the concerns over the swaps were ever put in terms of systemic risk but rather as just something that had higher than expected likelihood of default. It is difficult to overemphasize how incurious many at FP were.

13) What area in the AIG parent failed to note that AIGFP could call upon resources inside AIG upon downgrades, forcing a posting of collateral?  Treasury? CFO?  That had to be signed off on by someone at the AIG parent, no?

Every area. No one really looked at the absolute risk levels of the insurance FP was writing, no one looked at the CSAs, there were no autonomous risk procedures for determining valuations, no one modeled corporate cash flows in the event these swaps became a problem and it goes on. In July of 2007, when there was the first collateral demand from Goldman, much of the senior management of AIG was unaware this product line existed. That’s a problem.

14) Tim Geithner was supposed to be the Fed’s point man on derivatives.  How could he miss something this large? How do you think derivatives should be regulated?

Let me combine these two questions. Geithner missed it because he didn’t know enough to look for it, but I interviewed a number of senior Fed officials who had not missed AIG’s rapid balance sheet expansion, the leverage of the banks and brokers to each other and, ultimately, everyone to structured products. Their response was that the Fed (in New York) only analyzed bank holding companies, or the entities that owned the big banks. They fully acknowledged the financial filth going on but said it was at the operating units, where they had no ability to do anything. That was the purview of the Office of the Comptroller of the Currency, another federal regulator with minimal funding and difficulty retraining an experienced analyst corps. I’ll bet you can figure out how it went from there.

The only regulation that really, truly, deeply matters in pondering the credit crisis is the repeal of Glass-Steagall. Once banks were able to throw themselves and their funding capacities into market-making and underwriting full bore, nightmares could only result. To that end, the only regulation that matters in reframing a regulatory apparatus is the reimposition of Glass-Steagall in some form or shape. Commercial banks, all joking aside, have usually been pretty good at making loan decisions; conversely, when investment banks dominated the marketplace, risk was a function of how much capital a firm was willing to lose at one time. For all the mania’s and fads that come and go in the markets, from the mid 1930s onward, Wall Street did a decent job of keeping its insanities form effecting the economy too much.

It would be optimal if we got back to that.

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Many thanks to Roddy Boyd for the answers.  He want above and beyond again.