Banks As Businesses: Performance, Reform and Blindsidedness

8/14/2019 Banks As Businesses: Performance, Reform and Blindsidedness

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Banking as a Business: Performance, Reform, Judgment and Narrowness

By Dave Livingston, Managing Principal, Llinlithgow Associates (www.llinlithgow.com )

Dave is a management consultant primarily focused on improving enterprise performance by couplingstrategy with execution thru the design and implementation of workable, integrated management systems.He blogs on this and related issues in Economics, Markets& Investments and specific industries andcompanies atwww.llinlithwo.com/bizzx, his BizzXceleration blog.

Introduction

When the Forest Service fights a major fire they cant put the whole thing out all at once. In the famousYellowstone Fire of the 80s one of the problems is that areas that had been brought under control turned out to beonly temporarily tamped down. Underneath the ashes they were still smoldering away and when conditionsshifted, the wind picked up or changed direction, fresh ground was gained with new fuel, etc. the storm wouldburst forth again. Oftentimes with no warning. In fact we actually drove thru those fires one vacation and had theprivilege of literally driving thru a controlled area that was close behind us several hours later so that we had todrive miles out of our way to get back to our hotel. You might curse the inconvenience but then you had to stopand think what would it have been like to have been caught in the middle of it when it started back up again? Onthe whole were thankful for the judgment of the fire boss who saved us from a lot of trouble, and maybe evensaved our lives.

We were smart enough to obey the Fire Boss because we had too the roads were close. Now that thesmoldering re-regulation fires are beginning to burst back into flames the Finance Industry seems to be doing justthe opposite. Despite repeated attempts on the part of the Administration since the beginning to reach out andwork with them constructively they have been lobbying behind the scenes as hard as they can to limit and reducethe various reform legislation packages. Along the way they have repeatedly treated the political establishment,the Administration and the various regulatory agencies and the President with disdain and disrespect. Worse,they have treated the Public with disdain and disrespect by announcing record bonuses, arguing that those

bonuses were the result of their own performance instead of government funding and support and reacted in atone-deaf and disdainful fashion to the widespread distress in the economy that most people are suffering thru.

The core of their argument is that what they do is good for the economy and the country and their bonuses areearned and necessary to the efficient and effective functioning of their businesses. Sadly all the evidence isagainst them on that score. First, and most obviously, by almost destroying Western Civilization (thats really notmuch exaggeration either we came within a gnats eyelash of a second Great Depression which might havebeen much worse because of the accumulated debts engineered across the entire society by the Industry). Next,they came with inches of destroying their Industry itself, and certainly destroyed a decades worth of paper profits,as reported but actually more funny-money than reality. Third, thru the magic of financial engineering the Industryhas been the prime mover, admittedly with the heartfelt cooperation of the consumer, has saddled the economywith expanding and exponentiating debts. Then that debt has seriously hampered economic growth, drivensavings to negative rates and resulted in decades of declining and stagnant growth with negative total job

creation. In other words rather than efficiently and effectively allocating capital to help the economy they havemanaged to harm it in a profound way. And done so by by creating paper profits on which they paid themselvesexhorbitant bonuses. Finally, there have been few, or no, major innovations in the market (aside from internalproducts and services that simply worsened the fundamental problem) that created new value for the rest ofsociety.


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Strategy without execution is fantasy. Execution without strategy is thrashing.Either without a management system is unlikely.

Table of Contents

1. Ask Not For Whom the Siren Shrieks: Let the Finance Wars Begin 3

2. Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness 6

3. Pictures for a Prosecution: Wall St. Bonuses vs. the Public Good 11

4. Bonus Fantasies vs. Political Realities: the Reform Firestorm This Time 13

5. Firestorm Flaring up: Finance Reform, Compensation Wars & Sausages 14

6. Paying the Piper: Finance Industry, Performance, Value & Regulation 18

7. The Business of Banking: Challenges, Issues & Outlook 21

8. Jobs, Debt & Growth: Level Setting the New Normal 25

9. Pecora 2 Hearings, Malfeasances, Your Future & Cusp Points 30

10 About Llinlithgow Associates 34


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Ask Not For Whom the Siren Shrieks: Let the Finance Wars Begin

September 19, 2009http://llinlithgow.com/bizzX/2009/09/ask_not_for_whom_the_siren_shr.html

The title is a play on words of course, taken fromJohn Donne'sMeditation VII, which starts, "Noman is an island entire of itself; every man is apiece of the continent, a part of the main" and endwith "And therefore never send to know for whomthe bell tolls; it tolls for thee.". The message beingin a society we are all mutually interdependent.

Sadly, this is a message which not only seems tohave been lost on the Finance Industry but theywould appear, judging from last quarter's

earnings and their source in proprietary tradingprofits, to turned on its head. Ask not for whomthe bell rings for it rings for me, but never thee.Having been monitoring and analyzing thebusiness performance of the Industry for twoyears now we were, and are, nonetheless verysurprised.

Because the other side of that coin is that society requires that it's major organizations and institutions provide aservice that creates value. And, especially, does no harm to society. When the opposite is true, and when it lookslikely that the behaviors will continue, society has no choice but to act. Well this week is the anniversary ofLehman's fall and it behooves us to ask what lessons have we learned, what have we done to fix the systemicand systematic problems and what will we do. Washington has been focused on saving us from our own and the

industry's follies but the President marked the occasion with a speech to Wall St. putting them on notice that thereckless behaviors of the past will no longer be tolerated; and inviting them to constructively contribute to creatingnew regulatory regimes. An invitation they've had for months and been fighting in every possible way. The weekended with the Fed's announcement that they will start setting compensation policy. Meanwhile Barney Frank onMSNBC provided pretty clear indications of where he sees things going and Pecora II is about to kick off. Now it'sa siren rushing to the crime scene and the results could be very ugly.


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Perverse Incentives, BadConsequences

Let's review some stuff we've goneover before separately and put anew picture together, plus add insome stuff, from this week. Here welook at the overall performance ofthe Economy vs sector Profits, theEconomy vs Markets and Wall St.vs Society. The UL chart we'vetalked about a lot so moving on theUR chart is updated and shows realSP500 vs real GDP cumulativegrowth from 1950 to now.

The bottom triptych puts chartsshowing the growth of Debt with

Wall St. relative compensation andBonuses. Taken all together italmost seems to us that a completestory is being told, eh what? Butwhat we have is de-regulation thatled to a wave of financialengineering innovation that startedby creating value but soon focusedalmost entirely on internal products,

e.g. proprietary trading, that created a tsuanmi of debt leading tocompletely out-of-balance compensation for the Industry. Notleast amusing is that this didn't metastasize until this decade. Inother words despite all the tooth-gnashing about systemic

problems and accumulated history it wasn't really until the lastfive years that we all got ebolasized! Anyway that's how weread.

Give 'em More Rope

One of the interesting things, whatever else you might think, thepolitical sausage-making the Administration went thru onHealthcare was carefully managed and got buyin from all themajor stakeholders. The Administration took the same carefulsteps, signaling its intent in advance, contacting the players.trial-ballooning multiple aspects of its agendii and so forth.

Unlike the Healthcare stakeholders the Finance Industry hasbeen fighting tooth and toenail. Now that the rest of the agenda,like saving the economy, has made some progress theyapparantly feel it's time to dig into finance. We dissected themajor lines of business, which made money and which didn'tand how, in a prior post (BaU vs. NN I: Finance Fumes, Realitiesand Pecora II). The bottom line is that the Industry think that nowthat they've been saved it's time to return to business as usual.


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In point of fact all the bad capital is still on the books, it could take a decade to repair, the business models ineach line of business are broke, it's been government support and guarantees for Housing loans (80% ofmortgages are FHA), "bank" funds and various Fed instruments (TALF, etc.) that have let things return to asemblance of reality, when we were all trembling on the edge of the cliff.

Yet the Industry and investors are treating things as if it never happened. We use the Finance ETFs to gauge thatwhere IYG is the Industry, IAI is Broker-Dealers, IAK is Insurance, and IAT is Regional Banks. Now either we'recompletely nuts, the euphorialistic relief rally that the world didn't end is generating enormous momentum or we'reright and none of this is grounded in any of the realities we've just listed out. We know where we vote...how aboutyou? We think the Industry is going to go thru a decade of poor performance that reverses at least the last decadeof perversities, or more, and returns it to its roots and that's irrespective of what regulatory changes occur.

Get Ready for Adult Supervision

Any organization must provide, as we've said, avalue to society. It doesn't exist for it's own sakebut on sufferance.When you take that down organizations must:

1) create value-add (a profit for businesses),2) create a productive workplace

environment and3) contribute to the existence of a healthy

society.

The grades for the Industry are so bad here,unparalleled since the last time they screwed upthis bad, that we won't bother to give them. That'llbe your pleasure. Over and above those whenyou talk specifically about not creating socialdamages there are three further goals: 1) do no

harm, 2) act proactively to develop solutions to external problems created by the industry that no one firm canhandle alone and 3) contribute materially to addressing broader social problems where feasible; after all noenterprise can be healthy in an unhealthy society. It is a preeminent leadership responsibility for management todeal with these rather than ignore them; or worse try and actively oppose them while continuing to createproblems.

In the early part of the 20thC Theodore Vail, the first CEO of ATT, acted to create a productive and constructiverelationship with Federal and State regulatory authorities that kept ATT a profitable private company. The onlysuch company in the developed or developing world. The rest of the world's telecom is run by their PTT Ministries.It should be done, it can done and it certainly shouldn't be done in reverse. Vail proved himself and ATT capableof adult self-supervision. Not only did the Finance Industry do just the opposite but it literally thumbed its nose atsociety in the last two quarters. The Piper is beginning to ask for his pay.


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NO Plan? Don't Worry One Will BeProvided!

We'd ask, "where's the plan Wall St." but it'sbecoming clearer that one will have to be provided forthem. Or so says much of the public, Washington andthe rest of the Industry who was badly damaged bythe malfeasant behavior of a too well rewarded few.

And in the meantime here's some backgroundreading that collects the last two years of ouraggregate analysis plus our set on governance andsocial responsibility. We suggest you might want toperuse it to review and refresh yourselves on some ofthese points.

The Broken Finance Industry: Credit, Crisis, Collapse and Broken Business Models The Broken Finance Industry II: Crisis, Adaptation, Innovation and Value? The Corporation vs Society: Performance, Social Responsibility and the Win-Win

Finally well refer you to four public policy speeches that have recently been made by the President and membersof the Administration or of key regulatory agencies.

1) President Obamas Address to Wall Street: http://www.c-span.org/Watch/Media/2009/09/14/Obama44/A/23145/Pres+Obama+Speech+on+Financial+Crisis.aspx

2) Georgetown University Conference on Future of Global Financesa. Larry Summers on a new regulatory framework: http://www.c-

span.org/Watch/Media/2009/09/18/Obama44/A/23338/Georgetown+University+Conference+on+Future+of+Global+Finances.aspx

b. SEC Chair Mary Schapiro: http://www.c-span.org/Watch/Media/2009/09/18/Obama44/A/23305/Georgetown+University+Conference+on+Future+of+Global+Finances.aspx

c. FDIC Chair Sheila Bair: http://www.c-span.org/Watch/Media/2009/09/18/Obama44/A/23304/Georgetown+University+Conference+on+Future+of+Global+Finances.aspx


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September 27, 2009

Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness

http://llinlithgow.com/bizzX/2009/09/debt_wealth_finance_outlook_si.html

It's time to re-visit, update and wrap-up our discussion of the Finance Industry and the chances for regulatory andlegislative reform. On the one hand this is an important part of the domestic policy agenda, and in some senses,arguably the most important. On the other it's been back burnered ostensibly by the press of events which hasresulted in all the last few weeks punditry commentary getting it wrong, at least in our 'humble opinion.Analogously to Healthcare Reform the administration first focused on the necessary emergency measures whiletrying to build a sense of cooperative self-interest in the finance community. An attempt that, unlike the HCcommunities (believe it or not), has foundered on the rocks of short-term and narrow self-interest. A point we'vebeen arguing for a very long time and used as our central point in the last post which reviewed the state of play.Here we want to concentrate just a bit more on the stakes, theliklihoods and outcomes and the potential impacts.

In Fed We Trust: Our Near-Death Experience

David Wessel of the WSJ has written an excellent book on thecrisis, which he started before Bear-Stearns went under andwhich he tracked thru the entire crisis. While he's appeared onseveral talk shows, of various sorts, the talk he gave in aWashington D.C. bookstore was the best because he had timeto cover his findings in some detail and because of theaudience's pointed and intelligent questions. Before leaving thistopic we highly recommend your watching the CSpan video clip.(http://www.c-spanarchives.org/library/index.php?main_page=product_video_info&products_id=

288534-1&showVid=true )

He concludes by making three points: 1) we had a near-deathexperience and were saved by emergency heroics, perhapslargely those of Ben Benanke and the Fed, 2) we've survived theworst of it barely but have a long way to go before we're restored to health and 3) there's been little or no changein the regulatory and legislative framework.

We'll come back to that last point at the end, and it's vitally important, but our critical observation is that thecommentariat mis-understands the process the Administration is following. First, put out the fire and start therepair work while second, attempt to inclusively line up support. Now they are shifting to a full-bore press and wewould suggest that the Industry NOT under-estimate their chances. It wouldn't take much to fan the smolderingtorches into a conflagration.


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A Little History Review: DebtSince WW2

These potential reforms areimportant only insofar as we a)mitigate the chances of ithappening again, b) we maintain ahealthy, vibrant and contributoryfinancial sector while c) doingaway with the socionomicdysfunctions that almost destroyedthe economy. The root of all thisare debates over the level and roleof debt financing in the economyso we thought we'd review a littlehistory to put things in context. To

address that we built two sets ofcomposite charts from the Feddata on money flows and theresults make interesting viewing.

In the UL sub-chart current dollardebt (our estimates) grew fromabout $2.5T to about $31T from1945-2008; and contrary to currentheadline and political mythologythat's not Federal debt that's thelargest portion, it's Households and Businesses. Our post-war prosperity was built on a sea of it. In the LL chartthough you can see the structural shifts where relatively speaking Federal debt was shrunk while Financial sector

debt grew enormously.

These shifts are highlighted on the right-hand sub-charts as multiples of GDP where total debt grew from 1.6XGDP to slightly over 3.5X! More interestingly Household and Business Debt grew steadily until the '80s when itjump-shifted, and then did so again in the '90s and '00s. Bear in mind who was making that debt available - whichleads to the most startling growth. Financial debt grew 0.01X to 1.18X of GDP, or about 1,163%!!! In addition topointing out that it was post-deregulation that we began drowning in debt but in fact, contrary to popular politicalmythology, Federal debt was steadily paid down until the Reagan administration when it ballooned again, thenwas paid down during the Clinton years only to be re-built during BushII. Not what you normally would think, eh?


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Relative Debt Growth

The second chart shows thenormalized relative growth and

highlights many of these points froma different perspective. All thesecharts are built around cumulative %growth from 1945 to 2008 and showthe relative, normalized, growth ofeach of the major sectors. As youcan see in the UL growth in Financedebt outstanding completely swampsall other sectors, which is why theother charts break things outseparately. The LL sub-chart showsthe major sectors, excluding Finance,the UR shows Finance by itself and

the LR sub-charts shows Householddebt along with growth in CreditCards and Mortgages.

Here's the fundamental questionsthese charts raise in our minds:

1) What's the appropriate level ofdebt for a healthy economy? We'dsuggest something more in line with the points reached around the mid-80's, except for Finance.

2) If that's true what kind of regime will be required to evolve back to that point? How long might it take to getthere? Is it feasible and what happens if it's not?

3) If Banking and Finance need to return to their roots (not say 0.01X of GDP but something on the order of .25-.5X, ala the 1980's, what kind of Industry will we have? Is it even possible? Is it politically feasible given theheartfelt opposition of the Industry to even modest reforms?

Fighter's Go to Your Corners: the Prospects for Reform

Ah, there's the rub, as they say. It's not an accident that the Presidentmade a speech directly to Wall St. on this topic nor that Summers, Blairand Shapiro were addressing the Georgetown University seminar onFinancial Reform about the same time, nor that a whole slew ofregulatory changes were being announced by the Fed, et.al. during thesame time period. We've have to say that the agencies, the

Administration and Congress are headed for the mats, as SonnyCorrleone would put it over this. And should be.

But that kind of warfare does no one any good - it may simply be thebest alternative that we're all left with. We'll continue to argue that afterloosing (destroying) almost a decade's worth of funny-money profits it'seven in the Industry's own evident self interest to proactively and


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constructively participate in re-shaping the regulatory and legislative framework. Larry Summer's Georgetownspeech laid out the Administration's framework pretty clearly, as well as explaining the reasons and intents.(http://www.c-span.org/Watch/Media/2009/09/18/HP/A/23338/Georgetown+University+Conference+on+Future+of+Global+Finances.aspx )

Five major principles were laid out:

1) Capital Adequacy for systemically important institutions (which also implies no more off balance sheet greencurtains)

2) Resolution Authority - in other words the end of TBTF (to big to fail). As Larry put it we don't ever want tofind ourselves again where we were with FNM, FRE, LEH, AIG and MER with no institutional recourse.

3) Regulatory Arbitrage - no more shopping among regulatory agencies for the best deal, and that especiallyincludes international comparison shopping (if you don't think that was an important part of the recent G-20meetings think again).

4) Regulate Systemically - no more regulatory "prudentially" single institution by institution but ask whatimpact the collective will have. Think of it as the end of "we will assimilate your distinctiveness and make it ours".

5) Consumer Protection - need a separate authority to focus on the health and well-being of the consumerinstead of letting those concerns get swamped by concern for the financial health of financial institutions. That(hopefully of course) means the end of predatory lending practices or exploitative credit card marketing andmanagement.

And the Alternative?

Summers pursued a great analogy when he compared changingthe regulatory framework to how we deal with Automotive Safetyissues. For many decades the theory of auto safety was that itwas the responsibility of individual drivers. But as more and morevehicles got on the roads with higher and higher performance cars

we had an "epidemiological" problem - that is there were moreand more unnecessary deaths because cars were changing fasterthan humans evolve. By comparison then do we continue to letthe death toll mount or do we do something?

One thing the Industry is under-estimating outside the Beltway orNYC is the depth and breadth of public anger. One could arguewe saw similar outrage after the Tech Bubble burst with Enron, Worldcom, et.al. and the outrage petered out. Thedifference though, this time, is those actions didn't threaten society. Last June we were at a conference on thefuture of corporate governance and one session, focused on improving Board decision-making, was taken over byone gray-haired gentleman's anger at the breeches of fiduciary trust by the Finance Industry. Bear in mind thiswas a couple of hundred people all of whom were executives, board members or consultants with decades ofexperience. If they were so anger as to loose control what does the rest of the country think.

We suggest you listen to the accompanying vidclip of Michael Moore being interviewed by Dylan Ratigan on MSNBCand listen to Ratigan.


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October 15, 2009

Pictures for a Prosecution: Wall St. Bonuses vs. the Public Good

http://llinlithgow.com/bizzX/2009/10/picures_for_a_prosecution_wall.html

If you've been here before you may have noticed we like to tellour story with pictures and so shall it be this time as well, withthe slight difference that they'll be more stories and less thecomplex graphics we're prone to. By this time you've no doubtheard that Wall St. is fixing to pay another set of stunning multi-$B bonuses while the rest of us are still crawling across thefloor of the chasm, broken and bleeding on the rocks. Howdoes that make you feel?

It's likely our point of view is implicitly clear and if it's not thenseveral of the last posts will make it clearer. One of the

bloggers we both admire and have learned a lot from, BarryRitholz of BigPicture, has defended the bonuses as the way theStreet works and if we want it to recover and do its job that'sthe price. Aside from the moral reactions or the questions ofgood public relations we thought we'd speak directly to theimplied assessment of the contributions of the Street andwhether or not they are justified and earned. We have three major problems leading to a major challenge.

And We Paid Bonuses Because???

1) Currently the Street's profits are entirely dependent on public policy ranging from reduction in competition toimplicit guarantees of the TBTF banks to low interest rates to various quantitative easing programs, e.g. the Fed'spurchase of mortgage-backed securities and the FHA's being the source of 80% of the mortgage market flow. Thepoint being their profits are being made off our capital, not their own.

2) There is no evidence that the perverse incentives where all the gains went to the high-earners thru tradinggains (read speculation) while all the losses went to us are being corrected. Add to which the perverse structureled to the failure or near-failure (including GS which had a near-death experience and was only saved bygovernment action) of the firms themselves as well as almost collapsing Western Civilization.

3) The really deep argument is that banks and financial institutions are the intermediaries that efficiently andeffectively allocate capital to their highest and best use. Well the prior two points tend all on their own to destroythat argument entirely but, since we've been reviewing the record, let's review it. We won't repeat ourselves butwill simply cite several graphics we've previously put up and let you pop them yourselves because, taken alltogether they reach a clear conclusion.

Wall Street profits and compensation Historical Growth of Debt

o WSJ Debt Growth Savings, Investment and Growth Finance Industry Case Theory Finance Industry Drucker Criteria Performance


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What those charts tell you is a sequential story - a logical syllogism if you will - that makes perfect sense to usand, IOHO, completely destroys the argument that paying bonuses is innate in the industry, necessary forperformance, part of the culture and ensures that the Industry contributes to the greater good. What they tell us isthat, beginning with de-regulation in the mid-80s, that Wall St. compensation completely pulled away from the restof the economy because the industry made exorbitant profits, that we "indulged" in astounding growth inindebtedness beginning then, which created the profits that paid the bonuses while destroying savings andinvestment, that the periods of highest savings were also the periods of highest economic growth (this one isparticularly important), and that the Industry has failed in its duties to itself to perform as businesses and failed todeliver value to society. We really do urge you to review the charts and see if you agree with the syllogism. And ifnot then why not and what alternative data do you have to propose?

The opening vidclip is Sully Sullenberger appearing on Morning Joe(http://www.msnbc.msn.com/id/3036789/vp/33307524#33307524 ) and we put it up as an example of whatgood leadership is all about, in the small. We were particularly taken with and moved by Sully's comment that oneshould "take responsibility for the people". The next vidclip is also from MJ and is offered as a compare andcontrast for where we're at with regard to the Industry. We'll just list out some other MJ/MSNBC vidclips that addfuel to the fire. We'll particularly point you to the interview with Michael Moore, not because we don't think he'sover the top, but because he's representative of the firestorm that's smoldering away waiting to be fanned intoflame by more irresponsible behavior.

Is a second Great Depression possible? : Financial Times' Chrystia Freeland and Donny Deutsch joinMorning Joe to consider whether the U.S. economy is really recovering.

Rep. Waters 'glad' Obama going to New Orleans: Rep. Maxine Waters, D-Calif., joins the Morning Joegang to discuss the state of the U.S. economy and the president's quick trip to the Gulf Coast.

The end of easy money: New York Times' Peter Goodman discusses his new book, "Past Due," a look athow Wall St. made reckless bets and how average taxpayers took the hit

Michael Moore talks 'Capitalism': Filmmaker Michael Moore joins Morning Meeting's Dylan Ratigan to shedsome light on his new film, "Capitalism: A Love Story."

This is, in a way, another exercise in syllogism. Only this time it's sort of emotional syllogism but it also tells youhow many people are thinking the same things. After all, when a still avowedly conservative talk show host isrepeatedly castigating the Street and getting people like Dylan Rattigan or Maria Bartiromo agreeing with him we

think the case for smoldering embers just waiting to bust into conflagration is pretty well made. But just in case it'snot, and while it's still up, we'll point you to the most recent episode of NUMB3RS, which explores theconsequences of the catastrophe and the loss of faith: Playing Russian Roulette - Seven Men Out.

Real Leadership: Her Majesty as Exemplar

At the heart of this whole discussion is the central question, orquestions: what does a business owe society and what does atruly responsible leader owe his firm and society as a whole?Not surprisingly Peter Drucker considered those questionsyears ago and came up with some deep and profoundanswers, which we've discussed multiple times. With regard tosociety he saw it as the deepest management obligation to do

three things: do no harm, act to reduce negative externalimpacts and contribute to the overall health of society. Weconverted his writings into several simplifying charts over timeand we'd point you at two, for the same sort of pop-uptreatment: a Manager's Responsiblities and Drucker'sFundamental Principles of Executive Leadership.


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We think the case has been made pretty strongly that the Finance Industry has failed to satisfy either it's privatemanagerial responsibilities or the fundamental principles, and in fact, by being narrowly self-interested and short-sighted, has actually failed itself. It would be in each firm's own enlightened self-interest to adopt and implementthose Principles if for no other reason than that society can no longer afford to tolerate their continued violation.

So what does publicly responsible leadership look like? We think Her Majesty, Queen Elizabeth II, is as much anexemplar of the discharge of duty with the highest standards of personal integrity and honor as any public leaderaround. We'll also suggest that the movie "The Queen" captures those perfectly. If you haven't seen it we highlyrecommend it. But why? (http://www.youtube.com/watch?v=P8nD2KB0a_E )

The movie traces out a week that began with the death of Princess Diana and goes inside the palaces and theQueen's behavior to watch her change 50 years of behavior in response to her subjects need for public grief. Allin response to the irresponsible behavior of a spoiled girl who charmed the public but in fact failed miserably tolive up to her own voluntarily assumed responsibilities and duties. West Point's motto is "Duty, Honor, Country".It's what the Queen displays, ultimately it's what's asked of public leaders responsible for large institutions and it'swhat their own self-worth requires. Now that trailer only gives you a small flavor, you really ought to watch andstudy the movie, but these other clips will also help: Queen Reflecting on Her Life, Queen's Christmas Message andthe Queen & the Prime Minister. I don't know about you but she sets a standard that's hard for me to live up to!

Now, are we going to get it or not?

In the meantime there are a few brief readings excerpts after the break, some immediate prior posts and thepointers to our major collections of previous discussions on the Finance Industry and on Social Responsibilitygoing back almost three years now. We'll trust you'll believe that our brief discussion here is grounded in somecareful thought and some background digging.

October 16, 2009

Bonus Fantasies vs. Political Realities: the Reform Firestorm This Time

http://llinlithgow.com/bizzX/2009/10/bonus_fantasies_vs_political_r.html

If you're a fan of political theatre this is the season for you. After the stimulus and budget battles we've had a long-running, multi-scene Healthcare Reform debate that's almost Shakespearean! But the other one heating up in thewings is Financial Reform, which is going to be as much a sturm und drang drama as any other, and is movingrapidly from the cloakrooms on Capitol Hill to the front pages of the MSM and the talk shows.

This post should really be an addendum to the immediately prior post ( Pictures for a Prosecution: Wall St. Bonusesvs the Public Good (Add)) but there was so much that bubbled up that came to our attention today that we decidedto make it a seperate post. In particular we lost weigh too much time watching Dylan Rattigan's show this morningand then collecting various URL addresses so you could to. Now Dylan's always been a little loud and he's gottenmore so with his new show. So one could take these various clips with a grain of salt or more. If we were theFinance Industry we wouldn't however. For technical reasons we aren't able to create a placeholder of a recentBloomberg interview with Niall Ferguson on the state of the Industry but will try and create a little attention space.

It doesn't take too long so we recommend you watch it for the level set...on the whole he gets it mostly right (ourbasic prejudice for selecting recommendations though Niall has a track record of not having as deep a knowledgeof finance and economics as one would hope).

Ferguson Says Bank of America Shows Crisis Not Over

(http://www.bloomberg.com/avp/avp.asxx?clip=mms://media2.bloomberg.com/cache/vn2QTiRB6gaU.asf&vCat=/av&RND=552723310&A = )


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Industry Pushback and Administration Counter-attack

We've been on this topic for some time (years in fact) but particularlyemphasizing it for the last several months and our take is that the Industry bypursuing business as usual and self-interested, narrow and short-sightedlobbying as traditional is building up a backlash that could swamp them. And

under-estimating the commitment of the Administration, the magnitude ofcommitted opponents on the Hill and the deep-anger of the American people.Now the Administration held out a hand to the interest groups in Healthcareliterally days after taking office, and has slowly been pursuing its goals whilecontinuing to offer them the opportunity to be constructive in helping shape thenew legislation. http://www.c-span.org/Watch/Media/2009/10/09/Economy/R/24155/Pres+Obama+Pushes+Regulatory+Reform.asp

x )

Most of them were smart enough to take it and the Administration is in the process of winning this fight andgetting a pretty good bill to boot

The Finance Industry was offered the same opportunity but has deliberately chosen to bite the hand that fed it.Much more so than any of the HC interest groups. The President's speech in early September was a declaration

of war but recent administration speeches are a clear outline of intentions (Saddam Hussein are you listening?).The video clip above is a recent short speech by the President on a Consumer Protection Agency and financialreform in general. We urge you, again, to listen to it but not just for the content per se but for the tone and attitude.The President sounded as angry as we've ever heard him, and while much less strident than the folks onRattigan's show, the language and tone were pretty similar. When you get the President that disturbed with youyou are NOT in a good place.After the break you'll find some news story excerpts on the state of things, the Administration's intentions, someindustry news which illustrate how badly they are handling things and the whole slew of URL's for the video clipswe mentioned. You don't need to listen to them all but we suggest at least a couple.

Peter Drucker in his magnum opus "Management: Tasks, Responsibilities and Practices" has a whole sectiondevoted to social responsibility that is the most insightful and brilliant thing we've ever read on the subject. Hepoints out that no business can be healthy when society is hurting. But he makes a fundamental point that

business executives have a primary responsibility to fix problems they create before society is forced to fix themfor itself. Let's turn that around - it is a primary executive responsibility to constructively engage with society andhelp shape fixes to problems. To act otherwise is profoundly irresponsible. It is also counter-productive because,sooner or later, those problems will be addressed and the results will not be to industry's liking.

If we were considering investing in Finance we'd have three major problems:

1) there are lots of problems still exponentiating (bad loans, CRE losses, terriblebalance sheets, toxic assets, the need to raise capital and the lurking problem ofmortgage writedowns. Taken all together they mean the industry is facing years ofoperational challenges that make them poor candidates. But,

2) the business models of all the major lines of business are broken which makes

them even worse. Finally,

3) the industry's obtuseness and bad tactics are going to create a major strategicproblem for them on current course and speed!

We suggest you evaluate them with these factors in mind.


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UPDATE: apparently we aren't the only ones concerned about truth, justice, the American way and regulatoryreform. Both Jim Jubak and Barry Ritholz dicussed the topic (in fairness Barry's been hammering away for awhile). This is going to be as big a fight as HC and will define the playing field for your well-being as much for thenext several decades as anything else going on. If you don't take the hint go make a noise unto yourCongressional representatives!

Congress writes strong new regulations for banksand then exempts everybody but my grandma Maria Cantwell re: Loopholes in Financial Regulation

UPDATE2: This was a startling read in today's WSJ. While it was in a Heard on the Street and sounds like anoped (NB: one suspects the editorial page staff would have tarred and feathered the writer) it makes a strongcase for aberrational controls on bonuses created by government policy windfalls.

November 19, 2009

Firestorm Flaring up: Finance Reform, CompensationWars & Sausages

http://llinlithgow.com/bizzX/2009/11/firestorm_flaring_up_finance_r.html

Not to rush you along too fast but we thought we'd re-visit our previous posts onregulatory reform of the Finance Industry. Understanding the state of play ANDthe business performance of the Industry per se are important for their ownsake. In fact this post should be considered as another deep dive into the stateof the industry and as a case study. It's also important for several other reasons.

One of course is the question of how viable investing in the Financials is.

But because the industry is the ecology of the Marketsit is systematically important and influences how the

entire economy does. It also controls how well you owninvestment does. This is particularly important, aswe've been covering in multiple posts, because the oldideologies of Efficient Markets and Asset Allocation arebeing fundamentally re-visited. The long and short of itis that discussing reform touches BusinessPerformance, Markets and Investments and theEconomy! We will observe however that this famouspainting, "The Scream", originally done to express theanxieties of the early 20thC, pretty well captures mostfolks feelings about the Industry. Which means, ofcourse, that the pressures for reform are mounting.Which we'll discuss but pay attention!

Market Performance as Indicator

Let's start with a benchmark by looking at the stockperformance of the Industry and its sectors YTD. Weuse the XLF ETF as a proxy for the industry as a wholewhile SPDR ETF's for various sectors including Banks,


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Regional Banks, Capital Markets, Insurance and Mortgage Finance are also shown.

As you can they all moved pretty much together into, through and after the March Madness when everybodythought the world was collapsing and the Financial Sector was going to end. Thank goodness for the Stress Test -it's called Animal Spirits, as in the world's not ending. The recovery continued for everybody thru mid-May on theback of earnings surprises (told you we'd close the loops) that turned out on examination to be a lot poorer qualitythan you'd hope.

Then things changed. The Regionals and Mortgage guys took some big hits as the size and scope of the CREproblems became more apparent. And as the up and downs of Housing optimism waxed and waned as well,though they both climbed back in the ballpark to keep playing with tre other teams. Since then the Regionals havere-deteriorated a bit as reality starts to set in.

The other important differentials are with the Big Banks, the Investment Houses and Insurors. Strangely enoughthe Banks did relatively well but the real differential performer has been the Insurance Sector. Oddly enough theInvestment folks haves slightly under-performed - it looks like performance actually matters a bit and some horsesrun faster than others. Of course which ones are important questions.

Financial Reform and Reactions

For a while there with the news that bonuses were going to be paid but would be extremely large there weremultiple stories per day in the business press. Given that some of those bonuses were as large or larger thanthose paid during the decade of the leveraged financial boom that's pretty surprising. One might even use theword outrageous - lots of folks have.

Now we've covered the elements of reform several times in multipleposts as taking repeated deep dives on the financial business as abusiness over the last couple of years. So many times that we'vecollected all the prior posts into essay collections which, taken as awhole, are a pretty complete portrait, assessment and diagnosis of theindustry. Pointers to the URL addresses for those collections are in thereadings. If you're in the Industry, an investor or just concerned as weall should be we strong suggest getting them and reading them. Thenet net is that the old business models are broke and not coming back.But the business doesn't believe that, thinks business as usual iscoming back and is pushing as hard as possible against reform. ANDthe culture is still locked into the last three decades view of bonusesand excess compensation. It'll be interesting to see what happens.

As it happens both the House and Senate, with strong support and enouragement from the Administration, aremoving huge bills forward as we speak. One of the best surveys of the consensus views of what needs to bedone is one Geithner gave at a recent SIFM conference, during an interview by Charlie Rose. Rose alsointerviewed Dimon who was, overall, very supportive of those arguments but pushed back where his ox was beinggored. Rose has changed his web site so you just go to http://www.charlierose.com/ and scroll the exclusivearchives to find them.


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The Case For Reform

We think the case for reform is overwhelming on several counts. Butif you cast your minds back to the late '90s there was an interestingsituation where Brooksley Born, of the CFTC, tried to change te rules

of the game to level the playing field. She was squashed by somemajor players, including folks who are again in the arena, becausethey were all drinking they Koolaid. They have since recanted, ashas almost everybody. Except Lloyd Blankfein who thinks they arestill doing "God's Work" of course. We'll see how this ends up butwe're going to get something, it's going to be big and a biggerchange, comprehensively, than anything we've seen since the1930's. And let's not forget the Pecora II commission that's busy beavering away in some back rooms.(http://video.pbs.org/video/1302794657/ )

It's well worth listening to the entire PBS Special on The Warning, or so we think. You can find the web page forthe whole effort HERE. If you want to take a deeper dive on the political sausage-making and the state of play, aswell as the big picture implications and debates may we point you to: The Beginnings of a Great Debate: People

Singing, Politicians Making Sausage.

Hear the People Singing

In the essay collections plus previous posts digging into theIndustry, its performance as a business and its influence andimpact on the overall health of the economy we go into somedetail about the business case for business as usual. So let'sjust summarize our findings:(http://www.youtube.com/watch?v=x6-5g78Nr6Q )

1) Financial Industry malfeasance almost destroyed the

economy, brought on Great Depression 2.0 and might havecollapsed Western Civilization.

2) The collective and cumulatively losses of the last couple of years wiped out most of the last decades's profits,even though they were all funny money in the first place. In other words the Industry almost destroyed itself. It's intheir own best interests since obviously they can't be allowed to play without adult referees.

NB: the bonuses that the Industry started paying itself grew exponentially starting in the '80s, acceleratedin the '90s and turned into a bubble in the '00s. And put compensation completely out of line. There is noevidence that those bonuses contributed positively to the health of society. In fact all the evidence is theother way.

3) Post de-regulation in the '80s we began almost three decades of wild indulgence in debt and over-consumption

that loaded up the Industry, the consumer and business with leverage that we couldn't sustain.

4) That debt caused savings to drop to nothing and severely retarded investment and economic growth.

5) The lack of economic growth led to a relatively stagnant economy with poor job creation and flat to decliningwages and benefits. And that, in turn, has led to an increasingly stratified society where the top 1% of earners,strangely enough somewhat concentrated in the Finance Industry, to garner all of the gains of the last threedecades.


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When a society, historically, spends more effort on rent-seeking and power elites focus their careers on rulemanipulation then it eventually succumbs to sclerosis and dies. Just ask the farmers and peasants who harvestedall the wood on Easter Island and destroyed the ecology just to keep making giant statues for the Chiefs.

Sadly though the mood of things is pretty well captured by the song "Here the People Singing" from LesMiserables. The real problem is that the Industry had an opportunity to both fix itself AND to collaborate on re-shaping the regulatory framework in a constructive fashion. But has refused to do so. The evidence for helmetlaws and adult referees to make sure the game is played according to the rules seems to be overwhelming.

UPDATE: an interesting summary of the last "Lost Decade" and the triumph of a terrible culture and theconsequences for the rest of us: Farewell to Wall St.'s decade of hubris(http://articles.moneycentral.msn.com/Investing/CompanyFocus/farewell-to-wall-streets-decade-of-hubris.aspx )

December 14, 2009

Paying the Piper: Finance Industry, Performance, Value & Regulation

http://llinlithgow.com/bizzX/2009/12/paying_the_piper_finance_indus.html

With the blockbuster financial reform bill moving toward the floor, aPresidential 60 Minutes interview and major discussion with the bankersits time to re-visit the Industry, its status, performance and management.Not least of the triggers is JPM's presentation at last week's GSFinancial Services Conference but let's set the stage with Hoofy and Boogiving us their take on the public spiritedness of the Industry, asexemplified by the GS "Goldfellas". It shouldn't take long for you to figureout the movie they're riffing off of, not least because Blankfein does looka bit like Joe Pesci. But the real thing to keep in mind why is a Financesite/service like Minyanville taking this shot at GS and the Industry ingeneral?

(http://www.minyanville.com/audiovideo/724/2/23 )

While you ponder that question allow us to observe that this post is notjust its own thing, i.e. a FinInd update but also ties to the last several onthe state of the Markets/Economy and Business Performance.

On the former, in case we weren't clear, we'd summarize as: 1) there was a small run toward the dollar as thesovereign debt thing scared folks which drove up the markets confirming everything we've said, 2) some dozendifferent commentators from Paul Krugman to Rubini to John Mauldin to Mark Thoma have ALL come out to talk,in one form or another, about the "Mother of All Jobless Recoveries". If you'll recall our estimate is that we need46 million jobs to recover a state of prosperity but are going to be lucky to get 20 million.

In other words we're looking at doldrums decade of poor job growth, slow economic growth and constrained

profits and earnings. Which then leads to the critical question of what companies are prepared or preparing for avery tough environment thru efficiency improvements, strategic changes in operational effectiveness and creatingnew value thru real Innovation? Our answer was that most of them are heads-down and hoping just to get bywhile everything returns to normal. That the banks are still not lending, still have toxic balance sheets and aren'ttalking about new products and services is critically important.


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Consider J.P. Morgan (JPM): Exemplar and/or Exception?

One of the few that have beenwell-managed is Dimon's JPM.The graphic is drawn from last

week's presentation and asidefrom its content what we foundinteresting was that the lines-of-business he discusses are prettymuch, allowing for somecompression and poetic license,right in line with the enterprisemodels of the genericFinancial/Industry model we'vebeen using so much to assessthe Industry and particular firms.If you're interested the entirepresentation is downloadable

here.

Rather than just point you to the several business model/management performance charts we took all theaccumulated and posted essays analyzing the Industry over the last several years and created a Finance Industrybusiness performance collection. If you're an investor, a customer, concerned about the health of the Industry andits impact on the Economy or an employee this might be useful stuff to download, read, think about and decide.Finance Industry Futures: Credit, Leverage, Malfeasance and Broken Business Models , FFII: Crisis, AdaptationFailures, Alternatives and Recommendations and FFIII: Facing the Firestorm of Re-regulation.

Posting those all up also saves us from having to revisit old arguments that are long, complicated and wouldsuffer a bit from needing to be compressed here.

We're more concerned that you can use all this stuff as a jumping off point for your own conclusions rather thanthat you find our arguments faultless. But at least there's a relatively massive amount of analytical machinery foryou to re-use. We'll also point out that our analysis lines up pretty darn well, if we say so ourselves, with Dimon's.Not bad company for an amateur - so maybe we're not completely out of the ballpark.

The Political Factors: the Fat Cat Outrage Tsunami

One of the truly amazing things to us, especially given all the flashingyellow and read warning signs, is how completely tone deaf the Industryhas been to the political backlash just simmering away out there. IgnoringBlankfein's "God's Work" statement as a Freudian slip of the ego thePresident warned them last Winter and Spring, again in his speech to theStreet in Sept. and recently. Yesterday's interview was yet anotherwarning shot as well.

There is a mammoth Tsunami still building as last week's bonusdiscussions, pay decision, House Bill passage, windfall tax discussionsand recent SEC compensation rulings shows. Let's put that another way, borrowing the President's phrasing:"he's the only thing standing between them and the pitchforks". They've been fighting a valiant rearguard action toslowdown, delay and water-down the evolving legislation but it's moving massively forward thru the SausageFactory.


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It is a fundamental management responsibility to act in a socially responsible manner. Which means 1) doing noharm, 2) acting collectively to redress and correct those harms that are industry wide that no single firm can affordto tackle without disadvantage and 3) contributing to rectifying general social problems where needed andfeasible. The Industry's business case rests on the argument that they are vitally important for the efficient andeffective allocation of capital.

But a careful review of the data from the last three decades raises some telling counter-arguments:

1) Industry dysfunctions came within a gnat's eyelash of almost collapsing Western Civilization (almost literally).

2) Risk-preferred, bonus-driven and short-term decision-making wiped out a decade's worth of paper profits in theIndustry (translated: they need adult supervision having proven for their own and our sakes that self-responsibilitydoesn't work).

3) Total debt in this country, including Consumer, Business and Financial, skyrocketed beginning in the 80s,exponentiated in the 90's and bubbled in the 00's. Saddling the economy with an enormous burden and drivingSavings and Investment down.

4) Economic growth was highest when Savings and Investment were highest. Debt escalation displaced that andwe'll need to crawl back there, sadly thru forced de-leveraging and balance-sheet re-building and most likely after

struggling thru the Doldrums Decade.

5) It's been since the 80's that the Industry as a whole was innovating and creating value for its customers. In thelast two decades innovation has largely been restricted to financial engineering for internal purposes thatcontributed to the dysfunctional burdens.Again this is all visible in readily available data thru a little analysis. As is the tsunamic growth of the politicalbacklash. Rather than try to extract a few points we'll point you again to some essay collections published onlineas whitepapers and downloadable. One of the points of this whole post BtW is that in the current circumstancesthe political ecology is as critical a business performance factor as ROA, customer service or productdevelopment. Especially for this industry. Anyway you might want to also look at: FFIII: Facing the Firestorm of Re-regulation,Financial Reform, Industry Puschbak and Political Sausage-making, and Profit, Performance & SocialResponsibility.

Dharmic Denials: Alternative Approaches to Coping

We're going to let Hoofy and Boo have the last word here(http://www.minyanville.com/audiovideo/815/1/23 ), partly becausethis clip is also very funny IOHO and partly because of all the hiddenmessages.After you've had your chuckles and cries the real point is that chanting isNOT going to make any of this go away any time soon. If you're any kindof stakeholder the business performance assessments discussions needto give you serious pause for reflection. After three decades of"performance" that turned out to be based on leveraged Beta and nottrue value-creation what's the Industry's strategic outlook?

There's lots of short- and intermediate-term problems that could be withus for quite a while. But what efforts to truly create new products and services do you know about? As they say,where's the value-beef?

Beyond all that the re-regulatory firestorm, which is being feed by obtuseness and tone-deafness (couldn't they atleast pretend for a little while that they're sorry and will try and do better?), are 3rd best solutions. First best ofcourse would be for the problems to never come up. Second best would be for a light framework of principles and


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incentive mechanisms to be used. But, as Ken Rogoff points out (in the readings) along with many others in thesecircumstances we don't appear to have any choice.

December 18, 2009

The Business of Banking: Challenges, Issues & Outlook

http://llinlithgow.com/bizzX/2009/12/the_business_of_banking_challe.html

Not to rush you along but we're going to swing back andpick up some more Finance Industry news - not leastbecause so much happened this last week on theregulatory front. We mentioned the House moving out agiant reform bill last Friday but on Mon. the President metwith the executives (some of who were conferenced inbecause of D.C. fog!), the same day Mcain and McCaskellannounced support for a new Glass-Steagall, (this isREALLY critical) the SEC issued new regulations oncompensation, the WSJ had a conference on the "future of

finance" which didn't produce much in the way of reality-facing recommendations and Paul Volcker came outswinging all over the place (at the conference, one inLondon and elsewhere...whee!). It looks like that tsunami ofbacklash against business-as-usual might be starting toreally rear up, doesn't it?

The cartoon, as have similar composites, captures thegeneral reaction but the really interesting thing is that somevery heavyweight players are now pushing along the same

lines. They are fundamentally questioning the value ofthe Industry as it currently operates and the value it creates for society. And that is new.

Banks As Businesses: Whalen's Bloodbath

We've been raising similar questions for a while now and alsopointing out that the Industry will continue to face some fundamentalchallenges for a long time to come. It's not just refreshing to hearfolks with more clout beginning to chime in but, if we were involved inthe Industry, we'd start thinking about things like jobs, stockperformance, and minor little details like that. Not to mention whatwe'd think if we were investors. Fortunately Chris Whalen ofInstitutional Risk Analytics chimes in for us. And people listen to himand his firm for sure.


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Credit & Loan Demand

One of the major problems is that, despiteenormous sums pumped into the money andcredit markets, that money is not moving into

the economy. Partly because demand is poor,as you can see in this chart set, but mostlybecause the banks are reluctant to lend. Whichgiven the toxic assets, oncoming problems witha weak economy (loan losses, writeoffs, etc.)and the need to re-build their balance sheetsisn't really a surprise.

But it hampers the recovery very badly - in factthe hidden tsunami lurking out there is thenumber of small businesses who can't getcredit who are just about to hit the wall. All ofwhich is not only a continuing business

problem but adds to the political tensions ofcourse.

Re-visiting the Credit-Econ Death Cycle

This whole mess started with the ripplesfrom the collapse of leveraged syntheticdebt instruments but then quickly feedforward into the economy where creditconstraints accelerated a slowmotionslowdown that had turned into a serious

downturn and then a major crisis. But forover a year the problems in the economyhave been feeding back into the financialsector in the form of mortgage defaults,credit card non-payments, loandelinquencies and on and on.

That's going to continue for a while...creditcard delinquencies are up, there's a hugeinventory of "shadow" housing stockwaiting (for one reason or another) tocome on the market and it's not at all clearthat the banks are well-prepared for any of

this. If fact if Whalen has it right they'repretending it away. The other little tidbits ofinteresting information in the readings isthe reminder that it's Federal Reserve"subsidies" that are holding the wheels on

the wagon, whether it's mortgage backed securities (MBS's), special programs to buy back other debt, theTreasuries TARP program (some of which is now going to be directly targeted at small business!) and so forth.


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Finance in the Markets

It was fascinating for the Financials to leadus out of the March market madness whenthe much-criticized Stress Test actually

did it's job and convinced folks that thebanking system wasn't going to fail afterall. In fact we had two near-deathexperiences in the last year - last Fall andthis last Spring.

The first was a big surprise while thesecond also appeared out of nowhere.Since then Financials have led themarkets up, on the strength of earningsreports (which when you take them apartwere weak, didn't represent fundamentalstrength, did reflect a lot of bookkeeping

shennanigans and government aid butwere mostly trading profits).

That sense of weakness is reflected inhow the Financial ETF (XLF) is performingvs. the rest of the Sectors as well as theother Industry sub-sectors (IXG - globalfinancials, IAI - regional banks, IAI -broker-dealers, IAK - insurance). Asidefrom "intrinsic" industry risks and fadingoutlook you have to ask to what extent theFinancials are a "tell" for the broadermarket - since they were a primary driver (Barry Ritholtz Is Still Bullish on Stocks, But Not for the Long-Term).

We hope to get to it but here's a current SPX composite where some of this pops out at you.


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Banking as a Business: Phases and Spaces

This all comes back down to the fundamentalquestion that Volcker and others have raised,are raising and are starting to get out the

"hammers" about. We won't review our last poston the Industry (Paying the Piper: FinanceIndustry, Performance, Value & Regulation)except to say that the business case for socialcontribution and economic value-add wasthoroughly investigated and found to not holdmuch water.

Simple as it is we consider this chart to be thekey one in this whole post as well as a keystrategic assessment of the Industry, its history,performance and outlook. During the 60s theIndustry ran a boring business then it got

wallopped by the stagflation of the 70s. Duringthe earliest days of de-regulation though itresponded well by creating new products andservices that really created value for customers(a little more than Volcker's ATM). During the90s the weight shifted to rocket science,financial engineering and self-dealing (if thatcalls up images of the Industry playing with itselffeel free to indulge). During this decade that propensity to play only for themselves got weigh out of control anddrove all the other markets and burdened the economy with enormous debts, with (shall we say) very unfortunateconsequences. The real interesting question is where do they go from here.

Strong indications of business as usual and devil-take-the-hindmost aren't very encouraging and just the firestorm

that's going to move beyond smoldering pretty quickly we think. If it isn't already, that is. What we really hope isthat, having survived the Perfect Storm of their own making thru public charity and now being faced with severalyears of damage control, repair and re-building, they will move beyond self-dealing. And instead start focusing onoperational improvements and value-adding innovation for their customers. We'll say the jury is still out but thesmoke is looking kind of black so far.


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December 20, 2009

Jobs, Debt & Growth: Level Setting the New Normal

http://llinlithgow.com/bizzX/2009/12/jobs_debt_growth_level_setting.html

Two posts ago we took a quick slapshot at thestate of the economy (Slapshot in Time:Economy Status and Appalling Military

Metaphors) and the outlook to set up a deepdive on the underlying structural foundations,this post. And interrupted ourselves to divert onall the amazing news coming out of theFinancial Sector (The Business of Banking:Challenges, Issues & Outlook) with regard tothe smoldering firestorm of reform beingfanned into life. Strangely enough the two are

completely related, as we'll show here, butwe're going to start with long-term employmenttrends.

Lest, however, you think this is just boringeconomic data take a look at this story fromtomorrow's WSJ on the Lost Decade in themarkets (Stocks' 'Nightmare' Decade) or CalculatedRisk's comments on that and Employment (The Lost Decade).After we're done, if not before you should be convinced that they aren't unrelated. The accompanying chart showsNew Jobs, Net New Jobs (New-450K/Qtr needed for breakeven) and cumulative job creation from 1980 to now.We may have "lost"7+ million jobs during the downturn but according to our calculations we're actually 12.2 millionin the hole. The point being that for our economy to be prosperous and growing where wages go up and driveinvestment and new hiring, thereby in turn driving profits, earnings and markets, we need jobs, jobs, jobs. And, if

you recall the last econ post we estimated that over the next decade we needed 46 million of them and weregoing to be lucky to get 20 million (the BLS has since estimated that we'll create 15 million over the next decade).Welcome to the new normal.

Long-term Employment Trends

In fact the news on the job creation frontis, it turns out, as bad as it's been indecades (including during the GD - as CRpoints out in his post). The top sub-chartshows private and public employment sothe stack gives us total employment. Wehad longish periods of flat/sluggish job

growth in previous severe (or what passedfor back then) recessions but we've neverhad a decade where net job growth wasnegative as it is now.

If you look at the bottom chart that terribleperformance, how far we are in the hole orhow unlikely we are to dig out of it anytime


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soon should come as no surprise. It starts with YoY% growth/change and looks at the trends. The straight-linetrend is down, rather severely in fact. The non-linear trend is even scarier in a way - it tracks the straight-line formost of the time and then falls off the cliff. As if you all needed to be told that.

Growth = Jobs

The question that naturally follows from thatis what happened? Why has job creationbeen so poor? Well as it turns out there are,again, no real surprises. But knowing whatthe numbers are should make things prettyclear as to the outlook.The top sub-chart gives us, in read it off thechart form, the relationship between realGDP growth and job growth. You mightremember that we need ~2.5% growth injobs to breakeven on labor force andproductivity growth (roughly speaking that450K/month benchmark). That, in turn,

requires 3.5-4.0% GDP growth.

The bottom sub-chart tells us how we'vebeen doing on that front. The only time wegot net new job creation was during the late90s, when we also saw real GDP growthpushing toward 4.0%. Since 1960 jobgrowth has been getting weaker andweaker, with the straigh-line trend negativesince then.You can go back and think about what was going on, e.g. the malaise of the 70s as the excesses of the 60scaught up with us and combined with the oil shocks to retard growth, the slight improvements during the 80s aspolicy changed and the damage began to self-repair on thru the early 90s. But it was only when Investment duringthe Tech Bubble pushed growth up that jobs began to recover back to the halcyon glories of the 50s and early60s.

Wages, Economic Health andProsperity

If you thought a decade of null performanceon the markets and jobs was bad how aboutreal wages - which are the "beating heart" ofeconomic prosperity? If real wages aren'tgrowing neither is long-term demand. And if l.t.demand isn't growing then there's no

investment and ultimately no real profits. If youlook at real wage trends (red) they've been thenext thing to zero growth since 1965. PersonalIncome is slightly better though they droppedseverely during the 60s and 70s beforeflattening off and beginning to recover in the80s and picking up a bit in the 90s beforefalling back off a cliff.


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Depending on your political bent you might suspect that the greedy capitalists absconded with all the gains fromgrowth in profits but was that true?

Profit, Wages and Capex Trends

Well not exactly though on first pass it might looklike it. The top sub-chart shows the shares of realGDP that went to Profits, Capital Investment andWages from the late 40s to now, which reinforcesall the things we saw in shorter time-frames. Butthe 50s and early 60s were indeed a "GoldenAge" with significant improvements in Wagesgrowth. Strangely enough Profits performed wellduring that period as well, and Capital spendingshowed a rise. But in the late 60s Wages began along downhill slide that only leveled off andstabilized in the 90s. Profits dropped almost as

badly early on but then began climbing.

Part of the problem was that capital spendingpicked up, partly (we suspect as the result ofinvestments required to adjust the capital andtechnology base to less energy use, partlybecause of various regulatory burdens, e.g. newsafety regulations and partly to adjust to laborforce changes). But then capital spending leveledwhile profits surged.

When you compare aggregate growth in GDP and Profits from 1950 to now some very odd behaviors appear.They ran roughly with GDP until and then started lagging badly before beginning to pick up again, reaching amini-peak at the height of the Tech Bubble. But it was the decade of the 00s when they really turned into a bubble- one that burst. On the surface then you would argue that profits resulted from no hiring or job creation andinsufficient investment to increase the growth of the economy.


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Profits Pass Two: the Triumph ofFinance

When you break Profits down into Finance vs.

Non-finance a much different story emerges.Real profits from companies that made realthings started badly lagging overall economicgrowth until they did, in fact, experience theirown mini-bubble this decade.Where the profits really went was into theFinance Industry, beginning in the late 80s;which, interestingly enough exactly coincideswith de-regulation. Then they began explodingtoward the very end of the Tech Bubble andmetastasized this decade on the backs ofleverage and funny accounting. Until gettingpopped and wiping out the better part of a

decade's worth of paper profits.The bottom sub-chart compares the relativeGDP shares of Finance, Non-finance andWages. Basically confirming the story.

The Sad Tale of the Real Driver: Debt

The next chart starts to bring us to the real rootof the problem, which is the metastatic growth ofdebt. Consumer debt, business debt and,especially, Finance debt. The next chart showstotal debt by sector as GDP multiples. BtW -interesting to note that the best behaved folks

around were the Federal and State & Localgovernments, who actually lowered their totaldebt levels.

Consumers and businesses however startedramping theirs up. In other words our economicgrowth, such as it was, was fueled by debt andenabled by financial deregulation. When weargued in the last post that the business case forFinance being an effective allocator of capitalwas not true that would seem to be born out. Butthe real champion debt issuers were theFinance industry themselves. To the extent that

those funds were used to re-loan elsewhere there may be some over-lapping double-counting. But to the extentthat Finance debt was use to fund "investment" and trading (and bubbles and funny structured debt) the numbersare valid. If you want to see the chart that breaks down the details a little finer click here.


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Growth vs. Savings vs. Investment: Debtor Nation

This chart shows the long-run trends in economicgrowth, savings and investment. Notice that, on thewhole, the highest growth rates were when we had

the highest savings levels. When Savings begandropping precipitously growth started slowing downuntil it fell off another cliff recently. Savingsmeanwhile went to nearly nothing, and then wentnegative. And Investment growth nearly died.

The lessons seem fairly clear. Growth creates jobs,jobs drive wages which creates prosperity andsavings drive Investment which in turn supportsgrowth. If we want to get our feet back under us weneed to return to being a nation of savers whoinvestment in productive uses of our capital. So,sequentially, we're facing a strategic and structural

outlook of poor job creation, long-term constraineddemand as the consumer (and business)deleverages and a still bigger challenge in getting back to the kind of high-growth economy that benefits us all.

Debt vs. Savings

Just to bring that critical point home let's take a lookat Debt vs. Savings. Here we can see where theprecipitous decline in Debt (a good thing mind you)happened during the period of highest economicgrowth. Then debt started slowly increasing, thenaccelerating and then accelerating some more. Untilwe reached a point where the structural Savings

rate feel into a canyon, not off a mere cliff.Case closed, end of story. We need to save more,invest more and, hopefully, grow more.

In the meantime we've just defined the New Normal- which is the environment of de-leveraging and slowgrowth while we fight to re-establish the kind ofregime that's pro-growth.


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January 13, 2010

Pecora 2 Hearings, Malfeasances, Your Future & Cusp Points

http://llinlithgow.com/bizzX/2010/01/pecora_2_hearings_malfeasancs.html

The Financial Crisis Inquiry Commission (FCIC), orPecora 2, kicked off its hearings this morning with quickstatements from the chair and vice, testimony from theheads of 4 of 5 of the big banks, a second panel fromseveral investment banker/analysts with strongcriticisms and an afternoon panel from fourbanking/economic/housing experts.Frankly the hearings so far are stunning - intelligent,polite, informed, limited axe-grinding by thecommissioners (with some exceptions), almost noideology and a strong bi-partisan spirit of inquiry,digging into the data and understanding. In just today's

hearings (which we intended to listen to only for thekickoff but ended up getting sucked into for the wholeday mostly) we heard the entire crisis reviewed, mostof the major root causes id'd and the last two years ofback and forth raised, reviewed and either put too bedor confirmed. By and large the preliminary indicatorsare that our assessments align with the Commission's and the witnesses.

Just to set the stage however we'll start you off with a recent show from Bill Moyer's Journal on PBS where aneditor and a report for Mother Jones discuss their findings for why there's been such a delay in moving forwardwith reform and how the Industry has influenced things. (http://video.pbs.org/video/1380851536 )If you find yourblood pressure rising that was and is the intent. Perhaps the most interesting thing was that all the big bankersstarted off, stayed with and finished up with Mea Culpas and fairly forthright discussions of what went wrong (the

most intransigent and argumentative being Blankfein of GS, who more than got into it with the Chair).


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Where We're At: Impacts andCurrent Status

Let's start with some charts takenfrom Mark Zandi, of Economy.com,

testimony. Zandi by the way is wellrespected on both sides of the aisle,was an advisor to McCain and has areputation for even-handedness.Starting in the UL corner he tell usthat after a near-collapse thatgovernment intervention hasstabilized the financial markets(under questioning he stated that theStress Tests this last spring wereTHE major turning point). At thesame time he also said that themarkets are far from healthy, using

(UR) the bond markets and the levelof debt issuance as the criticalindicator.

He then went on to point out that itwas almost entirely the stimuluspackage that saved the economy perse from greater collapse and thatmany of the programs had large andbeneficial effects, leading to anestimate of 4% GDP growth in Q4.Yet also worried that the as the impact fades the risks of a W-shaped outcome are serious and would recommendanother $200B stimulus follow-on (again, this from a McCain advisor). He also pointed out that (LL) the labor

markets were damaged and recovering poorly and would remain in trouble for a long time. Since all that lines upwith everything we've been saying for months we thought it was profoundly insightful :)!

What Broke - the Analyst'sPerspectives

Interestingly, despite differences inperspective (and one commissioner withan ideological axe to grind) all of thewitnesses basically agreed to the sameset of problems and breakdowns. Sinceone of them (Michael Mayo of CalyonSecurities) was kind enough to provide

charts to back up his diagnosis weborrowed a subset to create thiscomposite. (all the exhibits can bedownloaded from the FCIC's web site atwww.fcic.gov).

Starting in the UL corner he first pointedout that there was an explosion of


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securities in the 00's AND that the Asset/Equity ratios of the Banks and Securities firms exploded;i.e. they gotthemselves leveraged to a fare-thee-well (really interesting despite the roots lying in the 80s this didn't explodeuntil this decade).

Moving down the left column that much of that issuance moved from secure instruments to structured productsand that this financial engineering drove a huge surge in fees. No self-interest here of course. Moving to therighthand column we see the concentration of this new issuance in real estate trading in one form or another, inwhich btw, consumers, et.al. were complicit as well - since consumer debt also exploded. The real money chart isthe last in the lower r.h. corner - which tells you what happened to compensation in the Finance industry vs. therest of the economy. So there you have it - graphic testimony to malfeasant greed run amok taking the innovativetechnology of securitization and metastasizing it this decade to drive fees, profits and bonuses. And, oh yeah,almost collapsing the world. Again - in so many words - everybody including Blankfein, Dimon, Mack andMoynihan (BAC), basically conceded all these points (and a good thing it was the new guy and not Lewistestifying).

The Long-term Strategic Impacts

So what are the long-term consequences?Well if you read our year/decade outlook on

the economy, markets and business you'vegot one set of answers. But we'll go back toMr. Zandi for his take - remember this isunder oath btw.Well Mark sees it pretty much as we see it -though if anything he's even gloomier,though he put it more simply and clearlyperhaps; and talked more about long-termdebt and savings. Nonetheless coming fromvery different directions we ended up withidentical conclusions.First off (UL) Consumers took a huge shotto their Net Worth that they will likely neverrecover and which will cause fundamentallong-term damage. Which you can see inthe Confidence charts (UR) for businessesand consumers - which despite improvement are still worse than at any time this data shows (NB: the spokesmanfor regional/community banks said something similar in his own words).

The two really sad, scary and critically important factors are the long-term structural impacts. In the LR you cansee the estimate of the long-term impact on GDP growth rates - we're going to be hamstrung for a long time. Andin the LL you can what kind of debt financing problem we got saddled with and will take a long time to work out of.In the readings below we have a very long accumulation of excerpts leading up to the hearings, setting out thebackground, some diagnosis and recommended resolutions and the impacts. The Commission is chartered totake the year to to reach its conclusions but this will indeed be the year of re-regulation in several forms or theother.


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The Hearings and the Assessment

There's been an enormous amount of criticism of theAdministration and Congress for not moving faster on allthis to quickly and magically fix it. Of course that's how we

got into these problems and the original PecoraCommission didn't reach its end and see new legislation foralmost four years. There was plenty else to do this yearwhich should have and did preclude starting hearings onthis matters. At the same time now people both have someperspectives and we've seen the Industry's true colors. Allin all we don't think things could be better positioned for asgood an investigation and re-think as we're ever likely tosee. CSpan is carrying the hearings live and also puttingthem up on its web site. It's at least worth some of yourtime to listen to the openings (if the Chairman and Vice'sstatements are on this) but we felt encouraged from the getgo, and more so as thing proceeded. This is as qualified a

group of public servants as you're likely to get, even considering the political process that brought them there.

During the course of the hearings Zandi su

Documents

Banks As Businesses: Performance, Reform and Blindsidedness