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What if there really is deflation?

2011-11-21T19:58:00.003-05:00

Published by clickbroker.blogspot.com.

Hard as it is to believe with high food and energy prices, statistics can tell you anything you want to hear. What can Bernanke actually do about deflation? Common wisdom would say QE3, 4, etc. But QE does not drop spendable money from helicopters as Ben wants us to visualize. It has not even expanded credit; it just lowered the cost of credit. And that is only for the best credits.

The majority of QE dollars have been sterilized by finding their back to the Fed’s balance sheet in the form of excess bank reserves. To Bernanke’s great distress, only Congress can hand people checks. So to quote Al Gore the “inconvenient truth” is that even if Bernanke can convince us that we have deflation, there is absolutely nothing he can do about it.

[JavaScript Games by Michael Steinberg: Color Splat Game, Magic Word Game and Scramble Word Game.]

Extreme Couponing leads to Bad Health

2011-06-29T12:21:00.000-04:00

Published by clickbroker.blogspot.com.

I watch with fascination as TLC’s Extreme Couponers (DISCA) stock up hundred of bottles of soda, frozen sweet treats, energy drinks, protein bars, can goods and other nonperishables that can’t possibly cleanse or provide any real nutrition to the body. As a person who completely divorced myself from processed foods, I wonder what I could eat if they invited me to dinner.

The show starts out each episode with a walkthrough of the participant’s stock pile; their neatly organized warehouse either contained in their basement or garage. Interestingly, in the most recent episode I saw the warehouse had spread to industrial style shelving in the master bedroom. How romantic is that?

These reality stars and their families are either obese or on their way to obesity. They talk about saving so much money that they can eat for free and use the money to go on vacation. While I find the show’s premise and characters entertaining, there is always a degree of sadness watching their health deteriorating. This is especially true seeing parents giving “free” cookies to their obese children and bragging that they will be eating “free” canned spaghetti with “free” tater tots for dinner.

The show is a celebration of processed food and supersizing. But the show could also be thought of as an extension of the lifestyle originated by Costco (COST) and now promoted by Groupon. These companies charge their members for the privilege of buying far more than they need. Savings? At least they are not encouraging customers to dive into the recycle bins for 50 copies of the Sunday coupon inserts.

Admittedly, the game is as important to the couponers as the savings. Some even give a large portion of their stockpiles to charity. But the real lesson of the show is awakening to how out of balance the American food supply is. We have a government subsidizing packaged food to the detriment of fresh food through industrial corn policies. Corn is the foundation of most processed foods.

Regardless of your political beliefs, America cannot solve its healthcare crisis until it solves its food crisis. We need to rebalance our subsidies from frozen to fresh, from industrial corn to table green vegetables and from sugar to fruit. This is not the nanny state, it is the reality. No disclosures. .

[JavaScript Games by Michael Steinberg: Color Splat Game, Magic Word Game and Scramble Word Game.]

Economic Shorts: Volkswagen and a Billionaire’s Chinese Misadventure

2011-06-28T07:28:00.001-04:00

Published by clickbroker.blogspot.com.

While the Treasury and Federal Reserve’s “strong dollar policy” is killing our currency, some empirical evidence might be showing its benefit. Volkswagen will soon be rolling out its new Americanized “supersized” Passat from Chattanooga. The car is to be built for America in America. Previously VW could not compete in the American mass market with German built cars.

CEO Martin Winterkorn spoke of benefits beyond anticompetitive exchange rates: “Trends are set in America … A U.S. factory can capitalize on those trends faster.” Speed to market and agility will drive America’s new manufacturing renaissance.

If housing bust billionaire John Paulson got fooled in the Chinese stock market, amateurs don’t stand a chance. Paulson & Co has lost more than $500m after selling its entire holding in Sino Forest, the Chinese forestry company fighting allegations of fraud. I have read many recent stories of Chinese companies reporting different results to American investors than Chinese regulators.

No disclosures.

[JavaScript Games by Michael Steinberg: Color Splat Game, Magic Word Game and Scramble Word Game.]

Is Bloomingdale’s Macy’s Ugly Duckling?

2011-06-27T09:49:00.001-04:00

Published by clickbroker.blogspot.com.

Strange question in the title readers might think. After all Bloomingdale’s is Macy’s (M) upscale branded department stores. But anecdotally it appears that Macy’s is following Target’s (TGT) restructuring to concentrate on its core brand. Dayton Hudson shed its moderate and upscale department stores and renamed itself Target. Now all the resources are dedicated to one core brand.

Macy’s became national through a series of acquisitions, bankruptcies and other reorganizations. Then they went through the process of rebranding most of their stores into Macy’s. Finally, the company was renamed from Federated to Macy’s. Only two brands remain – Macy’s and Bloomingdale’s.

Recently I visited Bloomingdale’s for the first time in a few years in a very upscale mall. Tacky is a kind description. The Macy’s store in the same mall was immaculate; Macy’s higher end merchandise overlapped Bloomingdale’s. Macy’s was crowded and Bloomingdale’s was empty.

Bloomingdale’s had not been updated for many years. The “classically modern” signature black and white tile was clearly dated. The carpets were stained and worn; the mauve-colored Formica in vogue about two decades ago on the checkout counters was faded and peeling.

Macy’s was loaded with merchandize while Bloomingdale’s was thinly stocked. Some parallels existed. Salespeople at both stores wore solid black business casual and both stores contained sale racks. Why the disparity in investment?

This same mall also contains pristine Nordstrom (JWN) and Saks (SKS) stores. Why would the upscale shopper not shop at Bloomingdale’s competitors?

No disclosures.

[JavaScript Games by Michael Steinberg: Color Splat Game, Magic Word Game and Scramble Word Game.]

Where does Kohl’s fit in?

2011-06-22T06:19:00.001-04:00

Published by clickbroker.blogspot.com.

The aspirational hierarchy used to be Saks (SKS), Bloomingdales (M) and friends, then Macy’s (M), followed by JC Penney (JCP) and Kohl’s (KSS), and then Target (TGT), Wal-Mart (WMT) and Kmart (SHLD). I can’t even place the aspirational desire for Sears (SHLD). During good economic times the hierarchy was easy to maintain, with cheap material and labor costs and free spending consumers.

The story of this past year has been higher material costs and disappearing cheap labor from so-called developing nations. The profits of higher priced retailers are supported by the brand value of the merchandise they sell. No surprise in Wall Street’s enthusiasm. The trouble comes in the middle and lower tiers.

Given that a $60 shirt does not cost double that of a $15 shirt to manufacture, brand equity plays a big role in profits. This gives a midline retailer a great deal of flexibility to challenge both the higher and lower ends. To a certain degree Macy’s is making it more difficult for Target, Wal-Mart and Kmart to present quality bargains. Target’s high end in clothing overlaps Macy’s low end.

For sure there are cultural differences in the customers that Macy’s and Wal-Mart attract. But there is probably a lot of overlap in Macy’s and Target’s customers.

So where does this leave Kohl’s? They have much nicer stores than JP Penney and the big box discounters. But if Macy’s is stretching down to Target, the middle ground that Kohl’s is fighting for is no longer needed. Many of the brands Kohl’s carries can be found at Macy’s for the same or lower price.

Frankly, Macy’s survival instinct in the highly competitive space has surprised me. They have proven far more flexible than I had imagined. Shopping Macy’s discounts and coupons gives more value than Kohl’s.

I believe that Kohl’s survival is based on coddling its middle age customers who are intimidated by Macy’s.

[JavaScript Games by Michael Steinberg: Color Splat Game, Magic Word Game and Scramble Word Game.]

Gentlemen Serving Gentlemen

2011-06-21T09:41:00.004-04:00

Published by clickbroker.blogspot.com.

I remember reading some time ago an article about the demand for schools training professional household help such as butlers and residential managers. One leading school emphasized they train gentlemen and gentle ladies to serve gentle men and gentle ladies. The theme being the servant’s respect for his or herself and their contribution is as important as their contribution itself. Only with the recognition of mutual respect can excellence be achieved.

The underlying theme is civility. Neither respect nor civility can be achieved without sincerity. This caused me to take a deeper look into the political climate that evolved over the last few years. Many now seem to feel that the Tea Party movement has given them the freedom to act disrespectful and surface innuendoes that might have been taboo only two or three years ago.

As the Tea Party (in all its forms) is losing momentum, right-sided politicians and the corporate elite are becoming more disingenuous and less civil than at the height of the movement. I am particularly disturbed by JP Morgan’s (JPM) CEO Jamie Dimon. While JPM entered the financial crisis stronger than most financial institutions, it still benefited from the government in its opportunist acquisitions of Bear Stearns and Washington Mutual. The contagion following Lehman and AIG would not have left JPM unscathed without government intervention.

Whether he acknowledged the good of government or not, Jamie Dimon accumulated immense good will and political capital during and after the crisis. He often talked about JPM making sacrifices for the good of the country, such as accepting TARP. Then suddenly he changed.

Jamie Dimon’s unprecedented lobbying effort to shape or derail Dodd-Frank (FINREG) failed to be as effective as he desired. So now he’s blown the covers off his offensive. Like the politicians, Jamie Dimon has been emboldened by the Tea Party to be belligerent to his regulator and savior Fed Chairman Ben Bernanke.

Jamie Dimon is unhappy FINREG regulations are being developed for trading derivatives on exchanges, debit card swipe fee caps, and additional capital requirements for large systemically risky banks. But instead of working civilly with the Fed, he thinks the people are with him to fight the process. Unfortunately, this time Jamie Dimon is wrong.

Jamie Dimon is not being a gentleman serving the gentlemen of the Fed.

[JavaScript Games by Michael Steinberg: Color Splat Game, Magic Word Game and Scramble Word Game.]

The Greek Crisis is Different from the Latin American Crisis

2011-06-20T11:11:00.003-04:00

Published by clickbroker.blogspot.com.

The top US money center banks have been through many renditions of the Latin American debt crisis over the last 40 years. Fortunately, Latin America appears fairly stable now and there is renewed enthusiasm for developing nations.

The seeds of the crisis started in the 1970’s when Citigroup (C) and other large banks recycled Middle East oil wealth into sovereign Latin American debt. When debt could not be repaid, it was restructured multiple times with the banks incurring losses. The Fed and Treasury eased the banks in their troubles.

Some professionals focus on the Euro currency as the reason a Greek restructuring would be so catastrophic. Others cite the losses incurred by the large European banks would leave them undercapitalized. The explanation that makes the most sense to me is that banks are far more interconnected now than in the past.

The clearest experts focus on the liquidity crisis that emanated from the lack of counterparty confidence occurring after the Lehman collapse. While primary exposure to Geek debt can be generally estimated, the related derivative exposure is near impossible to estimate. The difference this time around is no bank knows their counterparty’s indirect exposure to Geek debt.

Without exchange traded derivatives, no public record of exposure exists. Just like the housing crisis, the Greek crisis is really riding on the back of CDS (credit default swaps).

[JavaScript Games by Michael Steinberg: Color Splat Game, Magic Word Game and Scramble Word Game.]

Two Profound Enlightenments from Two Profound Fed Chairmen

2011-06-16T08:08:00.002-04:00

Published by clickbroker.blogspot.com.

The best understanding of the nuances of the Fed’s inner workings come from the casual comments during Q&A with former Fed Chairmen. Of all the comments from Volcker and Greenspan over the last few years, two were the most profound.

Volcker told us that the Fed adjusts its regulatory vigilance as a tool for enacting monetary policy. This explains why the Fed so adamantly fought to maintain its regulatory role during the negotiations leading to the Dodd-Frank (FINREG) bill. When former Treasury Secretary Hank Paulson proposed separating regulation from the Fed, I believe he understood this.

Greenspan told us banks cannot free excess reserves (at the Fed) to issue more loans because they do not have enough capital. Greenspan’s statement might not be immediately obvious. Excess reserves at the Fed carry a zero risk weighting, therefore they require no capital to maintain. Different types of loans have varying risk weights, but all would be above zero. Greenspan’s remarks are far different than the cry that there is no loan demand.

Controlling bank capital requirements and the enforcement of lending standards are powerful tools in Bernanke’s arsenal. The current balance is allowing the Fed to boost asset prices, while at the same time “controlling inflation.” The high capital requirements prevent the excess bank reserves from flooding inflation into the general economy.

Bernanke has in essence sterilized QE 1 and 2, while bidding down interest rates. With most assets prices tied to risk free Treasuries (bills, notes and bonds), as rates go down all other asset prices go up. Is Bernanke the real maestro?

[JavaScript Games by Michael Steinberg: Color Splat Game, Magic Word Game and Scramble Word Game.]

Hanging out at the Apple Store

2011-06-15T10:38:00.004-04:00

Published by clickbroker.blogspot.com.

I went to the Apple Store to test some JavaScript games I developed on the iPhone, iPad, MacBook Air and MacBook Pro. I always viewed the Apple Store like Barnes & Noble (BKS); come browse and play without being harrassed. Previously, Apple always had more customers than salespeople. Now, at least in my local mall, Apple has almost as many salespeople as customers. And they’re all trying to convince you to drink the Kool-Aid. Dedication is one thing, but a cult is something else.

No one can deny the dedication of Apple fans and the unique design prowess and genius of Steve Jobs. The products are undeniably gorgeous. But this Apple lurker has found them to be ergonomically challenged. The touchpads on the Macs require a hard press to simulate a mouse down or click, making a drag operation difficult. The virtual keyboards on the iPad are less than practical for serious users and impossible for people with normal fingers on the iPhone.

Jewelry is one thing and practicality is another. The Apple devices are excellent for content distribution, but for me anyway, are not as good as the Wintels for content development. I expect that many of you reading this will disagree with me.

Are these two anecdotal observations an indication that Apple is peaking? No one has ever made any money betting against Steve Jobs. But I get concerned when design overwhelms usability and when salespeople become too aggressive. Have the products stopped selling themselves?

I’m also wondering if Apple is overselling its coolness. How cool is it to see senior citizen salespeople wearing blue jeans and Apple T-shirts? Cool is only cool when it’s real, not fake.

The current wisdom is that Apple in the persona of Steve Jobs will never run out of innovations. The risk is that applying great design to standardized products has its limits. And believe it or not, Microsoft (MSFT) appears to reincarnating itself.

To invest in Apple now, you have to believe that Apple will continue to create completely new categories like the iPhone and iPad. Nobody ever thought Research in Motion (RIMM) would face creative destruction.

[JavaScript Games by Michael Steinberg: Color Splat Game, Magic Word Game and Scramble Word Game.]

Dividends Now vs. Dividends Later

2011-06-14T10:26:00.005-04:00

Published by clickbroker.blogspot.com.

A tale of two stocks, Cisco (CSCO) vs. Verizon (VZ): One has dropped in price significantly, while the other has risen significantly. One has a lot of cash, while the other has a lot of debt. One has a starter dividend, while the other has a mature dividend. One yields a little, while the other yields a lot. Both are mature companies with limited growth potential. Both are also in highly competitive oligarchies.

The question is whether to start buying Cisco below $15 in the hope that it follows its mature cash rich technology brethren Intel (INTC) and Microsoft (MSFT) in growing their baby dividends into active teenagers. At the same time, should we buy Verizon and potentially be disappointed if debt curtails their ability to continue the dividend at the current rate?

If you believe that Cisco will be paying at least $1 dividend in 5 years the choice is obvious to me. I would also start buying Intel below $17.50 and Microsoft below $20.

[JavaScript Games by Michael Steinberg: Color Splat Game, Magic Word Game and Scramble Word Game.]

The Distortion of Drug Copay Reimbursements

2010-10-12T12:21:00.003-04:00

Published by clickbroker.blogspot.com.

The largest pharmaceutical companies have started a disturbing trend of fighting consumer incentives to control drug costs by subsidizing copayments and coinsurance. At the extreme these companies are even subsidizing the purchase of drugs by consumers without any coverage for pharmaceuticals.

The past few earnings calls from the large health insurers highlighted an unexpected reduction in demand for medical services from their insured members. This surprising source of profits could easily be attributed to the economy, but I see it as fundamental shift in the insurance market to discourage care through higher deductible plans, copays and coinsurance. This trend won’t stop until the healthcare reforms are fully implemented in 2014.

Previously, the pharmaceutical companies complained that they could not sell drugs to consumers that avoided routine doctor visits. Now The Wall Street Journal’s “More Balk at Cost of Prescriptions” reports that consumers are leaving their prescriptions at the pharmacy counter when they find out how much their insurance company expects them to pay. The new word for deductibles, copays and coinsurance is the consumer’s “responsibility.”

Ten percent of brand-name prescriptions are being abandoned at the counter. The WSJ quotes a consumer with high deductible insurance saying “I can’t afford that” to a $335 bill. She then chose to buy her son’s prescription and skip her own. The average copay for Pfizer’s (PFE) Lipitor rose 87% to $28 since 2000. The Journal reports that prescription copays are reaching toward $100.

Bloomberg’s “Novartis MS Program Guides Patients to New Pill, Covers Out-of-Pocket Cost” reports that the company will reimburse up to $800 in copays and $600 in testing and monitoring expenses for its new multiple sclerosis drug Gilenya. The non-Medicare consumers must be covered by commercial insurance for the $4000 per month drug to qualify. Novartis (NVS) will also offer full reimbursement to consumers below 500% of the poverty level.

WellPoint (WLP) and UnitedHealth (UNH) have placed Gilenya in their top copay and coinsurance tiers. Medicare part D restricts reimbursements to consumers.

While persons receiving legal remedies for injuries or medical malpractice must reimburse their health insurers for medical costs, this does not appear to be the case with drug reimbursements from pharmaceutical companies. The drug companies are freely advertising on television that that your prescription is free after they reimburse your copay. So why not select the most expensive drug?

These practices are disturbing because they further distort the free market for drugs. First, drug companies helped the poor by raising prices for everyone else. This created a form of faux good corporate citizenship to maintain the current healthcare system. Now, when the middle-class majority can no longer afford their drugs, the companies are addressing consumer “responsibility” by raising prices to insurers. The net prices, insurer cost minus the consumer reimbursements, continue to rise.

Our good corporate citizens are not so secretly pushing up insurance costs. This form of cost shifting should be outlawed; it simply perpetuates the current system of Americans paying the highest drug costs in the world. The hidden cost of free is the worst form of deception.

Disclosure: Author is long PFE.

Health Insurance: Good of the Whole vs. the Parts

2010-09-21T14:06:00.004-04:00

Published by clickbroker.blogspot.com.

Economists often compare the good of the individual versus the good of the economy as a whole. While it is beneficial for each individual to cut back spending and debt to rebuild their personal balance sheet, this retards growth in the aggregate economy. I draw the same conclusion to preventive care now being implemented via healthcare reform.

The health insurance companies are blaming a disproportionate amount of rate increases on new mandates for preventive care without explaining their calculations. I imagine that the cost of the actual exams is minimal. The real cost is the treatment for ailments discovered on the specific insurer or self-insured employer’s watch. This is important because people change employers and insurers multiple times throughout their lives.

Many insurers have spoke about the high initial cost of first year Medicare and Medicaid enrollees due to deferred care. In the same light, it is clear that insurers have a vested interest in not discovering problems requiring treatment during their limited watch. While passing the hot potato is beneficial to each individual insurer, it costs the country more in the long run. Insurance companies and employers only benefit if they keep the enrollee over their lifetime.

I believe the conflict of interest, societal medical cost versus private insurer, explains why total medical costs are so much cheaper everywhere outside the United States. Healthcare reform has some provisions to redistribute the cost of adverse selection in the future guaranteed issue environment, but this will not be enough to overcome the disincentive for early intervention. The future will see a more active role of government in motivating individuals to manage their own care.

Single countrywide insurance pools, such as the UK, align incentives to reduce the lifetime cost of care versus the short term cost of care. High deductible insurance in America incentivizes deferral of care. The latest earnings calls from health insurers emphasized a surprising reduction in utilization of medical services by enrollees. The disincentives to use medical care by the insured population are especially high during difficult economic times.

Most of the political rhetoric focuses on price controls and rationing in Europe (socialization of care) compared to unlimited access to care in the United States. I won’t divert into how care is rationed in the United States. But, these arguments miss the point entirely. Until a single entity is responsible for a lifetime of care, costs of healthcare in the United States will never be controlled.

I see the government moving much more heavily into the role of responsibility for the lifetime of care of Americans. They will start by enticing Americans to improve their eating habits. This effort to increase awareness of the harm of obesity will have a negative impact on the packaged food industry as whole; especially the corn based food economy.

Both political parties will realize that short of a single insurance pool, improving the food supply is the only way to contain healthcare costs. Already, I have seen a substantial increase in the coverage of obesity related diseases in all of the major newspapers, including The Wall Street Journal and The New York Times, as well as even the most conservative cable news network. Holy Roger Ailes (the substantially sized president of FOX News)!

Note: The demise of the corn based food chain will primarily affect the seed companies Dow (DOW), DuPont (DD) and Monsanto (MON); corn processors Archer Daniels Midland (ADM), Cargill and ConAgra (CAG); and of course the packaged food industry General Mills (GIS) and Kellogg (K) amongst others. Although these are diversified companies, the impact won’t be subtle. Already the FDA has been asked to rename high fructose corn syrup to corn sugar after a consumer rebellion. The industries advertising the wholesomeness of high fructose corn syrup was to no avail.

No Disclosures.

Macro Trends in Technology and Banking

2010-09-07T12:20:00.005-04:00

Published by clickbroker.blogspot.com.

I would like to convey some macro trends in two of the most volatile and perceived economically risky sectors of the S&P 500. My analysis is primarily anecdotal, without taking a deep dive into the numbers.

Macro Trends in Technology
Apple (AAPL), Amazon (AMZN), the cable companies and “brick and mortar” book stores are taking a deep dive into the transition from physical to virtual content. Both sales of files and rental of streams are being heavily promoted. Bloomberg Businessweek’s "Intel Wants to Be Inside Everything" and “Don't Rule Out Apple Ruling Your Living Room” discuss the implications. Most analysts view this mass virtualization as a boom to the current entrenched innovators; too risky for me at their current stock prices.

The key takeaways from the Bloomberg articles is that Intel’s (INTC) low cost Atom processors are being embedded into all types of consumer devices (beyond entertainment) and Apple is building a billion dollar data center in North Carolina. This indicates that virtualization is requiring a huge investment in very physical, massive server farms. Intel said during its last earnings call that the economics are compelling for a server refresh cycle based on energy costs alone. Couple this with reduced form factors makes for a very short payback cycle.

I think Intel and Cisco (CSCO) will be the primary benefactors of this technology trend. The “box makers” and storage vendors face cut-throat competition. HP (HPQ), IBM (IBM) and Oracle (ORCL) are too diversified too get a big lift from the trend. Startups will be evolving to package Intel processors into denser and more energy efficient configurations. In Warren Buffett’s terms, the moat around Intel is too great for startups to penetrate its core. And the Atom processor might eventually dominate the mobile market; a dream I admit.

Cisco is concentrating on servers for the communication market, taking advantage of its primary market concentration. Cisco has a history of acquiring any technology needed to dominate. They can create a moat around specialty servers by optimizing data transmission. Cisco can out fox Dell (DELL) and the other server providers while leaving room for startups to innovate. Once innovators pass concept, Cisco will either copy or acquire them.

The Intel tale is based on the recurring revenue models of utility companies and software maintenance. Larry Ellison said you buy software companies to capture the recurring revenue. Intel is telling us that the server replacement cycle will shrink from up to a decade to just a couple of years going forward. Imagine the revenue impact if processors are replaced every two years in the large server farms.

Macro Trends in Banking
On the negative side Bank of America (BAC), JP Morgan (JPM) and Wells Fargo (WFC) are being asked to buy back residential mortgages that did not meet their warranty claims. This involves real cash payouts in addition to write downs in their own portfolios. Maybe their acquisitions were not such a bargain after all. Goldman Sachs (GS) is getting hit with slower activity and trying to be a good citizen in light of FinReg. New credit card and consumer regulations present challenges for Citigroup (C) and friends to redistribute fees among customers.

Regional banks face the additional problem of lending long with short term interest rates so low. Higher rates would actually loosen credit to all but the largest business. The borrow short and lend long is deadly in this environment, so banks are parking money in 1 to 3 year Treasuries, Agencies and excess Federal Reserve deposits.

But anecdotally the inverse trend seems to be developing; borrow long and lend short. The new regulatory focus on liquidity, in addition to capital, has banks extending the maturity of their wholesale funding and term debt. The Fed is providing a once in a lifetime opportunity to extend maturities for up to 15 years at a market rate of about 5%. The largest banks appear to be giving up short-term profits with near term funding for stability and assured liquidity. Investment banking activities of the largest banks can absorb the higher cost of financing and still be profitable.

The borrow long, lend short model favors the world’s largest banks. I see Bank of America, Barclays (BCS) and Goldman offering bonds ranging from 5 to 15 years to retail investors. What I don’t see is the large US regional banks participating. Many regionals have more deposits than they can lend so they cannot profitably invest 5% money without substantial credit and interest rate risk.

This means that the largest banks stand to be substantially more profitable than the regionals when interest rates start to rise. To copy the old Philadelphia college basketball league, the “Big 5” will see their 5% funding become a consistent profit generator over the next decade while the regionals have to pay up.

While all banks will benefit from rising rates, the interest rate margins will certainly favor those banks that can lock in funding now. Being the “Big 5” dominates the Financial Select Sector SPDR (XLF), this would be the best way to play the trend. Improved liquidity and more conservative operations lead to a much more secure, be it slow growth, investment thesis.

Note: The Philadelphia Big 5 includes La Salle, Penn, Saint Joseph's, Temple, Villanova. My banking Big 5 includes Bank of America, Citigroup, Goldman, JP Morgan and Wells Fargo. I purposely left out Morgan Stanley (MS).

Disclosure: Author is long BAC, BCS, C, INTC and WFC.

Existing Home Sales: Too Much Friction in the System

2010-08-24T16:45:00.003-04:00

Published by clickbroker.blogspot.com.

The National Association of Realtors’ (NAR) August 24 press release, “July Existing-Home Sales Fall as Expected but Prices Rise”, along with The Wall Street Journal’s inside look at the August 10 Federal Reserve’s “contentious meeting”, “Fed Split on Move to Bolster Sluggish Economy” left the market uneasy Tuesday morning. Headlining the NAR release; “completed transactions … dropped 27.2 percent to a seasonally adjusted annual rate of 3.83 million units in July from a downwardly revised 5.26 million in June, and are 25.5 percent below the 5.14 million-unit level in July 2009.”

Miraculously, Bernanke seems to build consensus each meeting to push mortgage rates lower and lower with little impact on transaction growth. Traders became concerned that the Journal’s inside look showed that Bernanke might not be able to maintain a united front. Publishing this level of detail prior to the Fed minutes is unprecedented. My intrigue is the objectives of those in the FOMC meeting that spoke so openly to the reporter.

Low mortgage rates might stimulate the economy through refinancing, but why is a sub-5% mortgage rate having so little impact on home sales? And given the reality of the numbers, why doesn’t the Fed recognize the limits of its power? First, home sales are not being restricted by interest rates and second, the Fed feels the need to act when Congress is tied in knots. The Fed believes that Congress will never get fiscal policy right and there is no time to wait.

Forget about the end of home buyer’s tax credit and its overhang. The credit was a boondoggle to the new home builders and “first-time” buyers. The real issue in the housing debacle is there is so much friction in the system that is it surprising any transactions take place. The friction in the existing home market is the only thing that has kept any of the new home builders out of bankruptcy.

Everyone recognizes that most sellers are underwater, many with multiple mortgages on their properties. Short sales can take 6 to 9 months to complete. Even bank preapproved short sales can take as long as 3 months or more. Foreclosed properties, bank real estate owned (REO), involve a complex and often lengthy negotiating process. The time required and uncertainty of conclusion makes this process impractical for most buyers, except investors and second home buyers. Throw on top of that sellers with equity are often strong enough to wait for their price.

From the press release: “A parallel NAR practitioner survey shows first-time buyers purchased 38 percent of homes in July, down from 43 percent in June. Investors accounted for 19 percent of sales in July, up from 13 percent in June; the balance were to repeat buyers. All-cash sales rose to 30 percent in July from 24 percent in June.” The price increase was due only to mix.

Hence, we’re left with an almost frozen market. And the Fed has no control over the mechanics of the housing market. The levers that worked in previous recessions are not working now because sellers won’t or can’t let go.

First the realtor sets the market price for the short sale property, and then the seller starts the negotiating process with the mortgage servicer for how much, if any, money the seller must bring to the closing table. The bank or mortgage investor might also require the seller to sign a promissory note to cover any deficiencies not forgiven. Any secondary mortgages or other liens make the process even more difficult. With each offer a buyer submits, the process goes through another round, requiring approvals from the servicer and the mortgage investor.

Often a low ball asking price leads to unrealistic buyer expectations while an asking price that seems sure to be approved would scare away buyers. Again, only investors and second home buyers have the patience to work through the process.

Foreclosures and REO properties are often sold through a modified auction process. Realtors advertise a low ball price to attract interest. Banks set a period of a week or more for buyers to submit offers; afterward banks hold additional rounds for rebidding until they are satisfied. Cash buyers are often given preference for their ability to close.

When the buyers have deposits tied up in the process, it is difficult for them to start negotiations on alternative properties. There is nothing the Fed can do to bring back the efficiencies of selling that existed in the pre-crash, equity positive market.

I am not a real estate professional and don’t know all the intricacies of the process. But I can still conclude that unless the shackles are removed from the system, few transactions to owner occupants will be completed. Investor owners are just another form of shadow inventory. There is no reason why banks and securitization trusts cannot establish a more standardized process. Quick decision making will move the merchandize.

The Insatiable Bill Gross Challenges Treasury Secretary Geithner

2010-08-17T15:16:00.002-04:00

Published by clickbroker.blogspot.com.

Treasury Secretary Geithner and HUD Secretary Donovan hosted the Conference on the Future of Housing Finance Tuesday, August 17, 2010. Among the esteemed panelists were PIMCO’s Bill Gross, Bank of America’s (BAC) Barbara J. Desoer, Wells Fargo’s (WFC) Mike Heid and the stellar brand builder from Moody's Analytics (MCO) Mark Zandi. Geithner’s keynote was that the only known fact is that the future of residential mortgage finance must change. But as each party spoke it became clearer that change was the last thing anyone wanted.

Some of the academics talked about counter cyclic mortgage structures such as increasing down payments during boom times and reducing down payments during economic stress. Others countered that affordability would prevent larger down payments when house prices were rising. Many gave lip service to affordability being limited to rental units. But, supporting or constraining the growth of bubbles and the economy in general was not the purpose for most of the attendees.

Gross and Desoer carried the tail end of the first panel. Both wanted an explicit 100% guarantee on mortgage securities, but Fannie Mae (FNMA), Freddie Mac (FMCC) and Ginnie Mae (HUD) should not hold any mortgages. Geithner said the GSE portfolios should be liquidated slowly. When other panelists spoke about shared risk, such as private investors absorbing first losses, The Professionals were not interested. Heid said it has to be private capital, public guarantee. How does this differ from the private profit, public risk that had been the outcry against current Fannie and Freddie?

Geithner stated that government must be adequately compensated for any risks it takes so that it does not lose money on its guarantees. The panelists had no interest in seeing that government was adequately compensated or not over extended. The private sector should not be encumbered in trying to protect the government.

Gross was not shy about selling his opinion. He started out saying that today I represent the good of the nation, which might be in conflict with the good of PIMCO investors. Then he blatantly said if the government did not fully guarantee residential mortgage paper, PIMCO would require a 7% to 8% interest rate. Given the importance that Geithner placed on mortgage securitizations in his opening remarks, Gross appeared to be threatening.

Next Gross weighed in on using mortgage finance to boost the economy and not so subtlety his own book. Fannie, Freddie and Ginnie should be rolled into one government owned entity. There should be no public/private insurance like the current GSEs. Private mortgage insurance to support low down payments would also be eliminated. The government guarantees everything.

Then Gross gave more substance to the rumors circulated by Wall Street, calling for the Treasury to allow all mortgages in the GSE portfolios to be refinanced down to about 4% as an economic stimulus. No consideration should be given to loan to value, credit score, second liens or the borrower’s ability to pay. Gross believes this would raise housing prices by 10%. So the government takes on the same risk for lower compensation; the direction opposite of Geithner’s objective of the government being adequately compensated for risk. Gross is asking the government to do something PIMCO flat out refuses to do.

Lastly, Gross want investors in GSE mortgage securities to lose their premiums on higher interest mortgages. The refinancing risk is already present, but a government induced mass refinancing is a black swan for mortgage investors and causes a higher spread over Treasuries in the future. Gross concluded by asking the Fed to retain a massive balance sheet. There’s no end to what Gross wants.

Note: In his book “The Big Short,” Michael Lewis cites short CDS investors worst fear was that the government would bailout the subprime market making their bets worthless. An intervention on the scale Gross is requesting could wipe out highly leveraged mortgage investors.

Disclosure: Author is long BAC, FMCC, FNMA and WFC.

Whole Foods, Whole Body, Whole Nightmare

2010-08-05T15:14:00.003-04:00

Published by clickbroker.blogspot.com.

The Wall Street Journal’s “The New Nutritionist: Your Grocer “ reports that Kroger (KR) started testing the NuVal nutritional scoring system in some Kentucky stores, with the potential for a national rollout. Each shelf price tag contains a NuVal rating from 1 to 100; the higher the rating the more nutritional value. Shoppers might be surprised that organic favorites such as Kellogg’s (K) Kashi brand and General Mills (GIS) Natures Valley don’t always score well.

Griffin Hospital’s NuVal system was developed by Yale University based on food labels and federal dietary guidelines. It is best used as a relative scale for slowly improving health. This is a big step in the right direction because as I wrote recently "You Can’t Lose Weight Counting Calories."

HyVee, Wegmans, Safeway (SWY) and Wal-Mart (WMT) have either joined the party or are about to jump in. Their programs range from suggesting healthy food choices based on data mining loyalty card purchases to offering dietary consulting services to their customers. Conspicuously missing from the healthy eating party is Whole Foods (WFMI).

The premise behind Whole Foods is making customers feel good about what they eat, regardless of how healthy the foods really are. Remember the old TastyKake (TSTY) slogan “all the good things wrapped up in one?” Philadelphia natives will. The idea is quality ingredients are all that matters; quality flour, sugar and salt. So you can feel better about Whole Foods chocolate or TastyKake cupcakes than other brands.

But are organic granola bars less harmful than conventional? With many of the brands stocked in Whole Foods center isles now available in most grocery stores, including Wal-Mart and Target (TGT), the competition is on. The relative nutritional value of some of Whole Foods most profitable items might soon be tested by customers, and the entire image of Whole Foods might be called into question.

When Whole Foods CEO John Mackey was at the height of his rant against healthcare reform, he said during an earnings conference call that he couldn’t believe all the crap they were selling. He stated a goal of moving back to a healthier selection and away from catering to foodies. After healthcare reform passed and the company’s fortunes began to recover from the economic catastrophe, all was forgotten. They still target customers who want to feel good about eating heavily salted organic potato chips.

Are nutrition ratings a Whole Foods nightmare alone or will the entire packaged food industry suffer along? I think we are looking at the start of a long term trend. Society will start demanding better nutrition as the cost of healthcare is increasingly borne by the federal and state governments.

Americans will begin to become aware that their food supply is slowly leading them down a path towards diabetes, cancer and other ills of obesity. Then, just like smoking they will start weaning themselves off packaged foods. I think this change will occur over the next 10 to 15 years. This does not bode well for companies such as General Mills, Campbell (CPB), Kellogg’s, Kraft (KFT), Coke (KO) and Pepsi (PEP).

I encourage readers to have some fun on the NuVal scoring page. Select cold cereals and see that Kashi Strawberry Fields (11) has a lower score than Post Shredded Wheat Frosted (31). Who would have thought that “seven whole grains on a mission” could have less nutrition value than a conventional sugar coated cereal. Let’s “keep’em full and focused.” (Post is a Kraft brand.)

No Disclosures.

The Redistribution Model of Retail Banking

2010-07-19T13:08:00.004-04:00

Published by clickbroker.blogspot.com.

The “got-you” model of investment banking made famous by Goldman Sachs (GS) is reaching obsolescence for the big retail banking franchises according to JP Morgan Chase (JPM) and Bank of America (BAC). With financial reform each customer will now have to carry their own weight. No longer will the financially sloppy, disadvantaged or simply naïve be tricked into paying high fees to subsidize the financially conscientious.

Overdraft fees are dead according to Bank of America. They think it is bad business to induce customers into opting into something the customer will regret the first time a cup of Starbucks (SBUX) ends up costing $30. Bank of America, Citigroup (C) and JP Morgan all see revenue losses related to credit/debit card interchange fees (Durbin amendment), but none has revealed their specific mitigation plans.

Citicorp appears to be shrinking its credit card portfolio to higher quality customers and making progress in selling or running off Citi Holdings. But it is bringing CitiFinancial back to life after Wells Fargo (WFC) announced its exit from subprime lending in a separate consumer finance unit. Citi said these customers have nowhere else to go. (CitiFinancial is being moved from Citi Holdings back to Citigroup.)

All of the mega banks complained that the interest margin compression is wreaking havoc on their current retail banking models. This form of Federal Reserve induced systemic risk brinks into question the true value of the national retail branch funding aggregation model that Citigroup, JP Morgan and Wells Fargo strove for during the height of the meltdown. I think Citigroup might now be happy that they lost out on the Wachovia mass market opportunity.

Based on the latest round of earnings conference calls, I believe that Citigroup might have gone from the worst to the best business model. This is further confirmation the selling off a controlling interest in Smith Barney to Morgan Stanley (MS) was impeccably timed. Consumer protection in FINREG will make the most profitable full-service brokerage products obsolete. Again, without a series of “got-you” products to sell, it would be much harder for each customer to pay their own way.

JP Morgan framed the quandary with the anecdote “if a restaurant can no longer charge for the Coke (KO), they will have to charge more for the burger.” Trouble is in banking just like the internet, most customers are used to getting the burger for free. Interest rate margins like advertising in the internet parallel are not pulling their weight, and fees are no longer working in either universe.

The banks all said that they are working on strategies to redistribute fees, so that all customers will be profitable and the total fee income will be sustained. But in the short term revenue declines are inevitable. None of the banks would answer how the redistribution would be modeled in detail, though analysts tried their best to prod.

JP Morgan gave a few hints in the credit/debit card arena. Merchants might be required to keep compensating balances to replace interchange fee reductions and even basic card customers might face annual fees. A few banks talked about monthly fees for retail bank accounts along the lines of utility bills.

The conclusion that I came to was that after the crash, there’s far less to sell in the mega banks stores and they have yet to figure out how to cover the cost of these vast branch networks. They are like deer in the headlights praying for the Fed raises interest rates to save them. Perhaps, Citigroup has by sheer luck turned into a princess.

Disclosure: Author is long BAC, C and WFC.

Trouble with a Committed Extended Period of Time

2010-07-12T20:01:00.003-04:00

Published by clickbroker.blogspot.com.

Bill Gross is developing a chorus in calling for Federal Reserve Chairman Bernanke to commit a time frame on extraordinary accommodative rates for an extended period of time. The longer the commitment, the better. The theory they are selling is that investors will start absorbing toxic assets if they are assured of low cost funding for a specific time frame.

This argument has many flaws. In fact, a Fed commitment to lower rates for a specific period of time actually reduces the risk in the carry trade of the world’s safest assets. The greatest risk in a leveraged position in Treasuries is changes in the cost of funding, not credit quality. Therefore, guaranteeing the cost of funding would actually move more money to the risk-free trade and away from productive capitalism.

The committed period of time being called for does not eliminate the collateral paradigm of finance. Speaking of small business lending, Bernanke said small businesses with good cash flow have lost access to credit because their collateral has lost value. The typical collateral for a small business is commercial real estate or the owners’ personal residences. The same principal has locked home buyers out of financing and homeowners out of refinancing.

Committed low cost funding will not bring bad assets into the pool of desirable collateral. It might add to the pool of willing investors, but not to the pool of able investors. In this economic downturn able is far more important than willing.

The real harm comes from the bubble being formed in so called risk-free assets such as gold (GLD), Treasuries and the few growth companies remaining on the stock exchanges. The bulls tell us they should be valued based on current interest rates; in essence no carrying cost. To a more limited extend the recent stabilization in residential real estate is also sitting on the shaky foundation of extraordinary low interest rates.

Yes it’s true housing is starting to form a mini bubble. The bubblelet will not be apparent until interest rates start to rise. And once the gold and Treasury bubbles start to pop, the world financial system trouble will brew again.

Gold, Treasuries and real estate are no ordinary assets. Together they form the collateral basis for most financial transactions. So artificially propping those up creates insatiable demand for the Fed never stopping.

Politically, Bernanke’s hands are tied. The public is unwilling to tolerate more Fed programs or quantitative easing. Gross and friends know this, so their creative genius is asking for the next best thing.

No disclosure.

Bill Gross cries for a Guaranteed Carry Trade

2010-06-24T20:21:00.003-04:00

Published by clickbroker.blogspot.com.

I couldn’t believe what I was hearing on CNBC during the 2:00 PM Wednesday FOMC announcement pregame show. Bill Gross (PIMCO) called for Bernanke to specify a hyper-extended period of time for extraordinary low interest rates. Gross wants the Federal Reserve to add so much confidence to the carry trade that junk bonds and other toxic assets will form a new bubble.

The simplest definition of the carry trade is to borrow short and lend long, capturing the spread. The risk is that an investor’s spread could turn negative if short-term rates rise before they exit the trade or they cannot roll over their short-term borrowings. The Fed has already allowed banks to print money by paying near zero to depositors and commercial paper buyers while capturing higher intermediate term Fannie Mae (FNM), Freddie Mac (FRE) and Treasury yields. But Gross is not satisfied because with 4.69% 30-year fixed mortgages and the 10-year note near 3%, the play is already squeezed.

The liquidity of Treasury and agency bonds allows players to exit the trade fairly easily with minimum potential losses. But the Fed’s extended period of time is not comforting enough to fund illiquid assets with short-term debt. The Bear Stearns (JPM) and Lehman (BCS) liquidity traps are still too fresh.

Gross’s influence on Fed policy is unquestionable. He called for a massaged Fed balance sheet and the direct purchase of agency securities. Two trillion dollars later Gross is still not satisfied. Instead of likely profits, he is now asking for guaranteed profits. The free market survivors now want the total end of moral hazard.

Gross admitted that the Fed cannot lower rates below zero, and its credibility would be at stake if it restarted quantitative easing. Besides, the safety play has already driven agency and Treasury debt to unprecedented levels. Such a bubble that players need to be concerned about a reversal when the austerity measures in Europe bring into question the relative safety of the US debt. Sovereign debt for sovereign debt, the US could become riskier than Europe.

So the interest rate risk in treasuries and agencies is too great, and the liquidity risk in toxic assets also is too great without the Fed enhancing its low rate commitment. Gross wants the Fed to give him confidence to increase his risk and subsequently his spread.

Banks have reason to accept the low agency spreads. They appease their regulators by lowering their risk adjusted assets, while still earning a leveraged profit. This is less appealing to asset managers who play leverage to a lesser degree. Uninsured funding does not face regulatory capital requirements, so there is little benefit to playing the risk adjusted asset game.

I am sure Gross would like the Fed to specify that zero interest rates will be maintained through the end of 2012. But the Fed surely realizes that would be too obvious a gift to Wall Street. Look for the Fed to be more creative in removing moral hazard in response to the double-dip.

For you ice cream fans, I am predicting a triple dip. Dip one was the housing bubble burst, dip two is the receding consumer economy happing now, and dip three will be the start of mortgage foreclosure deficiency judgments preventing the consumer economy from reemerging. In spite of Bernanke, even with Gross’s prodding, foreigners will force US interest rates higher. Sorry Bill.

No Disclosures.

Mother Merrill spawns Big Brother Merrill Edge

2010-06-21T14:04:00.002-04:00

Published by clickbroker.blogspot.com.

Is spawn the right verb for Bank of America’s (BAC) new online brokerage called Merrill Edge? This implies a new creation. Bloomberg’s “Schwab, Ameritrade, E*Trade Drop on Merrill's Plan” quotes a Raymond James (RJF) research note: “We believe this is simply a re-branding of Bank of America’s existing online brokerage.”

While I believe Bank of America has much to gain by leveraging Merrill Lynch’s prestige and brand power, they are cheapening the brand by starting Merrill Edge before it has a compelling offering. I shopped the commercial banks selling free trades and found their packages no bargain.

Merrill Lynch is trying to lure young Bank of America savers into its “farm club” before the banking and the brokerage are fully integrated. The demo is full of “coming soon” and an FBR analyst said the Bank of America “will need to invest hundreds of millions in technology, customer support, and branding to truly compete for new customer assets.”

At the same time, The Wall Street Journal’s “Merrill Makes Move Into Online Investing” cites concerns that an online brokerage could affect their full-service revenue. Some clients may switch trades generated from their own ideas away from their financial advisor or drop full-service entirely. Clients can lower their costs while still feeling the comfort of Merrill Lynch.

Other financial advisors are looking at the brighter side. Clients have been maintaining play accounts at Charles Schwab (SCHW) and Fidelity. Merrill wants to bring that money home. The financial advisers claim they must know all of the client’s assets in order to provide quality advice. They also like the idea of starter accounts under $250K migrating over time to full-service accounts.

I see two problems with Bank of America’s plans: I never liked it when the pioneer discount broker from San Francisco and the firm (AMTD) whose spokesman starred in the original “Law and Order” constantly called trying to be “helpful.” They were monitoring my accounts. I dropped both firms years ago when better and cheaper alternatives became available. If Merrill’s computers scan online traders’ accounts for potential full-service customers, the annoyance factor could be unbearable. Also, no one likes big brother monitoring their bad trades or their diversification.

Now that we covered the need to escape the potential smothering of Merrill’s farm club, let’s move on to the technology. Merrill Edge has put a much prettier face on the original Bank of America brokerage system. Techies call that a skin, because it’s only skin deep. Do you think the Apple (AAPL) iPhone/iPad generation will become believers? While most of the “technology” pushed by the by top online brokers has little practical value for most investors, no one should doubt that we are in a real time world. Streaming quotes and charts should be the minimum entrance requirement. Every creditable firm offers a trading platform; Merrill Edge does not.

Merrill Edge, stuck in the website generation, is suffering from the General Motors syndrome: don’t offer Cadillac technology in a Chevy - make the customer pay up. Dedicated online brokers don’t have to worry about protecting financial advisors; everyone has access to the best technology. Until Merrill Lynch gives up this fear, they will have trouble attracting the next generation of investors. While Merrill professes to be advisors to the wealthy, the majority of their clients might die off like the Mercury Marquis (F).

Astonishingly, even Buick is showing promise of breaking the GM mold, so there is hope that Merrill Lynch could see the light. But for now Merrill is looking to give seniors a boulevard ride.

I’m not quite ready to “swap my ride” for Merrill Edge and have the “thundering herd” on my ass.

Disclosure: Author is long BAC.

Casual Dining: Frozen Dinners with Waitress Service

2010-05-30T20:39:00.008-04:00

Published by clickbroker.blogspot.com.

Former FDA Commissioner David Kessler uses the terms “salient” and “hyperpalatable” in his book “The end of overeating” to describe how the processed food industry optimizes sugar, fat and salt to create highly addictive food. The New York Times’ “The Hard Sell on Salt” lets us into laboratories at Kellogg (K) to understand how three layers of salt are required to hold Cheez-It together: “Salt sprinkled on top gives the tongue a quick buzz. More salt in the cheese adds crunch. Still more in the dough blocks the tang that develops during fermentation.”

Campbell Soup (CPB) and Kraft (KFT) explained in the Times article that by removing salt beyond a certain point they are in danger of losing customers. When salt is lowered, fat and sugar have to be increased to rebalance. But most importantly, lower salt requires food processors to use higher quality ingredients. Salt masks the taste of low quality tomatoes and over processed meat.

Both Kessler and the Times focus on the public’s need to feel good about what they eat. While fat and sugar affect your weight in the near term, high sodium intake is tomorrow’s high blood pressure. Managing the sugar, fat and salt mix is really about managing the feel-good rather than the consumers’ actual health.

Kessler spends the first section of the book reviewing animal experiments showing that the right balance of sugar, fat and salt can override the body’s natural control mechanisms, leading to overeating. The final sections deal with how we can fight the overwhelming power of the packaged food industry with behavioral changes. Nothing is startling in these parts of the book.

The second section elaborates how food is optimized for addiction. The Snicker’s bar is “extraordinarily well engineered” according to Sensory Spectrum’s founder Gail Vance Civille; it disappears without leaving any buildup in your mouth. One or two chews are desirable, but then the food must form a single savory blob to be swallowed without any residue. Think about how cookies, crackers and chips behave in your mouth. Achieving taste can be done with artificial ingredients, but texture is very dependent on the balance of sugar, fat and salt.

Kessler does give us insight into how foods satisfy us. Fats are the most satisfying because they leave the stomach at only 2 calories per minute; proteins empty at 4 calories per minute and simple sugars at 10 calories per minute. We all know the quick spike in satisfaction and then hunger of high sugar foods. But fats take the longest to signal that we are full. This is the danger of excess fat in combination with sugar and salt.

Investors should find Kessler’s most interesting chapter “A visit to Chili’s.” It got me to wondering who provides the best user interface: Apple (AAPL) and Microsoft (MSFT) or Chili’s (EAT), KFC (YUM) and McDonalds (MCD)? This is not as odd a question as you might think. I expected McDonald’s food to be almost completely prepared in the factory, so it was no revelation that the fries and chicken breast are pre-fried and frozen before they get to the store. What I did not expect is that the casual dining segment is more about delivery than cooking.

I was naive to believe that cooks actually prepared meals according to strict recipes and procedures in the casual dining segment. I thought consistent quality and repeatability came through training. I should have realized that companies cannot expand to thousands of restaurants, including franchisees, by training cooks.

Kessler tells us that the GUI of the chain restaurant businesses are assemblers – not cooks. Flash freezing was the technical breakthrough. Each subassembly of the meal is frozen separately in the right size so that meal can come together in the store without any soggy parts. All the sauces arrive in jars or additional frozen packets. It’s just heat, plate and present to the customers. Consistency is not left to chance.

The restaurant business is about developing addictive food in an exciting atmosphere (the graphical part of their GUI). I had always believed the all moderately priced restaurants had to draw a line of where to semi-customize their food at the store; Greek diners in New Jersey are not exempt. How else could they have 99 entries on the menu? But Kessler taught us that chain style casual dining is a frozen dinner with waitress service.

I recommend Kessler’s book for any investor trying to evaluate large scale chain restaurants. It’s not just about health, it’s about business. The customer’s table is at the end of a long conveyer belt.

Note: Kessler talks with many flavor enhancement companies in the book, including McCormick (MKC), beyond the scope of this article.

No disclosures.

Goldman Not Ready to Stop Trading Against its Clients

2010-05-03T14:56:00.003-04:00

Published by clickbroker.blogspot.com.

The Financial Times’ “Goldman in PR bid to stave off crisis” reports that the firm is preparing for an advertising agency bake-off in an effort to improve its connectiveness with the American public. The firm whose CFO David Viniar emphatically professes in every earnings conference call is not retail bank, now feels it needs to develop a relationship. The public just does not understand Goldman Sachs’ (GS) economic role as a “catalyst for growth.”

The public be damned attitude is slowly receding with the heightened political and legal risks, but has the client be damned for the sake of maximizing profit or protecting the firm drive change at all? The Financial Times’ “Goldman plans to overhaul practices” reports the firm is initiating a very lawyerly approach to protecting itself from its clients. According to the FT: “Goldman … would now tell employees to seek confirmation from clients that they understand the risks associated with any given security, and how their dealings with Goldman might change their total exposure.”

The FT assumes that Goldman is positioning itself for a settlement with the SEC. But I see it as a PR move of little substance. It would be not be much more than reading key points from a security’s prospectus and asking clients if their portfolio might need more of the risks they are selling. It sounds like just the forward looking statements cautions at the beginning of every earnings call. Sophisticated investors would be afraid to appear naive in Goldman’s presence, adding to the meaninglessness of the verbal disclosure.

Salespeople are meant to sell and big deal clients are meant to impress with their sophistication. Goldman has no intention to change this profitable mix. Instead of the government pretending that it is fraudulent or even just unfair for a salesperson not to disclose the motive of their firm, they should require each investment bank to disclose whether they are acting for the benefit of the client or the benefit of the firm it each transaction.

The Wall Street Journal’s “Goldman Probe Shows Toxic Magnification” reports about the multiplier effect of a few bad mortgages. That’s right; the impact of originated subprime loans, as bad as they were, alone would not have been enough to bring down the entire world’s economy. Synthetic CDOs of John Paulson and Goldman fame would never have been needed if there were enough toxic mortgages to go around. Common sense would say when scarce goods are being synthetically created, longs are on the wrong side of the bubble. This supports the Goldman defense.

Warren Buffett’s defense of Goldman is “let the buyer beware” should always prevail. After disclosing that Goldman is his counterparty in some of his derivatives, it appears that Buffett is only seeking the protection of a stable partner. Self interest drives both Buffett and Goldman, that’s why they seek comfort in each other’s arms.

Realtors have set the precedence in disclosure. Buyers must sign a document which states that the agents are paid buy the sellers and represent only the interest of the sellers.

The government should focus on a very simple disclosure rather than any fiduciary responsibilities. Goldman should voluntarily disclose whether it is acting in the client’s, the firm’s or a third-party client’s interest in each transaction. In the case of the famous John Paulson synthetic CDO, Goldman would have had to tell the buyers that the firm was acting in the interest of a third-party client.

When Goldman acts as a market maker the disclosure would be that they are acting in the interest of the firm. In new issues the firm is acting in the interest of the issuer, and in structured products either the firm or a third-party client.

Again, common sense would say that unless a client is paying for advice – caveat emptor. But, intent is both the legal and ethical issue that Goldman must overcome. No one is asking Goldman to give free advice or determine the appropriateness of an investment for professionals. What everyone is asking Goldman to disclose is in whose interest they are acting with every transaction.

Goldman has taken a baby step forward since my prior post “Goldman Sachs: The Long and Short of Opaque”. But they still want to let market making mask a variety of transactions that favor one client over another, without disclosing that one client paid for the firm’s loyalty. Investors did not have to be told that John Paulson paid Goldman to create the synthetic CDO, or even that he bet against it. Only that some anonymous client paid to create the synthetic CDO and Goldman is acting in the interest of that client.

I do not see the need to disclose what the third-party’s intentions were, long or short. Only that the Goldman salesperson is acting in the interest of a third-party client. Too much is being made of the built to fail and shorting aspects.

A true market maker matches buyers and sellers, occasionally keeping inventory for a short periods of time. In the Paulson case, Goldman was clearly not a market maker.

Goldman, Buffett, the Journal and the FT are all focused on the battle between good and evil. This allows Goldman to continue pretending to reform. I believe that this time pretending will be to the firm’s detriment.

No disclosures.

The Humana Message

2010-04-26T13:05:00.003-04:00

Published by clickbroker.blogspot.com.

The Humana (HUM) conference call (4/26/2010) was one of the most informative in recent memory. The market’s early enthusiasm for the stock gave way well before the call concluded. Reversals of accruals and outsized premium increases accounted for much of the earnings. Commercial enrollment continued to fall while Medicare Advantage (MA) increased 19% to 1.74M members. The company’s unbalanced book continues to get worse, increasing its dependence on government programs further.

Humana profoundly stated that healthcare reform is now the law, so they must adapt and become much more efficient. Only the large and dominant insurers will survive; the other smaller players will either merge or go out of business. The dominate players will vary by market.

The company’s perspective on the upcoming medical loss ratio (MLR) regulations differed from other insurers public statements. While others primarily focused moving costs from admin to MLR, Humana was more concerned in how finely pools would be cut in calculating MLR. They believed they are close to the required 85% in large groups and 80% in small groups, but have too much administrative overhead and broker commissions in the individual market to meet the 80% mark.

While Humana might be able to meet the benchmarks nationwide, MLR varies by plan pool, state and even metropolitan area. If every individual product is weighed by a fine geographical slice, Humana sees difficulty.

While Medicare Advantage is in the process of almost completely engulfing the company, they say that their plans must be at least 15% more cost effective than traditional Medicare to survive under healthcare reform. This comes from the previous environment where MA providers were given a 15% premium over traditional Medicare. The path Humana sees to achieving this is disease management of their most costly seniors.

Disease management could take both positive and negative paths. Chronic seniors with long life expectancies would receive extensive calls and home visits from Humana nurses to insure care regiments are adhered to. This is the positive side the company highlighted.

The negative side of disease management is moving their entire MA population to managed care and making referrals cumbersome for the more frail seniors with short life expectancies and high end of life medical costs. This might be the private insurers’ route to pulling the plug on grandma.

Humana is accelerating its move into the individual market in preparation for the opening of the insurance exchanges in 2014. In another profound statement, the company sees an acceleration in employers dropping health insurance when the exchanges open. It will become much more efficient for employees to purchase coverage on the exchanges because only the most efficient insurers will survive the highly competitive exchange system.

Allowing employees of larger companies to participate on the insurance exchanges is phased in during the years following 2014. I agree with Humana’s analysis of the shift from employer to individual health insurance. I think it is truly a healthy trend as long as insurance regulation remains strong.

The evaluation of Humana as a stock rests on whether you believe they can deliver on the efficiencies their new business plan requires. This quarter’s success was built on onetime events and beating Medicare at its own game by 15% is difficult for me to imagine.

Politico’s “Democrats move to blunt Citizens United ruling” reveals that the Schumer, Van Hollen, Castle’s campaign finance bill will prevent government contractors from spending money to influence elections. This legislation could be as profound to private health insurers as the healthcare bill recently signed by President Obama. All of the major insurers are large government contractors, so their influence on public policy could begin to wane.

On the positive side, Humana has shown the wisdom to accept healthcare reform and is trying to adapt. However, I do not believe they will be successful. While they talk a good game, they more than hinted during the call that they are still counting on state insurance commissioners to prioritize insurer financial stability over lower premiums. Translation – they have not really convinced themselves that change is inevitable.

Disclosure: Author is long HUM puts.

Goldman Sachs: The Long and Short of Opaque

2010-04-21T17:03:00.005-04:00

Published by clickbroker.blogspot.com.

Goldman Sachs’ (GS) earnings call was startling arrogant in not remaining silent on the SEC fraud charges. Not only did they fail to disclose the Wells Notice in a timely manner, but challenged the SEC for not giving them a chance to settle before the public announcement. Goldman’s PR machine is so poor that Republicans are being forced to work with Democrats on financial reform as I write. Being legally right and morally wrong does not make for good politics or client relations.

Goldman has sustained itself being a firm that all others had to deal with, like it or not. They were smart enough to work within the letter of the law to offset much of their credit risk at major inflection points. Goldman turned up relatively unscathed, while leaving a bloody trial in their wake. Of course this is a bit of exaggeration for a firm with many clean businesses. But the smartest guys in the room are now saying to their clients “buyer beware.”

The main crux of Goldman’s defense is that buyers of the CDO targeted in the SEC fraud indictment were sophisticated investors who had enough information to make a reasonable decision. Goldman’s salesmanship should have played no role. And ACA, the portfolio developer, was sophisticated enough to act independently whether Goldman tried to influence it or not. It appears that both ACA and the banks that bought the CDO were putty in Goldman’s hands.

How sophisticated could ACA be if they agreed to insure items Paulson selected? Was ACA blinded by greed?

While sophisticated investor is often an overstatement for financial institutions, states, cities and pension funds being duped, Goldman’s argument that all investors know there must be a long and a short for all synthetic CDOs bears a closer look.

I will take a nonprofessional stab at it. The CDO is synthetic only in that the trust’s portfolio contains CDS rather than MBS or bonds. Once created, Goldman’s job is to sell it out of inventory to long investors. John Paulson’s short positions on the CDO bond tranches are completely separate transactions. Goldman being stuck with inventory that they could not sell bears no relevance to their commitment to the CDO, long or short.

The only place where balanced long and short positions are relevant is in the CDS included in the trust. Given that Paulson’s CDS were on the CDO itself and not the components, Goldman’s excuses during the conference call fell short. With the exception of ACA, the investors in the CDO could not be expected to know that Paulson used Goldman to build a CDO design to fail.

The long and short of sophisticated investors is that those often flattered with the term are taken advantage of, and the peddlers of ingenious financial products are losing their political influence. “Let the public be dammed”, “screw or be screwed” and “survival of the fittest” are no longer the best business strategies for the rocket scientist of Wall Street.

Finally, rarely are the innocent spared when the sophisticated players rumble. Look at state and municipal governments brought to their knees by Wall Street. Look at the many public and private pension plans and endowments humbled.

I believe that Goldman is in shock that morality now matters. The company that professes not to be a “retail bank” is about to be reformed by retail politics.

No disclosures.

Michael Belfiore’s “The Department of Mad Scientists”

2010-04-11T16:59:00.005-04:00

Published by clickbroker.blogspot.com.

Michael Belfiore’s book “The Department of Mad Scientists”, subtitled “How DARPA Is Remaking Our World, from the Internet to Artificial Limbs” tells the story of the quasi independent Defense Advanced Research Projects Agency. DARPA was started during the Eisenhower years as a fast moving effort to respond to Russia’s first satellite launch. Our civilian space agency was floundering and the military effort while progressing was under political fire.

When the political winds determined that space should be nonmilitary to benefit the entire world, the forerunner to NASA was born. DARPA survived, but had to find its life’s purpose. DARPA’s early progress as the employee-light pragmatic coordinator defined its culture in future years.

The original director and project managers only agreed to two year terms. What followed was fixed term limits of three to five years, with the termination dates posted on project managers badges. This created urgency for great thinkers to prototype their ideas in short order.

DARPA directors sought project managers that were way out thinkers rather than simply great engineers and scientists. Scientists might be able to think what is possible outside of current technological constraints, but DARPA was not afraid to consult with and hire science fiction writers for totally unconstrained ideas.

DARPA’s function evolved to prove the unthinkable was possible and put a rush on it. The likes of General Electric (GE), Boeing (BA), academia and garage scientists could be contracted for technical research and prototyping. Then the prototypes could be handed off to companies, such as Intuitive Surgical (ISRG) in 1999, to find venture capital and develop military and civilian products.

DARPA thinking is for what is deemed impossible, not the technology to get there. This led to internet and GUI mouse when they were the first to consider the importance of how computers interact with people. The first real graphical user interface was demoed to an astonished convention of computer scientist in 1968.

In the 1970’s DARPA sponsored experimentation in extrasensory perception (ESP) for “divining Soviet military secrets.” It seems everything short of astrology was fair game.

In 2005, DARPA took another stab at automated surgery with the military Trauma Pod. The Trauma Pad took the da Vinci Surgical System concept of human guided surgery to a field pod that automated all of doctor and nurses’ tasks, stabilizing the soldier while being airlifted to a medical facility.

DARPA’s focus and funding has been influenced to a limited degree by the political winds. Reagan wanted missile defense and mach 25 civilian and military air travel. Clinton quietly changed direction, but many of the initial prototypes continued to be enhanced. The important thing is DARPA’s culture has not changed through multiple presidencies.

Disclosure: Author is long GE.