Rosy Scenario and Her Evil Twin

Investment analysts, CEOs and government officials constantly project questionable positivity.  Prosperity is always around the corner, green shoots of recovery are everywhere, and a chicken will appear in every pot.  We pillory realistic if negative analysts as pessimistic naysayers, prophets of doom or worse.  But we ignore reality at our peril. More often than not Rosy Scenario often clashes with her evil twin Dashed Expectation.  The results are often calamitous.

Ignoring Reality

The last decade has brought ignoring reality to a high art form.  Linear extrapolation has brought the following prophesies:

• Dow 36,000
• Internet businesses with no customers and unrealistic business plans worth several times the value of established companies (IBM, DuPont)
• Ever-rising housing prices
• The FIRE economy (Financial, Insurance, Real Estate) supporting the entire American economy
• Sustained non-problematic leverage ratios of 30 and 40:1
• Debt growth several standard deviations greater than GDP
• Counterparties to derivative contracts always making good
• Never defaulting on sovereign debt
• Pension fund assets always earning between 7-9%
• Federal debt growing faster than tax receipts
• Public sector wages growing faster than GDP and tax receipts
• Aggressive accounting (Enron, Lehman) considered good financial engineering
• Zero interest rates restoring economic prosperity.

Past is Not Always Prologue

We are prisoners of our past experiences.  We expect the Federal Reserve to cut interest rates and the economy to magically recover.  We are surprised when the nominal unemployment rate is at 9.7% and the actual is 17%.   We are surprised when Wall Street bonuses soar and Main Street suffers.  We are surprised when Moody’s threatens to downgrade US debt from AAA rating. See Moody’s Says U.S. Debt Could Test Triple-A Rating

Rarely do we say that this time is different.   As a society, we have incurred debt far exceeding our capacity to repay.  Balance sheet recessions/depressions are far worse than previous inventory recessions.  Just as the Vietnamese fooled our World War II trained generals, the Federal Reserve and Administration are intent on fighting an outdated economic war.

It is time for some nonlinear thinking.  Instead of posturing, Congress should be asking Ben Bernanke for a Plan B.  Averting financial Armageddon is not enough.  JP Morgan CEO, Jamie Dimon, projected a banking crisis every five to seven years.  See Elizabeth Warren Exposes Jamie Dimon. As a society we can ill afford another year like 2008.  Reality is gaining on us.

How well did the five-year plans work out for the brittle Soviet system?   Is it time to ditch Rosy Scenario and deal with reality?

Related posts:

1. Can We Continue the Status Quo?
2. Are We a Socialist Country?
3. War on Prudence

Think that this spring’s “Robin Hood” movie will be a blockbuster at the box office? Next week you will be able to put your money on it.

Cantor Futures Exchange, a subsidiary of Cantor Fitzgerald, expects to open an online futures market next month that will allow studios, institutions and moviegoers to place bets on the box-office revenue of Hollywood’s biggest releases. Last week, the company learned from regulators that customers could start putting money into their accounts on March 15.

“I’ve worked in the futures industry for a long time,” said Richard Jaycobs, the president of Cantor Exchange, who has worked with derivative markets and the cotton exchange. “And none of the products has the overall appeal that this does. This just has a tremendous potential audience.”  See A Place to Bet Real Money on Movies

Mr. Jaycobs hopes to attract professional and institutional investors and is awaiting regulatory approval from the Commodity Futures Trading Commission.  Predictably, we will also be able to short a movie, and gamble on its failure.

Investing or Gambling?

The financial crisis has laid bare the “casino” nature of modern capitalism.  We have bet on everything from the failure of the housing market to the collapse of nation-states.  But movie futures from an investment banking firm?

Somehow the movie industry survived from Edison’s first motion picture in 1889 to the twenty-first century without a futures exchange.  The Times should have asked important questions: why do we now need a movie futures exchange?  Should the average investor be permitted to speculate in movie futures?   Is this truly investing, speculating or outright gambling?

“The Producers”

In an iconic and wildly funny movie, Zero Mostel and Gene Wilder brought us the ultimate Ponzi scheme.  Create a truly terrible and tasteless show, sell shares adding to many times the show’s purported cost by romancing amorous little old ladies to part with their savings, then close the show and pocket the excess cash. But in a twist worthy of O’Henry, the show is so bad it’s a hit.  And our two financial gigolos end up in jail, pondering their bad luck and ignorance.

Selling movie futures allows clever Hollywood executives to profit on terrible movies.  As anyone who spends time at the local multiplex knows, there are plenty of bad movies to go around. Soon the “Ten Worst Movies of the Year” could be a source of pride and profit.  Or someone’s pension source?  Where is the societal benefit?

The Financialized Economy

In The Mirage of a Financialized Economy, we pointed out the societal dangers of over focusing on things financial.  Where our best and brightest should be working on new medicines, alternative energy sources or great achievements in art and culture, they are creating movie futures.

We have also become a gambling economy.  When we are not being bombarded by ads for E-Trade, gold purchases or Bank of America, we are seduced into playing state lotteries, visiting Foxwoods or Las Vegas.  To enhance revenue and climb out of their financial pits, states have become willing participants in this folly.  And as we know, when the imprimatur of government involvement enters the scene, it is ever more difficult to discern the more from the less worthy enterprise.

Where are the advocates for unambiguously productive or worthy or timeless enterprises?  And where are the marketers and sales forces who can convince us to invest in them? I wouldn’t bet on finding them anytime soon.

Related posts:

1. A Reputation as Good as Goldman? Part I
2. The Mirage of a Financialized Economy

In the rush to save money in grim budgetary times, states nationwide have trimmed their prison populations by expanding parole programs and early releases. But the result — more convicted felons on the streets, not behind bars — has unleashed a backlash, and state officials now find themselves trying to maneuver between saving money and maintaining the public’s sense of safety.

One result: many of the newly released prisoners commit crimes!  How do we keep society safe against the growing cost of incarcerating the bad guys?

The State and Local Financial Crisis

In Where Are We Now? we discussed the budget deficits in 48 of 50 states, while all states but Vermont require them to be balanced.  The situation has deteriorated.  Michael Shedlock (“Mish”) has chronicled these massive budget problems and some state and local responses:

- Illinois – “The state is in utter crisis,” said Representative Suzie Bassi. “We are next to bankruptcy. We have a $13bn hole in a $28bn budget.”The state has been paying bills with unfunded vouchers since October. A fifth of buses have stopped. Libraries, owed $400m (£263m), are closing one day a week. Schools are owed $725m. Unable to pay teachers, they are preparing mass lay-offs. “It’s a catastrophe”, said the Schools Superintendent. See Rep. Suzie Bassi: “Illinois in Utter Crisis, Next to Bankruptcy, $13bn Hole in a $28bn Budget

-   New Jersey – Newly elected Governor Chris Christie found that: In the time we got here, of the approximately $29 billion budget there was only $14 billion left. Of the $14 billion, $8 billion could not be touched because of contracts with public worker unions, because of bond covenants, because of commitments we made accepting stimulus money. So we had to find a way to save $2.3 billion in a $6 billion pool of money.

When I went into the treasurer’s off in the first two weeks of my term, there was no happy meetings. They presented me with 378 possible freezes and lapses to be able to balance the budget. I accepted 375 of them. See Governor Christie: “Time to Hold Hands and Jump Off the Cliff” – Chris Christie For President?

-   California – Last year the state assured markets that it had solved its budget problem.  To meet deficits and cash shortages, the state treasurer is contemplating creditors in state IOUs, delaying payments to school programs and demanding that 80% of state tax be paid before it is earned. See California Delays Payments, Ponders IOUs Again, Demands 80% of Income Tax Paid Before It’s Even Earned

The Prison Industrial Complex

In his 1961 farewell address, President Eisenhower warned Americans against the military industrial complex.  We have created a “prison industrial complex,” with its expensive, unmanageable system of incarceration and monitoring.  One Connecticut study showed an average annual cost of $44k per prisoner.  Public sector unions with high salaries, generous overtime, defined benefit pension plans and retiree health care benefits are hugely expensive, and prison staffs are heavily unionized.

A Way Out

We have suggested in the past that government needs radical reengineering.  See Why Not Reengineer Government? Overhauling the criminal justice system should be a part of that effort. And there are possible solutions:

• Privatize prisons.
• Decriminalize certain offenses such as illegal drugs and gambling.
• Non-violent criminals should pay financial penalties, be confined to their homes, placed in half-way houses or paroled immediately.
• Community service programs should be re-thought to make best use of talents and skills of otherwise imprisoned citizens.
• Shorten prison sentences for all but the most violent felons.

Our criminal justice system has mushroomed with little regard to the financial costs to taxpayers. We have over-criminalized non-violent behaviors to all our detriment.  A reform in that system can pay both societal dividends, fewer citizens locked up and a financial dividend, lower taxes.  Perhaps this is one silver lining from the financial crisis.

Related posts:

1. Where Are We Now?
2. Consistently Inconsistent
3. Are We a Socialist Country?

The Slippery Slope

The road to hell is paved with good intentions.  I do not think any of the pillars of our economy intended that the country become socialistic.   Each entity was merely maximizing its own position, seeking to enhance shareholder value.   When financial crisis hit, our formerly capitalistic businesses could not rush to Washington fast enough to seek support, bailouts and guarantees from the government.   The government was only too happy to oblige with the passage of TARP and then an alphabet soup of government support and guarantee programs.  In one short crisis period from summer 2008 to spring 2009, the government ignored 200 years of American economic and constitutional history to save a group of greedy and profligate bankers and industrial corporations.   The end result: we privatized profit and socialized losses.

A Factual Progression

Here are the events that have taken us on the path to socialism:

• The Federal Reserve’s active role in the forced sale of Bear Stearns to JP Morgan
• The Government seizure of Fannie Mae and Freddie Mac
• TARP:  Government purchase of troubled assets from private financial institutions
• Goldman Sachs and Morgan Stanley become banks by expedited process  to obtain government guarantees
• Government seizure of AIG and complete payback to private institutions for credit derivative losses
• Federal Reserve intervention in broker mergers, with guarantees against losses (Washington Mutual with JP Morgan, Wachovia with Wells Fargo)
• Federal Reserve intervention with $1.3 trillion in loans to companies outside the financial sector (GE).
• Government removal of management at GM and Chrysler
• Restrictions on executive pay for banks receiving bailout funds
• Government restrictions on foreclosures unless there has been a Home Affordable Modification Program review.
• Administration desperation to pass comprehensive health insurance program.   See Timeline:Global  Economy in Crisis

How Did We Get Here?

We invited the devil in the door.  Banks claimed that they could not withstand loan and derivative losses.  Unemployed Americans wanted extensions in unemployment benefits and stimulus programs.  Nobody wanted to see the stock market crash and their portfolios and retirement plans decimated.  Big business wanted the profit opportunity in universal health care coverage.  Insurance companies did not want to hurt their policy holders.  Auto workers wanted to maintain their rich union contracts.  The litany goes on.

Once we were a brave, independent and self-reliant nation.  Now when adversity strikes our first inclination is to blame others and call Washington for a bailout or a handout.  I do believe in the concept of welfare.  Welfare was meant for the truly dire circumstance, the impoverished citizen. Welfare was not meant for auto workers to maintain above market wages and job guarantees, banks to get paid in full for risky derivative bets, GE or GM, homeowners who falsified their income disclosures to remain in McMansions or every insurance policy to be paid in full.

Capitalism is about freedom, risk and failure.  Without failure there can be no progress.  The slide toward socialism is an escape from freedom and ultimately an end to progress.

My European immigrant grandfather lived through the Depression, World War Two, and into the 1980’s.  He once told me he was most proud that he never went on relief (welfare).  We should return to the ways of our forbearers, regain our mettle and become too proud to ask for a handout or bailout.   Our freedom and that of our children depend on it.

Related posts:

1. Uncomfortable Questions
2. Freedom to Fail
3. Perverse Incentives

Perhaps the hubris went further.   Does Goldman believe that its status as a favored Federal Reserve “too big to fail” firm will insulate it from government investigation? Last week Ben Bernanke put a dent in Goldman’s Teflon shield:

Ben S. Bernanke, the Federal Reserve chairman, told Congress Thursday that the Fed was ‘looking into a number of questions relating to Goldman Sachs and other companies and their derivatives arrangements with Greece.’

Mr. Bernanke said the Securities and Exchange Commission was also concerned about how derivatives — financial instruments that are largely unregulated and do not trade on public exchanges — have contributed to Greece’s problems. ‘Obviously, using these instruments in a way that intentionally destabilizes a company or a country is counterproductive,’ he said. See In Greece’s Crisis, Fed Studies Wall St.’s Activities.

In Is Goldman Finally About to Be Leashed and Collared? Yves Smith observes and analyzes Goldman’s corporate culture.  As a former employee, she reports on colleagues’ piggish and overly aggressive behavior. But in an otherwise excellent post, I believe she overlooks the role of current compensation systems.

Pay Practices and Reputation

In previously discussing the banking crisis, we pointed out a fundamental principal: you get what you incent.

Banks were interested in generating upfront fees. Incentives were predicated on “making the deal.”  The best way to make a deal was to ignore the creditworthiness of the borrower.  The banker who made the bad loan suffered no personal financial penalty.  There was no “skin in the game.” Why not write as many loans to poor credits as possible? See Hard Truths from the Banking Crisis.

The Goldman culture incents a “winner take all” mentality.  Since it is a public corporation rather than a partnership everyone is an employee.    A highly mobile employee rather than an owner is far less concerned about the firm’s long term reputation.  That employee wants to maximize current compensation; worrying about future consequences is for suckers.  Drawing on this paradigm, we are not shocked by headlines excoriating the firm for trading against its clients’ interests, shorting the municipal bonds it helped underwrite, skirting EU rules, or tanking the housing market.

Goldman operates in a larger Wall Street and indeed general culture that encourages greed at the expense of overall civic good:

• Successful hedge funds report individual earnings in the hundreds of million dollars per employee.
• Loyalty is dead.  Employees change firms. Highly paid athletes change teams without a second thought.
• The media treats great wealth as reason for great celebrity.
• Compensation validates individual worth.
• Government backstops losses and allows gains to remain private.
• The zeitgeist promotes: “I better grab as much as I can now before the economy implodes.”

Does It Have To Be This Way?

Any alert Board of Directors should be asking some difficult questions.  Why aren’t we concerned about the long-term firm reputation?  What do we want the corporate culture to be? Just because we can legally do a transaction should we be doing it?  How do we blend partnership-based personal accountability with a public corporation structure?   How do we get employees to care about the long-term view?  How do we meet the competitive threat of hedge funds and private equity without damaging corporate reputation? How does our compensation system comport with these concerns?

Yves Smith noted that it was as dangerous for anyone to get in the way of a Goldman employee and a profit making opportunity as it was to get between a predatory animal and its kill.  Goldman has managed to get itself between a very worried Obama Administration and a very angry public.  How ironic if the Goldman predatory lion becomes the Administration sacrificial lamb.

Related posts:

1. A Reputation as Good as Goldman Part II
2. A Reputation as Good as Goldman? Part I
3. War on Prudence

American business is about maximizing shareholder value…You basically don’t want workers. You hire less, and you try to find capital equipment to replace them.

Workers are expensive. Federal, state and local employment laws make them more so.

New Deal Labor Legislation

In the late 19^th and early 20^th century, rapid industrialization resulted in powerful owner/capitalists, virtually powerless workers, and deplorable working conditions.   Upton Sinclair’s The Jungle dramatized the deplorable state of affairs in the meatpacking industry.  In reaction, in 1935, Congress passed the Wagner Act to permit union organizing. Then it enacted the Fair Labor Standards Act to establish minimum pay, limitations on hours and pay for overtime work.  Perhaps labor legislation should have stopped at that point.

Nothing Succeeds Like Excess

New Deal labor legislation was just a springboard for greater federal control over the workplace.   Since 1964, there has been a flood of labor and employment legislation and Executive Orders.

• The Civil Rights Act prohibits race, color, religion, sex or national origin and pregnancy discrimination.

• The Age Discrimination in Employment Act prohibits age discrimination.

• One Executive Order prohibits all forms of discrimination and requires affirmative action.  This includes training and outreach programs and other positive steps which must be incorporated in written personnel policies and a plan which must be updated annually.

• The Equal Pay Act requires that men and women in the same workplace be given equal pay for equal work.

• The Americans with Disabilities Act prohibits disability discrimination. The Rehabilitation Act requires most federal contractors and subcontractors to take extra measures to hire and promote qualified disabled individuals.

• The Occupational Safety and Health Act requires employers to meet legal health and safety standards.

• The Employment Retirement and Income Security Act (“ERISA”) sets uniform minimum standards to assure that employee benefit plans are established and maintained in a fair and financially sound manner.

• The Workers Adjustment and Retraining Notification Act requires that covered employers provide notification sixty days before a plant closing or a mass layoff.

• The Family and Medical Leave Act provides covered employees with entitlement to up to 12 weeks of job-protected, unpaid leave during any 12 months for the following reasons:

-Birth and care of the employee’s newborn or adoption or foster care of a child

-Care of an immediate family member (spouse, child, parent) who has a serious health condition

- The employee’s own serious health condition

These are the major pieces of federal labor and employment legislation, but there are additional enactments regulating the employment relationship.

Since we live in a federal system, state and even municipalities impose additional employment, benefit and labor obligations.  Moreover, the courts have intervened to create doctrines such as wrongful discharge to limit an employer’s right to dismiss an employee at will.

Real World Consequences

Much of the above legislation is grounded in noble sentiment: workplace fairness and employee protection.  But there are real world consequences: a loose definition of “serious health condition” allows employees to take large unpredictable amounts of time off, harming production schedules.  Affirmative action programs require lots of staff and recordkeeping, extra recruitment and training, and slower hiring.  ERISA imposes fiduciary liability on plan sponsors. With virtually every workplace sector protected, firing an employee is difficult, with the ever present danger of a discrimination or retaliation charge. And so the American workplace is now one of the most regulated areas of our economy.

Laws are often a hidden tax. See Ask Your Congressional Representative to Do Nothing.   Allen Sinai has reached the correct conclusion: why hire expensive workers who have a host of protections and entitlements when you can substitute cheaper capital (automated machinery, robots, computers, etc)?  In a globalized economy where a highly motivated, well-trained Chinese worker makes about $1 per hour, the over protected American worker may have priced himself out.

If the Obama Administration is serious about reducing the unemployment rate, it should be thinking about shelving expensive health care initiatives and the Employee Free Choice Act.  More employer cost will equal less American employment.

Related posts:

1. The New Reality: Permanent Job Loss
2. Thinking About Jobs
3. It is All a Derivative of Productive Enterprise

Building a successful business is difficult. Once an entrepreneur raises capital, he must deploy it properly.  He must hire employees, build factories, develop products, plan marketing strategies, manage production, packaging and shipping, and a myriad of other activities.

A recent concept, financialization is defined as:

…a term sometimes used in discussions of financial capitalism which developed over several decades leading up to the 2007-2010 financial crisis, and in which financial leverage tended to override capital (equity) and financial markets tended to dominate over the traditional industrial economy.

[It] describes an economic system or process that attempts to reduce all value that is exchanged (whether tangible, intangible, future or present promises, etc.) either into a financial instrument or a derivative of a financial instrument.  Source Wikipedia.

Financializing the economy promised a short cut to making money.  We are now paying for that false promise.

Living through Financial Engineering

I started my corporate career in 1977.  I worked for a telecommunications and manufacturing conglomerate that served 27 million telephone customers, employed 250,000 people worldwide, manufactured products ranging from the humble incandescent light bulb to sophisticated microchips.  Leaders in the company were operating executives.  Executive compensation was moderate.

In the 1980’s and 1990’s the winds of financializing change swept through corporate America.  The underlying producing businesses were viewed as stodgy and unimaginative.  Paper mills, lighting plants, railroads and telecommunication companies were boring “cash cows.”   “White shoe” business schools preached financial innovation, or to give it a more professional sounding name, financial engineering. The CFO function dominated.  Executive compensation increased exponentially.

The number of engineering opportunities was boundless:

• Terminate pension plans and pocket the surplus assets
• Create leveraged employee stock ownership plans to make 401k contributions
• Take out gigantic company owned life insurance plans on large swaths of the workforce
• Issue huge amounts of debt and buy back the company’s equity
• Create voluntary employee benefit trusts to pre-fund retiree health benefits for unionized employees.
• Create leasing and realty divisions within the company for both internal and external needs
• Take the firm private through a management organized leveraged buyout

These are but a few of the financial techniques employed to inflate company earnings or turn a quick profit. Most of these strategies involved taking on large amounts of debt and exploiting loop holes in the tax code. None of this enhanced the productive capabilities of the underlying business. The “cow” was slowly starving and the bricks and mortar of the enterprise were crumbling.

Enron and WorldCom

The beginning of the new millennium saw two major American corporations, Enron and WorldCom, disintegrate.  Accounting fraud was at the heart of these collapses.  Enron created off shore entities to hide losses and posted yet unrealized revenue as profit.  WorldCom underreported line costs by capitalizing items which should have been expenses.  They also inflated revenues through bogus accounting.  Not only did these entities hurt their shareholders, but also their competitors who had to compete again these fraudulent entities for scarce capital.

Sarbanes-Oxley was passed in 2004 to stop these accounting maneuvers and restore integrity.  The subsequent collapse of Bear Stearns and Lehman tells us that Sarbanes-Oxley failed, and that financial transparency still does not exist.

The Evils of Financialization

Financialization of the economy has become an evil unto itself.  Culprits in the 2008 financial crisis: sub-prime lending, mortgage-backed securities, collateralized debt obligations, off balance sheet structured investment vehicles, hedge funds, private equity,  excessive leverage are all the progeny of the 1980’s schemes and strategies to enhance corporate financial performance.

I have two observations.  First, many of these maneuvers are nothing more than alchemy applied to finance.  Old saws such as “there is no free lunch” and “you can’t get something for nothing” remain true.  Slapping a Nobel Prize or a prestigious business school imprimatur on a strategy does not change these universal truths.

Second, an early rule of investing I learned is: when one sector becomes more than 30% of the value of the S&P 500 index, sell that sector. This was true in the 1980’s when the oil sector passed that benchmark and in 2008 when the financial sector did the same. Too much of society’s resources and human capital are now tied up in one area of the economy. At least in the case of oil there was a real societal good.

The financial industry in 2008 and now has become a financial casino without the glitz or charm of the Mirage. In fact, it has become a mirage and that says a lot.

Related posts:

1. The Organic Economy
2. The Barbell Economy
3. It is All a Derivative of Productive Enterprise

Sydney Weinberg

In 1930, Sydney Weinberg became the head of Goldman Sachs. He ran the firm for the next 39 years.  By 2010 standards, he was an unlikely person for the job. He had left school at 15 (1907) and started at the struggling brokerage firm as a janitor’s assistant.  He then served in the Navy during World War I, returned to the firm and ultimately became co-head of the securities trading group. He is credited with saving Goldman Sachs from bankruptcy during the Depression. See Annals of Business: The Uses of Adversity by Malcolm Gladwell

In 1956, Weinberg managed his greatest corporate coup. Goldman Sachs was selected to handle for the Ford Motor Company the enormously difficult, largest ever until that time, initial public offering.  The effort took two years. The most fascinating part of the transaction was Weinberg’s fee:

When Henry Ford had asked Weinberg at the outset what his fee would be, Weinberg had declined to get specific; he offered to work for a dollar a year until everything was over and then let the family decide what his efforts were really worth.  Far more than the actual fee, Weinberg always said he appreciated an affectionate, handwritten letter he received from Ford which says, along with other flattering things, “Without you, it could not have been accomplished.” Weinberg had the letter framed and hung in his office, where he would proudly direct visitors’ attention to it, saying: “That’s the big payoff as far as I am concerned…” The fee finally paid was estimated at the time to be as high as a million dollars. The actual fee was nowhere near that amount: For two years’ work and a dazzling success, the indispensable man was paid only $250,000. Deeply disappointed, Sidney Weinberg never mentioned the amount.  See The Partnership: The Making of Goldman Sachs by Charles D. Ellis.

Weinberg understood the value of a continuing relationship with Ford Motor Company and was soon appointed to their board.  Moreover, for nearly a half century, Goldman became the chief investment bank for Ford which vaulted the firm into the top tier of Wall Street firms.  To Sydney Weinberg reputation was everything.

Tradition and the Making of a Culture

John Weinberg followed his father Sidney as head of the firm.  The younger Weinberg preserved his father’s ethic and corporate culture.

Once upon a time, Goldman Sachs shunned publicity.  During the period from 1930 to 1969, Sydney Weinberg ran Goldman Sachs where he developed a staunch corporate cultural aversion to publicity.  During the 1970s, a tandem of John Weinberg and John Whitehead assumed the reigns of leadership at Goldman Sachs.  Whitehead left the company in 1984 to enter public life.  John Weinberg carried on in the same vein as his father Sydney – shunning publicity – to the point where he hired a man to keep his name and his firm’s out of the press.  He kept him off the full-time payroll (though he sat full-time at a desk in head office) so that if, improbably, a comment did slip out, it could be honestly dismissed as not coming from a Goldman Sachs employee.  John Weinberg served as sole senior partner and chairman until 1990.  His mantra was to put the client’s interests first and he wouldn’t allow Goldman to be involved in (sic) hostile takeovers. See All Roads Lead to Goldman Sachs.

As a young law student, Ben Stein interviewed with John Weinberg.  He was impressed with Weinberg as a “smart guy,” but also surmised that he inherited the position from his father, Sydney Weinberg:

But what I did not know about John Weinberg was that even though he was rich and well connected, as a young man he joined the Marines to fight the Japanese in the Pacific, then fought again in Korea. That was America’s ruling class then. The scions of the rich went off to fight. See Looking for the Will Beyond the Battlefield

Clearly, John Weinberg believed that honor and service to one’s country mattered.  But in the current Goldman and Wall Street culture, going off to serve one’s country is for the common folk: why do that and miss out on so many deals and great bonuses?

What Changed?

The end of the Weinbergs’ era can be traced to several factors.  First, Goldman Sachs, Morgan Stanley and other large investment firms were partnerships.  This means the partners were investing their personal fortunes.  Moreover, retained capital was extremely important to the future success of the business.  Thus, there was a limit on executive compensation based on capital and personal preservation.  Second, as firms went public, it was easier to convince a less involved board of directors (rather than partners) to pay large bonuses to executives. Third, those same executives became increasingly greedy, and probed and trampled ethical boundaries. Short-term thinking reigned on Wall Street.  Fourth, compliant government officials endorsed and enabled these behaviors instead of regulating them.

Finally, we need to look at the important intersection of law and ethics.  Just because something is legal does not mean one should do it.  A legal thing is not always an ethical thing.  Would the Weinbergs’ have permitted Goldman to take positions against their own clients?   Would they have forced AIG into insolvency? Would they have designed scams to fool the EU? I doubt it.

It will be a long time before Goldman restores its reputation.  And President Obama is not catalyzing any restoration of ethics or reputation by calling the current Goldman CEO a savvy businessman.   By its actions, I doubt if Goldman Sachs cares.

Related posts:

1. A Reputation as Good as Goldman? Part I
2. Goldman and the Winner Take All Society
3. Trust Once Lost

“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

Warren Buffett

Arguably the greatest living investor, Warren Buffet, clearly valued a person’s or an organization’s reputation.   In 2008 Buffet was the “white knight” investor for a struggling Goldman Sachs, investing $5b in the firm.  A mentor of mine had wise complementary counsel to Buffet’s:  when providing legal advice, be sure that you would be comfortable if that advice were to appear in a New York Times, Washington Post or Wall Street Journal front page article.

We live in  an age of greed, and indeed supreme irony.   Perhaps Mr. Buffet never shared his wise advice with the senior management of Goldman Sachs.  Worse, maybe he did and they ignored him.  In any event, how has Goldman’s reputation fared?  Let’s examine three separate front page New York Times articles.

Banks Bundled Bad Debt, Bet Against It And Won (NY Times, December 24, 2009)

Goldman Sachs sold mortgage-backed debt securities to pension funds and insurance companies. To hedge their position and to profit from a decline in the housing market, Goldman created a synthetic derivative security called Abacus. This second security was a direct bet against the position of their institutional clients. The mortgage-backed debt securities sold to the institutional clients performed poorly, with losses in the billions. Some of the original securities were of such poor quality that losses occurred within months of issue. Goldman created these synthetic securities well in excess of any hedging needs, permitting it to profit handsomely at the expense of its institutional clients.  The obvious ethical problem was succinctly stated:

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

The SEC and other governmental agencies are investigating Goldman and other firms to determine whether or not they violated “fair dealing” rules.

Testy Conflict with Goldman Helped Push A.I.G. to Edge (NY Times, February 7, 2010)

AIG insured some of Goldman’s complex mortgage securities.  When the housing crisis deepened, AIG paid Goldman $2b to cover potential losses. AIG later asserted that Goldman had inflated the potential losses and sought monies back. Goldman countered that it was due even more money.  The SEC is now looking into whether or not Goldman’s demands for loss coverage depressed the mortgage market and hastened AIG’s demise.

In another supreme irony, after the government took over AIG, Goldman received an additional $12.9b from taxpayers, one hundred percent of expected losses.

Wall St. Helped to Mask Debt Fueling Europe’s Crisis (NY Times, February 14, 2010)

Goldman’s questionable financial maneuvers were not confined to the United States.

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting.

The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.

European authorities are looking into the role of Goldman and others in skirting EU rules.

Is There Another Way?

Has the American public been lulled into believing that this is an acceptable way of doing business, or do we require the people involved to be publicly excoriated, tried, convicted and jailed before we acknowledge their tactics were shabby?  Is Goldman Sachs an institution now synonymous with crafty machinations and greedy outcomes? Are its tactics symptomatic of a Wall Street “disease?”  Is there an alternative way of doing things?  Does reputation matter?  Part II will examine these issues and possibilities.

Related posts:

1. A Reputation as Good as Goldman Part II
2. Goldman and the Winner Take All Society
3. Trust Once Lost

Slow Motion Depressions

Policy makers in Washington and other western capitals are recently smug. They proclaim that, through coordinated monetary and fiscal response, we have averted the Second Great Depression.  More bluntly, all we have done is throw a lot of money at the problem through unprecedented monetary easing and a fiscal policy of bailouts and stimulus bills.  The core financial issue remains:  western countries and the US in particular have too much debt and insufficient income to service that debt.  Depressions have their own timetable. In my opinion, government intervention has only slowed the timetable, but definitely has not averted the event.

The Magic Act

Politicians and central bankers are a bit like magicians.  While an observer is firmly focused on the right hand we miss the left hand’s activities, which are hiding in plain sight.   Just look at current economic and financial trends:

• Increasing Risk of Sovereign Debt Default – In late 2009 a problem arose with the financial solvency of Dubai.  Much like the subprime crisis in the US, financial pundits assured the public that the Dubai default was minor and self contained.  Yesterday, credit protection for Dubai rose to a record high exceeding the November peak. See Dubai CDS Hits 652, Ploughs Through November Highs As Gold Jumps.   Greece too is on the verge of sovereign debt default and is seeking a European Union bailout.  Portugal, Ireland, Italy and Spain are reportedly in dire financial trouble as well.  The United States, Japan and United Kingdom are not immune from talk of default.
• Crisis at the State Level – The Center for Budget and Politics has projected 48 of 50 states will have budget deficits.  Cumulatively, the Center estimates an $180b shortfall for this fiscal year.  All states with the exception of Vermont have a balanced budget requirement.  Some assistance to the states has been proffered through the American Recovery and Reinvestment Act, but it is questionable whether this aid can continue. See Recession Continues to Batter State Budgets; State Responses Could Slow Recovery. It is more likely that states will follow the lead of newly elected Republican Governor Chris Christie.  Recognizing that the state is on the edge of bankruptcy, Christie has declared a fiscal “state of emergency” and intends to slash $2.2b from the budget. See Chris Christie Declares Fiscal ‘State of Emergency,’ Paving Way for NJ Spending Cuts. The crisis in municipal finance portends trouble in the municipal bond markets.  The unsuspecting public has purchased municipals in search of yield and instead may receive an unpleasant surprise.
• National Fiscal Irresponsibility – President Obama signed into law a $1.9t increase in the debt ceiling, raising it to $14.2t. As the administration has predicted deficits out to 2020, this ceiling will rise each and every year. Also, it does not include the Christmas Eve bailout of Fannie Mae and Freddie Mac which provided “unlimited financial assistance” to these two entities. We will likely exceed our previous limit of $400b on financial assistance under emergency bailout provisions.  See US Promises Unlimited Financial Assistance to Fannie Mae and Freddie Mac.  Moreover, how can we continue to finance these deficits without an increase in interest rates?  However, such an increase in interest rates could put the US in a “doom loop,” as interest payments become the dominant budget line item crowding out other federal spending programs.
• China – Recently China has made a number of financial moves that do not bode well for the US and world economy. First, China has ordered its currency managers to withdraw from any US dollar denominated risk assets, such as corporate bonds, equities and only invest in US guaranteed assets.  Second, it has raised its reserve requirements on its own banks to dampen an over-inflated domestic real estate market.   Speculation in Chinese real estate has reached the point that Jim Chanos, a respected investor, predicts an economic collapse.  See Jim Chanos: China Bubble Ready to Burst. Given the size of our deficits, the US desperately needs China to continue purchasing US government securities. The world needs China as a growth engine to continue world trade and prevent a second leg of the recession.

Harbingers of the Economic Unraveling

Before the next phase of an economic crisis there are often clues to impending problems. Some harbingers to consider:

• Junk Bonds – The Greek crisis has spurred investors to sell junk bonds, highly risky assets, at the fastest rate since 2005.  As a result credit spreads are widening between treasury and higher risk corporate bonds. See Junk Bond Spreads Widening: A Canary in the Coal Mine.
• Problems in a Treasury Auction – Last week’s US 30-year Treasury bond auction was considered a failure.  Indirect bids, that is, foreign buyers, dried up and the government had to offer a yield of 4.72% compared to an expected yield of 4.687%.  See Dismal $16b 30 Year Auction
• Credit Card Problems – Capital One, a major credit card issuer, reports that in January delinquencies rose and that expected unrecoverable loans have risen to 10.41% from 10.14% in December. See Capital One: Credit -Card Delinquencies Rose in January.
• State and Municipal Finance –In its upcoming July 1 fiscal year budget, California expects a $20b shortfall.  Illinois has a $61b pension shortfall, and is borrowing to make contributions.   Harrisburg, Pennsylvania, is contemplating a March 1 bankruptcy filing.  These stories are the proverbial tip of the municipal finance debt iceberg. See Illinois Pension Fund $61b Underwater; State Borrows Money for 2010 Contribution; California $20b in the Hole Again.

Reality

Till now the policy direction of the Obama administration and other western leaders has been to “extend and pretend:”  we will ignore economic realities by permitting banks to suspend “mark to market accounting” and we will send various administration spokesmen to spread the fairy dust of “green shoots” to pacify an anxious public.  Essentially, we have an economic policy of faith and hope that willfully ignores reality.  Economics does respond to the laws of mathematics.  Like a termite that silently eats away the wooden supports of a house, excessive debt has eaten away the structure of the world economy.  There will be more troubled countries like Dubai and states like California before this Depression has run its course.

Related posts:

1. Seven Black Swans a-Swimming
2. Relying on the Kindness of Strangers
3. The Macroeconomic Picture or Connecting the Dots