Monday, September 29, 2008

Black Monday 2008

Today's 8.8% down-move marks the S&P 500's worst sell-off since Black Monday, 1987, when it collapsed 21%. (See table below: top-ten sell-offs since 1950)

Year-to-date, the market is now off 25%, and 29% from its all-time high of 1565.15 (October 9, 2007).

The possibility for a substantial bounce certainly exists. Since 1950, the market has closed down 6% or lower on nine separate occasions. In eight of these, it finished the year higher than that closing level for an average gain of 12%.

The ninth time occurred today.
Beware, however, one significant difference: in none of the eight previous sell-offs was the economy in recession.

Where the market goes from here depends on its participants rediscovering confidence in price discovery; Congress's next attempt at a rescue plan could help facilitate this.

Sunday, September 28, 2008

A September to Remember

Below, a breathtaking sequence of financial drama – still ongoing with Wachovia teetering; Hurricane Ike and abysmal economic data not included:

9/7: Fed nationalizes Fannie Mae, Freddie Mac
9/14: Fed refuses to rescue Lehman Brothers; Bank of America purchases Merrill Lynch
9/15: Lehman files for bankruptcy protection
9/16: Credit rating agencies downgrade AIG
9/17: Fed nationalizes AIG
9/19: Rescue plan proposed (three-page document)
9/21: Goldman Sachs, Morgan Stanley form bank holding structures
9/25: FDIC seizes Washington Mutual; JPMorgan purchases banking assets
9/28: Agreement reached on rescue plan (now 110 pages); vote due this week

The rescue plan's key details:
  • sellers: financial institutions, pension plans, local governments, community banks
  • purchase mechanisms: reverse auction, direct purchase (criteria not yet determined)
  • transactions posted online
  • financing: Treasury-issued debt (one giant carry-trade?)
  • proceeds (cash-flow, profits) go towards debt reduction
  • equity stakes in firms that benefit
  • compensation limits: no golden-parachutes, clawbacks in certain cases
  • option for firms to purchase insurance instead
  • oversight: bipartisan board and inspector general
  • five-year limit on recovering money spent; government can then force firms to pay for shortfall
  • government can make loan modifications on principal, interest rate, maturity
  • SEC has option to suspend mark-to-market accounting
  • $250 billion granted immediately; presidential request for next $100bn; Congressional right-of-refusal on final $350bn
Look to normalized interbank lending as a first sign of success.

Libor/Treasury spread in September…
…and since 2005
Let’s hope for calmer weeks ahead.

Friday, September 26, 2008

Trust the Network

The information network created Wall Street's turmoil; it can end it.

In the late 90s, the IT revolution's sudden emergence shifted the balance of power from the sell-side (financial intermediaries) to the buy-side (financial investors). At the same time, global socioeconomic upheaval opened numerous risk opportunities: Europe's single market and free trade across emerging economies.

Lush liquidity and imperfect regulation and oversight fueled a high-stakes battle.

In the years that followed, Wall Street fought to regain its information monopoly by forming massive proprietary trading and investment vehicles.

But as big as the Big-Five grew, they could never achieve the scale required to win.

The enemy: a disaggregated network of thousands of investment firms – some white-glove institutions (large fund complexes), others partnerships built to survive only a few years or months on exploiting market inefficiencies.

And this shift is not unique to Wall Street: Microsoft has battled this same economic force in its war against open source software; the same holds true for the media industry. It’s even happening in health care with consumer-information tools challenging the traditional value chain.

The force at play here is the Internet economy, and its notion that scale is amorphous.

On Wall Street, the information network acts through the financial markets. Lawmakers and regulators need to facilitate this by amending – especially now – capital restraints: taxes and regulation.

We restore confidence by addressing turmoil as an adjustment – not a crisis.

Anything less obstructs future gains from a new, powerful economic force.

Thursday, September 25, 2008

The Workforce as a True Asset

Investment banks feature highly productive workforces.

New hires navigate a rigorous interview process; many come directly from the world's best graduate and undergraduate programs.

Some might produce immediately, but most work through one, two or more years of intensive training and apprenticing.

Although this investment may not generate a return for several years, it can be substantial when it does – often magnifying over time.

While some workers create products – a structured security or research report – others transact, often with the firm's capital.

In both cases, they generate intellectual capital fundamental to the firm's current and future cash flow.

So, what does it mean if the workforce is a firm's primary investable, cash-generative asset? Should we capitalize it like any other asset?

Let's, for example, think of payroll (bonuses, in particular) as an amortization expense. Asset life could be the average employment term (say, 15 years; late 20s to early 40s), and the discount rate the firm's cost of capital (10% or higher due to elevated risk).

On the old model – balance sheet $100, capital $4, sales $4, and compensation $2 – we calculate a 15% increase in assets and leverage, which rises from 25 to 29. To compensate, a firm might have set aside additional capital. Though resulting in lower returns, it would have likely achieved a more balanced business-risk profile.

Big banks' rise-and-fall demonstrates how much going-concern value hinges on the workforce's output.

Future generations would be wise to heed this as an accounting reality.

Wednesday, September 24, 2008

Another Kind of Leverage

Though often expressed as a financial term, leverage also reflects how firms structure their operations. High fixed costs, debt-like corporate torques, allow capital-intensive firms to accelerate profits when sales levels increase and capital costs decrease.

Take two companies: "A" and "B". Both have an $80 cost base on $100 in sales. "A", however, has $60 in fixed costs and $20 in variable costs; "B" has the opposite mix. Because "B's" contribution margin – the percentage difference between sales and variable costs – is lower (40% versus 80%), it gains less profit on increasing sales.

However, "B", a labor-intensive firm, suffers less on declining sales growth since it can adjust more easily.

Because fixed costs include expenses on tangible assets such as property and equipment, financial analysts often measure the leverage effect as a depreciation-to-sales ratio. The following chart applies this to the overall economy as the ratio of fixed capital consumption to GDP.
After 1982, financial markets' rapid evolution shifted capital allocation decisions from private boardrooms to the open market: the stock market provides the best example, rising from 15% of GDP to over 130%.

Having increased tenfold in the period before this, leverage moderated.

Likewise, economic volatility abated, despite Wall Street’s typical gyrations.

Today’s lost confidence in financial markets risks not only making operating leverage costlier, but also forcing less transparent capital allocation decision-making.

If, also, the economy stalls, earnings prospects for capital-intensive firms would darken further, leaving open the question how less leveraged firms might compensate.

Monday, September 22, 2008

A Disturbing Lack of Confidence

By forcing bank holding structures onto Morgan Stanley and Goldman Sachs, the Fed accomplishes what it believes the markets would've done had the shorts stayed on, perhaps avoiding at least two big questions: Would either have been too big to fail? Would this have incited a cataclysmic run on everything financial?

Once again the Fed’s action speaks to an extreme lack of confidence in financial markets, occurring the same time Secretary Paulson hopes to assume unlimited power.

Because the market wasn't pricing the mortgage assets in question, this decision might be well-founded... or it might not. What if market activity was in fact accelerating price discovery that government action over the past year had stalled?

In Goldman and Morgan (and the bulge-brackets before them), short-sellers were targeting mispriced books-of-business, forcing potential buyers to play their hand.

The selling wasn’t random: it avoided agency-centered broker-dealers. Jeffries and Raymond James have outperformed both the big-boys and the market itself (strong support for the good old-fashioned notion of true intermediaries – not proprietary traders masquerading as intermediaries).

At the right price, we have to believe that buyers would have materialized (there certainly isn’t a lack of firepower ): What’s the point if we don’t have this confidence?

We'll never know what that level is, only that several large financial institutions couldn't withstand the anticipation.

In a world in competition for capital, our government’s election-year distrust of the financial system could be the highest price of all.

Saturday, September 20, 2008

Cost of Capital

Market turmoil is drawing attention to the financial system's core constituents: capital and liquidity.

Capital is money that a firm uses to invest in growth: an obligation to a lender (debt), direct investment in exchange for ownership (equity), or an obligation that converts into ownership (hybrid).

Liquidity reflects the firm's ability to pay for this in interest and dividends.

Because growth takes place over time, firms assume risk in the differential between money received (revenues) and money paid (expenses). To protect against this, firms will often retain excess profit (this differential after capital costs).

Depending on competitive positioning and market environment, firms pay lenders and owners more or less relative to each other – within and across industries.

Until now, the financial system has provided plentiful, inexpensive capital. If, however, risk levels remain elevated, lenders and owners will demand larger payments, which would stress liquidity as occurred this week on Wall Street.

Capital-intensive firms – those having a higher proportion of fixed costs to variable costs – hazard a challenging environment, while labor-intensive firms (many in service industries) may benefit.

The effect, though, won’t be uniform.

Investment banks, for example, would be nothing except for the intellectual property their workforce generates. This past week demonstrated the extent to which this service industry's labor (a variable cost and large component) consumes capital.

Expect higher capital costs to force top-to-bottom reassessment of industries and companies: punishing some thought to be high return-on-capital and favoring others actively managing down fixed costs.

Friday, September 19, 2008

Root Cause

The next stage in Wall Street’s transformation: sorting through the blame wars, at this point a Verdun of mass finger-pointing.

Much of this is political, coming ahead of a presidential election featuring starkly contrasting ideologies.

While greed, a broken public-private incentive behind home ownership, the Fed's liquidity push, poor regulation and credit-rating oversight are all contributing factors, the defining factor is neither financial, regulatory nor emotional: it's both technological and socioeconomic, and, ironically, extremely positive for the long-term.

In the late nineties, broadband Internet galvanized the US economy, and Wall Street, in particular.

Information advantages that sell-side firms had continuously monopolized suddenly shifted to the buy-side, establishing and advancing short-duration investment cycles (weeks, days, minutes).

At the same time, capital market reform sweeping across the globe extended the risk curve: new markets and new products translated into new opportunities for newly empowered money.

The effect snowballed during the 2000 to 2002 downturn, as alternative strategies flourished. Reacting quickly, the sell-side shifted to a proprietary model, at least among those who could (and were willing to) leverage themselves.

After 2003, spreads narrowed as markets stabilized; risk-takers compensated by doubling up on mortgage derivatives and other inexpensive financing.

It’s precisely the connection between these unprecedented root causes ten years ago and today’s drama that legislators need to respect.

More important than the remote probability of the same twin factors recurring, markets, in holding Wall Street to account, have already elevated transparency.

Rules that obstruct this adjustment process would trigger extreme carnage.

Thursday, September 18, 2008

And Then There Was One

Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley – all gone (or nearly gone ); the last one standing: Goldman Sachs.

Revered and reviled, Goldman invokes Wall Street’s ultimate image: money, power, arrogance – standards against which others define themselves.

During the 2000 to 2002 market downturn when investment banking revenues plummeted, Goldman transformed itself into a massive proprietary trading vehicle (indeed, the world’s largest hedge fund), taking advantage of cheap liquidity and directional markets. The chart below shows just how much this progressed as a percentage of total revenue.
Between 2001 and 2007, its risk exposure ballooned: leverage jumped from 17.1 to 26.2. Value-at-risk (“VaR”, the amount it could lose on a particular trading day) increased from $38 million to $138 million, a rate nearly twice the rise in its shareholder’s equity.

As of September 16 (its latest earnings statement), VaR stands another 30% higher at $181 million, but against a smaller capital base, and share price 50% lower and sinking.

How might the government perceive its demise: too big to fail, or best left to the markets? Is there a conflict of interest in the Treasury Secretary having been its chairman? (It would certainly be telling if Paulson, a banker by background, would decide on the fate of its current chairman, Lloyd Blankfein, a trader.)

Even in its darkest hour, it would seem improbable that Goldman would not pursue some sort of control position; perhaps its best option: going private, where it was prior to this ill-fated journey.

Tuesday, September 16, 2008

Confusing Crisis with Adjustment

No doubt, we’re traipsing through tumultuous times, but what’s got us amazed is that we’re not already much worse off. Consider the extent of the housing slump, now well into its third year, and the nosedive in financials, which for the most part began over a year ago.

Many are saying this is the worst crisis since the Great Depression, which would be terrible indeed: in the four years following the 1929 crash, the economy shrank by a quarter.

An identical occurrence today would put us at 1997 levels in 2012 – or 2011 or 2010 depending on your starting point.

With each Wall Street generation seemingly repeating the same mistakes – and each generation getting shorter and shorter – there could be good reason to be fearful, except that the global landscape is now completely different than 75 years ago (even ten years ago).

Now, capitalism motivates a much larger percentage of the world population, with local and transnational capital market infrastructures supporting this – and behind these, regulators and lawmakers, often in cross-border communication.

A vast worldwide network of investors – from large institutions to private individuals – directs capital flows according to market-driven risk-return metrics, including money into and out of US assets.

Wall Street might be in turmoil, but is Wall Street the complete global system? To what extent is this system already compensating, and at what cost?

We suspect the once-in-a-century phenomenon isn’t the crisis itself, but the adjustment process offsetting its worst effect.

Monday, September 15, 2008

Wall Street and the Economy

Since 1994 – as measured by the AMEX broker-dealer index (XBD) – the investment banking industry has suffered three major downturns, including the present one. The table below illustrates these both in terms of index performance and the corresponding change in real GDP (periods begin and end with XBD peaks and troughs).

The steepest index decline occurred in 1998, a whopping 91% on an annualized basis. Despite this, the economy grew by over 1% (4.7% annualized). Even during the market collapse of 2000 to 2002, which featured our last official recession, the economy still expanded.

Over the current downturn, the economy has likewise strengthened as of the most recent GDP reading (Q2 2008). If we consider this – as we should – through the current quarter (Q3), GDP would need to be 2.2% lower than last quarter in order to have contracted alongside the banking index.

That’s negative 8.8% annualized! After so many hundred-year events in the past few weeks (makes you wonder how valid our reference points are!), anything's possible – but likely?

More important, we see the current crisis as a striking example of how Wall Street and Main Street have evolved to a point where financial risk is sufficiently contained in the former.

Assuming lawmakers and regulators do not reverse this powerful dynamic, the great surprise of 2008 will be how little the latest “hundred-year” crisis disrupted the overall economy.

Sunday, September 14, 2008

Lehman's Demise

Could the big three – Goldman Sachs, Morgan Stanley and Merrill Lynch – be next? A year ago, they were trading at all-time highs, and this would have seemed preposterous.

Not so today. On similar balance sheet concerns, Merrill is down nearly 70% this year, and 82% from its January 2007 peak. At its current market cap ($26 billion), total collapse would not be incomprehensible; in just the past 3-1/2 months, market participants erased the equivalent in Lehman shares.

And the question doesn't just apply to the traditional bulge-brackets: UBS and Citigroup's misfortunes have not only bled tens of billions of dollars in shareholder value, but also eviscerated the universal banking model (okay, that depends on whether JP Morgan and its European counterparts intend to trump Sandy Weill as the modern-day Alexander).

With the exception of Goldman, each firm now trades at ten-year lows: a round-trip of several hundred billion dollars in aggregate – not including a multiple in ancillary effects throughout the financial system.

The iceberg might have been the housing bust, but mispriced risk and concentrated capital doomed these unsinkable ships from the get-go. Hedge-fund-happy bankers poured client profits (and shareholder dollars) into vast proprietary operations, completely transforming once agency-centered businesses.

The winners, and the new face of Wall Street: Raymond James, Jeffries and other traditionally-oriented intermediaries. This should be good news too for capital markets in desperate need of freer flowing money and more transparent risk pricing, though such an outcome may unfold all too gradually.

Wednesday, September 10, 2008

Taking on the Drug Supply Chain

In financial markets, a market-maker provides liquidity by standing ready to buy or sell a security at a quoted price. In return for assuming this risk, market participants compensate him with the bid-offer price spread (often negligible) and a commission. Though normally transparent, pricing can vary substantially based on the transaction size, and the dealer’s market knowledge (defined as market share).

In the prescription drug market, pharmacy benefit managers (PBMs) play a similar role. Because drugs are much less liquid than most securities (let's not forget complex derivatives), the spread and associated fees afforded PBMs are much greater: a combination of mark-ups and rebates.

While folks have transacted in securities for centuries, the prescription drug trade in its current form is only about two decades old – defined mainly as a generics and mail order-driven marketplace.

A dramatic agent of change, information technology has considerably expanded employers' potential bargaining power over recent years; now, mounting economic uncertainty is forcing decisive action.

On September 2nd, Caterpillar introduced a pilot project targeting full transparency across the supply chain. Aligned with Walmart's powerful retail network, the project strikes directly at spread-based pricing (AWP, MAC) and standard discount contracting.

If financial markets offer any evolutionary clues, this could open a substantial door into increased price competition (spread compression). As with broker-dealers, expect PBMs and other intermediaries to counter by continuing to invest in market knowledge and ancillary services as means of protecting pricing power.

Sunday, September 7, 2008

Is the Worst Over?

One shuts down its flagship fund; rumors swirl of an even bigger one closing, and the Feds take over two others that weren't supposed to be in the business to start with.

The first and second, Ospraie and Atticus, are what folks might call "traditional" hedge funds; both bet wrong – badly.

The latter two, Fannie Mae and Freddie Mac, are not ostensibly hedge funds, but speculated just as if they were, and suffered similar results. This included purchasing not only risky Alt-A and subprime mortgages, but also mortgage-backed securities. They then applied questionable accounting to hide the losses.

Now, both vanish completely into Washington's marbled halls and vast ledgers. Both will answer to folks whom we elect into office on a host of issues completely unrelated to their ability to manage complex financial institutions.

With so many high-profile speculators facing unprecedented losses, we know life cannot be easy for everyone else, especially as the seemingly safest institutions disclose deep dives into the same riptide.

At least the rules for the new landscape are clear: risk balances with return and accountability matters.

The question, though, is: Will conservatorship now convince the markets that the worst is over?

Because the game has switched from shareholders to taxpayers, we’ll be one of many watching the fall campaign for clues on what the new administration plans to do with the government's recent acquisitions.