Friday, February 27, 2009

Just past five score years ago Harpers Magazine published Mark Twain's story, Captain Stormfield's Visit to Heaven, a first person satirical, narrative of a dead sea captains' trip to heaven. Among the many surprises he experienced that contradicted his earthly expectations was his discovery that the greatest and most celebrated "prophets" in Heaven were often regular people, a Boston bricklayer or a New Haven bartender, instead of the self-promoting public figures of the day who dominated the front pages of nineteenth century newspapers. The remarkable Hudson River landing of US Air flight 1549 this past January gave us a splendid terrestrial example of the calm professionalism of a regular guy juxtaposed with the hysterical microphone grabbing of our ostensible political, business, and journalism leaders.

The safe landing of that flight was not simply the confluence of a good pilot and a pacific river on a clear day. The Captain had flown for over thirty years, trained in gliders and run an air safety company. Similarly well trained were the first officer and the flight attendants. Years ago an anonymous regulator had insisted that flexible expandable chutes be placed at the doors for water landings. A clever aeronautical engineer had anticipated the apocalyptic loss of all hydraulic power, caused by the two engine flameout, by inventing the raw air turbine (RAT). The RAT emerges automatically from the belly of the plane during a loss of power, is spun by high speed air, and provides the emergency electricity to operate the flaps and rudder to turn and to land the plane. The ferry boat crews and others drew upon their training and the safety equipment required, by regulators, to be on the ships to complete the rescue. The controllers passed along timely options to the crew. Even the passengers, except one who requested her seat mate leave the raft to go search in the aircraft for her fur coat, showed great discipline and sense while exiting and awaiting help. A Google search to see which adjectives were frequently used to describe the conduct of the landing reveals: "methodical, calm and professional". None of them required political action committee contributions, bonuses or stock options to do their job well.

Now we turn to the circus handling our economic challenges. Congressional hearings are as professional as student council meetings debating the merits of a student smoking porch. High on the throne of inquiry the thoughtful insights have ranged from suggesting executive suicide, publishing lists of the wealthy as vigilante targets to throwing out hundreds of years of contract law in order to satisfy their ersatz outrage over $168 MM of bonuses paid by a black hole corporation into which $170 billion has been heaved. Clearly, none of the political leadership have doctorates in forestry. Ironically, none of this outrage appeared when Messrs. Daschle & Geithner reported failing to pay their taxes. True outrage is reserved for actual taxpayers. While the credit markets, the key to an economic revival, remain virtually shut, the politicians indulge themselves in sophistry that would make a college "Frat" blush. We need to call for a "Silence of the Hams".

A two week "cone of silence" should be placed over Washington so thoughtful dialog, uninfluenced by the camera, can occur. Reconsideration of Glass-Steagall, federal goals for home ownership, the government's role in picking industrial survivors, tax policy and broadened regulations should get a full, thoughtful hearing. Should credit default swaps, which have become "Weapons of Math Destruction", be regulated or at least barred from speculation? To what duty of care standard should corporate executives and employees in banking and other industries be held? Should a new category of "government ownership" be created in which contracts are voided, analogous to Chapter 11?

The current "squeaky wheel gets the grease" approach is turning many industries into mimics of the airline business, where the latest carrier to file Chapter 11 becomes the low cost provider to the detriment of all the healthier companies. AAA Berkshire Hathaway now pays more to borrow than its government backed competitors. In the auto business, GM offers 0% financing which Ford and the others cannot reasonably offer. AIG is now the price leader in insurance which is costing millions in profits to the unsubsidized. Consistent efforts to remove Darwinism from business will lead to woeful inefficiency, a conclusion already reached by the government of Sweden in connection with Saab. Economies have cycles which no government effort can reverse, but their efforts can dampen the size of the swings and provide financial refuge for those harmed by the downturns.

Citicorp continues to be the case study for a vacuum of thoughtful corporate leadership. Over many years, the Board has let management acquire disparate businesses with little apparent strategic benefit and left them sufficiently decentralized such that risk control was suborned in favor of fee generation. Oddly, despite the hundreds of thousands of employees on their payroll none were being groomed to run the company. All of the senior management at Citi was hired from the outside in the last three years and virtually none had commercial banking management experience. Recently, after five consecutive quarters of billion dollar losses the CFO stepped down. He was replaced by a man with no CFO background and one year of service at Citi. In a remarkable new trend that smacks of stock promoting Citi announced their two month results for January/February 2009 were profitable, if you excluded write-down losses! Will they soon be announcing profitable Tuesdays?

The recent liquidity crisis has provided the spade to unearth a colony of alleged Frauds:

ID Darin Palmer $ 40 MM CT Paul Greenwood/Stephen Walsh $553 MM TX Alan Stanford $ 5 Billion DC Yo-Yo Ma Cello Playing at Inauguration TX Rod Stringer $45 MM NY Nicholas Cosmo $380 MM IN Marcus Schrenker Up in the Air FL Arthur Nadel $40 MM NY Mark Dreier $500 MM NY Bernie Madoff $50 Billion

Sadly, most of these men abused their friendships, religious beliefs or professional standing to simply steal from others. Regulating will not stop thieves, nor will it help people gullible enough to invest in ideas that sound too good to be true.

In an ironic twist created by our tax law an investor who lost $100,000 with Bernie Madoff is better off than one who lost $100,000 in the sale of Citicorp stock. After one takes into account the 10% AIG loss reduction, a taxpayer still gets to deduct the entire Madoff theft loss at an ordinary income rate of 35%, while the stock sale loss is limited to $3,000 per year at 15% rate if there are no offsetting gains. In a period when policy is looking to encourage real investment, not just spending, perhaps the amount of capital losses deductible should be enlarged to encourage risk taking.

Similar to other financial assets, the value of private equity holdings have fallen dramatically in recent months. Fund vintages 2004-2007 are going to be facing an interesting dilemma if the markets rebound in the next twelve-to-eighteen months. The structure of most PE firms calls for a return of capital and a preferred return to be paid before the general partner (GP) gets paid. The simple math of time and portfolio losses will make exceeding the preferred hurdle a challenge. The math will set up a potential tension between maximizing the value of a fund for investors or maximizing fee income for GP's when the carry incentive is gone.

I’m Rob Morris and I approved this blog.

Just Past Five Score Years Ago Harpers Magazine Published Mark Twain's Story...