05.27.08
Posted in Blog at 4:33 pm by Andrew Clearfield
Law is the wisdom of the old,
The impotent grandfathers feebly scold;
The grandchildren put out a treble tongue, 

Law is the senses of the young.
—W. H. Auden
“Law Like Loveâ€
One of my favorite moments from investment meetings occurred when an analyst in his mid-30s was struggling to explain why his favorite investment idea had gone awry. This was a major consumer products company whose stock had tanked and new CEO and management team had been sacked, having badly misjudged the company’s markets and squandered a good deal of the company’s magnificent brand equity. “I just don’t understand it,†he’d said. “They were even . . . young.â€
There may not be much that is new under the sun, but I would submit that comments such as this were unlikely to have ever been made anywhere in the world before our present age. In the wake of the latest bursting bubble, and only eight years after the collapse of the High-Tech stock market, perhaps investors need to consider whether the prevailing ageism of our society has risen to the point where it becomes a concern for corporate governance as well.
Usually, it is the other way around. An aging or even senescent chairman and his long-serving board refuse to surrender control or designate successors, and a shareholder revolt is necessary before fresh blood can be brought in to revamp strategy, modernize production, and eliminate poorly-performing product lines. This is the reason why most governance activists focus some attention upon the ages and lengths of tenure of directors, and most consider it positive if a company has retirement rules for directors, as it does for other employees. Just as a ‘seniority culture’ can rob a company of innovation and energy, as well as fueling turnover of exactly those employees one needs to retain, a gerontocracy in the boardroom can make it impossible to implement long-needed changes of the most fundamental sort. A major objection to the “Imperial CEO†is that, as human experience has all too often shown, most absolute rulers stay too long, not that they do not stay long enough.
But one can have too much of a good thing. Not only does imposition of a radical youth culture rob a company of the judgment most likely found in experienced managers and directors, it removes all sense of continuity. The young have no investment in the past because they have very little past to invest in. Outsiders are in an equivalent position: with a different personal history, they normally have no feeling for what made the company (and most of its existing employees) tick, and what will motivate or demotivate them. Too much turnover at the top can cause the company to lurch first in one direction, then another, with very little ability to keep the whole organism (and a company is an organism, no matter what the charts and diagrams in a consultant’s presentation might imply) working smoothly together. One major consulting organization supposedly recommends an employee average turnover rate of seven years. Unless one is dealing with a totally failed business culture, such advice is not only erroneous, it is criminal.
As Shakespeare’s Iago ironically notes, you cannot make a silk purse from a sow’s ear. Nor, pace naive optimists, can you make an honest man of the vicious, deceitful Iago. Similarly, you cannot make a tractor and earth-moving company into a branded fashion products company, a distilling company into a media company, or the Last National Bank into Goldman Sachs. You can, of course, fire everyone and start from scratch, but that is not transformation, it is green-site construction using someone else’s money. Re-positioning can be beneficial and necessary, but there are many limits, not the least of which are public perceptions and the entry barriers to another, already competitive marketplace. The chief virtue—and vice—of the young is that they have always had a hard time believing in limits. And occasionally, amazing transformations do take place. But they are the exception, and to depend too much upon one’s ability to make miracles is a good way to land with a crash. For one’s employer, older and supposedly wiser, to depend upon a lucky star to continue to make miracles, is not merely the triumph of youthful hope over experience, it is imbecility.
The dream that someone has come up with a way to repeal the hard laws of “that dismal science,†economics, is a youthful dream. Enormous advances have been made, and we no longer live either in the subsistence economy of our ancestors nor in the Malthusian world of the 19th Century. But the New Era of permanently higher equity prices of the 1920s dissolved in tears, conglomerates turned out to be less, not greater than the sum of their parts, the Nifty Fifty with their 40 to 100X p/es were taken out and shot one by one, Web-based merchants turned out not to be able to sell more than the disposable income of every country on the globe, and now we have discovered that a carefully structured basket of high-risk mortgages is still risky. It is not that the enthusiasm of so many young analysts, portfolio managers, and traders was utterly misplaced, but that having demonstrated there was merit in their analyses, large organizations proceeded to bet their entire future upon them.
Concerned, responsible investors—not those momentum-driven types inclined to chase every ignis fatuus hither and thither in the swamps of investor fashion—should be equally concerned when the management of a company in their portfolios shows no sign of being capable of renewing itself with fresh blood, and when a management commits itself blithely to radical house-cleaning for no obvious reason. A lack of experience is always a disadvantage, just as is a refusal to take reasonable risk, or a refusal to pay attention to new trends and developments in the marketplace. Sometimes one may compensate for one’s own disadvantages by judicious use of the abilities one does have, but it is a struggle, and it is up to the skilled manager to see that a certain balance is preserved in decision-making, and in the corporate culture. It is a board’s job to see that management tries to compensate for its deficiencies, not that it pretend those deficiencies do not exist because the last few quarters have been strong.
The Société Générale’s senior management was stunned that a rogue trader could almost destroy their bank. Daniel Bouton, the Chairman and CEO, was especially astounded that so much damage could be done by someone so young and unimportant that no senior executive had so much as heard of him. I must insist on the contrary, it is only someone so young who would have had the temerity to try such an outrageous scheme. We have all grown up with the ever-compelling story of the fearless youth: a young man no one had ever heard of scaling the heights, unaided, in one heroic rush. It is the story of the youthful King David, the Siegfried of Wagner’s Ring, the boy Arthur who pulls the magic sword from the stone. It is also, alas, the real-life history of Jérôme Kerviel, except that he and his employer fell flat on their faces. This is the true apotheosis of the youth culture.
Permalink
05.08.08
Posted in Blog at 8:32 am by Andrew Clearfield
—April 23rd, 2008
The boom-and-bust, euphoria-followed-by-despair cycle seems a permanent feature whenever future gain is contemplated by a mass of human beings. As Warren Buffett so aptly put it, investing in the stock market is like being in partnership with a very wealthy manic-depressive. Periodically, in his manic phases, your partner will offer you too much for your share in the business, and you should sell it to him; when he is overly depressed, he will offer you his stake in the business for far less than it is worth, and you should buy it back. Unfortunately, most investors are more likely to follow this “partner’s†moods than to take advantage of his pocketbook. This is human nature, and explains why it is possible to make an excess return from otherwise efficient capital markets: irrational enthusiasm makes peaks too high, and irrational pessimism makes troughs too deep. When the national mood swings are too great, and too many market participants in too many markets get stampeded, these market phenomena can completely overwhelm the real economy. This is how the agricultural decline beginning in 1926 and the stock market collapse of 1929 morphed into the 10-year Great Depression.
Does it always have to happen this way? In remarkably similar circumstances in the early 1930’s, elected officials and their advisors decided that such manic-depressive phenomena should no longer be allowed to infect the commercial banking system, and they came up with the Glass-Steagall Act. Deposit-taking institutions were not allowed to create or sell most securities, and the underwriters of securities were not allowed to engage in commercial banking. Later, the barrier was extended to wall off the insurance sector as well. But financial innovations in the 1980s allowed the super-brokerage/ investment banks to undercut the commercial banks’ franchise, and the threat of disintermediation further impelled the big banks to lobby for repeal of the Act. Diversification was supposed to make big banks less risky, and provide the investment markets with more capital to finance the expansion of industry.
Perhaps it did make life better for issuers. But the first beneficiaries of repeal were the owners of investment banking businesses, who were able to sell their sexy firms to big, rich, dull banks at high multiples to future earnings. Traders, syndication administrators, stockbrokers, and other underlings in the once-stratified world of investment banking suddenly began to make seven and eight-figure bonuses just as the major dealmakers had. And the banks began to experience a roller-coaster in earnings such as they had seldom seen before. Issuers of securities may have benefitted by forcing underwriters to put their own capital at risk, but shareholders and other stakeholders in the big banks have had a less joyous experience. As Kenneth Lewis, CEO of the Bank of America, recently put it, “I’ve had about as much investment banking fun as I can stand.â€
Under the Glass-Steagall system or its even more compartmentalized U.K. counterpart, single capacity, the troubles of a brokerage house or an underwriter were seldom of national concern. Brokers were primarily agents, and did not invest much for their own account. Underwriters, which were traditionally under-capitalized service businesses, were skilled at unloading their risks in a few hours. As unlimited partnerships, most Wall Street or City of London firms were careful to limit their own risks.
In the U.S., this changed with incorporation and admission to public quotation. Once stock exchange members were permitted to issue shares, they could play with someone else’s capital, buy deals, and put tremendous sums of cash to work in proprietary trading, in effect competing with their own customers. The customer may not have felt so happy with the service he was getting, but the investor had a new way to speculate upon business cycles: buying shares in the investment banks for the dizzying ride through an anticipated bull market, and holding the commercial banks for yield and safety, in more uncertain times.
Mergers and industry consolidation have undone this choice. The move to diversify the commercial banks’ own businesses has led to less, rather than more stability. Now banks’ results are usually dominated by their returns from capital markets activities. Given the ever-rising opacity of increasingly complex derivative structures, the bank has itself become a huge black box, and no investor can be sure of its contents—the boards of the banks themselves are not sure!
In the U.K. and elsewhere in Europe, the abolition of single capacity was imposed by the American investment banks as a precondition for investment in these markets. U.S.-based “global†investors were more comfortable with a system with which they were familiar, especially when it meant that they could seem to be driving a harder bargain by negotiating commissions. Most did not bother to find out what they might be losing by the exchange. The important thing was to be more ‘modern,’ and ‘professional,’ i.e. to be more American. The partners and shareholders of these smaller entities loved being taken out at huge premiums to their net worth, of course, and no one asked the shareholders of the acquirers if they minded paying for this bonanza. As the brokers merged with the market makers, and the combined firms merged with the merchant banks, few asked if the system was taking on more volatility.
During the stock market crash of 1987, North American underwriters stuck with huge blocks of BP in their syndicates were in serious trouble, and begged the British government to pull the issue. Their British counterparts, having sub-underwritten the issue with client investment funds and insurance companies, as was usual under traditional British practice, were unhurt. The Canadian investment banks were almost all driven to the wall, and had to be bought and recapitalized by the commercial banks. In answer to the Americans’ pleas to Westminster to pull the issue, Margaret Thatcher famously asked, “If underwriters aren’t there to underwrite risk, what are they there for?â€
But the solution has been to put more capital into ever-larger monolithic intermediaries, rather than to analyze the system. The answer to all problems is inevitably ever-more burdensome controls and ever-larger compliance bureaucracies. A major bank is almost destroyed by a rogue trader, operating in an obscure department that was never supposed to be taking on risks. An even larger bank has to be recapitalized twice because of excessive involvement with one single form of trading vehicle; its shareholders have lost two-thirds of their investment in nine months. One of the historically best run of the independent investment banks has to be bought out—at seven cents on the dollar—because of a minor subsidiary whose exposure featured in almost no one’s model of the bank. Are these huge bureaucratic organizations, which have such difficulties monitoring the hundreds of different activities in which they are involved, necessary in order to have flourishing capital markets? Are the funding requirements of business only met by mega-banks capable of treating every type of financing as if it were a commercial loan, which they can carry themselves? Should pension management and broking be under the same roof as corporate finance and trading for the house account? Most important of all, are any regulators asking themselves these questions?
Permalink
05.04.08
Posted in Blog at 11:35 pm by Andrew Clearfield
—April 7th 2008
I have long felt that the marriage of investment bankers with stockbrokers was an unholy alliance, and that whatever its commercial justifications, it served the investment community very poorly. Now we discover that the promiscuous fusion of commercial banks, investment banks, and investment managers serves the general public and the broader economy even more poorly. I wish I could take more satisfaction from the fact I am able to say that I have told other investors so, for twenty years.
In 1987 or 1988 I received a visit from representatives of the Zurich Stock Exchange who wanted to ask me, as a fund manager at CREF, for my opinions regarding proposed changes in Switzerland, following upon the de-regulation of the London market. After a brief discussion of what the exchange hoped to accomplish, my questioner opened with what he assumed was a rhetorical question: “After all, the most important thing investors want is low transaction costs, is it not?†The poor man must have thought there was something wrong with his English when I answered, “No.†So he rephrased his question, and I had to explain to him that the most important thing for us as foreign investors was to receive good information, particularly from the local ‘Street,’ so that we knew what we were buying, and were buying and selling at appropriate price levels. Compared to the cost of making mistakes, transaction costs were a small part of the cost of doing business. He protested, “Everyone else is telling me that the most important thing is the lowest possible cost of transactions.†I had to tell him that in my opinion they were either kidding themselves or lying to him. “None of us have enough resources to evaluate foreign shares on our own as critically as we can evaluate shares in our own market. Moreover, we don’t have the same access to market news and market sentiment as do the local stockbrokers.†I am sure he must have placed my comments in the ‘Nut’ file.
In retrospect, I probably misrepresented the case—by understating it. Experience has shown me that most investors don’t have the internal resources to evaluate any shares as thoroughly as their counterparts on the sell side. The logical conclusion would seem to have been that investors should have favored anything which promoted the integrity and independence of brokers’ analysts. Instead, investors’ steady downward pressure on commissions and fees advanced the invasion of investment banking salesmanship ever further into brokerage research, and investment funds have had no choice but to invest heavily in their own research staffs in order to offset the heavily biased and frequently dishonest recommendations they now receive from American-style unified investment banks. That in-house research still leaves a great deal to be desired is shown by the number of times I have seen senior investment officers listen carefully to extensive internal analysts’ presentations, and then stroll off to consult surreptitiously with favorite sell-side analysts before making up their minds.
In the brave new world of integrated investment banks, when a sell-side analyst does dare to speak out against a banking transaction or any other favored client, retribution is usually swift. As traditional relationship business has gone out the window both on the brokerage and the investment banking sides, the commercial bankers themselves have become increasingly transaction-oriented, and thus the universal bank has become an industrial organization, dedicated to selling a product by volume and marketing power, rather than a service provider, dedicated to attracting and growing the dependency of clients through the quality and reliability of its services. Conflicts of interest, an ever-present danger to a service organization, are much less critical to an industrial producer, whose priority—maximizing sales—is usually clear. In such an organization, it becomes increasingly difficult for the dispensers of sage and sometimes cautious advice to be heard, whether they are advising some clients of the firm, or their own senior executives.
How does this pertain to the current crisis in the banking sector? Very simply, investment bankers, as innovators of products to be sold, have created (not for the first time, either) a defective product, and sold it, not only to the bank’s investing customers, but also to the bank’s senior executives themselves. Dealmakers, long adept at selling their dazzling visions to target boards, became more accustomed to selling them to both sides of a transaction as relationship banking waned. From there it was but a brief jump to practicing their salesmanship on their own corporate managements. That careless use of the Structured Investment Vehicle, with its fundamentally risky marginal quality loans at its base, might be dangerous to its owner, was never a part of their sales presentation. It may never have occurred to the bankers themselves that they were selling a dangerous product: star salesmen are seldom engineers. Salesmen sold, traders traded, and the profits rolled in, until the risks of having many times one’s net worth in assets all levered to the same thing—house prices—suddenly became apparent when the underlying market did what it was never supposed to do, and stopped rising. The markets in these hugely derivative instruments became discontinuous, prices gapped downwards, inventory became less than worthless, and huge banks, the central institutions of the financial system, became technically insolvent.
Increasingly, the universal bank has become a matter of its best employees acting in their own interests only, and not infrequently in opposition to the interests of the bank. The compensation schema of the old, risk-taking financial services intermediary, with small fixed compensation and large cash bonuses, has not mated well with large, diffuse organizations whose long-term survival is a precondition of economic stability. The universal bank became what the incorporated investment bank had already been, a stable of independent contractors, temporarily housed under one roof. Should the markets trust such an agglomeration to evaluate the risks inherent in its increasingly complex innovations, and to use those innovations responsibly?
Permalink