Who’s the Fall Guy?

There are lots of folks who believe that the Dow is crashing because the financial world didn’t get the tax-cutting, deregulating Republican that they are supposed to have favored. I don’t think so. Both Barack Obama and John McCain supported tax cuts (in different ways), both decried lack of governmental oversight in the financial markets and both understood the need to absorb the pain while restructuring for a sound recovery. Strangely, I do not think that the election results had much to do with the Dow fall.

Instead, November 5-7 happened to be the precise days that a lot of financial information was reported; the “numbers” are coming out – they’re not Republican numbers or Democratic numbers, they are American numbers now. And here what Wall Street has been looking at in the last few days. How do you think you’d react looking at all this new information?

1. The U.S. Department of Labor just announced the highest unemployment rate in a quarter of a century. 3.84 million Americans are reported now unemployed and receiving unemployment benefits. Late October showed an increase of 122,000 in people who are continuing to receive unemployment benefits – the worst number since 1983.

2. The non-partisan Government Accountability Office (GAO) just advised President-Elect Obama to consider a top-down redo of the governmental oversight structure of the financial markets, which has been assembled and patched over decades in a piecemeal debacle of missing pieces, special interest concessions and failed vision. The GAO’s notice stated: “The current crisis facing the nation's financial markets dramatically illustrates the ineffectiveness of the regulatory system in overseeing the increasing complexity of U.S. markets, institutions, and products that have rapidly evolved over the last 30 years." It is clear that there is a litany of failure: the negative impact of the repeal of the once-required separation of traditional commercial banking from trading/investment banking (the partial repeal of Glass Steagall in 1999), to an unregulated derivatives market, to under-regulation of private equity and hedge funds, failure to address over-borrowing (with insufficient equity) at every level from homeowners to corporations, to a failure to impose meaningful standards on the credit rating organizations.

3. Retail sales in October have sunk to a low according to the ICSC-Goldman Sachs index, the weakest October performance since at least 1969 when the index began.

4. Worker productivity (the amount an employee produces for every hour on the job) slowed down by 3.6 percent.

5. Corporate earnings reports (for the last quarter, and the projections for the next quarter) have been pouring out, and the results are dismal.

6. The economy contracted at a 0.3 percent pace in the third quarter, which ended in September.

7. Foreclosures continue unabated and housing prices continue to fall. Bottom is still a ways away.

8. Overseas, the Bank of England just took an axe to its benchmark interest rate by 1.5 points, cutting it to 3 percent. This means the dollar strengthens but our exports drop.

I’m Peter Dekom, and I live here too.

Bar Tab Up in a Down Market

Morgan Stanley canceled its Christmas parties this year. The November 3, 2008, New York Times wrote about on the trading floor of the New York Stock Exchange: “Of the 1,366 broker’s licenses available for an annual fee of $40,000, only 553 are being used. In 2006 there were 3,534 people working on the floor; today there are 1,273…‘The stress now is the lack of business,’ says Benedict Willis III, 48, a senior broker who started here in 1982. Moments later he is interrupted by applause. It is the sound of a lost job: a floor broker of 20 years has just been laid off from a major firm, and now his colleagues are showing their respect.” The laid off trader escaped to the bar across the street.

Other “professionals” on the Street – the big “private equity” funds I’ve written about in the past – remember the days when they looked for “undervalued” public companies with lots of free cash flow that they could buy. Why? Because companies with free cash flow can carry debt, and being able to carry lots of debt meant you could borrow lots of money. Buying a company that had borrowing power meant you could put a small sum down, much less than normal, and cause the acquired company to borrow itself into oblivion to finance the rest of the purchase price. They called it “leveraging” – pushing a company to the edge of its borrowing ability to finance its own purchase.

For public shareholders of the acquired company, they enjoyed the premium paid to take that stock off their hands. They were long gone when the private equity firm stepped in to “create efficiencies of scale,” “eliminate the dead wood,” “spin-off” valuable assets and lay off the “unnecessary” layers of actual workers. Their goal? To “flip” that company back into the marketplace – leaner, meaner and at a significantly higher share price. The profit trail was long and glorious. Young MBAs and senior partners of these private equity firms worked long hard hours and were paid king’s ransoms for their services. Many billionaires were made. Leveraging was king!

Sound familiar? A bit like the subprime borrowers who took on massive debt with little or no down? Almost, with one huge difference. On Wall Street, the debt was not incurred by the private equity firm – that pleasure was relegated to the “asset” (the acquired company). With all that free cash flow, servicing the debt might have been fine in a growth marketplace, but just like the subprime debacle, when the markets crashed and no one could take a company back public, as the “asset” sat on a private equity shelf, the debt still had to be serviced.

The private equity firms now have “assets” with lower values, but they’ll still be around for the long haul, but those “assets”… well… the names of the acquired companies, many listed in the Times, are brands we all know, including: Neiman Marcus, Metro-Goldwyn-Mayer, Toys “R” Us, resorts like Harrah’s Entertainment and lenders like GMAC, the financing arm of General Motors as well as a few that have already filed for bankruptcy like Linens ’n Things, Mervyn’s and Steve & Barry’s. Private equity firms, until a few finally went public, were built by investments from very wealthy individuals, investment funds and, most sadly, money from pension funds.

Because they were built on the investments of “big boys,” private equity was one of the least regulated categories in the financial sector. And now, as these “assets” lose revenues in a terrible market, all that debt has to be restructured in a world that no longer allows pigs free access to the debt trough.

The Times continued with this quote: “There’s absolutely going to be a lot of pain to go around [in the world of private equity and their "assets"],” said Josh Lerner, a professor of investment banking at Harvard Business School. “The big question is how apocalyptic it will be.” Same issue that killed Lehman, Bear Stearns, subprime borrowers with little down, and a whole host of companies and people who thought that growth never ends.

It would have been okay if the negative impact stuck only to those who caused the problem, but now, people who never borrowed too much, worked hard for a living and bought their dream homes on a solid basis, are watching their pensions erode, their jobs disappearing, their businesses fail for lack of credit and their home values crash (sometimes losing the homes in a foreclosure resulting from a job loss). So much for “free market deregulation.” When we fix the system as we must, overleveraging – for both people and companies – has to be toast!

I’m Peter Dekom, and please vote tomorrow. It is a very important election.

And We Thought the “Me” Generation Died in the 1970s?

There are lots of words for it – rainmaker, master of the universe, senior managing director – and we even have polite words for making money by feeding on failure and misery – turnaround specialist, reorganization expert, distressed properties specialist. Strange thing is that at some level, we need this senior level financial expertise to make American business work. The anachronism, as today’s thedeal.com points out, is the underlying compensation system in our financial institutions, not the services we need to continue.

The problem is that the “Street” encourages “deal flow,” almost at any expense and exorbitantly over-compensates the originating dealmaker (sometimes the deal-making team). Congress is looking at pay levels for CEOs and maybe the top ten most highly-paid executives in publicly-traded companies that have been and will continuing feeding at the Federal trough; it is struggling with Wall Street bonus pools, even in recessionary times, that can fund the governmental budgets of small nations. Sometimes the seven and eight figure pay levels can extend way beyond the “top 10” in any one company. When one person can get an eight or nine-figure payout from “deal flow” alone, something is terribly wrong.

Today’s thedeal.com put it this way: “The practice of giving outsize rewards to big-time risk-takers based mainly on their results in a given year is one of the main reasons we have a financial sector that's too big and too self-serving. As financial firms become more and more focused on maximizing compensation for employees, they get more and more distracted from their basic reason for existing: managing society's wealth and directing it to productive purposes.”

The solution isn’t so easy. If you significantly reduce these deal-related mega-bonuses by taxation or fiat, the smart traders and rainmakers simply will move to a jurisdiction where such caps do not exist. You can try and regulate them when they deal in U.S.-based assets, but these loophole experts can easily navigate around that barrier. As damage mounts from the derivative asset meltdown and the crass manufacturing of toxic securities that have sucked the life-blood out of many middle-class American dreams, it is very clear that the federal government, whether dealing with industries that require federal licenses or simply applying the “commerce” clause of the Constitution, has the power to regulate this compensation trend and limit if not stop the madness.

This becomes an even bigger problem as we allow, even encourage, huge financial institutions to swallow smaller, under-performing structures, amplifying their long term power and reducing free market competition – literally giving single companies the ability to create macro-economic impacts on global markets by themselves. With that increase in size and power, there needs to be a concomitant increase in oversight, regulation and responsibility.

The problem is that the United States cannot accomplish this task without the full cooperation of those nations who also operate global financial centers – but I would suspect that there is a global appetite for change. The upcoming November “Group of 20” economic summit, hosted by the United States, is an excellent forum to begin solving this issue. The list of attendees is impressive: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, South Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, Britain, the United States and the European Union.

The underlying issue, however, is whether financial institutions can literally afford to anger entire nations, inflict catastrophic financial damage on the global markets, and continue to reward individual deal effort at the expense of everything else.

I’m Peter Dekom, and I hope someone is listening.

Circular Reasoning - Helping Default Rates Rise

We've moved passed greed as the major motivator on Wall Street (trust me, it will be back, unchecked as ever), into basic fear. Trying to picture that the Michael Douglas character in Wall Street, if you remember that film – who touted greed – saying, “Fear, for lack of a better word, is good.” Just doesn't seem to fit the character. Hoarding capital and not lending it, investing in Treasuries producing an effective “negative interest rate” (you pay more to borrow than the interest you receive on the investment you make with the borrowing) – fear at its jolly best.

But it is near Halloween, and scary stuff is in vogue. So here’s another fun fact. As the market explores the depth and damage of the loan default insurance market (the lovely credit default swaps I've detailed in earlier blogs), the criteria for corporate borrowing just added one more variable. In addition to routine reviews of the company’s credit rating (which produces a formulaic interest rate based on the U.S. prime rate or the European equivalent – LIBOR), major lenders have added the cost and pricing of credit default swap (CDS) paper on the prospective borrower.

Today’s Washington Post’s Dealscape noted: “Tying the [credit] lines to swaps could leave corporate borrowers in the lurch since the derivatives are often used by speculators to bet on a default by those who don't actually hold the company's debt and aren't listed on any government-regulated exchanges.” So the non-kindness of strangers, trading your risk profile in unregulated derivatives (CDS paper), could cause your corporate interest rates to rise high enough to trigger the very default that the CDS paper is supposed to insure against.

Sounds really stupid until you realize that, according to Bloomberg, “Citigroup Inc., Credit Suisse Group AG and other banks are starting to shift away from basing the rates of $6 trillion in revolving loans solely on a combination of the borrower's debt rating and a mark-up to LIBOR.” And this has actually happened to food-processor Nestle SA, cellphone maker Nokia Oyj, and electrical power-generating FirstEnergy Corp.

I can see sympathy lacking in this issue. No tears. So let me add one more variable to the mix. Those credit lines fund payrolls! They keep people in jobs, who pay mortgages, and buy “stuff.” So the circle is indeed vicious.

Fear on Wall Street also arises as Congress drills down on this $20 billion set aside for Street traders and bankers – year-end bonuses the companies claim are essential to retain the best and the brightest (who caused this mess?) – in light of the taxpayers’ sacrifices in the bailout plan. Some Congressmen want to expand the coverage of salary reductions to the top ten highest compensated folks in any company (but in large investment banks, there could be hundreds receiving significant seven figure and even eight figure bonuses!).

I'll end this tirade with a letter from Henry Waxman, Chairman of the House Oversight Committee:

"While I understand the need to pay the salaries of employees, I question the appropriateness of depleting the capital that taxpayers just injected into the banks through the payment of billions of dollars in bonuses. Some experts have suggested that a significant percentage of this compensation could come in year-end bonuses and that the size of the bonuses will be significantly enhanced as a result of the infusion of taxpayer funds."

He’s Henry Waxman, and I approve his message.

If You’re Confused, Think About the NYSE

Liquidity, liquidity, liquidity! Yeah, the Dow had its worst week in its entire history. Yeah, we have not seen a market decline like this since 1929. Friday started off really horrifically and ended just plain “bad.” But we can bottom this out if stubborn Henry Paulson and a few other government leaders will simply address the fundamental problem of businesses being able to function, fund payrolls with receivable financing and move on - maybe even stop the mortgage debacle.

This morning’s New York Times underscored the problem: “In the credit markets, conditions went from bad to worse. Borrowing costs for banks and companies jumped once again as investors sought safety in Treasury bills despite earlier signs that the government might take equity stakes in troubled companies to try to halt the credit crisis. It was the worst single day for junk bonds ever, and the cost of borrowing shot up for even blue-chip companies: I.B.M. agreed to pay 8 percent interest on $4 billion of 30-year bonds, about twice the rate at which the federal government borrows money.”

Okay, Wall Street, if it’s tough for you, think about the small businessmen and women who can't even borrow at 10%!! Hey Henry, when is your trickle coming down to the people? When are you going to get the point that the hoarders, the big financial institutions that suckled at the breast of the Federal Reserve, ain’t doin’ no tricklin’?! They're borrowing from you (the Fed - the government) at a low rate and then lending you (the government) that money by using their borrowings to buy Treasuries? If you want small business and homeowners to have local access for basic funds, guess what?! You actually have to get down and get local. End of broken record. Please end the broken credit market with the obvious solution.

I’m Peter Dekom, and I approve this message.

The Incredible Bottomless Pit or Are We Searching for the Bottom Now?

As the big financial institutions gorge themselves on cheap Federal Reserve loans, smaller local banks are cash-dry as a bone. Even after a $25 billion auto industry bailout, GM is mulling whether to shut down plants and implement massive lay-offs, because people don’t buy big ticket items in unstable times, and its gets worse where there are no car loans to be had anyway. It’s the big example of what’s happening everywhere. Is this a “slow motion crash” as the Wall Street Journal states or have we hit the point where it is obvious that we are “throwing the baby out with the bathwater”? Are we at or near the “bottom”?

As the Treasury Department (the Administration in general) still fights direct consumer assistance, is still unwilling to freeze foreclosures so that mortgage rates can be reset in a sensible time frame, won’t guarantee grassroots receivable financing… what else can they do that does not involve this direct individual, consumer-targeted relief? If we have to play by their “work through the institutions only” rules, can the government still make a difference? While the efforts outlined below most certainly are not the best and most immediate solutions, the answer is “yes, there are steps they can take” that will help.

The Treasury is considering trading equity stakes in smaller banks in exchange for cash infusions; that policy should carry the string of immediate available small business cash to support payrolls. The government can also guarantee inter-bank loans, from the big cash-rich banks to the grassroots local banks that are best suited to distribute capital to local borrowers. Finally, federal officials can start setting mortgage rate caps where teaser rates and ARMs (adjustable rate mortgages) have dramatically increased monthly mortgage costs. Under the terms of the bailout plan, and where banks and financial institutions accept government loans or insurance (virtually every lending institution in this country), the government has rule-making power to implement these strategies very quickly. Not the best solutions, but at least the kind of movement the market needs to see quickly.

And here’s where I am sticking my neck way, way out… If the government takes these steps now (as the beginning of a litany of many more steps), I honestly believe that the market is looking for a bottom. If it happens, a GM reorganization won’t help stop the fall, but we can survive that as well. It shouldn’t take that much to convince Americans that the stock market – a leading psychological indicator of positive growth – is not going to crash much farther. The market will begin to vacillate instead of dropping day after day… and with the right government support… stabilize. But the market “sheep” need some market leaders to change their attitudes.

I’m Peter Dekom, and I approve this message.

Comes Now the Night - Doing It Right (Part 2)

As we watch markets falling at levels reminiscent of the Great Depression, and states attorneys general implementing direct actions against corrupt banks and implementing moratoriums against foreclosures that have not appeared from the feds, it does appear that we need some federal action immediately, before the markets freeze up so badly that lay-offs become permanent job losses. Fire!

1. Impose 120 day federal moratorium on foreclosures of residential real estate.
2. Until a bigger plan can be implemented, provide instant federal guarantees to banks operating under their reasonable and standard business practices in providing “receivable” financing to small business owners (those with fewer than 1000 employees) consistent with past practices (this means lending against sales that have been made but not yet collected). This will stop unnecessary bankruptcies and layoffs, perhaps permanent job loss, that will vastly exceed the cost of the guarantee. Begin looking at growing the credit markets to bigger companies as the economy justifies.
3. Ask the Department of Labor (with input from other federal agencies like Energy, Interior and Transportation) to submit a plan to create a massive job corps to rebuild our nation’s bridges, dams, highways, levees and comparable infrastructure under the supervision of the existing building trade unions, but at entry-level wage rates. Prepare to submit that plan to Congress and the President within 60 days. Since this represents a productivity investment, the fact that it may strain the federal budget must be ignored. It will pay for itself many times over and will put a huge cadre of unemployed workers in paying jobs.
4. Ask the Department of Education to prepare a budget and an action plan to: a. retrain laid off workers into fields where growth clearly exists (traditional and alternative energy, health care, etc.), and b. to add one additional hour per day to junior and senior high schools in math and quantative science (can be applied math, such as is standard in manufacturing or construction) to upgrade our national schools to provide competitive job skills (another productivity increase).
5. Invoice and collect the $79 billion of oil revenues sitting in the Iraqi government, and give them their wish of an accelerated withdrawal starting now (muster out 2/3 of the returning troops and send the other 1/3 to Afghanistan), to stop the drain on our budget – whether you are for or against the war, we just do not have the money to pay for it (this is not a productivity investment). The civil war will continue as we depart – it would no matter when we left.
6. Phase out water-wasting and unproductive ethanol farm subsidies over three years and all other farm subsidies (which mostly benefit large corporate farmers, whose commodity values are soaring in this market) over five years. Terminate the oil depletion allowance.
7. Train local and federal investigators and prosecutors in the prosecution of the white collar crimes that gave rise to this debacle. Go after the folks who lied on their loan applications, the lending officers who told them to do it, the financial wizards who having done the numbers still insisted on creating the “derivatives” that pushed us over the edge, and the senior managers at banks and other financial institutions who either encouraged this misconduct or chose to look the other way as it fell beneath their feet. Make them pay – in cash, assets and, perhaps in serving time.

I am sure that what I have written will offend one special interest or another, but what is at stake is the America I know and love. Time is not on our side. We need action. Now!

I’m Peter Dekom, and I approve this message.

Foreign Government Reassurances - “We’ll be Alright; It’s an American Problem”

The international finger of blame is pointed at America as the under-regulated “free market” economy with loopholes drafted and designed by the special interests that benefited from the massive over-borrowing, fully sanctioned by the government. “It can’t happen here,” cry the nations of the world with their figures outstretched. Because the U.S. has been viewed as arrogant – trying to win a civil war in Iraq where it is not even supporting either faction (how do you win a war when you’re not a party?), telling the world that “you’re either for us or against us,” and in international opinion, an unbridled cowboy doing whatever it wants as a self-appointed global policemen (incurring massive military bills paid for with deep and unprecedented borrowings in the international market) – this is sadly being taking in as the payback for American hubris, something we just plain deserved.

But the international impact is just settling in. The European Union, which suffers from a lack of general EU oversight on financial institutions (still, for the most part, a local national matter), is beginning to see the ripples from our meltdown tsunami their way across the ocean. Many European banks drank at the toxic glass of over-leveraged American securities, and are shuddering near collapse as a result. Germany just issued an edict guaranteeing the safety of their bank deposits, and has moved to take over more than one financial institution. England is forcing sales of financial institutions and moving shaky banks to stronger players. Luxembourg , Belgium , Ireland , Sweden are all implementing ad hoc or overall “bailout” policies of their own.

Across the world, regulators are taking one more look at their “it can’t happen here” mentality and finding banking and financial institution anomalies within their own sacred cows. Further, as U.S. consumer demand drops like stone in a flurry of survival instincts, as small businesses shut their doors or postpone deliveries, the manufacturing economies of the world are gasping at the magnitude of the impact this reality is having or clearly will have on their financial viability. Financial capital Dubai is watching real estate values plummet and deal flow subside as oil prices have fallen mightily from their pinnacle a few months ago. The Singapore stock market plunged on Monday trading (along with its Asian brethren), a trend that carried over to Wall Street this morning.

While the U.S. market remains the shakiest, because the majority of toxic securities were born and consumed locally and the underlying consumer-homeowner market is hitting extreme negative growth, the harsh reality is that this is a global problem that is going to require global solutions. “Smug” is rapidly being replaced with “Oh my, it is happening here!”

All eyes are now on how America implements her bailout, and many overseas analysts know that if the Department of the Treasury focuses first on the big financial players, postponing the micro solutions until later – leaving bleeding small cash-strapped businesses (employers!) to writhe on the floor of the economic emergency room – many in economic death throes (since most working Americans are in small businesses), to allow the acceleration of real estate value-killing foreclosures to continue unabated without a moratorium, the tipping point taking us to a super-recession or even a depression is still out there.

If the soaring U.S. unemployment rates (which mask under-employment and those who have given up; they’re probably vastly higher) aren’t clear enough, then our leaders need a massive voter campaign to sound the alarm. The Treasury can deal with both issues at the same time – what it cannot do without dire consequences is take care of the big boys first and believe that the solution on Main Street will trickle down later. That option is no longer on the table, if it ever were.

I’m Peter Dekom, and I approve this message.

When “It’s Just Them” becomes “Just Like Me”

I saw a photograph today – a man holding a banner that read “[expletive] jump!” – beneath the hallowed halls of a Wall Street tower. It was sent as a joke, but the message was clear: a huge segment of Americans thinks the government is seeking to bail out “them.” “Them” is bad folk, who for reasons of greed and power, created an artificial market that eventually and justifiably collapsed. “They” deserve to be punished, even go to jail, and if our pensions suffer a bit for while, it’s got to be worth it.

And that’s the problem with the government’s plan. The order of the fix just looks bad. The theory is to shore up the institutions, revive the fundamental borrowing power that is the life blood of American commerce and homeownership, and the new stronger structures will then resuscitate the poor homeowners whose property values have been driven down, who cannot get loans for simple business needs or to buy or sell a home.

The problem is one of perception. Because the plan does not start with the homeowners, placing some kind of moratorium on foreclosures, the “bailout” is not viewed as one that helps the common man, the small business or the homeowner… even if that will be one major result of the current proposed legislation. The fact that small businesses pay their employees from receivable financing, that jobs depend on borrowing power just to exist, that real estate has no value if no one can buy it and the fact that growth-directed investments – the kind that create jobs – cannot operate in a vacuum without lending ability, well, the legislation on the table pumps money into the institutions, so the fact that Main Street benefits just as much as Wall Street seems totally lost.

As I’ve said before, if homes lose more value, then the mortgages that the government is buying in a bailout have to be worth less too. Foreclosures kill home values, so we better start there. The message is better too; it doesn’t look like greedy pigs are getting a second helping. The “institutions” – the “them” – have to come second. The punishments for failed management and misleading the public into this mess need to be clear to the electorate. And right now, we need some major remedial economic legislation, if for no other reason, to begin to rebuild the economic trust that vaporized in the last few weeks… a trust that must exist if we are to have a viable economy.

I’m Peter Dekom, and I approve this message.