Lieutenant Island Views : Commentary About Finance, Politics and Baseball

Tom Toles’ Take on the Estate Tax

April 3, 2009
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As my mom often tells me, “many a truth is told in jest”. Tom Toles captures the estate tax argument in a cartoon. What is hard to believe, in times like these, is that there is substantive Republican discussion about the estate tax. For those in the Republican leadership who have gripes about the $7million limit before taxation that President Obama proposes, they and their constituents should be happy if they can still pass that level of tax free capital to their children. They may not realize that many who might have been able to do so can no longer do it due to the financial crisis. Likewise, when they had a chance to increase the limit, they overreached and sought to completely eliminate it on a permanent basis. Fighting over this issue now raises a serious issue of certain leaders’ priorities in a conflagration!

Let’s Look Under the Banks’ Hood (Declining revenues may take care of that nasty compensation issue)

April 1, 2009
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A quick look at the first quarter ’09 Underwriting revenue statistics released today by DealLogic suggests that Underwriting may not be such a big source of increased profitability for banks. While total proceeds raised increased 27% from $1.344 billion to $1.707 billion, industry wide fee income was down 11.9%. The results were far worse for a number of the former industry leaders whose liquidity and stability are in question.The differences are, in part, explained by the fact that there was less activity in the higher margin areas of equity and less than investment grade debt issuance. More interesting is a look at the underwriting revenues of individual banks. Only Deutsche Bank and Royal Bank of Scotland posted increases in underwriting revenue. Names like Citi, Goldman and BofA did not fair well at all. If Citi and BofA are going to have up first quarters, it won’t be from underwriting. Citi’s first quarter revenues were down 31.3% and B of A’s declined a whopping 56%. The mighty Goldman Sachs fell from third to tenth on the League Table and saw its underwriting revenues fall 45%, which was worse in total dollars and percentage terms than even Citi’s results.

The changes probably reflect a few things. First, the more stable banks, like JP Morgan and Deutsche, are likely to be the leaders going forward. While Citi and BofA were still marginally ahead of Deutsche, their precipitous declines point to an issuer abandoment trend that may not be quickly restored. Were it not for a few old relationships, which probably meant joint books on the right and conferred less real revenue than DealLogic thinks, they would likely be behind Deutsche. Second, were it not for major refinancing by investment grade names, who were taking advantage of market windows and proactively moving to protect their balance sheets, revenues would have been much worse for everyone. These event phenomenons, if true, may not be indicitive of great ongoing revenue streams. Third, Goldman’s fall off reveals just how dependent they really were on equity and less than investment grade issuance. In the last few years they evolved into a higher risk shop dependent on proprietary trading and investments together with higher margin and risk underwriting.

Perhaps the Obama administration need not worry about legislating bank compensation. Decining Underwriting and other bank revenues may do the job for them!!

Bank Underwriting Revenues First Quarter 2009 v 2008 may be found below:

The End of the Beginning or the Beginning of the End of Hedge Fund and Private Equity Economics?

March 30, 2009

Saturday’s Wall Street Journal has an interesting article (“Calpers Tells Hedge Funds To Fix Terms-Or Else”) which details the California Public Employees’ Pension Fund’s (“Calpers”) attitude toward hedge fund and private equity compensation. Calpers is the nation’s biggest public pension fund. It has seen its hedge fund and private equity portfolios decimated this year along with its myriad other equity oriented investments. This is necessitating a reallocation of their portfolio which will mean substantial cuts in funding for “alternative investments” like hedge funds and private equity. Calpers’ reallocation issues has done more to put the fear of God into heathen PE and hedge fund managers than would any overzealous preacher! Loss of Calpers money can put a dent into any fund’s asset base and be a harbinger of incremental losses as other funds follow Calpers’ lead. Reallocation also gives Calpers extraordinary “muscle” to demand favorable terms from those with whom it chooses to invest. As the article points out, some of the modifications in terms that it is looking to achieve include:

• Reduction in annual fees (now 2-3% on avg.) and carry from 20% to something significantly less
• Recoupment of fees paid in good years to cover subsequent bad performance
• Managed accounts solely for Calpers to reduce the impact of redemptions by other investors
• Greater disclosure of assets and potential limits to leverage

Implementation will come primarily with the deployment of new money rather than amendments of existing fund investments. While it will take some time to implement the changes desired, they will have a chilling effect on the compensation and operations of many hedge funds and PE shops. Because so many institutional fund investors follow Calpers example it is likely that some fund managers will opt for dissolution or be forced to that decision by an inability to raise adequate capital. If Calpers succeeds, the face of alternative investments will look very different in the coming years. It also won’t help the value of homes in the Hampton’s or large apartments on Park Avenue.

It is quite possible that the fund business will follow the example of Major League Baseball. Top performers like Paulson and Soros may still be able to demand their terms because of their stellar track records in the recent downturn. Others will see a dramatic change in life and pay because they did not measure up in the clutch. There won’t be many Johan Santanas or Albert Pujols in the fund world. To make matters worse, Calpers is signaling that they have no intention of spending as freely as the Steinbrenners!

Paul, We Love You But Get a Grip!

March 27, 2009

The same guy who says that the Obama Administration should be spending trillions more on everything does not like the government’s plan to liquify toxic bank assets. He also seems to hate the capital markets. I guess he thinks that the incremental trillions he wants us to spend come from the printing press rather than the global markets.

What is the real source of his problem? He is is a truly smart guy but today’s piece in the New York Times really lacks clarity. His article “The Market Mystique” fulminates on multiple topics but never really specifies the underlying sources of his problems.

He clearly sees a need for more regulation of markets and then grudgingly admits that the Obama Administration is moving to significantly increase regulation. He dislikes markets and won’t come to grip with the fact that they can’t be ignored. He seems to forget that even in his favorite generation, the fifties, the government used markets to finance its operations. Maybe he thinks that in that era, America was like the Fonz and always had money but did not have to do anything to get it! Only the Fonz failed to realize that there is no free lunch.

It is less clear what Krugman wants other than for banks to admit that the assets have a low value. The argument comes down to what is fair value. If banks follow Krugman’s draconian solution, it could be Lehman redux, unless mark to market rules are eliminated, which his logic would argue against. Forcing big markdowns triggers capital inadequacy issues and, probably, government takeover (s) of some big banks. In this scenario, the FDIC gets to own the assets and probably lots more as a result of a collapse in market confidence (remember what happened when Lehman fell). The government would have to step in and, like it or not, figure out how to finance everything it acquired. It would have to go to the markets. The fellows who make up the markets might not have a Krugmanesque point of view (those Chinese fellows, in particular, have no sense of humor when it comes to losing money in American assets). The elegant thing about the Geithner plan is that it does not deny the valuation issue and provides government funding. The difference in the plan versus Krugman is that it does it by attracting outside capital and reigniting trading in the assets. Krugman’s plan lays it all on the government’s shoulders to finance after triggering a very negative series of events. We saw this with Paulson at the helm. do we want to watch it again?

Paul, please take a bite of a reality sandwich. You can’t avoid markets so use them for our benefit. Obama, Geithner and equity investors get the joke. Why can’t you?

Spitzer for Treasury Secretary? Are You Joking Katrina?

March 25, 2009
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Recently Katrina Vanden Heuvel, Editor of the the Nation, has been suggesting that Treasury Secretary Tim Geithner should be replaced by Elliot Spitzer. We know that she and her husband have been his friend since their days at Princeton but her suggestion is an embarrassment. Perhaps she is letting friendship cloud her judgment. Aside from the fact that Spitzer pleaded no contest to several of the crimes (Mann Act violations, illegal currency wire transfers, aiding and abetting prostitution etc.) that he often used to coerce his targets when he was New York Attorney General, he may have been the root cause of AIG’s demise. His actions, which forced out AIG’s long time CEO, Hank Greenberg, led to new management which took the company in the wrong direction. Greenberg’s successors had a difficult time maintaining his earnings record. They went for what they saw as easy money in credit default swaps and other esoteric insurance products. This was a large and real deviation from the way Greenberg ran the company. We all know the rest of the story.

The laws of unintended consequences really can be punishing when you act in a vindictive manner rather than as a result of a deliberate strategy.

As a secondary question, does Katrina expect an easy confirmation for her friend Elliot? Larry Summers was kept away from the Senate confirmation process because he spoke out about the gap between women and men in scientific fields of study. Imagine if he had broken multiple laws to hire $5,000 per hour hookers! At least Elliot paid his taxes.

From Whence Cometh Our Financial Mess?

March 22, 2009
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Beneficiaries of a Jesuit education learn early that logic and careful analysis are predicates to better judgments and conclusions. Jesuit pedagogues would also suggest that careful analysis and judgments are also necessary for appropriate corrective actions in addressing major problems. When it comes to our current national and global financial mess, blaming the usual suspects (George Bush, greedy CEOs, Wall Street, high executive compensation et al) or pandering to mass frustration may be cathartic but can never be confused with analysis or be a basis for corrective action.

In the coming days, we hope to address the nature of many of the issues that we believe contributed to our current economic troubles. We will endeavor to do so in a clear, simple and concise manner. Please do not be offended if we do not cover each issue in the first or second post. We believe that the issues fed on one another and are best examined seriatim rather than in one fell swoop.

What then were some of the most significant issues?

• The Growth of Leverage, Particularly in the Last Five Years
• Credit Default Insurance
• Mark to Market Rules
• CDOs (Collateralized Debt Obligations) and CLOs (Collateralized Loan Obligations)
• Failure to Guarantee Fannie and Freddie Preferred Shares
• Letting Lehman Fail
• Delayed and Insufficient Action on AIG
• Treasury “Crying Fire in a Burning Building” to Pass TARP
• TARP Mismanagement

From these issues flowed incremental and very significant problems and issues including:

• Bank Failures and Capital Inadequacy in the Financial Sector
• AIG Insolvency
• Sub-prime Surge and Failings
• Mortgage Foreclosures
• Stock Market Meltdown
• Post-TARP AIG Compensation Levels

In the coming days we will deal with each issue and seek to expand our discussion by building on each issue and reflecting on subsequent problems that flowed from them. Stay tuned!!

(Note: While the author has long admired the discipline, training and learned nature of the Jesuit Order, he is neither a Roman Catholic nor the beneficiary of a Jesuit education.)

Wall Street Compensation Legislation; A Pyrrhic Victory

March 20, 2009

Members of congress recently passed a bill which will tax all individuals working for institutions which received over $5billion of TARP (Troubled Asset Relief Program) funds at a rate of 90% of all income earned over $250,000. Rather than basking in the glory of their decisive and punitive action, perhaps members of Congress should go back to their Plutarch and Roman history to learn about Pyrrhic victories. The tale of King Pyrrhus of Epirus, whose army suffered irreplaceable casualties in defeating the Romans during the Pyrrhic War, has lessons applicable today. Plutarch reported the King to have said after his final victory that “one more such victory would utterly undo him”.

Congress had a victory which could utterly undo the recovery progress that has been made to date and certainly result in a number of unintended negative consequences. As I say this, in no way am I apologizing for the bad judgment, avarice or possible malfeasance by bonus recipients at AIG. It is disgusting on its face. That said, the solution being proffered gives America a Pyrrhic victory. The reason is that it goes way beyond AIG. To punish some 400 people, Congress chooses to take action that has innumerable negative consequences:

1) It discourages future investment by private investors in a public/private TALF (Term Asset-Backed Securitization Loan Facility) program to restart asset securitizations-logical concerns arise as to potential government intervention in compensation and the general investment decision making of such private investors

2) It raises significant issues as to the sanctity of contracts and whether the government could unilaterally force the breaching of contracts with institutions in which it has made TARP investments-If you can’t rely on a written contract, what can you rely on?

3) It will likely lead TARP recipient banks to take actions to rapidly repay their TARP investments. While this may sound good, they will likely do it by decreasing lending to generate requisite capital for TARP repayment-Is this a time we want to take action which discourages lending?

4) We have seen the adverse consequences of inadequate regulation and supervision of highly motivated and intelligent players on Wall Street. That said, the problems really were generated by a small minority of the participants on Wall Street. The majority were honest hard working people who have suffered significantly in terms of job loss and investment in their companies’ equity (the currency which very many were paid with significant liquidity restrictions). Do we really think that they will want to stay working on Wall Street or that we will continue to attract top minds to an industry where top performers make substantially less compensation than do the lawyers, accountants or mid level executives at businesses across the nation with whom they work? It would be a mistake to think that top people have no alternatives. Foreign institutions are already seizing on the opportunity to strip American firms of top performers (BofA/Merrill is now suing Deutsche Bank for just such an action). Other savvy Wall Street veterans with significant experience in prior downturns are simply retiring or turning to other more remunerative and/or less stressful pursuits.

5) The real bad guys already have made their money. The rogue traders and irresponsible CEOs making $30-50million per year over the last ten years are crying all the way to the offshore bank. To punish the AIG 400 the way that Congress desires, we also have to punish those tens of thousands who we expect to remain at their posts to clean up the mess. Who among us really believes that spanking the innocent for the misdeeds of others is an effective motivational tool??

How did it ever get to this place to begin with? The answer to that lies with Hank Paulson’s ill conceived three page TARP plan to give money to desperate institutions with no pre-conditions. While not quite the moral equivalent of giving an alcoholic another drink, it is not a completely inappropriate analogy. In the United Kingdom, Gordon Brown clearly saw the need to stipulate significant preconditions to the granting of bailout funds. Tim Geithner’s comments that he did not know about bonuses etc reminds one of Inspector Reynaud’s comment in the movie Casablanca as he closed down Rick’s Cafe for gambling (after accepting his winnings). The time for assertive action was then. For Geithner to not have thought about compensation and contracts is naive. He was and is an experienced hand at dealing with Wall Street. He is neither naive nor stupid. Moreover, he had the example of Gordon Brown to follow (repugnant as it may be for an American financial titan to follow the example of an over educated son of a Scottish preacher). The sad reality is that he either was unduly influenced by Paulson, opted to not fight with Paulson for fear of adversely influencing markets or lacked the fortitude to do what had to be done at the time. As a result, and to paraphrase Julius Caesar, another ancient Roman, “the die was cast”.

What then should be done about AIG? Initially, each bonus recipient should be both “jawboned” and told that they will be publicly identified with all of the attendant ridicule. While many may not mind, there is tangible evidence that a number do care and are stepping forward to return their bonuses. All who do not voluntarily return the bonus money should be subjected to investigation to determine if their deportment was appropriate to warrant receipt of such a bonus. If found lacking, litigation should be undertaken. Finally, the government should seek the agreement of all other TARP recipient institutions to refrain from hiring or doing business with such individuals and/or institutions which hire any of the AIG 400. This de-facto “Black List” would serve as a powerful signal as to the government’s intention to avoid doing business with people who are not “on board with the program”. It will similarly provide a material disincentive for TARP and non-TARP recipients from hiring any of the AIG 400. Because TARP recipient firms firms like JP Morgan, Citibank, Morgan Stanley et al touch so many players in finance, this is a draconian threat to the future employment prospects of anyone who does not “play ball”.

The government needs to make it clear that it will take appropriate action on the AIG bonuses and not tolerate the AIG bonus situation from occurring again. It is equally important that it must not allow a mob mentality to impair its judgment in a manner that results in a Pyrrhic victory of expediency and unintended consequences over the desired administration of serious punishment for non-compliance with the people’s wishes.

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About author

Mr Thaler is currently the Managing Partner of Lieutenant Island Partners, an organization providing corporate finance advice and general consulting to corporations and not-for-profit organizations. Mr Thaler retired as Vice Chairman of Deutsche Bank Securities in early 2008. His background includes experience as an investment banker, senior manager, business builder, college professor, not for profit board chair and trustee. In his thirty plus years as an investment banker for Deutsche Bank and Lehman Brothers, he has been involved in numerous significant debt and equity financings, mergers & acquisitions, leverage buyouts, restructurings and cross border transactions. Of particular note, Mr Thaler has been one of the most active participants and strategic advisors to the homebuilding industry. In a period of significant turmoil and losses, he was one of the few active bankers to the industry who did not have either a loss or credit write down. He is currently advising several public builders on strategic matters and is an adjunct professor of finance at Morehouse College in Atlanta, Georgia. Though he lives in New York, he is a life long Red Sox fan!