In ordinary times it would be ignorant to ask, “Who’s going to bail out the Fed?” — but then again these aren’t ordinary times.
Solvency of the Federal Reserve Bank shouldn’t be an issue because it carries the full faith and credit of the United States of America. In theory, the only way the Fed could need a bailout is if the federal government fails.
While theory is interesting, political reality is an entirely different story. The Federal Reserve is putting its future at risk by ignoring its own likely financial results when it raises interest rates. Simply put, rising interest rates will hurt the Fed by making interest costs higher and asset values lower.
Congress has gotten used to spending profits made by the Fed. Based upon first quarter results the Fed is on track to turn over more than $110 billion in 2011.But what happens if the Fed’s profits suddenly turn to losses? Will Washington remember the Fed’s enormous earnings and cut them some slack?
In the mafia, you are only as good as your last envelope. Congress works in much the same way. It’s a sure bet that Congressional memory won’t last more than a single missed payment. When the Fed stops kicking up to its Congressional bosses, it’s future will be in serious jeopardy.
While the Fed isn’t like any other bank in America, it is still subject to the immutable rules of math and interest rate risk. If the Fed starts to earn less on its investments than it pays in interest on its deposits, it will lose money.
That is exactly what the Fed is facing when interest rates rise — that it will pay more for deposits than it earns on its investments.
Taken in isolation the Fed’s balance sheet looks more like an overleveraged hedge fund than a shining example of prudent risk management. The Fed has almost no capital to back up its big macro bet on interest rates and the shape of the yield curve. Higher interest rates or an inverted yield curve where long-term assets yield less than short-term assets will cause problems.
The Fed borrows money by accepting short-term floating rate deposits from banks. It uses its cash to purchase mostly long-term fixed rate bonds. Through the monetary stimulus programs of QE I and QEII the Fed has purchased a boat load of long-term fixed rate bonds and now owns approximately $2.3 trillion of these assets.
When short-term interest rates increase the positive difference between what the Fed earns on its investments over what it pays to borrow money will shrink. If interest rates rise enough, the Fed will start booking losses.
A simple stress test on the Fed suggests that an increase of between 3.00% and 3.50% in the federal funds rate will turn the Fed into a text book example of a Congressional basket case. For the vast majority of the Fed’s existence, the Federal Funds rate was above its breakeven point of around 3.25%.
Even worse, the Fed’s assets, Treasury bonds and mortgage-backed securities, will fall in value when interest rates go up. It is a universal bond truth that when interest rates rise, the market value of fixed rate investments falls. Falling market values will restrict is ability to trade into higher yielding assets without realizing market value losses.
Unlike all other banks, the Fed has essentially no equity to absorb losses. It is required by law to transfer the vast majority of its profits to the Treasury every year and as a result has only $53 billion of equity backing up almost $2.7 trillion of assets. If the Fed were a private bank it would be immediately classified as critically undercapitalized and seized by regulators.
The Fed was there for Citigroup and Goldman Sachs and the entire financial sector but who will be there for the Fed?
As a practical matter the Fed cannot hedge its interest rate risk. While other banks can buy interest rate swaps, futures and options, the Fed is not like other banks and will be subject to a double standard.
The Fed will never collect on hedge contracts bought from Wall Street oligarchs. Hedging is a zero sum game —if the Fed makes money that means someone on Wall Street loses.
The “too big to fail” banking crowd will make the Fed’s hedging contracts uncollectable in less time than it takes to clean up after a K-Street cocktail party. There is just no way that Wall Street will voluntarily pay the Fed a few hundred billion when Congress is around for a bail out.
I happen to be a supporter of the Fed’s monetary policy and think that Mr. Bernanke and the Fed staff have done an amazing job. I am not suggesting that the Fed balance sheet is out of control or that they have been irresponsible by accumulating $2.3 trillion of assets.
However, the Fed staff just is not anticipating the firestorm of criticism it will receive when it stops earning money for Congress.
Mr. Bernanke has not laid the groundwork with the public for losses and is giving Fed haters ample ammunition to attack the institution. Just imagine if the Congress had to include funding for the Fed in debt limit debate.
In a perfect and intellectually honest world, losses at the Fed would be a non-event. But we don’t live in a perfect world. The Fed is setting itself up for political opportunists to take cheap shots without consequence.
By not dealing with the certain math of interest rate risk, Bernanke risks becoming the guy who gives Congress an excuse to end Fed independence.
Last week while appearing on FOX Business Network I was repeatedly asked why the SEC was bothering with a civil enforcement action against Citigroup for alleged bad 2007 mortgage portfolio disclosure. My FOX Business friends thought that the SEC’s action was dumb because the U.S. Government is the largest stakeholder in Citigroup and effectively controls and funds the company. They assumed that the SEC action could never amount to more than the SEC getting money from the U.S. Treasury through a Citigroup fine.
I disagreed with everyone that morning and shocked them by saying that I was worried that the SEC wasn’t being tough enough.
The SEC’s proposed action against Citigroup fits right into the model for effective regulatory enforcement even though my FOX friends didn’t see it.
During my first year of law school I learned that there are three principal objectives that every law enforcement and regulatory agency needs to try to achieve. The Citigroup SEC action meets all three objectives and therefore should be pursued.
Law Enforcement Objective #1 – Retribution
Retribution is a nice way of saying punishment, i.e., “an eye for an eye”. It is usually achieved through jail time or the payment of fines. The SEC action against Citigroup is a civil case so the payment of a fine is the form of retribution being sought.
Since the U.S. Treasury is the largest stakeholder in Citigroup, my FOX friends didn’t understand why a fine will punish wrong doers. Everyone assumed that the fine would be indirectly paid by Treasury.
Of course, the government isn’t the only owner of Citigroup (private shareholders will pay their share) and Citigroup does have directors and officer’s insurance coverage. Most likely the majority of any fine will be reimbursed through directors and officers insurance and won’t come from the U.S. Treasury. While punishment of Citibank’s insurers isn’t a SEC objective, the insurance industry will be a lot more careful about making sure other companies pay attention to securities laws if insurers feel financial pain.
Also, if Citigroup is found to have violated the securities laws (which is needed to assess the fine), such a finding will likely trigger Citigroup’s right to sue its former employees who were responsible. Also, lawsuits brought by former shareholders against Citigroup and its officers and directors will have a much better chance of success if the SEC finds that Citigroup violated the law and assesses civil penalties against the company.
Law Enforcement Objective #2 – Segregation
Segregation takes place when the government forces a “time out” and preventing offenders from breaking the law again and again. It is a simple technique that works just as well on adults as children.
Segregation often, but not always, means jail time. However, without sending people to jail, law enforcement professionals can segregate non-violent offenders and stop future bad actions. As an example, a driver who receives too many speeding tickets can lose his license and be given a time out from driving too fast. And, a stock broker who repeatedly lies to his clients can be given a time out from being a stock broker and won’t have the opportunity to lie to more clients.
The SEC has the authority to force Citigroup employees to take a time out from being directors or executive officers of another publicly traded company.
While the SEC is not alleging that Citigroup’s 2007 mortgage portfolio disclosures were criminal, they are saying that they were wrong and didn’t comply with securities law. A finding of civil liability is more than enough for the SEC to force a permanent time out for Citigroup’s officers and directors that were responsible for the 2007 mortgage disclosures.
Law Enforcement Objective #3 — Deterrence
Deterrence is achieved when potential wrong doers are afraid of punishment if they are caught and therefore try to avoid doing bad things.
If the SEC gives Citigroup and its executives a “get out of jail free” card because of the bailout, the SEC will set a bad precedent for other companies in which the U.S. government has a financial stake. And that precedent will be looked at by millions of employees who work at companies in which the U.S. government has a direct or indirect stake. The SEC needs to make sure that it doesn’t convert financial bailouts into an immunity and pardon program.
Deterrence is a very personal thing; in little kids and adults alike, the fear of being caught and punished is what often deters people from doing bad things. Concern for consequences has to be the same for companies in which the government has a stake as for companies in which the government doesn’t have a stake. The SEC needs to draw a line in the sand and show that they aren’t a paper tiger when the government has an investment.
The thing that I found most unsettling about my conversations last week at FOX, both on and off air, was how much our culture had changed since the bank and thrift crisis of the 1980s. Back then it was a certainty that if a banker was suspected of violating any securities or banking law he would be investigated and prosecuted. And, if investors lost billions or the government had to step in with aid there were definitely going to be consequences. Today, enforcement is something to be debated and, apparently, it is acceptable for some individuals and corporations not to be held responsible for their bad actions.
The long term survival of the U.S. as an economic superpower depends upon the integrity of our financial markets and everyone needs to take for granted that securities laws will be enforced. The consequences of violating the law can’t be different for different companies. Anything short of vigorous enforcement is inconsistent with the U.S. retaining its special place in the global economy and our culture of fundamental fairness.
The accounting profession still hasn’t gotten mark to market accounting right. The rules and their application remain a serious danger to the economy and government intervention is needed to save Main Street from being the next victim of fair value accounting. On April 9, 2009 the most recent changes to mark to market accounting were announced and restored a little sanity to accounting; just not enough to declare victory in this ongoing war against accounting terrorism. Most people don’t realize that the adoption of FAS141R governing merger and acquisition accounting moved the battle from Wall Street to Main Street. At the same time, new conflict lines on Wall Street are forming around the recent earnings releases of Morgan Stanley and Citigroup. Both companies had absolutely preposterous fair value accounting disclosure that distorted their earnings. Surprisingly, within Wall Street, fantasy accounting seems to be making a comeback over common sense. America needs to stop accounting insanity before fair value accountants enslave what is left of the U.S. economy.
The Newest Wall Street Battle — The Fantasy Of Marking Liabilities To Market
In the last two weeks the U.S witnessed supposedly serious accounting professionals try to explain how financial disclosure is enhanced when companies pretend that they aren’t going to pay back their debts. In the “make believe” world of fair value accounting marking liabilities to market is done as liabilities are assets (which they aren’t) that can be traded by the reporting company. It is the application of this rule that rendered Morgan Stanley and Citigroup’s earnings announcements rubbish. Even worse, the examples of Morgan Stanley and Citigroup undermine the integrity of the financial reporting of every public company in the United States.
The rule on marking liabilities to market is just plain ridiculous. It neither promotes transparency nor produces anything resembling reasonable accounting accuracy. Basically, if a borrower’s liabilities are trading at a premium or a discount to the value that is shown on the borrower’s balance sheet, the borrower is supposed to recognize either a gain or a loss on those liabilities as if they either aren’t going to pay back their debts or as if they are going to pay more than owed.
As an example, if a fictitious company called “Sunshine Inc.” were to borrow $100 in the public debt markets and the trading price of this debt were to decline to $80 then Sunshine Inc. would recognize a $20 gain on its liabilities as if it had repurchased them in the market. It doesn’t make a difference if Sunshine Inc. actually has the cash or intent to retire its liabilities, merely its debt trading at $80 is enough to trigger a gain. That is what Citigroup did in the first quarter. Its liabilities traded at a discount and it recognized a gain of about $2.5 billion in a quarter when, on a consolidated basis, the whole company earned about $1.5 billion. That means, without the make believe of fair value accounting, Citigroup lost a lot of money in the first quarter.
On the other hand, if the debts of Sunshine Inc. were to magically trade up in the market then Sunshine Inc. would record a hit to earnings. And, that is what happened to Morgan Stanley; they previous recognized valuation allowances on its liabilities and, much to its surprise, the trading price of its debt went up. As a result, Morgan Stanley’s first quarter earnings were trashed when it recognized a $1.5 billion hit to revenue. Because of fair value accounting Morgan Stanley reported a loss of $177 million for the first quarter.
Neither Morgan Stanley nor Citigroup’s earnings announcements made any sense, provided transparency or improved the credibility of management. Nothing happened to either company’s operations, cash flow or asset values during the first three months of 2009 that should have caused either accounting adjustment. What Morgan Stanley and Citigroup did is almost the same as writing up or down shareholders equity because of changes in the price of their stock on the NYSE (which of course makes no sense either).
The Main Street Battle — FAS141R’s Sneak Attack On Corporate America
Almost unnoticed in all of the mark to market hype is FAS Rule 141R. This rule repealed merger and acquisition accounting as most people know it and replaced the old rules with new guidance that is about as clear as mud. But unlike most of the other mark to market rules that only attacked the nation’s financial sector, FAS141R is like a guided missile tracking right down the middle of Main Street.
The reason that FAS141R hasn’t gotten a lot of press is that no one understands it. And, I include myself in the group of “confused” because, despite my best efforts, I don’t understand how the rule is supposed to be applied. I have attended seminars on FAS1414R and have read multiple presentations on it. While I don’t believe I am the smartest person in the world, I do believe I am a trained financial professional and, since the late 1970s, accounting has been a language that I thought I understood. I received a degree in accounting from the Wharton School and taught accounting at the college level. I practiced accounting at Coopers & Lybrand (in a bygone era of the Big 8 Accounting firms) and have been what I hope was an effective and good CFO of two companies (one of which was NYSE traded). But, no matter how hard I try I can’t understand the new rules and haven’t found anyone who, after I ask a few questions, understands them either.
There is no way accounting rules can be defined as “good” when they are so complicated that normal business people can’t understand them. The conclusion that I have come to is that FAS141R is a sneak attack on Main Street.
Perhaps the best description of the new merger and acquisition rules is the summary of FAS141R that KPMG provides on its web site. Set forth below are excerpts (I added the emphasis).
The standards will have a pervasive impact on accounting practices that have been well understood for many years. The changes introduced by the new standards are likely to affect the planning and execution, as well as the accounting and disclosure, of merger transactions…
FAS141Rcontinues the evolution toward fair value reporting and significantly changes the accounting for acquisitions that close beginning in 2009, both at the acquisition date and in subsequent periods. The standard introduces new accounting concepts and valuation complexities, and many of the changes have the potential to generate greater earnings volatility after the acquisition…
The new rules change which transactions are going to be regarded as business combinations and expands the scope of mark to market accounting to all of the assets and liabilities of the acquired business.
Mark to market accounting is no longer the enemy of just Wall Street; now all U.S. companies that hope to ever do a merger or acquisition can look forward to spending quality time with their accountants discussing the finer points of liquidation value accounting. And, since pretty much every U.S. company will sooner or later either acquire another company or be acquired, mark to market accounting is the guided missile that will create havoc for all.
I can’t wait to hear the howl of pain when the CEO’s of industrial companies try to figure out the fair value of assets that have no trading market and make no sense to be valued at the “price someone will pay for them in the market” outside of a going concern, and more particularly the existing going concern. Wait until CEO’s and CFO’s are asked about the market value of used software, computers, desks, engineering drawings. “Not much” is the “fair value” of most used hard assets when valued asset by asset, desk by desk, computer by computer.
So, in a haze of obscurity, confusion and complication, mark to market accounting is morphing from a Wall Street problem into a Main Street attack. It won’t be long before managers and executives of industrial companies complain that they are managing their companies to satisfy the mark to market accountants.
We need to get control of the accountants who are making up these amazingly dumb and incomprehensible rules. Accounting is out of control and unless the dialogue changes to one of simplicity and sanity sooner or later accounting rules will burn us all.
In 1998 the current banking crisis was both predictable and predicted by Congressional leaders and a future Comptroller of the Currency.
In April, 1998 the House Committee on Banking & Financial Services held hearings where “lessons” from the 1980s bank and thrift crisis were discussed and fears of industry consolidation were expressed. Hearings transcripts clearly demonstrate that the United States learned important lessons in the 1980s and 1990s…and then promptly forgot them.
The chilling 1998 transcript provides a roadmap for how to avoid blowing up banks and taking down the economy. But, instead of learning from the past, banking regulators and other politicians from both parties veered off course and drove the economy into the ditch.
The backdrop for the 1998 hearings was a wave of massive consolidation of the banking industry and concern that systemic risk was being created by institutions that were“too big to fail”.
During the 1998 hearing John Hawke, then Under Secretary of the Treasury and soon to be Comptroller of the Currency until 2004 stated:
“… I would say that we have a lot to learn from the experience of the 1980’s, but I think principal among the things we have to learn is that you can’t deal effectively with an industry like the savings and loan industry when it is already insolvent.
That was the problem that Congress faced. The industry was insolvent by 1980, and we were all pretending that it wasn’t. We tried to deal with remedies that were intended to gamble on an insolvent industry pulling itself out of insolvency.
I think the congressional response in later years, putting emphasis on the maintenance of high levels of capital, putting emphasis on prompt corrective action and on better disclosure, is a marked change from what happened during the experience of the 1980’s.
When an industry or institution is insolvent, it is too late to try to bring remedies to bear, and regulation and supervision should be aimed at preventing insolvency and bringing market forces to bear, so that we are not dealing with institutions that have no net worth left. That was the problem of the 1980’s.”
Congresswoman Carolyn Maloney knew what to do with insolvent banks, i.e., shift losses to:
“…the person who is initiating the risk and make them realize they will have to pay for it…if you make a mistake, if you squander money, take all these outrageous risks, they…are going to have to pay for it, not the American taxpayer…”
Representative Joseph Kennedy understood systemic risks of putting together larger and larger institutions. Of course, the banking establishment considered Kennedy a lightweight intellectual populist who opposed financial innovation (like sub-prime mortgages and predatory lending). But, as it turns out Kennedy may have been the smartest guy in the room. In 1998 he said
“…Sometimes when I look at what has happened in the banking world in the last couple of months, I think that maybe the chairmen of these banks have just gotten a prescription for the Viagra pill. I think every time I turn around they are growing and growing, but I don’t know what is going to come of it.
Mega-merger mania is the new Beanie Baby of the American financial scene; everybody has got to have one, but at the end of the day they are not worth very much…”
Kennedy understood that bigger isn’t better and size isn’t the same thing as value.
The Late Congressman Bruce Vento agreed with Kennedy when he said:
“…I am concerned about mega-anything, especially mega-entities with deposit insurance backed by the taxpayer and an implicit moral hazard phenomenon that is assumed.”
But Congressman Maurice Hinchey voiced the most unsettling and predictive words of the 1998 hearings. He worried about Citigroup and its relative power and sheer size (at the time Citigroup had acquired Travelers Insurance and was trying to get Glass Steagall legislation revoked) when he stated:
“…the Citigroup companies are essentially playing a very expensive game of chicken with Congress…”
History repeats itself and Citigroup and other mega institutions are again playing chicken with Congress. Destruction of the U.S. economy is threatened if they are not bailed out.
Next week the United States will debate how to fix the banks. The nation will be given the false choice of either:
economic ruin; or
saving shareholders of failing banks through the formation of a “bad bank”.
The debate will employ politically-charged words like “nationalize” and “socialize” to describe what happens to banks that are actually “insolvent” and “failing”.
Institutions resisting seizure will imply that their companies have value which the Government wants to unfairly expropriate. Communist regimes and tin pan dictators “nationalize” profitable companies. But, the banks that are in trouble aren’t profitable and aren’t able to survive without government assistance. The companies at risk of seizure don’t have enough net worth to survive as going concerns.
Professor Nouriel Roubini and other non-establishment economists have been pushed aside as they plead with leaders to stop playing along with failing bank managements and face reality. But, as in 1980, regulators and political leaders don’t want to admit the obvious about insolvent institutions. Instead, just like in the 1980s they seem willing to bet that insolvent banks will somehow pull themselves out of trouble without going through the pain of resolution. It isn’t a bet that has worked in the past.
The “bad bank” that the Obama Administration is considering is a bad idea that perpetuates the fiction of solvency.
A good idea (and one that worked in the past) would be to form a “bad bank” that acquires bad assets from insolvent institutions following their seizure by the FDIC.
What is at stake is who benefits from the cleaning up of the banking sector, current shareholders or taxpayers?
It’s pretty clear that the members of the 1998 House Financial Services Committee would have voted that taxpayers should get the benefit from the bad bank clean-up, since the taxpayers accepted the risk and paid the cost.
It is a shame that each generation of banking regulators and political leadership has the opportunity to relearn the lessons of the past at the expense of the citizens of the United States. It would be better, and cheaper, if each generation simply studied the past and stopped rediscovering the obvious truth “that you can’t deal with an industry when it is already insolvent”.
I have been an outspoken critic of too much leverage in the financial system for the past several years. On CNBC and Fox Business Network I have spoken out against the dangers of bank and brokerage over leverage and suggested that such over leverage could cause a repeat of the Great Depression. Like a giant oil slick, the financial services sector of the United States has been an inch deep and a mile wide for years. Clips of some of those interviews can be found at http://www.firstcapital.com/financial_news.html. Regulators don’t seem to care about management strategies that have driven the economy into the ditch and shareholders don’t seem worried about managers that lack both common sense and basic financial training.
The events of the last 12 months have seemed so unbelievable to me that I have started to wonder if there are ANY minimum standards of knowledge and training to be the CEO or CFO of a global United States based financial institution.
Many jobs in the United States have minimum educational and training standards. Doctors attend medical school and get licensed. Lawyers are trained in law school and take the Bar Examination. Even the people that take care of our pets, fix toilettes and build our houses have standards that they must meet before they can hold themselves out as experts.
But, what about the executives of large banks and brokerages? What are their minimum educational or competency standards and do they meet such standards?
It turns out that pretty much the answer is CEOs and CFOs do not pass any examination, are not licensed and have no minimum educational standard. Who is qualified to be a bank CEO or CFO has been pretty much left up to the Board of Directors of each institution.
With no “national standard” for bank and brokerage CEOs and CFOs I decided that I would create my own standards and benchmarks for measuring competence. So, this blog is about the standards that I think should apply to the leaders of global financial institutions and whether or not CEOs/CFOs meet such standards.
Education. I think that educational standards fly in the face of this country’s “Horatio Alger” ethic and are “elitist”. After all, Abe Lincoln only had about 1 year of formal education and was perhaps the greatest President of the United States (http://showcase.netins.net/web/creative/lincoln/education/glance.htm). Lincoln probably could have run a bank or brokerage (after all he ran a civil war). Vincent McMahon, CEO of World Wrestling Entertainment, is able to run a large and successful corporation and he probably doesn’t have any formal educations (other than perhaps in pharmacology). If McMahon can run wresting he can run a bank. George Bush went to college (and graduate school) but pretends that he didn’t. President Bush runs a whole country!! And, Howard Hughes didn’t graduate from college even though he was pretty smart. I am certain Mr. Hughes could have been a banker in today’s environment.
And, since college isn’t required neither should knowledge of economics, finance, accounting or economic history. Nor will requirements include higher level math such as Algebra, calculus or statistics. CEO/CFO candidates shouldn’t be expected to master more than basic addition, subtraction, multiplication and division (with a calculator).
Work experience and/or apprenticeship requirements. Abe Lincoln didn’t have a lot of executive experience before being President, so neither should bank CEOs/CFOs. Hedge fund managers, i.e., the “Kings” of corporate finance, don’t need any prior experience (and many of them don’t have any). So why should a higher standard be imposed on CEOs/CFOs of global financial institutions?
Minimum reading and general knowledge and where to find it. There are some standards that I think should apply in terms of general knowledge and minimum reading material. However, given no real education, work experience or apprenticeship requirements, these standards need to be “reasonable”.
After rejecting the local public library as a source of reading material for high level financial executives (remember I want to have reasonable standards for our nation’s financial leaders and most books in the library have “big words”), I decided to go to Barnes and Noble. If it is important to know it is probably found in the extensive selection at Barnes and Noble.
In the business section of Barnes and Noble I found two business books that seem perfect. Neither book used big words or a required lot of math, and to understand them an advanced degree (like an Associate’s Degree from Palm Beach County Community College) wasn’t required.
The first book I chose, The Little Book of Value Investing is part of the “Little Book” series published by Wiley.
In the dust cover the publishers ask “Do you care about your money?” Well, bank and brokerage CEOs and CFOs are suppose to care about money. The publishers claim that that only an IQ of 125 is necessary to understand the book. In fact, The Little Book of Value Investing says that that any IQ greater than 125 is “wasted.” Well, an IQ requirement was a new concept but one that I decided is reasonable. But what “sealed the deal” for The Little Book was the fact that the publishers claim that the reader will “[learn] to put your money to work like a banker” (and since we are searching for proper standards of knowledge for bank CEOs and CFOs….). And, for readers that have trouble reading, there is an audio version of this book. Barnes and Noble features The Little Book of Value Investing on their web site at http://search.barnesandnoble.com/booksearch/results.asp?WRD=the+little+book+of+value+investing.
The second book, Value Investing for Dummies, is even more natural for money center bank CEOs/CFOs. Value Investing for Dummies claims to teach how to “detect hidden agendas in financial reports.”, “understand financial statements” and “assess a company’s value”. The book explains “fundamentals and intangibles”, has “tear-out cheat sheet(s)” and features “a dash of humor and fun”.
The Dummies series of books are well known reference books for discerning readers and learners. After all, the Dummies series has mastered such esoteric and difficult topics such as seasonal addictive disorders in their Seasonal Addictive Disorders for Dummies (a must read for all mental health professionals), the conundrum of the human genome in their groundbreaking Genetics for Dummies work (I understand it is required reading at most medical schools), the mystery of the 1980s personal computer in their newly revised DOS for Dummies (finally an easy to understand reference book for people with a computer phobia) and how to kill time while waiting in an airport in the seminal work Su Doku for Dummies (if only I had this on my last trip to Asia). The most authoritative list of Dummie books can be found on the Barnes and Noble web site at http://browse.barnesandnoble.com/browse/nav.asp?visgrp=nonfiction&n=1000005131&ne=1000005131&Ns=SERIES_NUMBER.
So, what about those minimum standards for the global financial leaders?
What should they know about leverage?
According to The Little Book of Value Investing quite a bit.
In the “Little Book” chapter titled “Sifting Out the Fool’s Gold” I learned
“The first and most toxic reason that [companies don’t do well] is too much debt. In good times, companies with decent cash flow may borrow large amount of money on the theory that if they continue to grow, they can meet the interest and principal payments in the future. Unfortunately, the future is unknowable, and companies with too much debt have a much smaller chance of surviving and economic downturn.”
The Little Book chapter titled “Give the Company a Physical” continues to teach and illuminate in terms that everyone can understand.
“Much as a doctor consults patients’ charts to see what condition they are in, look to the balance sheet to see what shape the company is in. The doctor needs to know all the vital signs to make a diagnosis. A balance sheet is effectively a company’s medical chart….”
Readers are told that they
“….want to make sure that the company is not overly burdened with debt, and that there is enough capital to stay in business during bad times.”
Leverage trends are identified as important in the Little Book when it continues to state
“…it is useful to observe trends over the past few years. Are liabilities growing faster than assets? This could be an indication that the company has to borrow more and more money just to stay afloat…”
However, Mr. Browne (the author of the Little Book) appears to be a purest (which is perhaps a controversial position) when he states that he
“…prefer(s) to subtract intangible assets from [equity]” when calculating the amount of debt to equity because equity less intangibles gives him “…a better picture of how much actual equity there is in a company that could potentially be realized if needed.”
The Little Book of Value Investing continues to warn
“In general a high debt-to-equity ratio means that a company has been financing its growth by borrowing. Leveraging the company by increasing debt levels is a double-edged sword….there is a real danger of default and bankruptcy down the road. The less debt on the balance sheet, the grater the margin of safety.”
In conclusion the Little Book points out
“A strong balance sheet is a good indicator of a company’s stamina, its ability to survive when the going gets tough.”
Value Investing for Dummies has similar lessons for CEOs/CFOs when in “Fundamentals for Fundamentalists” it asks and answers the “age old” question of “How much [debt] is too much?”
“[The] excessive use of debt signals potential danger if things don’t turn out the way a company expects them to. Leverage is a good thing when things are going a company’s way. Debt financing can be used to produce more ….profit and, in the end, a bigger business….But as everyone knows, this can work the other way….Industry standards and common sense apply to debt-to equity ratios.?”
Later in Value Investing for Dummies the reader is again warned that
“Financial leverage can be a good thing – to a point, and as long as things are going well.”
So, how do the CEOs/CFOs some leading banks and brokerage firms stand up the standard of knowing and applying the information found in The Little Book of Value Investing and Value Investing for Dummies?
Let’s start with the management team from Bear Stearns. As it turns out, when it failed Bear Stearns had the highest debt levels of any of the major brokerage firms. At 33.53 to 1 at the end of 2007 Bear Stearns was massively overleveraged and apparently didn’t understand that with so much debt “there [was] a real danger of default and bankruptcy down the road.” (from The Little book of Value Investing). And the trends for the past 5 years of leverage were bad. Management didn’t realize that they were increasing the risk of a failure and up until the very end had little idea of the trouble that they were in. Moreover, common sense would suggest that when the company was “burning down” playing tournament bridge probably wasn’t the best crises management strategy. Clearly, the management team at Bear Stearns needed to spend some time at Barnes and Noble honing their skills and as a result failed the competency test (not a big surprise).
The Lehman Brothers team in place during 2007 also failed the competency test. With leverage at approximately 30.70 to 1 (and having added material amounts of additional leverage during 2005, 2006 and 2007) they only seem to have a marginally better understanding about risk and leverage than the Bear Stearns team (maybe that is why Lehman Brothers almost failed like Bear Stearns). However, Lehman’s new CFO Erin Callan seems to pass the competency test. Since she took over as CFO the firm has been reducing its debt burden while at the same time increasing its equity and improving its “Net Leverage” ratio by almost 25%. By the way, Erin understands that when calculating Net Leverage she is supposed to deduct goodwill and other intangibles from equity as suggested by The Little Book. Erin appears to be the star of the Lehman Brothers executive suit.
At Citigoup the team headed up by Chuck Prince clearly didn’t know what was in either the Dummie or the Little Book series and were appropriately terminated. However, the new team lead by Vikram Pandit seems to have the “right stuff.” He is raising capital and reducing debt as fast as humanly possible. I guess his team has been hanging out at the Starbuck’s in his neighborhood Barnes and Noble.
What about First Capital? First Capital operates at a Net Leverage Ratio of about 3 to 1 (which is about 1/10th of Lehman Brothers’ ratio after Ms. Callan began to perform her magic and 1/15th of Citigroup’s Net Leverage Ratio at December 31, 2007). We didn’t increase our leverage over the last 5 years and are careful to manage both debt and equity to maintain what is considered to be a “fortress” balance sheet. I guess we pass the leverage competence test.
In future blogs I will discuss additional CEO/CFO competency tests using criteria found in The Little Book of Value Investing and Value Investing for Dummies. I am confident that First Capital will continue to pass the test but less confident about others.