The recession and credit crunch have shifted financial risk from banks to small and midsized businesses (SME) that often must extend credit to customers to make a sale. When companies extend credit, in effect making unsecured loans, they’re acting like banks but without the credit management tools and experience of a banker.
Credit Redi is designed for small businesses to quickly spot customer credit risk. Small businesses typically don’t have access to information that provides transparency about customer credit worthiness. Credit Redi is a credit risk management tool for small and mid-sized businesses. It only takes one or two bad receivables to damage an SME’s financial health. Market conditions quickly change and its critical to have some type of business insight into the businesses SME’s work with.
Credit Redi is also an excellent tool to determine the financial health of critical suppliers. A key supplier going out of business could have disastrous consequences for SMEs. Credit Redi monitors the financial health of existing suppliers and help managers make wiser choices in supply chain and business partner decisions.
Risk: SME, credit risk, supply chain, partnerships, customers, receivables
…“the “money-management business” (with its plethora of mutual funds, investment counseling firms, and hedge funds) has so many practitioners who’ve grown up in an era where it’s all been about marketing and not risk management,…” “If 2004 goes bad, it will go really bad “ Bill Fleckenstein Contrarian Chronicle
This candid remark is an astonishing observation. The assertion that money management is more about marketing then risk management is a bit disconcerting. The most recent Security Exchange Commission’s (SEC) announcement concerning its investigations of brokerage firms for receiving commission payment premium’s by asset management firms for directing investors into purchases of preferred mutual funds is the latest example of how this statement is a tragic reality for investment product consumers.
We live in the era of radical capitalism. It is characterized by fierce political pronouncements of the sanctity of laissez-faire principles and the ultra aggressive pursuit of free markets, resulting in the increased rationalization of the market mechanism into our culture and daily lives. For many readers this statement is not surprising or profound. Marketing is king, and if you have any doubts about it, try locating a music station in New York City that is not wed to a Top 40 play list or Talk Radio format.
However, as this Milton Friedman vision of utopia continues its inexorable march of rationalization, a strange alchemy is taking place. As businesses damn the torpedoes to pursue markets, ethical business practices and sound corporate governance principles are being sacrificed at the alter of EBITDA, ROE, P/E’s and the Holy of Holies those sacred stock options. The ironic twist to all this is that these aggressive business practices defended on the grounds that they enhance shareholders value are actually seriously eroding the values of brands, profit margins and market capitalizations. Ask a shareholder of Enron, Parmalat or WorldCom about the clever corporate stewardship of these company’s former management teams and you’ll get a resounding thumbs down.
But there is something deeper going on here. When investors entrust their money to an investment manager, they may be attracted to the sizzle (remember past performance is not indicative of anything) but what they want is still the steak. Investors want an investment manager that can understand their investment goals and risk tolerance and provide them with an investment vehicle that can balance that risk tolerance with the capability of realizing an expected return. The act of giving a manager discretionary power over an individuals retirement fund, a union’s pension portfolio, a family office or child’s educational financing vehicle is a tremendous act of faith that requires an extraordinary degree of confidence in the manager’s ability to provide an acceptable return, but to also be a trusted fiduciary that has the requisite operational support and controls in place that will safeguard and honestly seek to grow and protect an investors capital.
Mr. Fleckenstein’s assertion that risk management has taken a back seat to marketing and product placement is unfortunately an accurate assertion. The financial services industry is unique in the sense that it is the loam of all capitalist constructs. Yet as a business, financial services companies are no different from any other economic enterprise. All companies create products and differentiate themselves through the value proposition incorporated into their product. Intrinsic to the product creation process is a determination of the type of materials that will form its composition. A conscious decision is made as to how the product will be positioned and marketed, its performance metrics determined, customer service resources required to support the product as consumers use it and how it will be distributed. Once those variables have been determined, a profit margin is added and a value proposition to potential customers is conveyed. The value proposition that is communicated to consumers comes to be known and identified as the product brand. An investment product is designed to essentially address current and future financing requirements and the risk profile of the consumer are central to the design and purpose of the product. That is why this bifurcation is so dangerous. It undermines the inherent purpose of the investment product and should more truthfully be marketed as a product that enriches the commission merchant that may over a specified period of time garner a return for the investor. Think about all the Enron employees who had their 401k’s invested entirely in Enron stock.
This is probably the most significant point and primal differentiator of companies that manufacture financial products with that of companies that manufacture consumer durables. Financial products facilitate the flow of capital through the markets. It feeds the invisible hand that guides and directs all economic activity. If the flow of financial products is impeded, or abates due to consumers lack of confidence, a consumer driven economy like that of the United States will suffer greatly. Foreign governments and institutions buy US Government bills, bonds and notes because of the well-earned confidence they have in Uncle Sam’s stable currency and it’s ability to pay it’s debt and provide a fair return to all note holders. However if that confidence goes away, Uncle Sam will have to curtail its deficit spending, raise taxes on its people and enter into other messy measures to remain economically viable. Confidence is a lovely thing both for nations and companies and once that confidence is lost it is a difficult, if not an impossible thing to regain. Confidence is the basis of risk management. Credit risk and rates of return, the key variables of risk management, all start with the certainty of confidence.
Yes, from an investment performance point of view 2003 was a terrific year. All major equity indices were up. Thanks in large part to a federal tax rebate program the US economy grew by 8% during the 3rd quarter, prompting Mr. Greenspan to proclaim with a certain degree of confidence that the recession had ended. Yet from corporate governance, business confidence point of view, 2003 business news makes the turn of the century robber barons look like acolytes of Mother Teresa. To restore confidence investment managers need to develop a Sound Practice program that will repair the breech and bridge the bifurcation of marketing and risk management within the investment management enterprise. Lets turn our focus on how and why this bifurcation must be bridged.
Sound Practices Builds Confidence
The explosive growth of the global hedge fund industry and the important role it plays in providing market liquidity and as an alternative asset class for high net worth investors and institutions is increasingly placing the industry in the global spotlight and many regulators, interest groups and institutional consumers are demanding greater transparency and advocating increased oversight and government regulation.
The Long Term Capital Management debacle, George Soros’s unilateral assault on and profitable dismantling of the Pre-Euro Exchange Rate Mechanism, numerous hedge fund blow-ups through poor management controls or outright fraud, and the most recent disclosure of the widespread collusion of hedge fund arbitrageurs and mutual fund managers to conduct market timing trading, is seriously eroding investor confidence in financial institutions. This is creating a political climate favorable to enhanced regulation and oversight of financial institutions. The recent investigative actions of New York State Attorney General Elliot Spitzer, and the appointment of William H. Donaldson to head the SEC are clearly political responses to the crisis in corporate governance and regulatory malfeasance.
At last count, there are approximately 20,000 companies engaged in investment management within the United States. Some investment companies are regulated by the SEC, some by the Commodities Futures Trading Commission (CFTC), some by the National Association of Securities Dealers (NASD), some conform to best practices required by custodial counter-parties, and some are guided solely by the good conscience of the fund manager.
In this rapidly expanding market, managers are seeking to differentiate themselves and attract investors assets through slick marketing campaigns, presentations, road shows, and shameless boasts about a mangers progeny, experience and past performance. Attestations of operational readiness and management’s commitment to ethical corporate governance is usually covered with a statement that lists the prime broker, the accounting firm for auditing and the administrator for transfer agency and shareholder communications. The manager believes that by listing the service providers (corporate brands) they convey a message to the investor that they are operationally sound and have the operational controls in place to satisfy all contingencies. Unfortunately, these service providers are retained for a very specific purpose and taken in aggregate do not amount to the implementation of a unified sound risk management program. Indeed, Arthur Anderson was a leading provider of services to the alternative investment management market and reliance on this brand to infer regulatory compliance or adherence to sound operational practices was clearly a miscalculation.
In the day-to-day operation of the business the tension between regulatory compliance and entrepreneurial zeal is usually resolved in favor of doing the transaction. When we asked an executing broker working a large sale transaction for a first time hedge fund customer if the hedge fund identity had been properly documented and verified in conformance with the rules of the USA PATRIOT Act he stated, “They’ll never answer these questions and if we ask they’ll simply go to another broker to work the order. We’ll take the hit to do the deal.” Yes this broker made a calculated decision based on the potential that the hedge fund was not entering into this transaction to launder money through the capital market system or was a front for terrorist financing. He was probably right, and earned his firm a nice commission for working the 100,000-share block at $.05 per share. But what if he was wrong? Was the premium commission rate a fair return for a ruined reputation, a million dollar fine, the revocation of your industry license, a lifelong ban from the industry, or even a prison sentence?
What are Sound Practices?
Sound Practices are a set of standards and operational controls that mitigate numerous risk factors in the investment management enterprise. Sound Practices address the investment process, its decision and operational support functions, capital introduction, compliance requirements, business continuity, fund strategies and investor communications within a set of defined expense ratios.
What’s the difference between Sound Practices and Regulatory Compliance?
If we accept the definition that compliance is a set of externally imposed rules required to insure that counter-parties of a transaction and the rules governing the transaction meet acceptable minimum standards to facilitate an ethical and efficient exchange of value; I think we come pretty close to the meaning and nature of compliance and the purpose of the functions required to support it.
In the United States, depending upon the type of products a financial services firm offers, there may be or may not be a governmental agency or Special Regulatory Organization (SRO) that is charged with compliance oversight and enforcement of its business practices. The Office of the Comptroller of the Currency (OCC) is charged with the responsibility to oversee compliance with regulatory statutes for savings and loans, thrifts and banks. For broker/dealers the NASD is the SRO oversight body. For mutual fund companies and publicly listed companies, the SEC is the regulator. Future Commission Merchants are regulated by the CFTC; and hedge funds, -sometimes referred to as an Unregistered Investment Company (UIC)- at present escape any formalized regulatory oversight body.
Each regulatory body has its own set of compliance rules, guidelines and enforcement mandates. One can imagine the overlap and confusion that occurs when a bank owns a broker dealer, which owns an asset management firm, that offers mutual funds and off shore hedge fund products to institutional, retail and high net worth investors. The maze of regulators and the differing and sometimes contradictory regulatory requirements creates a reactionary and possibly antagonistic response to regulatory examinations and demands. At the very least, compliance is a significant cost of doing business and adds little to the intrinsic value of the product offered by the institution. The added expense of compliance deals with the structural aspects of the market, not the intrinsic value of the product. This is a dangerous bifurcation in its own right. A financial product, (specie for the capital markets) requires a denigration of value to assure a controlled velocity through a regulated market structure.
For companies that view regulatory compliance as a necessary evil that tempers entrepreneurial pursuits and whose function is an added cost of doing business; these organizations will develop a best practice culture that is inherently restrictive. This type of corporate response to regulatory or best practices initiatives will always be overwhelmingly reactive and places the enterprise at great operational and regulatory risk.
Sound Practices are different. Sound practices are a set of internally (organically) developed operating principles that inform the values of ethical corporate governance, is enforced by internal management and seeks to become invisible as it ingrains itself into the operational and business culture of the firm. Sound practices must be viewed as fundamental to a firm’s value proposition, organically grown and endemic to the corporate culture and proactively conveyed to the market as a premium brand.
The internal development or organic growth of best practices as a central desire and objective of the corporate enterprise is revealed as central to product brand and the value proposition offered in the market. This positions the firm and its products as a premium brand. The business benefits of a sound practice program are enhanced margins, product performance and the attraction of quality clients and vendor relationships. More importantly it differentiates the firm in a crowded market because its quality brand is perceived by the market as endemic to the firm’s corporate culture and as such is inherently superior to something that is externally imposed by some governmental or regulatory body. On a macro-economic level the socialist or state capitalist experiments in highly regulated planned economies are the logical extreme and true antithesis of a sound practice culture.
Within the hedge fund industry in the United States the concept of Sound Practices first surfaced in an industry study entitled Sound Practices for Hedge Funds. The study was an industry response to the Clinton Administration’s request to examine the lessons learned from the Long Term Capital Management implosion and recommend basic guidelines to avoid similar disastrous occurrences in the future. The paper was a breakthrough on a number of fronts, placing the science of risk management and the utilization of risk measurement tools at the center of the investment management enterprise. Though the study was a political response to a catastrophic market event, the real purpose of the study was to temper the drive to regulate the hedge fund industry. In essence, the authors of the study asserted that regulatory oversight is not needed if hedge funds implement and maintain a sound practices program. Sound practices will allow investment companies to remain unregulated and will assure that the industry is fully capable of self-policing through the creation of practice standards. Indeed, any regulation or governmental oversight will further drive the industry offshore to more discreet and tax friendly domiciles and could potentially drain capital and liquidity from the US capital markets.
Operational Risk Mitigation
As previously stated, developing and adhering to a set of best practices principals and guidelines will add intrinsic value to product and corporate brand. The purveyors of Business Performance Management (BPM) solutions routinely boast the claim that publicly listed companies that practice BPM have P/E ratios that trade at a 15% premium to industry peers who have not implemented a BPM strategy. The question whether BPM is a silver bullet to enhance market value or whether BPM practitioners are leading companies dedicated to implementing programs and mechanisms to build shareholder value are irrelevant. What is important is that BPM practitioners are implementing processes and tools to understand and isolate operational risk to create product delivery and decision support mechanisms that build intrinsic product and corporate brand value. Thus at its heart, BPM practitioners seek to heal the bifurcation of marketing and operational risk management and firmly establish and display the synthesis as central to the value proposition a company delivers to its clients.
Operational risk factors in the investment management complex are numerous. They include valuation practices, system infrastructure, business continuity contingencies, vendor and service provider dependencies, risk management tools, risk management function segregation and asset gathering or capital introduction and investment acceptance principles. All of these risk factors are significant and each one on its own could threaten the ongoing viability of the enterprise. Each risk factor must be addressed in detail with a comprehensive programmatic approach to develop and implement processes and controls to enhance best practices to support the function and mitigate the risk factor associated with the business process. The Basel Capital Accord (Basel ll) proposes the introduction of a capital charge related to the operational risks of financial institutions. Basel II defines operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.”
As an example, poor record keeping or an honest miscalculation on a corporate action treatment or security valuation can be forgiven. After all, the restatement of earnings -even during the Sarbanes Oxley Era- in corporate America is common. Laundering money for criminal enterprises, or heaven forbid, financing terrorism goes way past lax controls. In the eyes of the law it is criminal, in the eye’s of regulatory authorities it’s a serious offence, and a heavy fine and asset forfeiture is possible. If this occurs, in the mind of the consumer the fund manager is guilty of two counts of treason. The first count of treason the fund manger is guilty of is against his country. The second count the fund manager is guilty of is the betrayal of a sacred fiduciary duty. A hedge fund manager would probably never recover from this type of avoidable catastrophic risk event.
Fund managers need not look at compliance with the USA Patriot Act as another cumbersome compliance requirement that will be expensive to address. The belief that compliance will antagonize or annoy potential clients and may in fact drive them to a competitor whose controls are not as stringent and whose compliance laxity facilitates transactions by making it easier for investors to place assets with the competitor may hold some truth. But shouldn’t a fund manager avoid those types of clients anyway?
Compliance with The USA Patriot Act requires that investment companies conduct due diligence and maintain and administer a Customer Identification Program (CIP). Investment companies should view compliance with the Act as an opportunity to develop a Know Your Customer (KYC) capability that enhances and enriches the client relationship with the firm. When fund managers make KYC the cornerstone of their product development initiatives marketing will then truly serve the risk management requirements of clients.
The process of conducting the KYC due diligence exercise results in a more in-depth understanding of the customer. As managers are verifying customer identification information they will routinely uncover residential, employment and family histories that give them a better perspective on the client’s needs, their appetite for risk, other fiduciary relationships the client has and the source of the clients wealth. The regulatory objective of the KYC process is to verify the clients identity and to make sure they are not a money launderer or terrorist. The sound practice objective of the KYC process is to cover the regulatory requirements and more importantly to gain insights and understandings into their personal and business motivations. Armed with this understanding the manager can design or offer an investment product that will address the client’s risk management requirement. Client’s will appreciate the fact that managers are conducting this due diligence to insure that their funds will not be commingled with money launderers or terrorists, and that the firm is taking appropriate steps to insure that they transact business with reputable clients whose ethical and moral standards are similar to their own high standards.
As clients experience the KYC discovery process, they will begin to understand that the firm is committed to delivering a qualitatively superior value proposition. The client experience will help them to understand that the marketing focus of the firm is to acquire trusted customers and the depth and quality of client relationships are established to understand client needs and requirements. The client will also gain the assurance that regulatory risk and the potential for large fines and asset forfeitures are minimized due to the care the firm has exercised in determining that its clients are the right type of clientele and that the firm’s management has created operational controls and processes to prevent the risk of money laundering within the investment management enterprise.
Furthermore, subscription and redemption releases are facilitated due to proper controls in place with administrators and custodial institutions. This places enhanced liquidity at a fund manager’s disposal allowing the manager to practice effective cash management techniques that position the manager to take advantage of investment opportunities that may arise. This raises the possibility of developing a more effective collateral management capability that will tighten spreads on haircuts and dramatically reduce financing expenses. The credit rating of the firm would improve allowing lenders to further reduce financing rates to capture the funds business in a competitive credit and financing market. The reduction in the cost of capital can dramatically affect investment performance and the marketers can truly boast of a source of alpha that is directly attributable to operational sound practice processes.
Having proper procedures and business processes in place with administrators and custodian institutions will also facilitate the transfer of shareholder data to accountants for tax and audit purposes. This will expedite the delivery of tax and performance information to shareholders, generating savings in preparation fees and lessening the possibility of costly restatements. This will reduce and maintain fund expense ratios to absolute minimums. Marketers can clearly demonstrate that the fund managers are good stewards and are as concerned with minimization of business expenses as well as investment performance and high watermarks.
Increased transparency and the opportunity to dramatically enhance shareholder communications and reporting will be a strong attraction to many investors. Indeed, many institutional investors demand a level of transparency, communication protocols, and reporting tools that would have been unthinkable only a short while ago. As sophisticated institutional participation grows within the industry, the implementation of a sound practice program will be the only way hedge fund products can incorporate the necessary value proposition that addresses their risk management profiles and requirements. Sound practices and the compliance function become significant differentiators and powerful marketing tools. At last, the bifurcation is healed.
James Wolfensohn, President of the World Bank has been quoted as saying, “Corporate governance is about promoting corporate fairness, transparency and accountability.” Sound Practices is a necessary prerequisite for effective and ethical corporate governance. Fund managers must accept it’s precepts and sell side institutions and other industry participants and service providers must demand compliance, disclosure, ethical trading principals, honest research, operational integrity and a full commitment to its implementation and adherence. Effective corporate governance practices will restore the faith of the investing public in the global financial services industry and maintain the rationality of the world’s capital markets. It will also please investors to see realized enhanced returns on investment portfolios and help fund managers to fully participate and enjoy the benefits of a thriving hedge fund practice.
Originally written January 5, 2004, the article is significant because it raises concerns about financial services product marketing practices that still need to be addressed six and half years later.
You Tube Music Video: Mike Oldfield, Tubular Bells
Risk: regulatory, consumer confidence, sound practices
Today is Yom Kippur. It is the Day of Atonement. The Jewish faith marks this day each year as a day to reflect on our sins and shortcomings we have committed during the past year. It is a day of personal assessment. Calling all to examine how we have failed to live a life in conformance to our highest aspirations and ideals. It is customary to recite an Al-Chet confession prayer. The Al-Chet is a confession of a persons past year sinful behavior. It is hoped that this admission of sin leads to reconciliation with the aggrieved and an awareness that helps to establish a pattern of improved behavior in the future.
It is good that we commemorate such a day and use it to a constructive purpose. After all, how many among us are without sin? How many of us have achieved a level of perfection that obviates the need to reflect on how we can improve and make amends to those we may have hurt? To be sure, even the best among us have fallen short of the glory of God. The divine Higher Power that keeps mere mortals rightsized and humble when our egos and perception of ourselves grows too large and burdensome. The need to keep a strong self will from running riot is critical. It is particularly dangerous when a person or corporation is unaware and ambivalent to the collateral damage its actions spawn through the naked pursuit of self interest and ambition. In a sense, God is the ultimate celestial Chief Risk Officer that keeps wanton will in check.
The Day of Atonement is an important day because it is a day of transformation. It calls for self examination and transformation. Once we have learned the nature and extent of how our actions and inaction have negatively impacted ourselves and others, we are called to make amends to set things right. It is a day that requires considered action to improve ourselves so we can become a positive force for change in the world.
Considering the year that just transpired in the financial services industry, I wonder what an Al-Chet confession for risk managers would include. We need a strong dose of atonement so we don’t repeat the egregious mistakes we committed last year.
An Al-Chet for Risk Managers:
I was not strong enough to stand up to my boss
I put selfish gain ahead of ethical considerations
I falsified or hid data to conceal results
I failed to be objective
My risk model was too subjective
I ignored warning signs
I was in over my head
I did not understand all the risk factors
I failed to get an outside opinion
I was beholden to monetary gain
I was victim to group think
I placed institutional interest ahead of ethical considerations
I failed to admit I was wrong
I was not honest with regulators
I was not honest with shareholders
I looked the other way
I failed to act
I conveniently overlooked infractions / irregularities
I made exemptions
I did not understand the depth of the problem
I know there are many more.
Please help me to uncover, understand make right and overcome.
You Tube Music Video: Aretha Franklin, I Say a Little Prayer
Risk: compliance, reputation, catastrophic risk, moral hazards
Bankers are catching some major heat. Senators are screaming at the money lenders in an effort to have them explain what the banks did with the $350bn they gave them in the first round of TARP funding. Now that the second $350bn tranche of TARP funds is about to be dispersed, the politicians want assurances that a good portion of the money will find its way into the economy in loans to small & mid-sized enterprises (SME). All believe that this is critical to halt the specter of the deepening recession.
If it wasn’t so serious it would be funny. Banks are getting yelled at by the politicians for not lending. Angry constituents are beating up the politicians for giving the banks the bailout money in the the first place. They complain that the Treasury Department is giving banks taxpayer funds at a 1% interest rate that banks in turn lend back to taxpayers at interests rates that are considerably higher. To close this circle of pain, consumers are getting nasty calls from their bankers and debt collection agencies, threatening them with punitive actions if they don’t pay their mortgages and outstanding credit card balances. Everyone is a debtor in this comedic cycle of pain.
Now that banks are flush with cash from the second round of TARP funding they must start lending and SMEs need to start borrowing. Its that simple. What is not simple is breaking the stalemate of confidence that exists between lenders and borrowers. Risk aversion is extremely high. Banks are very concerned about adding credit risk exposures to commercial loan portfolios. A recession creates enormous market challenges for SMEs. Bankers need to develop an enhanced sense of confidence in the management and business prospects of an SME before it will extend credit.
Both lenders and borrowers can come together in a shared understanding if they are willing to engage in the deeper work that is required by the new business realities. SME managers must be aware of the business and risk management practices that bankers generally look for when assessing credit worthiness. SMEs must be able to demonstrate to lenders that they are committed to sound risk management and corporate governance practices. SMEs must also be prepared to meet transparency requirements of banks with honest and timely disclosures.
Bankers actively seek SMEs that are run by focused and capable managers. SMEs that can demonstrate effective risk management skills and an awareness of the challenges and opportunities present in their market will find that bankers are more then willing to extend new credit facilities to them. Bankers will have greater confidence in these SMEs if they understand and believe in the SME business model. Bankers lend with confidence when they understand how businesses can generate sufficient cash flow and profits to pay back loans. Bankers need confidence that credit risk is being mitigated. SMEs enhance banker confidence that they are a good credit risk by demonstrating a strong risk management and corporate governance culture.
Fortunately there is tool that bankers and SMEs use to build mutual understanding and trust. The Profit|Optimizer helps to generate the confidence needed to help banks lend capital and SME to effectively deploy it.
Get the Profit|Optimizer and confidently be a lender, be a borrower and break the cycle of pain to get our economy going again.
You Tube Video: Liza Minnelli, Joel Grey Cabaret, Money
Risk: credit, market, small business
President Obama’s announcement that he intends to limit compensation for CEO’s of banks that accept TARP funds is only the tip of the iceberg. This one gives real meaning to the concept of Good Bank/Bad Bank and it could get ugly. As the government led economic recovery plan is implemented the banking system will still require massive capital infusions to maintain solvency. This will usher in far reaching structural and systemic changes in the banking system and capital market industries. Executive compensation is but a minor issue.
These structural changes risk creating a bifurcated banking system. The Bad Bank, so designated because it was placed into a timeout with a capital infusion by a benevolent state agency will be forced to change the banks demeanor and the manner in which it conducts business. These Bad Banks will become wards of a state intent on controlling behaviors by minimizing the risk posture these types of institutions can assume. Good Banks, so named because they remain above the need to accept the federal largess of TARP funds, will be free to conduct business without the additional cumbersome oversight of regulatory agencies.
What will the topology of a bifurcated banking system look like? A model that one may consider could be found in the People’s Republic of China where state controlled banking enterprises conduct business alongside emerging private sector banks that are mostly agencies of large global investment banks. In the US the history may be reversed; but the full or partial nationalization of weak banks will create a new institutional hybrid that will need to function under different ground rules then those imposed on fully privatized domestic banks.
The Bad Banks will become quasi-state run enterprises. Their business model and charter will be highly risk adverse forcing them to focus on mortgage related and low margin retail transactional type business. These banks will be required to maintain expensive brick and mortar branch networks to make sure that all sectors of society have access to the financial system. This might actually provide a growth opportunity for these types of banks because the “unbanked sector” of the economy remains large. A large and vibrant money services business (MSB) industry has flourished and thrived to serve the unbanked sector. The unbanked sector purchases banking services and it represents a significant expense burden on the underclasses and working poor who don’t have checking or savings accounts. Bringing this sector into the state banking system would also help to combat money laundering and the loss of tax revenues of cash based businesses. The sale of money orders, money transfer services and the sale of savings bonds and other fungible certificates will become a source of revenue dedicated to paying down the TARP debt.
The Bad Banks will not just become glorified MSBs. Bad Banks will need to focus on the stressed mortgage and credit card debt markets. These customer facing retail lines of business will offer a full line of workout resources to stave off the rate of home foreclosures and credit card delinquencies.
The Bad Banks will be capitalized with the Level III toxic assets that Hank Paulson so shrewdly purchased from the large investment banking institutions. The Treasury Department can dispense with FASB valuation rules and use these assets to value the collateral to maintain sufficient levels of capitalization in line with Basel II recommendations. Smoke and mirrors perhaps; but backed by the full faith and credit worthiness of the US government who can argue?
Equity shareholders in the Bad Banks can expect to see their shares underperform the market and its Good Bank peers. A balance sheet loaded with questionable asset quality, high debt to equity ratios, low margin businesses and high overhead due to excessive fixed costs all conspire against the Bad Banks shareholders potential of realizing a handsome return on their investment.
The Good Banks, liberated from the tyranny of balance sheets polluted with toxic assets and freed from the need of additional rounds of TARP funding will be energized with new entrepreneurial zeal. They will be free to ply their trade as evangelists of free market laissez faire capitalism. The Good Banks will be unencumbered by any new regulations federal agencies impose on the TARP dependent Bad Banks.
Unfettered from bureaucratic control, the Good Banks will be able to fulfill their mission of maximizing value for their shareholders. The risk profile of the Good Banks will be considerably different from that of the Bad Banks. The focus of their business will be on marketing higher margin and more risky financial products. They will offer investment banking and other transactional services and will command fees on scales radically different from the Bad Banks collecting two bits for each money order sold. The Good Banks will offer a full array of investment products and transactional services. Hedge funds, brokerage transactions and a full range wealth management services will be part of the product portfolios of Good Banks.
The Good Banks blessed with healthy balance sheets and strong cash flows from steady product sales into high net worth market segments will embark on aggressive acquisition programs of financial service providers. Healthy regional and community banks will be purchased on the cheap with the blessing of the acquired company’s shareholders who want to be freed from the tyranny of state control and TARP dependency. Good Banks will be the preferred bank for a vibrant and growing small business market and will command healthy fee income and sit on generous account balances this type of business provides. If a small business or retail customer account underperforms or becomes delinquent the account will be banished to the workout professionals eagerly waiting in the Bad Bank.
The Good Banks will be more like a giant private equity firm holding a vast portfolio of public financial companies and services providers. Good Banks will be nimble and voracious practitioners of free market capitalism. The accouterments of affluence like generous stock options, corporate jets, exotic junkets, splashy corporate parties will be in full swing. Larry Kudlow should have nothing to worry about. Free market capitalism as the only sure road to wealth and freedom will remain open to anyone as long as they have the means to pay the modest toll.
You Tube Video: Ennio Morricone, The Good the Bad and the Ugly
Risk: systemic, banking, market
Obama wants Congress to authorize the release of the second $350 Bn in TARP money authorized under EESA. Apparently he has called his good buddy Bush and asked if he would be kind enough to pull the trigger and release the funds. Perhaps Obama is concerned about the ability of Citicorp to make good on its separation agreement for his key adviser Robert Rubin?
When Paulson envisioned the TARP, I guess they figured that if they just threw a TARP (Troubled Asset Relief Program) of money over the banking problem everybody would forget that our banking system is broken. I believe this a a kind of ostrich strategy. Just suggest to all American taxpayers that all they have to do is stick their heads in the sand and pretend that the TARP money is saving our crashing banking system. All should be oakie dokie.
During the holidays I welcomed a little respite from the real time news feeds of the capital market carnage that the credit crisis has wrought. The daily bulletins that our investment portfolios and 401K’s are worthless and that our home equity nest egg is gone with the wind seemed to have abated. But now that the holidays are over the sad news concerning our nations economic health is starting to trickle in again. Today two little news items came across our desk arousing our curiosity about the $350 Bn Paulson, Kashkari and the rest of the crew at the Treasury Department has been throwing at US banks and bank wannabe’s.
The first item elevated my comfort level a couple of notches. The FDIC is requesting that banks receiving TARP program monies need to improve reporting on how the provision of credit products and lending is being enhanced through the participation in the program. WOW what a thought. The Treasury Department dolls out $350 Bn and as an after thought is now setting reporting requirements as to how the taxpayers capital is being used for lending to restore the economic vibrancy of the stalled economy.
If taxpayers and politicians remain unsure as to how the TARP monies are being put to good use by the banks one doesn’t have to look further then the news items concerning Morgan Stanley’s interest in purchasing Citibank’s investment banking arm. Citibank owner of the remaining vestiges of Salomon Brothers and Smith Barney have been under investor pressure for years to divest its brokerage divisions. The transformation of the banking industry as a result of the credit crisis will accomplish this feat. Citibank continues to require major capital infusions. So far, Citibank has received almost $45 Bn in TARP and federal assistance monies. It still requires substantial capital to remain solvent, Mr. Rubin’s separation package notwithstanding. Morgan Stanley flush with at least $10 Bn in TARP money will put it to good use by acquiring Citi’s brokerage unit on the cheap. This asset for cash swap exchange is a telling example as to how TARP funds are being deployed by its recipients.
I can’t believe that many American taxpayers are feeling too good about their money being used to enrich the shareholders of Morgan Stanley and to protect the threatened equity capital of our countries once largest banking institution. In a capitalist economy you need institutions that are allowed to fail. If capitalists are protected from the possibility of failure they can’t be rightfully called a capitalist. Given all that the capitalists have been through with the credit crisis, recession and bank failures; we cannot allow our financiers to experience an identity crisis as well. That would be cruel.
You Tube Video: Grateful Dead, US Blues
Risk: banks, market, credit
During the last Great Market Crash it was said that you needed to take extra care as you made your way through the canyons of Wall Street. Apparently legions of bankrupt investors and brokers were jumping out of the windows from the precarious ledges of their skyscraper offices many stories above street level. I don’t believe that an instance of leaping from a building to commit suicide over failed investments was ever verified during the last Great Crash. Though I am certain that some did close out their positions with dramatic finality of self liquidation, the documentation on jumping is slim.
Yesterdays news on the self inflicted death of Adolph Merckle follows close on the heals of last months suicide of Rene-Thierry Magon de la Villehuchet. Mr. Merckle apparently amassed a large short position in the German auto manufacturer Volkswagen. He was engaged in a form of takeover arbitrage pitting his investment prowess against the elite German auto manufacturer Porsche. He was confident that the fortunes of the depressed industry segment would deteriorate dragging Volkswagen down with it. Porsche’s interest in Volkswagen buttressed its equity value in the face of the market meltdown. This generated a loss of over 400 Mn euro’s for Mr. Merckle. He decided to walk into the front of a train near his home to close out his position in life.
If the high profile deaths of Mr. Merckle and Rene-Thierry cast an added depressive pall to the market crash, the disappearance of Sonja Kohn adds an element of intrigue and danger. Mrs. Kohn has dropped out of sight, leaving the firm she founded, Bank Medici, in the hands of Austrian regulators, who took it over last week. Mrs. Kohn was a key marketer of Bernard Madoff’s investment fund. She purportedly raised lots of money from the world’s well to do and power elites. According to reports, she had some clients among the Russian Oligarchs. These are the types of people that you try not to disappoint let alone swindle. They have a way of settling scores with people who don’t live up to their end of the bargain.
My has the worm turned. Last year at this time the wealthy and powerful were reveling in their decade long run of good fortune the kind markets bestowed upon them. This year evaporating wealth, financial ruin and death silently stalks them. Their salons, country clubs, penthouses and boardrooms offer them no protection from the aggrieved people of their making and a tortured conscience.
You Tube Video: Prokofiev, Romeo and Juliet
Risk: reputation, fraud,
Last night I had the distinct pleasure of attending Prmia’s History Making Series lecture that honored Edward Altman at the Deloitte and Touche Conference Center in NYC.
Mr. Altman, The Max l. Heine Professor of Finance at the Stern School of Business at NYU, was honored for his life long contribution to the study and development of credit risk analysis. His foremost contribution is the development of the Z Score which uses financial ratio benchmarks within an industry segment to determine corporate financial health. He has made many contributions to the study of credit risk, corporate finance and investment analysis of debt securities.
His presentation covered the development of credit risk analysis since his first published work concerning the Z Score in 1968. Mr. Altman was funny, intelligent and very engaging and he raised some dire concerns about the current credit market environment and what it may forebode. To be fair to Mr. Altman, he pretty much stuck with the subject of the development of the discipline of credit risk analysis and like Alan Greenspan went very light on market prognostications.
Some brief highlights of Mr. Altman’s presentation:
Stressed the importance of a healthy corporate credit culture and its neglect has contributed to the current crisis.
Bankruptcy workout and recovery rates will suffer due to current state of credit market.
Lenders need to combine quantitative and qualitative factors to determine loan default probabilities.
Risk managers need a better understanding of the correlation of debt ratings and corporate performance.
Mr. Altman also stated that corporate bond defaults could approach 11% next year and that other securitized asset classes are under severe pressure.
Mr. Altman also opined about the etymological origins of the phrase, “waiting for the other shoe to drop.”
Music Video: The Credit Crunch Song
Risk: credit market, research, economics, corporate finance