Sense on Cents

In the midst of the current economic turmoil, nobody in our country has gone unscathed. With rising unemployment and falling 401-K valuations, everybody is looking for scapegoats. Prior to my passing judgment on any situation, I prefer to investigate fully the details and circumstances rather than shooting from the hip. President Obama’s gunslinger approach may resonate with his constituency, but for those who care to understand the details, let’s probe further. Without a full review of compensation practices, a blanket condemnation, in my opinion, is the height of pandering and akin to a fan heckling an umpire without reviewing the videotape. Over and above that, widespread government intervention into compensation practices is a VERY dangerous precedent; be careful what you wish for!!

Let’s go into the world of Wall Street compensation. Any executive on Wall Street will readily admit that their assets walk out the door every night and back in the door every morning. Managing those assets is the crux to managing a business. In my opinion, the same could be said of any business. While there are a handful of smaller brokerage houses on Wall Street, the bulk of the business is executed with the larger shops. The compensation at all of these shops (Goldman Sachs, JP Morgan, Morgan Stanley, Bank America, Credit Suisse, UBS, Citigroup) is structured as salary plus bonus. The bonus can run upwards of 90% of the total compensation for revenue producers. Over and above the simple salary plus bonus structure, anywhere from 25-75% of the bonus will typically come in the form of company stock which is paid out over the course of three to five years. That stock component and delayed payout are known as the “golden handcuffs” because it restricts the ability of an employee to leave a firm. How and why? If an employee leaves a firm, he or she walks out without that portion of his compensation. Additionally, Wall Street firms further restrict a wide swath of senior executives by imposing non-compete agreements. How do these work? At many shops, if a senior executive decides that he wants to leave the firm, he can only receive his “delayed payout” if he chooses to work for a not-for-profit or in the field of education. If an individual is let go, he will receive his “delayed payout” on its’ schedule.

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This piece is strictly a walk down memory lane and reflects on Wall Street interaction with overseas clients. A little something light for a weekend break. Enjoy!!

As a trader, salesman, and then sales manager, the most critically important factor in growing a business, and ultimately a franchise, was the development of deep, meaningful, and longstanding relationships. While I would try to be very customer friendly in all my roles, ultimately human nature dictates you will not get along with everybody. Simple business logic, along with strict rules of compliance, highlight the necessity to “know your customer.”

While the bulk of our mortgage business in the early to mid 1980s was located here in the United States, in the late 1980s Japanese investors became very active in our sector. This development presented some real challenges including:

1. time differential
2. type and level of engagement
3. impact of cultural differences

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Was it only a mere 4 weeks ago when we had a 3% upward move on the first trading day of the year? Do you recall that most equity analysts and money managers were calling for a turn in the economy by midyear and that people should increase their equity exposure?

In fact, for the first four days of the year the atmosphere was somewhat ebullient with markets holding those 3% gains. I wondered what the analysts and money managers were seeing. Not seeing it myself, I wrote the following on January 8th:

I believe a best case scenario for the equity market is that it merely marks time and does not further retract. I have a very difficult time making a case for a rallying equity market. I am more in the camp that we will likely retest the equity lows seen on November 20th. We may penetrate those lows by another 8-10% which would bring the S&P into the 700-725 area from its current level of 915. I do believe the prices in the corporate bond market, including the high yield space, largely reflect the concerns highlighted above. I also believe that despite the Fed and Treasury purchasing government and mortgage debt, these rates will end up higher at the end of this year than they are now simply due to the growing deficit. A move higher in these rates will potentially cause further anguish within the equity markets.

Every coach knows that the films don’t lie and the stat sheet speaks volumes. In that vein, let’s look at the stats for January and see “which players are making the grade.” The tickers under the high yield, mortgage, and municipal bond headings are electronic trading funds (ETFs) that I use as surrogates for those sectors.

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Growing up as one of eight kids, seven boys, dinnertime was always interesting. More often than not, milk was spilled, vegetables were hidden, and you better not be late because the food went quickly. Every week to ten days, get ready for leftovers.

In a similar vein, today’s market activity, economic news, and financial stories felt like one of those “leftover” dinners. There is still plenty of juice in the meat, but we have already seen some of these items. Let me put some ketchup, A-1, black pepper, and worcestershire out here to spice things up.

The stock market on Thursday totally reversed Wednesday’s upward move. Does that mean investors are discounting the concept of Bank Transition that we discussed the other day? Not at all. In fact, I still have “reason for optimism” because an entity like Bank Transition is critically important to rebuilding the financial foundation of our country. If anybody wants to reread that piece, though, don’t overlook the fact that I said we will still experience serious economic pain for an extended period. That said, if we want to come out on the other side of this, sooner rather than later and in better shape, we need Bank Transition. Hopefully, readers can understand the context of my writing. I am not a day trader. I still think we will likely see the lows seen on November 20th. The mere fact that Bank Transition will likely be launched gives me reason for optimism. I hope that clarifies things. If not, please don’t be bashful.

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In the midst of the discussion on nationalizing parts of our banking industry, I am hearing increasing banter of the likelihood that the Obama administration will launch an “Aggregated Bad Bank.” Perhaps I am too literal, but if this initiative is launched and works as hoped, I would recommend a name change. Let’s use “Bank Transition.” Ultimately, the name is less important than the implementation and effectiveness of this entity, but being a positive person and optimist by nature, the term “bad” does nothing for me. How might this entity work? Why is it a good and necessary development? What might it cost? Why wasn’t this move made by Paulson and team? Does this mean we can finally go back to the good old days of the last 5 years? So many questions. Let me try to clarify and offer my opinions.

1. How might this entity work?
As I have referenced previously, I always focus on an entity’s mission and funding. “Bank Transition” would most likely be managed by Sheila Bair of the FDIC. It would be mandated to purchase “toxic assets” (primarily distressed CDO (collateralized debt obligations) assets backed by an array of loans…mortgages, credit cards, auto, manufactured housing, commercial mortgages, corporate loans, and credit default swaps). It would be funded via the issuance of FDIC or FDIC-like bonds. Don’t be surprised to see a separate name used, such as “Transition Bonds,” which would have an explicit government guarantee. These bonds would probably have a few different maturities (1yr, 3yr, 5yr) to provide a degree of financial flexibility for this entity.

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I will admit the term “agape” is not part of my general vocabulary. In the process of looking it up, I see it defined as “in a state of wonder or amazement, often with the mouth wide open.”

After Bernie Madoff and a string of other smaller but no less sordid financial scams, I will admit that I am “agape” after having just reviewed the latest Ponzi scheme that was broken just yesterday.

While Bernie Madoff grew up near Far Rockaway, just a little further out on Long Island is the small town of Hauppauge. The waters surrounding that community possessed a shark by the name of Nicholas Cosmo. This predator ran a shop known as Agape World that largely preyed upon blue-collar workers. The operation was nothing more than a front for a $375 million Ponzi scheme that defrauded thousands of investors.

Let’s take a quick look at the website for Agape World. A few observations:

1. No mention as to any executives. Who runs the show? Red flag!!
2. No mention as to where assets are held. How about a bank, custodian, and trustee? Red flag!!
3. The firm does reference a recommendation by Dun and Bradstreet, a quality credit rating service. OK, let’s check it.  Hmmm, see what I mean?

$ 375 million dollars later….

The tide remains very low and the garbage is really starting to smell.

Madoff, Cosmo, Nadel, Schrenker, and every other con artist should be put away for life, not only for stealing money but for violating the trust and confidence of so many.

LD

Over the course of the last two decades, we have seen a massive increase in global trade in conjunction with a wide array of free trade agreements.

For those who do not track these agreements, two of the United States’ formal trade agreements are:

1. NAFTA: North American Free Trade Agreement
2. CAFTA: Central America Free Trade Agreement

As a country, we have formal trade agreements with certain nations but trade extensively around the world. For those who care to further explore the nature and extent of the U.S. trade agreements, you can do so at http://www.export.gov/fta/index.asp.

Our trade with China presents particular challenges. China has a significant level of quality control and worker safety issues. There are serious questions about Chinese abuse of human rights. On the foreign policy front, China is closely allied with states that sponsor terrorism, including Iran and Sudan. As a nation, we had very limited interaction with China until President Nixon engaged them during his tenure. In the late 1970s, we had a mere $2.5 billion in trade with this most populous country in the world. Fast forward and at the end of 2007, our level of trade topped $300 billion.

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Neither rain, nor snow, nor darkness, nor gloom of the economy, the market, or the world of global finance will keep us from our regularly scheduled departure from “Central Station.” Our ride departs at 9am and will take us through many hills and valleys of our economic landscape before returning to the station at noon.  So much to discuss and view as we roll along. Our forum is open to discussing issues from a macro and micro level. From New York to Washington to Europe and Asia, we can explore any avenues you’d like.

Please remember, there are no bad or silly questions. Don’t be bashful . . . ask anything. I offer honest opinions and thoughtful advice. For our newer riders, your conductor is not a professional financial planner but merely a longtime Wall Street veteran who wants to help you make some sense of the current twists and turns along the economic track.  Please bring a friend, grab a coffee, settle down, as you’re amongst friends on this ride.

Aaaaaaaaaaaaaaaall Aboard!!

While we wait for our ride to depart, I want to take this opportunity to highlight a very special guest on my Sunday night radio show, “LD’s Dollars and Sense,” with the folks over at No Quarter Radio. We will be joined by an individual who, in my estimation, has more professional Wall Street relationships than any other individual. Allow me to share the background of the legend that is…..Michael Maloney. Michael started working on Wall Street in the mid 1960s at the tender age of 16 for a specialist firm on the floor of the NYSE. In 1970, Mr. Maloney was an equity block trader for the venerable Stone and Webster. In the late ’70s, Michael moved into the world of financial recruitment and career consulting. He is known as “the man to see” for those looking to move onto or within the world of Wall Street. He has longstanding relationships that would fill the Manhattan directory and has lived to tell about them. From placing chief investment officers to back office assistants, from working with the major investment houses to startups, Michael truly epitomizes the phrase, “it’s not merely what you know but who you know.” Please join us for a fascinating look back and, simultaneously, a piercing view forward with “the man to see,” Michael Maloney!! “LD’s Dollars and Sense” can be heard on Sunday nights from 8-9PM on No Quarter Radio. You can listen to all archived No Quarter Radio episodes at any time. And don’t forget that No Quarter Radio episodes are also available as free podcasts on iTunes. Just open up iTunes, go to the iTunes store and type “No Quarter Radio podcast” in the search window. Complete No Quarter Radio iTunes instructions are always listed at No Quarter in the right column. Thank you to the great folks at No Quarter!

~ LD

We had a few readers ask about the prospects and meaning of nationalizing parts of our banking system. For those who have already seen this Q/A, I beg your indulgence as I try to spread the importance of this topic to a wider audience. Also, to our friends MBC and his close cousin MPC, I hope you do not mind my sharing your questions.

Comment by MBC | 2009-01-21 21:15:32

 Hi LD,

Can you explain what the ramifications are if we nationalize US banks?  You had written in a previous thread, “the strong likelihood that the banking system in the United States has some form of nationalization. These are truly historic and challenging times and how this banking meltdown is handled from here will be both gut wrenching and critically important to our immediate and long term economic health and well being. We will be watching VERY closely.”

Thanks so much, remember like you are explaining to a high school student.

Comment by LD | 2009-01-21 22:02:46

MBC,

Well, given that we have never nationalized banks and had them continue operating all I can do is offer my opinion. We effectively have nationalized banks via the FDIC (Federal Deposit Insurance Corporation) but then paid off the depositors and closed the doors after selling off assets.  That is what I am recommending for institutions that are deemed insolvent.

This approach was taken in Sweden in the early ’90s and the economy recovered fairly quickly (a few years). In these instances, the shareholders are effectively wiped out. The creditors (people who have lent money to the banks) would get paid out up to the FDIC limit (250k) for individuals. For institutions which have lent money, they would have their repayment largely if not totally guaranteed by the government. Departments or divisions that have value could then either spin themselves off or be sold. After all this is done, shut the doors. The party is over. Why would such draconian steps have to occur? Simply because the losses on loans of all types along with losses on investments will have overwhelmed the capital in the bank.

The government may very well take the step of nationalizing the institution but continue to operate it in hopes of generating revenue to writeoff the losses. What is the risk here? That the losses on the loans and investments just merely get worse and it ends up costing even more money down the road than it would cost right now. This approach was taken in Japan in the ’90s and the economy did not turn around for a full decade (it is called The Lost Decade).  

In each of these scenarios we need to be aware that the motives of the government are far different than the motives of private capital. The government is here to serve the public welfare. The private capital is in business to serve the interests of shareholders. Given changed motivations, we can only assume there will be different business practices. Ultimately, we are trying to achieve not only stability in the banking system as a whole but growth and increased lending. Does this make sense? Hope it helps.

Comment by LD | 2009-01-21 22:11:46 

MBC, After writing my own response to your question, I just saw this article from the Wall Street Journal, “What if Uncle Sam Takes Over Your Bank?”  The people there must be monitoring NQ for ideas….(lol). I have yet to compare my reply to the article.

Having now just read the WSJ article, I hope that my comments with their detail fully clarify the nationalization topic.

~LD