Fix the Accounting, Then Fix the System

Almost all of the bailout plans being discussed fail to consider a simple fact: without the homogenization of accounting rules, any plan will represent a piecemeal approach to the problem. Some banks are holding out their hands to get TARP funds; they are on the brink of failure and are seeking a lifeline. Others are saying "Nah, we don't want them (TARP funds)," because they don't want the more stringent oversight applied to TARP recipients. In both cases, the motivations are less than pure, and neither facilitates greater lending to stimulate the economy. The system is broken, and current proposals do nothing to address the overarching issue: we don't know the true tangible book value of ANY financial institution, and therefore are unclear as to which have strong capital positions, which are on the verge of failure, and which are essentially bankrupt but have been propped up temporarily with taxpayer dollars. As has been suggested by many, draconian steps must be taken to repair the system. Problem is, the only thing draconian so far is the damage done to the wallets of every US citizen today and tomorrow.

What needs to happen, right now, is to make EVERY financial institution apply mark-to-market accounting to their portfolios. No readily observable market? Have an administrator apply an independent third-party valuation that takes into account polling possible buyers. The only circumstance under which mark-to-market accounting can be avoided is if an institution has the intention of holding an asset to maturity and has the term financing in place to carry it. The two biggest problems with the current accounting regime relate to leverage and illiquidity. Banks have been financed largely with short-term capital, piled on top of a sliver of equity. But when assets have maturities extended either due to a changing rate environment (e.g., rising term rates cause mortgage-backed securities to experience longer maturities) or to rising illiquidity (e.g., CDOs, CDS', high-yield bonds, leveraged lending commitments, etc.), the lack of term capital puts them in a very precarious position almost overnight. These kinds of surprises could have been avoided by forcing mark-to-market treatment, as we would have seen a precipitous decline in carrying values much faster than we did and dealt with the problem far more quickly. 

As it stands today, those who argue against mark-to-market treatment say "This will just exacerbate the capital problem at troubled banks. And after the markets unlock, those assets will be salable at far higher prices." Exactly. Let's smoke out the problems NOW, and figure out the magnitude of the problem NOW. The fact that assets might fetch higher prices in the future is immaterial if you don't have the balance sheet to get to the future, and it is certainly not the taxpayer's responsibility to support those institutions' common stockholders and bondholders in this mission.

On Monday, President Obama should get together with Mary Schapiro of the SEC and insist on a clean accounting of all financial institution balance sheets - IMMEDIATELY. We can then truly put a good bank/bad bank plan into motion that will be built on a strong foundation, instead of continuing to pump money into the Citigroups and Bank of Americas, firms with hopelessly distorted capital structures that need to be redone. NOW. People - Congresspeople, pundits, economists, bankers, President Obama, and everyone else with a vested interest - needs to get over themselves about what it means to be American. We screwed up - big time. Americans are an optimistic, can-do people. But in the absence of policy clarity, aligned motives and strategic thinking, we will limp out of this crisis like a terminally wounded animal. Alive, but destined to never regains its former swagger. We can get our swagger back, a better swagger, a swagger built on real value and not on vapor, if only we have the guts to effect real change. And it all starts with something as mudane as accounting. But sometimes the most complex problems can be addressed with the most simple solutions. And the beginning of our journey of healing has to be the marking-to-market of financial institution balance sheets. We simply can't afford to wait any longer.

I Just Don't Get It

Why is the market so jazzed by the sketchy details we have over the "new" bailout plan? Buying bad assets, but at what price? Who is bearing the cost, the US taxpayer or the bank's common stockholders and debtholders? Early handicapping is that the taxpayer is going to take it on the chin. This is bad for many, good for a few. Not much of an improvement over TARP: The Horror Movie. I just don't get it.

Corporate earnings across most sectors have been awful with prospects that are not encouraging. Banks, even those that have been "bailed out" one or more times, are still posting stunning losses. The Fed and other central banks are getting cheers for pushing rates progressively closer to zero. Is this really the panacea that the equity markets have indicated over the past several trading days? I just don't get it.

I eagerly await the details of the stimulus plan. $800+ billion is certainly a lot of money. But how much of this monumental sum will be squandered on projects that have little impact on job creation? How much horse-trading will be done on the floor and between President Obama and Congress to get something, anything, done? The stuff I've read so far is not terribly impressive. I am concerned that the incredible momentum of Obama's electoral victory might be wasted if a more transformational plan does not emerge that receives bipartisan support. Yet the equity markets roll on. I just don't get it.

Americans are, by nature, an optimistic people. This is a very fine attribute that has served us well at many points in our history. But there are times when an abundance of realism is called for, and when actions need to be strong, swift and transforming. But few of the steps we've witnessed to date fall into that bucket, except the sheer amount of money spent with little to show for it. I just don't get it.

Many smart people have put forth ideas for dramatically re-shaping the financial sector and for using high-impact, high-ROI fiscal stimulus to get people working and to enhance the infrastructure and competitiveness of our nation. Yet precious few of these idea seem to be getting through. Maybe it is just too early in the new Administration to expect such things in our programs. But when $800 billion stimulus packages are getting approved by the House and there are few bold, sweeping moves contemplated by the legislation, it appears that our voices are falling on deaf ears. I just don't it.

Just maybe the Fed can push rates to zero and China and Japan will continue buying Treasuries. Just maybe fear will keep the dollar strong while we run multi-trillion dollar deficits and keep rates across the curve low. Just maybe Citigroup and Bank of America can be bailed out without trashing common shareholders and certain debtholders, and cost US taxpayers less than if they were taken over and worked out. Just maybe millions will get back to work because low rates will help banks rebuild their balance sheets, enable businesses to borrow and invest, create a massive mortgage refinancing windfall and get consumers spending again. Just maybe we don't need an upgrading of our physical and technology infrastructures; it's good enough. Just maybe all of our dreams really will come true.

I just don't get it.

Learning from Failure - SIIA Keynote Presentation 2009

SIIA Previews Presentation 2009
From: infoarbitrage, 9 minutes ago

SIIA Previews Presentation 2009

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Roger Ehrenberg's Keynote address at the 2009 SIIA Previews Conference, New York City

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Nationalization Isn't a Dirty Word

The time has come to acknowledge the depths of our problems. It has already been demonstrated that propping up failing institutions does nothing but delay the inevitable. It consumes staggering sums, it wastes time, and it prolongs what will invariably prove to be one of the sharpest economic downturns in generations. A downturn that originated not in the real economy, but in the financial economy. The credit bubble fueled the housing bubble, shortly after the stock market bubble had been pricked. Easy money plus poor regulatory constructs with a touch of fraud was just what was needed to bring down the system. Sadly, many companies and industries have been effected that had nothing to do with and extracted little benefit from the financial bubble. So while our financial institutions are getting their comeuppance, the rest of the economy is being dragged down with them. It is just wrong, simply not fair, but it highlights the importance and interconnectedness of our financial institutions with the other engines of our economy. Without a healthy financial sector, the real economy simply cannot flourish.

Today we are lost. Our leaders are wandering around, trying to address the problems in a patchwork manner. Pork abounds. None other than Barney Frank, head of the House Financial Services Committee, used his position to extract funds for a small institution in his home state.  As long as the rescue plan is administered in this manner more money will be wasted, confidence will be destroyed and little progress will be made in helping get our financial sector - and, therefore, the rest of our economy - back on its feet. The time has come for a change.

The answer lies in the complete takeover of sick institutions. Call it nationalization, call it what you will, but it is the most expedient, most cost efficient and ultimately least disruptive way to accomplish what needs to be done. The goal is not to have huge swaths of the US financial sector owned and controlled by the Government. They are particularly bad operators and skew market forces, and should be viewed as a catalyst, as a stop-gap to address the current crisis. Fact is, they are the only institution with a large enough balance sheet and the power to jump-start the healing process, which means segregating illiquid assets (Bad Bank) from performing, liquid assets (Good Bank), warehousing and working out the Bad while selling off or spinning out the Good. While this would wipe out the common equity and much of the debt of sick institutions, it would end the charade that there is any real equity and debt value left in many of them, save for the largesse bestowed upon them by Treasury via TARP. Time to end the largesse and the pork and to get on with the hard work of really solving the financial sector's problems.

The newly-created Good banks will have clean balance sheets, rational capital structures and be open for business. They will be able to lend money without fear that they'd be better off saving it, and will make rational lending decisions without Government intervention. A group of healthy banks in a sick economy does not mean that lending will all of a sudden take off. The prudent banker will only invest when risk-adjusted returns are sufficiently attractive. But those healthy companies that have been squeezed by the credit crisis will now have access to better-priced capital, and will have a range of institutions offering competitive rates from which to choose. This condition does not exist today because of the fear across the banking sector. Unfortunately, only the Government can take away this fear by using its balance sheet as a bridge to clean things up. But rather than squandering taxpayer dollars by "insuring" the walking-dead banks of today against portfolio losses, the money would be better spent marking bad assets down, letting the US taxpayer pay a depressed price, creating optionality by warehousing them on the Fed's balance sheet and selling them after the credit market dislocation has abated.

What this really amounts to is a virtual restart of the US banking sector. Mistakes have been made on a scale too massive to imagine, and it is up to us to deal with these mistakes thorugh a combination of decisive action and sensible regulatory changes. But let's not get too hung up on terminology; there is work to be done.

It's Not About Hope

Like most, I watched yesterday's Inaugural festivities with interest, less in the pomp and pageantry and more in the messaging from our new President. While I don't think it will go down as among the most memorable and quotable of addresses, it was blunt, honest and grounded. But let's be clear; notwithstanding the positive sentiment around Obama's taking the reins, and the hope associated with his plans, his achievements will be based on policy decisions and not on hope. And while sentiment will play a role in our recovery, it will not be the driver of a rebound. Changes in sentiment that impact people's financial behaviors will come from real changes in our Federal Government, the economy, and the health of our financial institutions and local governments. And these changes will only happen if Obama is willing and able to make the hard decisions necessary, such as:

1. Aggressively taking over failing banks, recapitalizing the healthy parts with public and private capital and working out the rest over time;
2. Providing a mix of tax incentives and public funds for upgrading our technology infrastructure;
3. Using tax policy and access to our National labs and Universities to unlock trapped intellectual property that can be used for innovation;
4. Developing a durable solution to the morass that is Social Security;
5. Constructing a plan for re-invigorating public education, using market-based methods and vouchers to create a culture of high achievement that is accessible to all; and
6. Investing in re-training displaced workers from dying industries to make them productive, fulfilled and able to secure a healthy future for themselves and their families.

None of these things are easy and require broad-based, bipartisan support for passage. But for the Obama Administration to be truly successful, he will have to take on these massive, mutli-generational problems. While it is easy to say that the hand he's been dealt is not fair, and that bar for what constitutes success has been set too high, he has been handed an historic opportunity to restructure key elements of a badly broken system.

As is my wont to use derivative metaphors, the Obama Administration is not unlike a very valuable at-the-money option. The question is, will he reward the call buyers or the put buyers? Because my hunch is that option sellers will be the losers here; something explosive will happen. The question is in which direction.

Obama's Big Chance

Albeit reluctantly, the Senate gave the go-ahead to release the additional $350 billion in TARP funding contemplated by the original plan. A 52-42 vote isn't exactly a resounding vote of confidence, but who can blame the Senators for their cynicism given the manner in which the first $350 billion was disbursed and the utter lack of tracking and accountability? The representative case for support was articulated by Senator Richard Durbin:

“It’s money that can be spent, may be spent, by the new president, Barack Obama ,” Illinois Democrat Richard Durbin  said before the vote. “I want to give President Obama the tools he needs to breathe life back into this economy.”

To his credit, President-elect Obama acknowledged that this vote was a struggle because of the widespread displeasure over the handling of TARP I:

“I know this wasn’t an easy vote because of the frustration so many of us share about how the first half of this plan was implemented,” Obama said in a statement. He promised to set strict pay limits on executives at companies receiving funds, provide more loans to small businesses and ensure “taxpayers can see where their money is spent.”

The question is, will Obama yield to populist rhetoric and Congressional photo-ops or will he do the ugly work that needs to be done? What worries me are intentions such as these:

To overcome political objections, the incoming Obama administration pledged to spend $50 billion to $100 billion on a "sweeping" foreclosure-prevention effort. It also said it would impose tougher restrictions on banks that receive government aid, including requirements on banks to lend money, increased restrictions on executive compensation and curtailed dividend payments for some firms.

I'm not sure what a "sweeping foreclosure-prevention effort" is, but it worries me. Requirements for banks to lend money? A really, really bad idea. While some of the badness that happened over the past 5-7 years led to distorted markets, e.g., abnormally cheap credit, instruments that received high ratings inconsistent with their risks, fraudulent loan origination practices, etc., coming in and distorting them further is not a recipe for a healthy recovery. Plenty of people directly and indirectly hold mortgages that were originated in an honest manner but whose payers either can't or don't want to service their debt. Should they be penalized because the servicer wants to foreclose and/or the payer no longer wants to fulfill an obligation on a house with no remaining equity? The incentives are perverse, and the ripple effects of a wholesale mortgage restructuring project would be far-reaching and re-distribute wealth in potentially unfair and inappropriate ways.

Forcing banks to lend couldn' be a more intellectually bankrupt idea. The business of commercial banks is to lend money when the risk-adjusted returns exceed its cost of capital. Just lend money, because we said so? We've seen this movie before - it's called Fannie Mae and Freddie Mac - and it doesn't end well. The right way to approach the problem is to create truly healthy banks, either out of currently sick institutions or de novo, and to let them make rational lending decisions. If the Government sees a particular constituency that requires funding, don't force a bank to do it if it doesn't make economic sense. Either create a discrete program or use tax incentives to generate the necessary resources. The worst possible outcome of TARP is to create another generation of sick institutions by forcing them to make irrational loans to satisfy the moral (or public relations) objectives of our Government representatives. Obama needs to fight this urge with a vengance.

Then there is the issue of using TARP for non-financial sector problems - like the auto industry. In order to ensure support from the Senate, Larry Summers, the future head of the National Economic Council, made the following remarks:

In a nod to concerns about how the bailout has expanded beyond financial firms to include the U.S. car business, Mr. Summers said the second half of the funds would be used to help prevent "systemic consequences in the financial and housing markets," not to implement an "industrial policy" that would aid various troubled industries. To assuage Republican concerns, the Obama team also agreed to provide additional support to the auto industry only "in the context of a comprehensive restructuring."

This is good news. There is TARP and there is industrial policy, and there is good industrial policy and bad. Lobbing cash into a sick auto industry without a comprehensive approach to the problem is bad policy. Bad like TARP has been bad, providing sick institutions with cash without fundamental changes in their businesses, management, or the promise of an appropriate risk-adjusted return. Fortunately Mr. Summers is smart enough to know this, and he will hopefully keep Obama from veering off course.

How Obama handles the financial crisis over the next 180 days will set the tone for his entire Administration. He needs to be a strong, pragmatic, independent thinker who refuses to be swayed by headlines or popularity contests. He needs to earn the respect - not the love - of the US citizenry. This means making decisions for the long-term good of the country, even if it means incurring excruciating short-term pain. Palliatives are the easy way out; set rates to zero, pump additional trillions of liquidity into the economy, restructure all non-performing mortgages of people below a certain income threshold, bail out dying industries that employ hundreds of thousands of workers, support local public-works projects, and watch our country slide by on his watch and then absolutely crater after he leaves office. Many would choose this course because, well, it doesn't require much imagination or tolerance for pain. But it is the wrong thing to do.

Obama has the potential to be the most impactful President in generations if only he has the intestinal fortitude to do the hard work and to make the hard decisions required. Forces will conspire to push him off this path. He must resist them.

SOC or Bust

With the implosion of Citigroup and the depth of losses across the banking sector, including today's announcement that Bank of America is seeking additional bailout funding, the time has come to create and empower the Stabilization Oversight Council (SOC). The Treasury, positioned as the only game in town with respect to policy-making to deal with the financial crisis, has come up way, way short. While they need to have a seat at the table, other voices need to be heard as well. And not in a one-off, haphazard way, as has been done since the beginning of the crisis, e.g., the Treasury administers TARP, the FDIC drives the mortgage-restructuring strategy, the White House intervenes on behalf of the automakers, the Fed wrings their hands in public but to little effect, etc.. The SOC will take a holistic approach to the problem, working to develop solutions that fit together, are sequenced properly, and are both clearly communicated and transparent in their elements and their monitoring. A clean slate is needed, and I'd recommend that it be created before the next $350 billion is pushed out the door. Because if this $350 billion is used in a manner similar to the previous $350 billion, the taxpayer rip-off and policy failures will place an unacceptable and unnecessary burden on subsequent generations.

While it is seductive to spend stimulus dollars on infrastructure, the auto industry, and every other constituency that has come out of the woodwork with their hands out, priority number one has to be a plan for fixing the financial services sector.This extends well beyond fixing balance sheets, thought this certainly needs to happen (via takeover and Good Bank/Bad Bank restructuring of failing institutions), and includes items such as:

• Simplified and clarified accounting standards: Mark-to-market accounting treatment on all trading portfolios not supported by term financing. Tightening of consolidation rules to prevent the shunting of risk into off-balance sheet vehicles with opaque disclosures. Key themes: transparency and full disclosure.

• Revised regulatory standards: Revised capital requirements that are detached from Value at Risk (VaR) and calibrated to the business cycle, e.g. higher capital/larger reserves in good times, lower capital/smaller reserves in bad times. Key themes: capital requirements that take into account asymmetrical risk distributions, built-in shock absorbers to force capital accumulation while it is plentiful to prepare for inevitable turns in the business cycle.

• Restructuring of the ratings industry: Eliminate the inherent conflicts in issuer-funded ratings. Create an independent and impartial body to issue and maintain ratings, partially funded by the deal. Key themes: independence, transparency, free from bias, paid for as an implicit due diligence expense by investors.

This is not about bailing out undeserving bankers; they will be fired, their stock wiped out. This isn't about creating another real estate bubble; it will take years for existing inventory to be worked through, partially-built homes to be finished and sold and current sellers to find buyers at anything other than distressed prices. This is about getting the US to face into its problems, to swallow an expensive, bitter pill and to move on. But we can't move on with a financial system in shambles. We can't restructure the auto industry, make necessary investments in technology infrastructure and enact effective tax policy in the absence of healthy, functioning credit markets.

Another key element of the plan is creating a culture of transparency, honesty and responsibility, three items sorely lacking as evidenced by reasons for and magnitude of the credit crisis. While cynics may scoff, I don't see the presence of these things as being anathema to making money or supporting the free markets. To the contrary, I believe they can usher in a healthier, more sustainable investment climate, one where investors and individuals alike will have more realistic expectations of returns and reduced volatility due to fewer unpleasant surprises.

The time has come for a change. TARP hasn't worked. The banking crisis has only deepened. We need the best minds from relevant disciplines to build a comprehensive plan for stabilizing the financial system. Perhaps President Elect Obama can use his energy and fresh perspective to taken an unconventional approach to solving our problems. He can be the catalyst; he is not the answer. The SOC is the answer.

Citigroup - Somebody Please Say "Game Over"

From the Wall Street Journal Online:

Until recently, Citigroup Chief Executive Vikram Pandit had repeatedly backed the company's "universal bank" model. But with directors and executives now bracing for a fourth-quarter operating loss of at least $10 billion and federal officials worried about previous turnaround efforts, Citigroup has decided that more dramatic action is needed, according to people familiar with the matter.

Shrinking Citigroup won't be quick or easy. The company is assigning management teams to handle the gradual disposal of units and other assets, but a person familiar with the matter emphasized that Citigroup doesn't plan to engage in a "fire sale." Efforts to find buyers also will be complicated by rocky market conditions and the recession.

Citigroup already has pursued some pieces of its downsizing push. For example, executives have been trying for months to reduce its exposure to Japan, where rising defaults are hurting profits. Citigroup also has been searching for about a year to find a buyer for Primerica, which sells mutual funds, insurance and other financial products.

That auction hasn't resulted in a sale because of a scarcity of buyers willing to pay what Citigroup regards as a reasonable price, according to people familiar with the matter. 

As part of the new plan, Citigroup executives are considering the possibility of creating what is known as a "good bank-bad bank" structure, these people said. Under that structure, Citigroup would create a new corporate entity to house what it regards as its core businesses.

The "bad bank" would hold around $700 billion in assets, with the remaining $1.1 trillion considered core. The entity would face accounting-related complications, and Citigroup hasn't settled on the approach, people familiar with the discussions said.

It is hard to articulate the contempt I have for the Treasury surrounding their handling of the Citigroup situation. Is it any surprise we (the US Taxpayer, that is) now find ourselves in this position? You can't blame Vikram, Win and the stellar board for sitting back and letting the Government throw money at them in a panic without addressing the core issues at hand: namely, erosion of both on- and off-balance sheet asset values together with difficulty in funding these assets.

What if, just what if, Treasury (together with the SEC) had said four months ago - game over, guys. Employ FAS 157 across your asset portfolios, show us exactly how broke you are, hand us the keys, we'll settle accounts with those who are owed money and say too bad to those who aren't (common stockholders and unsecured debtholders), sell of the good assets and warehouse the bad at marked-down levels. The Government could have worked out illiquid derivatives positions over time without causing a market cataclysm. Oh, and Management and the Board, don't let the doorknob hit you in the butt on your way out. You'll be hearing from a few lawyers any day now. These decisive actions would have saved taxpayers tens if not hundreds of billions of dollars, yet we still have the good ol' Citi management at the helm steering the ship. It's almost like the Madoff situation; he's dead, yet somehow he's still sending millions jewelry to his friends and family. He should be in the clink. And Citigroup Management should be on the street.

Why is legacy Management getting to decide how and when to dispose of assets on our dime? The firm is bankruput save for Treasury's largesse. Someone needs to say game over - now - that has the best interests of the US Taxpayers and the financial markets in mind. Because up to this point, it is not clear that anyone has been looking out for these two key constituencies.

The Citi Never Sleeps - Only its Board, Risk Managers and Regulators

The Citigroup of the past decade is THE shining example of an array of costly failures: accounting policies; business strategies; management compensation schemes; risk management practices; and Government policies. And now we see that Citigroup is doing badly; more badly, in fact, than many thought likely. Rubin is out. Smith Barney is being jettisoned for a little cash and some accounting profits. Desperation is taking hold. Will more bailout funds be required, notwithstanding the egregious deal the second-time around? You can bet on it. We are now seeing the sequel to the original Citigroup drama, As the Stomach Turns.

Accounting Policies

First, there was the Sandy Weill empire-building phase. In short, accounting standards gone awry. Because of the "pooling method" of accounting for mergers, Sandy was able to bolt on enterprise after enterprise by doing stock deals that met the necessary criteria. This resulted in effectively slapping together two sets of historical financial statements without showing the "goodwill" (premium paid over tangible book value) paid for in the deal. And because there were no charges to earnings for the amortization of goodwill, Citigroup could defer the time when it needed to come clean that it had paid too much for acquisitions and that the goodwill didn't really exist. Happy for Sandy, his largest deals (Primerica/Travelers and Travelers/Citicorp) were done prior to the end of the pooling method pursuant to FAS 141 and 142. Surprise, common shareholders! We paid tens of billions too much for the businesses we bought. But the joke is on you. To even greater effect, Citigroup availed itself of a juicy 21st century accounting fiction, Special Purpose Vehicle (SPV) accounting, that laid the foundation for its cataclysmic collapse over the past 18 months.

Business Strategies

Sandy figured out something truly brilliant: by growing so large he created a firm that was "too big to fail," but just big enough to get paid outsized sums for facilitating its growth-by-acquisition strategy. Get paid on the upside and bailed out on the downside. Whether it was simple greed or an amalgam of greed and market prescience, his strategy worked beautifully. He got paid princely sums while the firm was in rapid growth mode and got out near the top, his minions - and the US taxpayer - were left to deal with the detritus after-the-fact. This may have been his most brilliant business deal of all; working with his Board to get paid for high-risk, ultimtely transient earnings and bailing out at just the right time. Has anybody showed such skill at market timing? Nice work, Sandy. Further, his approach was also deeply flawed from a corporate finance perspective. With few realizable synergies among his portfolio of businesses, it would have been more efficient and created greater shareholder value by having these businesses as stand-alone entities. They would be been more focused, properly financed, received the necessary managerial oversight and attracted the best investors for their particular business activity. Asset allocation is always done best at the investor level; corporate managers only have an incentive to get big, and the friction and distraction associated with managing a disparate array of businesses is costly for both shareholders and the businesses alike.

Compensation Practices

Grow the numerator (revenues), avoid charges to the denominator (goodwill), take more risk and back up the compensation truck at year-end. It really wasn't that complicated. Conglomerators for decades have played a similar game and made away with monstrous rewards for their era. It is only that so much had been written about pooling and its being an accounting fiction that Boards and HR departments should have been hip to the game by the late 1990s. This, together for paying for short-term results, particularly in its trading businesses, contributed to a compensation culture that was skewed towards all the wrong things - top line growth without an approriate discount for risk and persistence. Not smart, guys.

Risk Management Practices

When the intellectual purity of Jamie Dimon was still at hand, he sharply reduced Citigroup's exposure to Russia - and fast. He closed down the Risk Arbitrage group at Salomon. He was laser-focused on the risk side of the equation. Once he left, nobody stepped in to fill the void (except that LTCM guy). It decided to crank up the securitization machine and to play accounting gimmickry, circa 2004: the SPV game. It pushed hundreds of billions of dollars of CDO exposure off-balance sheet, meeting the accounting critieria for de-consolidation while retaining enough risk to have the assets come flying back onto its books if certain "unlikely" things happened. Well, they did and they did, and these SPVs, which enabled Citigroup to present financial statements and footnotes that drastically understated its real exposure, were the key contributor to its undoing. While this was certainly an accounting game, it was also a severe breakdown in risk controls because regardless of where these assets were housed, Citigroup retained real economic exposure to their performance. And Citigroups risk management team, without question, fell down when it came to taking these SPV risks into account.

Government Policies

While Sandy set the table, Hank and Friends have been trying to clean it up, without much success. First a $25 billion injection, no strings attached. Then a massive backstop deal whose cost is currently unknown, but is many multiples of the original staggeringly large cash injection. Yet the problems still remain. Why? Because the Treasury has been reluctant, for some reason, to get tough with Citigroup's management and to clean house once and for all. Take over the firm. Employ a good bank/bad bank strategy. Force mark-to-market accounting across the banking sector and see exactly which institutions are the walking dead, which are broken but can be repaired and which are a.o.k. Develop a consistent plan. Execute the plan. Stop with the one-off, band-aid solutions. Citigroup needs a redo, just like the auto industry. And just like Social Security. Wipe out common and junior debt holders. Sell off good assets to the private sector or spin them off. Warehouse bad assets and work them out over time. But Sandy was right; shareholders and the Government permitted Citigroup to become too big to fail. Well, it needs to fail. Just not in the haphazard, destructive way that Lehman failed. It can be done much, much better.

Someone needs to take Citigroup out behind the barn and shoot it. Because if we don't, it just may kill us in the process. 

Wall Street, Circa 2010: Disaggregation and Specialization

The Wall Street of today is almost unrecognizable from that at which I worked for almost two decades. The rise of the trading culture, first brought into the mainstream by John Gutfreund and Salomon Brothers in the 1980s and which lasted for more than 20 years, is now a vestige of the past. Huge trading losses have been posted. Risk limits have been taken down. "Structured Product" is now a dirty word. Securitization? Don't want to hear about it. Asset-backed what? Sell - sell now! What started as a way to manage risk and to parse it out to those best positioned to bear it - the mortgage-backed security - evolved into something that lost its raison d'etre. The course of increasing complexity and distance from its intended goal, risk management, was a key contributor to the financial crisis we are encountering today. Much has been written about the "why" of Wall Street's demise, but I'd like to consider a slightly different question: What now? What does a functional Wall Street of tomorrow look like? What businesses does it choose to be in? Where and how can it bring value to clients, both issuers and investors, in ways that are logical, straightforward, transparent, and consistent with its objective to increase its own shareholder value?

Industry structure: Disaggregation and Specialization

What used to be the bulge bracket Wall Street firms and their international peers had become financial supermarkets. Securities trading and issuance. Corporate advisory services. Asset management. Retail brokerage. Even insurance. In essence, the Sandy Weill model of the one-stop financial enterprise. This model was doomed from the get-go and the financial crisis will only hasten its demise. The concept of internally diversifying cash flows by seeking to operate a pile of loosely-related businesses under one roof never made sense, theoretically or otherwise. And yesterday's announcement that Citigroup is looking to unload Smith Barney only reinforces the point - although Morgan Stanley clearly has a different view of things.

Disaggregation of Securities Dealers and Equity Research

Securities Dealers, those that help companies issue capital and to make markets in those and other securities, will continue do this. One related businesses will be bundled with securities dealers: Investment Banking. Issuers need advice on how and when to issue, and may also want M&A advice: Investment Bankers will continue to provide this service. The difference between how it used to work and how it will work in the future is the disaggregation of Equity Research. The major securities houses will have global distribution platforms for connecting issuers and investors, and to provide markets on a worldwide basis. There will be relatively few of these players as the cost of maintaining a global distribution platform is huge and, in my opinion, a natural oligopoly. But research will be "open sourced," as the charade sometimes called "Wall Street single-stock research" is finally exposed. 

Having the securities underwriter issue a "puff piece" as part of the IPO selling process is a waste of time, money and is fraught with conflicts. The Global Settlement was just that - a settlement. It wasn't a solution. There only reason for bulge bracket firms to pay for costly research operations is if they help Investment Banking land deals. Bulge bracket research budgets in the early 2000s were in the $500 million to $1 billion+ range. If one were to disaggregate commissions into payment for research and execution, it is safe to say that investors attributed little value to Wall Street research. So how did the gap get filled? Investment banking mandates, together with outsized commissions on "hot" IPO deals that precipitated the Global Settlement in the first place. Transparency will enter the research venue, where investors buy research from the best providers at a known cost. There is no reason why a securities dealer should have better research than anyone else, and given that this is not their area of specialization it isn't clear that they should be in this business at all. Added complexity is almost always a bad thing, and securities dealers have enough to manage without operating a separate research arm. 

Disaggregation of Securities Dealers and Commercial Banking

A solid idea in concept, but fraught with conflict and potential magnification of risks. Seems logical from the Wall Street perspective; let's simply migrate up the right hand side of the balance sheet, providing everything from bank loans to term debt to mezzanine, convertibles to preferreds to common stock. The problem is, however, that bank debt and bridge loans were used as levers to secure other, higher margin pieces of business such as IPOs, M&A, junk bonds and derivatives. So what you'd get are a bunch of very smart, very aggressive, very crafty, super-money motivated product specialists pressuring the commercial bankers to make loans whether they liked them or not. "It's for the good of the (firm) relationship" was the siren's song. What they really meant to say was "It's for the good of my P&L (and the basis for my year-end bonus)". This is clearly not the best way to manage risk or allocate capital.

The risks borne by securities dealers - market risks - are fundamentally different than those absorbed by commercial bankers - credit risks. This is why large financial firms have two discrete risk hierarchies governing these distinct exposures. However, if one takes the evolution of the markets to the limit, then market risk and credit risk effectively intersect, e.g., a company's debt is as liquid as its stock and every slice of the right hand side of the balance sheet is listed and tradable. In this case a company's credit risk would be priced, in real time, by the market, and one could assess the appropriateness of the risk/reward trade-offs embedded in each security. Arbitrage would keep the relationships efficient. This is what capital arbitrage trading strategies seek to do today, but by using a mix of liquid (listed equities) and less liquid (credit derivatives, bonds and bank loans) assets. But the time when credit and market risks intersect is a ways off, and building integrated platforms predicated upon this condition that are laden with conflicts results in a flawed business model.

Disaggreation of Securities Dealers and Retail Brokerage

The bundling of retail brokerage and securities was a mistake of both scale and conflicts of interests: scale because the entities are simply too big and the cultures to different to manage, and there are few natural synergies between the two businesses; and conflicts because retail brokers are more heavily compensated to push proprietary in-house products than third-party products, resulting in advice to clients that is biased, at odds with the fiduciary responsibility brokers have to their clients. How can Morgan Stanely resolve this conflict? They can't. A combined Smith Barney/Morgan Stanley retail brokerage operation will be a prime candidate for spin-off when the IPO market recovers. The integrated financial enterprise resulted in a broken system; the crisis will provide the impetus to fix it.

Disaggregation of Securities Dealers and Proprietary Trading

Wall Street firms generally have several pools of trading risk, some of which are customer-related and others which are purely proprietary. Being in the securities business means taking market risk. Firms will underwrite deals, buy positions from customers without having the other side of the trade, shape its book to best position it to make money from customer flow, etc. However, this is very different than taking non-customer driven, proprietary positions in the market. Given the need for separation between the customer-serving flow traders and the proprietary traders, it is not clear that securities deals need these proprietary trading operations at all. Since they can't benefit from information about customer flow, there are no true synergies between this operation and the rest of the securities business. In good times these businesses can mint money and help bolster the bottom line. But in bad times these businesses are a distraction and can cause management to lose focus on what really matters - firm clients. Morgan Stanley's decision to pare back its proprietary trading is no surprise; if the goal is to create a less volatile, more customer-focused, sustainable franchise, then it stands to reason that this is yet another business that need not be part of the legacy Wall Street mix.

Disaggregation of Securities Dealers and Illiquid Assets

OTC derivatives - CDS, swaps, etc. - were the engine of growth and profitability at many Wall Street firms. Part of the appeal was opaqueness, e.g., I can hide how much I'm making. Part of the appeal was capital efficiency. These businesses consumed tremendous resources to function effectively - credit, documentation, legal, operations, etc. However, this opaqueness has also contributed to its downfall, as the need to unwind and/or settle mind-bending numbers of transactions and the collateral impacts has highlighted a fundamental flaw in the OTC derivative market's evolution. These weaknesses can be addressed by shifting a large number of these transactions to exchanges, substantially increasingly liquidity, transparency, simplicity and collateral management. The securities dealer of 2010 will have an active and profitable derivatives business; it will just look more like stock trading circa 1990 than what it has for the past 20 years. Will there be some "exotic," hard-to-price risks that will reside on the Securities Dealers' balance sheet? Certainly. But it will be a small number that is aggressively managed to ensure that it stays small and doesn't get out of hand.

Conclusions

The Securities Dealer circa 2010 will be laser-focused on client business: raising capital, distributing risk, and trading within the scope of customer flows. This is the culture and this is what they do best. Equity research will become an industry unto itself, moving beyond the "independent research" moniker it wears today. In tomorrow's world all research will be independent. Who wants biased research? The jig is up. Corporate lending will be done by commercial banks. Glass-Steagall separated Investment Banking and Commercial Banking for a reason. While I don't think that these regulations are necessary, as an investor I'd prefer to put my money into a pure-play Securities Dealer and a pure play Commercial Bank than a combined entity any day. Better managed. Fewer conflicts. More profitable. Retail brokers will become independent enterprises, offering their clients an open-source platform of the best products and service available, without the incentive to push a single house's product line. They will compete on client service, financial planning, portfolio design and after-fee performance. This would be an attractive business for investment, as it will possess stable cashflows and a strong brand free from conflicts. Proprietary trading will likely be done outside the province of the Securities Dealers, in a healthy hedge fund and institutional asset management framework (more on that in another post). And the illiquid asset business - OTC derivatives, etc. - will move towards exchanges, looking more and more like a stock trading business under the Securities Dealer's umbrella.

2010 will be a better world on Wall Street. Greater focus. Fewer conflicts. More profitable. Less risky. It is now up to Mr. Market to make this happen.