Vertical Integration in a Rapid World

I have long been a student of organizational structure. In general, I've been a proponent of specialization and laser focus. This works against the concept of conglomerates specifically and vertically-organized enterprises generally. A recent Wall Street Journal article highlighting several recent examples of vertical integration piqued my interest. Just why is it that vertical integration seems more compelling today than it did even five or ten years ago? What has changed in the environment to have caused the perceptions of many to do a 180? Is this a rational adaptation to a different landscape or a costly fad that will invariably run its course?

Vertical integration has often been linked with monopolists seeking to exercise control over a particular product or market, e.g., Andrew Carnegie and steel in the 1850s, Henry Ford and automobiles in the 1900s. From mining operations to refineries to ships and rails to factories and distribution, these companies controlled every part of the their supply chain. They overpowered their supply chains with capital, and barriers to entry were high. Starting a new steel company was no mean feat, and competing against Henry Ford wasn't a picnic, either. But over time, as these industries globalized, the value of each part of the supply chain shifted. Japan became a powerhouse in steel from a processing perspective, creating high-quality steel with few defects at low cost. But they didn't have control over the raw materials supply chain. Technology and quality management became the key sources of differentiation, and the US steel companies that were slow to adapt got crushed. A similar phenomenon happened with the Japanese and the auto industry, where they didn't control the bottom layers of the value stack but used technology, process engineering and customer focus as sources of competitive advantage. In the face of superior technology and control processes, the power of vertical integration withered.

Fast forward to today. We're seeing several examples of the return to verticalization, including those cited in the WSJ article: Oracle, Boeing, HP, and Apple. The general knock I've had against these kinds of moves is that a company has a core competency, and when it strays from that competency it sub-optimizes. For example, can a company really design and manufacture the best hardware AND software? Can it design and manufacture the best printers, communications equipment AND run a world-class consulting business? Wouldn't it be better to put all of one's efforts into a particular area, achieve market dominance and high profit margins, and dividend the cash out to shareholders rather than spending it on acquisitions to achieve vertical dominance? Certainly over the last 30-40 years the pendulum had swung towards specialization, as the vertically integrated companies got picked apart up and down the value stack: there were always companies better, stronger, faster than members of a vertical organization. But something has changed. In a word: speed.

The world has flattened. Supply chains are global and fragmented. Information dissemination happens at lightening speed. Customer preferences drive design and not the other way around. Think about the impact Apple has had by controlling the user experience, a seamless integration of hardware and software. This is markedly different than the Dell/Microsoft/Intel experience. Apple is selling not just a product but an experience, an image. Dell is selling a bundle of features. And Apple is able to achieve this partly because of vertical control of its value stack. Dell is a procurer and an assembler. And they are very good at it. But Apple's tight integration laid the foundation for a host of add-on hardware and software solutions that augment the core experience. Dell simply can't go to these places because it lacks the holistic perspective and control. Assuming perfect access to all materials in its supply chain, might Apple be able to deliver its customer experience better and more cheaply by simply focusing on software and product design than it does today? Sure. But given that perfect access doesn't exist and that speed is critically important to adapting to changing customer preferences, does vertical integration create a kind of option value that a more fragmented supply chain lacks? Undoubtedly.

Historically specialization has conveyed perceived option value, where the best suppliers can be tapped at all times and with weaker suppliers being replaced in the name of ruthless efficiency. But I believe option values have flip-flopped. Specialization may, in fact, represent a short option position, as scarce resources can be parceled out by sharp suppliers to the highest bidder, while those with vertical control can respond and react in real-time to changes in market conditions. Might the pendulum swing back in the other direction? It always does. But might vertical integration be in vogue - and the rational and adaptive approach to best serving customers and maximizing profits - for the next few decades? I'd say so. And I have to admit I never thought I'd say that...

Why I'm Not Blogging

I've been at this since July 2006, doing my thing. Writing when I've felt inspired, irked, righteously indignant, touched, happy and sad. Blogging has become a significant and meaningful part of my life, one where I am able to express myself on my terms, write about issues rattling around in my head, and to connect with people across the world and from different walks of life. Discovering blogging has truly been a gift. It is hard to imagine living without my blog.

Then why am I less interested in blogging than I've been in nearly three years? While I'm certainly not the most prolific blogger, I've created a veritable War and Peace of content during my blogging career. 2-4 times per week, very consistently, with a few 2-week "vacations" and some jags where I've written nearly ever day for weeks. But I can honestly say that I've never felt less interested in writing than right now. I generally keep a list of potential topics and I currently have stuff on that list, but whenever I look at it I think, "That's work." Blogging has never been work to me, so that kind of feeling is both unpleasant and scary. Have I lost my inspiration? Has my well run dry? I have written a lot about a wide array of topics, and my writing tends to be pretty intense and detailed, not little pithy entries or linkfests, so maybe I'm just spent. Or maybe...something else is going on.

I know my feelings have to be anything but unique, but I am mainly interested in the "why." Has anything changed in my life over the past, say, three months, when the frequency of my postings has notably declined? Well, after passionate and enthusiastic writing about the economic crisis, the Obama Administration, the Treasury, Paulson, Bernanke, etc. I just got tired. Is it because of the "bear market bounce?" Maybe. Is it because I don't want to simply write derivative crap of the stuff I've written previously? Possibly. Is it because I don't feel anyone gives a shit what I say? I'm sure that plays a part in it, too. I tried really hard for a period to be heard by those in Washington, in positions of power, but to no avail. There were plenty of voices to be heard, and mine simply was not one of them.

But there has been some other stuff that has been going on as well. I've never worked harder at my investment business, IA Capital Partners. Between working on new investments, my Board commitments (which I take very, very seriously), some advisory work with some of my companies and considering taking some outside capital, it has been pretty time consuming. Also, my trading company, Kinetic Trading, has been taking lots of time. I've been very focused on building this business, and it has been going very well. Starting something from scratch is hard, and making the transition from a "virtual" company to an organization with a home base, employees, strategic partners and outside capital is very exciting but a tremendous amount of work. Finally, I've been super committed to my boys and their love of baseball. Coaching my older son's team and supporting my wife in her coaching of my younger son's team (and acting as their pitching coach) is a labor of love in the Spring, but man, does it take time. No complaints, but I feel as if I spend 50 hours a week on my feet. Oh, and then there is my Board work for my kids' school, Little Red School House/Elisabeth Irwin High School (LREI). Again, a labor of love and something I deeply believe in (progressive education, humanism, providing opportunities to children across the socioeconomic continuum, etc.), but I chair the Finance Committee (making me Treasurer), am a leader in fund-raising and other stuff. In short, I'm in pretty deep.

So when all of this is mushed around, I think my lack of interest in writing has less to do with time (I've never had any, anyway; I've always just created time to write somehow) and more to do with lack of mind share. My brain is pretty stuffed with all my current interests and responsibilities, and I simply don't have the opportunity to contemplate my navel and think deep thoughts right now. My thinking is much more task-focused, much more project oriented. And since my blog isn't a business for me, it is a passion and an outlet, I'm simply not compelled to write. It's sad, but true. While this is my current state, I am hopeful that when things calm down I'll once again feel the inspiration and have the mental capacity to get back to it. On a certain level I feel guilty about not writing; I feel like I'm letting my readers down. But even more importantly I simply miss it. I miss the feedback, the dialogue, the back-and-forth, the spurring of new ideas that come from those who comment on this blog. And if I don't write, I completely miss this dynamic.

In the immortal words of the Governor of California, I'll be back. I just wish I knew when.

Twitter is our id, Facebook is our Ego

I was speaking with my good friend Howard Lindzon, my partner in several Twitter-related investments, about the differences in the way people communicate on Twitter and Facebook. Howard's sense is that everybody lies on Facebook; that people represent a kind of "false self," so that it is hard to really know what a person is like from their Facebook profile. He feels differently about Twitter, however, holding the belief that people's tweets are a much closer representation of their true self than Facebook. So that someone who is a jerk on Twitter is likely a jerk in real life, and someone who is thoughtful and careful in their tweets is also like that offline. After considering Howard's theory, I am convinced that he is right. Then it hit me. There is a framework for conceptualizing the differences in peoples' communication between these two media: Freud's structural model of the psyche. In short, Twitter is the id, while Facebook is the ego.

The Twitter experience is one of quick bursts, rapid-fire communications that flow from one's brain straight out to one's fingers and onto the screen. For most, there isn't a ton of premeditation that goes into one's tweets. As we've learned with email, there are things people will say in an email that they would never say to someone's face: this has cost large corporations hundreds of millions of dollars in fines and billions of dollars in lost market value resulting from thoughtless, unmediated behavior. An entire industry, email monitoring, has emerged from the disasters of Wall Street and other businesses where impolitic, hurtful and downright stupid communications have been dredged up in discovery associated with myriad lawsuits. While real-time messaging behind the corporate firewall is now aggressively monitored, the lion's share of message volume is out in public for all to see. And there isn't a ton of motivation for mediating one's tweets; also, given the bounded nature of the messaging, it often results in a quick stream-of-consciousness that reflects the need of the tweeter to be heard and/or their desire to impress or shock. Consider Freud's description of the id, circa 1933:

It is the dark, inaccessible part of our personality, what little we know of it we have learnt from our study of the dream-work and of the construction of neurotic symptoms, and most of this is of a negative character and can be described only as a contrast to the ego. We all approach the id with analogies: we call it a chaos, a cauldron full of seething excitations... It is filled with energy reaching it from the instincts, but it has no organization, produces no collective will, but only a striving to bring about the satisfaction of the instinctual needs subject to the observance of the pleasure principle. [Freud, New Introductory Lectures on Psychoanalysis (1933)

In short, it is all about me, I can't really control it, and it feels good. This seems to me to be a pretty interesting way to think about many peoples' use of Twitter: "I'm getting a coffee;" "I just had a lousy subway ride;" "Check out this article, it's really good;" "isn't Congress missing the boat on this issue?;" etc. I WANT TO BE HEARD. I WANT PEOPLE TO CARE. I WANT TO FEEL IMPORTANT. READ ME! READ ME! Do most people actively manage their image on Twitter, or is it merely a reflection of one's inner self? I'm going with the latter.

Facebook, conversely, requires a much bigger upfront investment to get value out of the medium. A user needs to create a profile, invite friends, join groups, and establish an identity. This is a deliberate process, one which prompts at least some thought (at least among those over the age of 21). It is clearly not the ADD Twitter experience, where one need take no more than 5 seconds to rip out a tweet off the top of one's head. The user has enough time to use their conscious thought to create and maintain a Facebook presence, leading to an output that is more reasoned and more calculated than their Twitter identity. This sounds a lot like Freud's description of the ego:

...The ego is that part of the id which has been modified by the direct influence of the external world ... The ego represents what may be called reason and common sense, in contrast to the id, which contains the passions ... in its relation to the id it is like a man on horseback, who has to hold in check the superior strength of the horse; with this difference, that the rider tries to do so with his own strength, while the ego uses borrowed forces [Freud, The Ego and the Id (1923)]

With a Facebook identity representing a stake in the ground, it takes on a sense of permanence, of solidity. This is something that begs for more time and consideration than the Twitter stream, a constant cacophany of jabs, jokes, jousts and jeers. A mountain versus a river. A stock versus a flow. Their characters are entirely different and appear to tap into different parts of our make-ups. It is the difference between what we want others to see and what we can't help showing. The ego and the id. Our mediated self and our raw, inner being.

What Keeps Me Awake At Night: Economy Edition

The stress tests are done. All is well. Green shoots are popping up all over the place. The worst is behind us. Everything is cool, right? Well...

This is how my nightmare goes. The US Government has adopted the following mantra: BUY TIME. Buy time for:

• the stock market to recover;
• sentiment to improve;
• retail demand to pick up;
• credit markets to open up;
• bank balance sheets to be rebuilt;
• banks to lend to both consumers and small businesses;
• businesses to begin hiring again;
• homeowners who were once on the edge to be able to pay their mortgages;
• real estate prices to rise;
• residential and commercial mortgage-backed security prices to rise; and
• TOXIC ASSETS TO BECOME DE-TOXIFIED.

The US Government has done everything in its power to avoid the perception that it has lost control. Statements such as "None of the largest banks will be left insolvent," providing both direct capital injections and indirect support through the FDIC debt issuance guarantees, the AIG payouts that were funneled to Wall Street counterparties, TALF, etc. Further, the SEC and Congress were silent when FAS 157 was relaxed, providing further support to bank and insurance company balance sheets "as is." Buying time. Congress could have forced transparency, could have let the largest banks get restructured, could have facilitated a comprehensive plan against the illiquid asset problem. But this was not the path taken. And if the stock and bond markets continue to go straight up and if risk premia fall, then the "Big Brother" approach taken could be vindicated.

But what if, just what if, the economy hasn't turned the corner? What if job losses continue apace, residental mortgage defaults continue to rise and corporate bankruptcies spike? As defaults ripple through the system, given the lack of transparency and granular, easily accessible data around mortgage-backed security vehicles (CMBS, RMBS) and credit default swap (CDS) positions, how are we to untangle the mess in a timely and efficient manner? How are investors supposed to accurately price risk in the absence of this data? The US Government can continue its posture of uber-borrower, but this game can only go on for so long. Let's say the Chinese government gradually reduces its net purchases of US Treasuries, and also shortens the duration of its Treasury portfolio. As the US Treasury continues to run the printing presses, the Chinese would gradually build a compelling argument (and a powerful economic position) as to why the US Dollar should no longer be the global reserve currency and the basis of exchange in oil. Profligate spending coupled with fewer willing buyers will drive up US dollar long rates, debase the currency and set off a very unpleasant inflationary cycle. With plummeting real asset values, spiking inflation and high credit costs, the US would be in a very uncomfortable position, indeed.

The Administration and Congress have clearly taken the path of least resistance. Wiping out of the stockholders and unsecured bondholders of our largest financial institutions would have been a political nightmare, but it would have enabled the market to purge the excesses that our system has wrought over the past decade. An emphasis on generating comprehensive data and full transparency around toxic asset portfolios would have also helped in the process, creating a much clearer picture of ultimate ownership and a basis for working out the problem credits (and counterparties). This wouldn't have produced nightmares, it would have yielded wakeful pain followed by catharsis and and way forward. The path taken looks and feels good today, but potential troubles lurk just below the surface.

Is there a monster in my closet? Well, maybe...

On a Crash Course With the Rule of Law

As noted in my post on the invariable failure of the Treasury's PPIP initiative, it is impossible to coax liquidity from the sidelines if asset owners are unwilling to trade at a price approximating market value. In this case, banks perceive themselves to own a valuation call option, one where they hope time will boost asset values such that underwater (at least on a mark-to-market basis) securities have time to recover. While this is a negative approach supported by weak and ineffectual accounting rules, banks are not violating the rule of law.

Consider, however, the looming time bomb that is the Commercial Mortgage-Backed Securities (CMBS) market. With the hundreds of billions of 5 year paper originated between 2005-07, there is a huge refinancing requirement just over the the horizon. Many, if not most, of these projects are not readily financiable in today's market environment. Further, the complexity of their capital structures has given rise to an array of misaligned motives that will invariably find their way into court. Think about the unrated, junior most layer of the capital structure. These investors, with expected IRRs at inception of 20%+, are looking at a zero payout at this point  However, many also hold the servicing rights to the structures, and are charged with the responsibility of acting in the best interests of all debt holders. With the scepter of refinancing just 1-3 years out, all is not looking good. But with the hammer of their contractual rights and historically low interest rates, they are currently able to service the debt without the pressure of necessarily selling out, which is exactly what the AAA senior tranche would like them to do. So you have the AAAs who felt very secure in a liquidation scenario not controlling the timing or manner of liquidation, while the unrated z-bond holders are bust on a mark-to-market basis but holding most of the cards. At the end of the day the magic of securitization didn't disseminate risk, it spread responsibility. And in the absence of a need to mark-to-market, the vehicles can continue to exist as members of the walking dead. Now that the day of reckoning is rapidly approaching, their legal construct will necessarily be tested. The General Growth Properties bankruptcy will be our first mega-scale test of whether these Special Purpose Entity (SPE) structures hold up. This is a clear indictment of the way these vehicles were established, and the blame lies squarely at the feet of the structurers (convoluted and conflicted, no?), the rating agencies (AAA-rated super senior? Really?) and the investors (were these documents ever read?). When all is said and done, the rule of law will show us the way. But if the courts determine that the legal underpinnings of the CMBS market were somehow flawed and that the contractual terms between the junior and senior creditors are abrogated, then what is an already complex and fractured market will only get worse with a seemingly endless stream of litigation and confusion.

Another train wreck is the auto companies. Chrysler is currently staring into the abyss, soon to become part of the Fiat family. In the meantime, Chrysler's bondholders are in a game of chicken with the US Government, which would like to portray them as "obstructionist" and "putting their interests in front of preserving the company." Well, duh. What else did the the Government expect them to do, donate their holdings to the Chrysler pension plan? The kind of coercion and stiff-arming going on here, if not amicably settled, will land the Obama Administration and recalcitrant Chrysler creditors in a pitched court battle, which could have ramifications for not just the auto industry but any sector where the Government seeks to get "enthusiastically" involved. Is restructuring under the Administration's watch somehow more beneficial to all constituencies than under the experienced eye of the bankruptcy court? While the Administration has been pulling strings from the sidelines and tacitly engineering the bailout of the financial sector, it has steadfastly refused to force troubled institutions to face into their problems, whether through bankruptcy or radical restructurings of their businesses. The inconsistencies between the treatment of the autos and the banks is blinding, likely leading to suboptimal outcomes in both cases. Pussyfooting around with the banks. Wielding the hammer with Chrysler and GM. It just doesn't make sense.

One thing is certain: while many transactional lawyers have found their business drying up, bankruptcy lawyers will be in strong demand for years to come. May heaven help us all...

The US Government: Over-engineering for Under-performance

Beginning with Bush and Paulson and continuing with Obama, Geithner and the newly-emboldened Ben Bernanke, the US Government has adopted the posture of over-engineering our emergence from the financial crisis, with an eye on stock market performance. Plans have been highly complex, rescues have been largely one-off and Congress has gotten into the business of executive compensation, company-specific tax policy and other minutia. The alternative: broad, sweeping, clearly communicated and transparent policies, those to which investors and taxpayers alike can rapidly assimilate and react. It is a matter of trust, and trust has been in short supply ever since the crisis hit. Unfortunately, the US Government's involvement has done little to rebuild trust on Wall Street or on Main Street. The result of the Administration's plans is depression followed by mania followed by depression, as incomplete or misleading information is slowly disseminated into investor consciousness while the equity markets see-saw depending upon which side of the wave we find ourselves. And recent bank earnings are only one shining example of why we are now locked into a painful, protracted process of false hope, failure and rebirth, when we could have chosen quick, deep pain, and transitioned to real hope and rebirth in a much shorter time-frame. But the US Government does not believe the US citizen can withstand such pain; they'd rather take the path of least resistance, delay the inevitable, buy time and pray that we - the collective "we" - get bailed out. Unfortunately life seldom works this way. If you've got it coming to you it generally comes: the only question is how quickly you can get it to go away.

When I hear friends both inside the major banks say "But we just reported earnings of $x billion and beat Street estimates; why is our stock getting hammered?" or "Our stock is trading at x% of book value when our earnings power is improving, why do investors continue to lack faith in our institution?," it only highlights the disconnect between the Wall Street (and Administration) world(s) and the real world. Clearly few investors look at Citigroup and Bank of America's headline earnings and think them to be of high quality: out-sized trading revenues, debt revaluation and one-time gains dominate the story. Customer revenues generally are poor. Credit charges are skyrocketing. Every kind of loan portfolio is under pressure. And with the mind-bending error of weakening the mark-to-market guidelines, transparency and financial statement clarity is worse than ever. The American Bankers Association and their lobbyists thought they were really smart; let's press the Financial Accounting Standards Board (FASB) to weaken FAS 157 (mark-to-market guidelines) in order that our member firms can show better earnings and capital ratios. And they were successful. But surprise! Investors are not all as stupid as they sometimes appear. They looked right through the reclassifications and accounting changes and determined that earnings quality stunk. Hooray! Citi beat Street estimates. Yippee! Bank of America hit the cover off the ball. But not if what you are looking for are real earnings and true indications of sustainable revenues and financial health. Once again, we have taken a big step backward in the transparency and trust departments. These are areas where the Administration and Congress should be showing strong, decisive leadership. Sadly, they are not.

You now have CEOs of TARP recipients rattling their sabers saying that they want to return the funds, shortly after printing historic trading gains off the backs of US Government debt guarantees and TARP funds. This is clearly not the outcome the US Government had in mind: a direct transfer of value from the US taxpayer to common stockholders of TARP recipients. But if you develop a program as complicated as TARP which impacts multiple constituencies in vastly different ways, it is not surprising that chaos and adverse PR would result. And, suffice it to say, we are still mired in the toxic asset issue. As predicted, the PPIP is dead on arrival. With a weakened FAS 157, regardless of the demand fomented by enormous liquidity on the sidelines together with cheap Government-sponsored leverage, the supply side will simply not show up. Without a clear requirement to clean up their balance sheets, banks will simply milk the option delivered to them on a silver platter by the FASB. They will wait it out, not lend significant sums, engage in financial engineering to make their capital ratios look good, all with the tacit if not outright support of the US Government. This was not the way it was supposed to work. But if you take the path of least resistance, you generally deserve the least attractive results. Not surprisingly, this is where we've ended up.

The US Governments, past and present, had a clear idea of how they wanted the financial reconstruction to go: stabilize the largest, most troubled institutions; let one go to show that they are still free marketeers at heart; loosen accounting standards to make supporting the largest institutions less costly, at least in the short run; use moral suasion and cajoling to encourage supported firms to lend; and then let time work its magic by enabling broken portfolios to recover in value and for earnings to be rebuilt through "riding the yield curve" and lending with Government-subsidized borrowings. But all did not go according to plan. Policies became highly fragmented as each institition was treated as its own separate case, creating uncertainty in the markets and on Main Street. Public relations became a problem as bailed-out firms started paying bonuses, ostensibly with taxpayer dollars. Compensation caps were enacted. Tax policy was used to attack contractual bonus payments. The forest was long ago lost for the trees. The dream of engineering a soft landing is now long gone. The best that can be hoped for is getting through without a financial crisis of staggering proportions. And it didn't need to be this way. Fewer, clearer, more aggressive policies with an emphasis of transparency and communication. Then let the markets do what they will do. Obama & Co. should really be called the Bloomberg Administration: because with such a focus on Wall Street and the stock market there must be a Bloomberg terminal on every desk. Our leaders need to switch them off - now. They do not hold the answer.

A Few Thoughts for a Breadless Holiday

Yes, I am referring to Passover. A truly wonderful holiday, one which chronicles the Jewish people's exodus from tyranny in Egypt. As part of our remembrance, we don't eat "leavened bread" (stuff that rises). In short, no bread. Given the depths of the financial crisis, bread is in short supply among those of any religious persuasion these days. We're all in the midst of our own personal exodus, trying to find our way from poverty back to a healthier, more sustainable prosperity.

The irony of Passover story and its linkage to today's circumstances isn't lost on me, so I thought I'd share a few thoughts about what I'd like to see "Pass over" in the ensuing weeks and months:

1. Pithy sound-bites from the US Government about how the worst of the economic crisis is over;
2. Erratic and conflicted thinking as it relates to the banking sector and every other sector in need of assistance;
3. The thought that propping up sick banks will actually make bad assets turn into good ones, like magic;
4. Immigration policies that keep those outside our borders who can best help our country remain at the forefront of research and innovation;
5. Senior politicians in positions of power with real or perceived conflicts with those whom they influence;
6. Adjustments to accounting rules that make bank earnings look rosy when underlying portfolio problems are still acute;
7. A loss of focus on the importance of alternative energy even though oil prices are 65% off their highs;
8. The sentiment that Americans who choose to save and/or de-lever are somehow un-American, because Americans are supposed to borrow and consume, right?;
9. The White House trying to please everyone all of the time, instead of taking bold stances and pushing through difficult, but correct, legislation; and
10. The power of lobbyists and special interests in times of crisis, when their influence should be marginalized for the greater good.

This is merely a start. But as I sit here breadless and thinking about our future, I hope, and have confidence, that the best is yet to come.

May We Live in Interesting Times...

Consider these events of the past week:

• Life Insurers may gain access to TARP funds (though "only" $130 billion remains under the current authorization) to deal with a severe liquidity crunch. Several of the largest life insurers - Hartford, Genworth, Lincoln National - scrambled to buy thrifts shortly after TARP came into being to gain a place in the queue. Few have really focused on the implications of a sick life insurance industry. Trillions of assets. Hundreds of trillions of insurance in force. The largest buyers of corporate bonds. If life insurers really feel a liquidity crunch, they will spit out their liquid assets, e.g., corporate bonds, by the billions, sharply raising the cost of capital for businesses across the country. This is not a happy thought when businesses are under so much pressure to begin with. Also, like banks, life insurers are enormous. Consider what a TARP II might look like with life insurers as part of the bail-out; it will make the $700 billion TARP I look positively cheap. But does the stock market care? Nah. But corporate bond spreads certainly haven't moved in lock-step with the equity rally; credit traders appear to know something their equity counterparts don't. Like, how to quantify and price risk?

• The Administration is pushing money managers to create "Bailout Bonds," or the ability for retail investors to play the PPIP game. I have heard some bad ideas in my day, but this one is up there. The rationale is ostensibly "Don't moan and groan about those money managers making all the money off the Government bailout programs; you can do it, too." Linking together the Government, Wall Street and Main Street in one big, happy bailout embrace. This is being directed at a retail public, many of whom haven't the faintest idea of how to properly plan for their financial future. How about providing a tax refund for taking a life-cycle investing class? How about investing people's Social Security balances intelligently? Providing the cash-strapped US consumer with an opportunity to buy bailout paper is patently irresponsible. It is nothing more than a PR stunt to put a damper on complaints that the Blackrocks and PIMCOs of the world are getting sweetheart deals at the taxpayer's expense. Given how the Administration has chosen to address te financial sector's problems these complaints have real merit, but creating yet another money-making vehicle for the large retail asset managers is not the solution. Fixing the plan the right way, by creating a centralized troubled asset vehicle that takes on assets at market value which get worked out over time for the taxpayer's benefit, solves the problem without marketing spin and PR stunts.

• Goldman Sachs is issuing stock to repay its TARP funds. Goldman has enjoyed a 162% run-up since its November low, trading just shy of $125. I understand it wants to repay the Government, but when smart market-timers like Goldman are selling, take heed. Generally it means the market has run up and is due for a breather. Whether it is a breather or a collapse, who knows, but is certainly doesn't portent good things for the equity market - or at least the GS stock price - in the near term.

Next week's market action should be fascinating. On a tiny bit of good news and a bunch of bad news the market roared higher. With bank stress test results on the horizon and more bad earnings reports coming up, the recent rally will be sorely tested.

The US Government: Manufacturing Outcomes

It appears that the Financial Accounting Standards Board (FASB) - the "independent" rule-making body of the accounting profession - and the US Government are in almost perfect sync. One week the FASB relaxes FAS 157 - the mark-to-market standards applying to financial asset portfolios - while the next brings the Treasury Department's release of bank stress test results. The Treasury, without question, has tremendous latitude in how it reports the results of the stress tests, and if it chooses it might well incorporate the expected benefits of the "new" FAS 157 on bank capital balances. This would have the beneficial public relations impact of showing banks as being much healthier than the former accounting regime would indicate, the regime that forces banks to deal with the reality of where their assets would clear the market. And while naysayers would have you believe that marking-to-market assets which are intended to be held until maturity is harsh, I'd counter with this simple question: does the bank have the term capital, and, therefore, the ability, to fund these assets until maturity? If the answer is no, which is invariably the case given the massive size of bank illiquid asset portfolios relative to term capital, then marking-to-market is the prudent way to reflect its true financial position. The US Government is conveniently staying silent on this part of the debate. But what else should we expect? The business at hand is that of manufacturing outcomes, regardless of their basis in reality. 

Merely the latest formula to describe the US Government's approach to spinning the financial crisis:

Relaxing FAS 157 + Release of Treasury stress test results = A Positive Manufactured Outcome

The stock market will initially cheer the positive results, following the US Government's lead. But once reality sets in, the reality that deals with market values, financing terms and solvency, the pretty picture that has been painted won't look so good. But hey, things are OK for now, right? For now.

Bailing out the Bailout

It has been both frustrating and painful watching the US Government's response to the financial crisis unfold over the past year. That said, the events of the past two weeks have dropped our Government's response to new depths. Mistakes compounding mistakes, while the PR machine is spinning to ensure that neither the US public nor its allies perceive things this way. First, the Treasury and the Federal Reserve applied inconsistent policies to distressed financial institutions, allowing some to live (AIG, Bear Stearns) while others were left to die (Lehman Brothers). Next, they stuffed certain terribly sick institutions with $200 billion of taxpayer dollars in the form of direct capital injections and capital guarantees (Bank of America, Citigroup, Merrill Lynch), little of which has flowed through to either new lending or the resolution and winding down of massive illiquid asset portfolios. And this doesn't include AIG, which itself consumed $170 billion of taxpayer dollars, much of which went directly to AIG's counterparties, a separate bailout unto itself. And certain of these institutions (Goldman Sachs, for one) were already recipients of TARP funds. Now, the Treasury proposes a plan, the PPIP, to engage the private sector in helping to liquify these illiquid asset portfolios, which only serves to highlight the divergent motives between the buyers (who wish to acquire cheap assets with Government-sponsored leverage) and the sellers (who are seeking to garner above-market prices for assets in order to clear their books without mark-downs). In short, PPIP lacks a catalyst to encourage the sellers to participate in the program. Finally, Thursday brought a relaxing of the FAS 157 mark-to-market standards promulgated by the Financial Accounting Standards Board (FASB), further reducing the likelihood banks will proactively address their toxic asset woes. Because if they can mark their books and they say they intend to hold these illiquid assets for the long haul then there really isn't a problem, is there? All the public wants to hear about is executive pay, because this is what our leaders want us to think about. All form, no substance. Due to poor policy-making, a lack of leadership and fear, we are no closer to solving the financial system's deep-seated problems today than we were back in September.

One would have thought that squandering and losing track of a few hundred billion dollars would have spurred the US Government, the Treasury and the Federal Reserve into action - constructive action - but this has hardly been the case. We've only seen more of the same. But our officials are certainly pleased with themselves in light of the recent stock market rally. This surely has to be validation that they are on the right track.They've placated the big banks, offered up fodder for already wealthy structured asset investors (BlackRock, PIMCO and the like), preserved their lobbyist cash flows by allowing the accounting rules to be changed for the banks' benefit (needless to say, the American Bankers Association was pleased with the FASB's change of heart) and staved off a market meltdown, right? Time will tell, but I am not optimistic. The embedded problems are the same: multi-trillion dollar asset problems; balance sheets laden with illiquid "hold to maturity" assets funded with much shorter duration liabilities; inadequate transparency into bank portfolios; poor tracking of US taxpayer dollars deployed in the bailout; special interests driving critical parts of economic policy; and the sense that the game isn't being played fairly and for the benefit of the American people. It is a lack of trust that is central to our country's problems, a breach that new runs deep within most of its citizens. If our Government can allow the rules of the game to be changed in mid-stream (as they were with Lehman Brothers, TARP, FAS 157 and company compensation), then how can the markets and its citizens judge when things are truly better? An absence of both trust and transparency are enormous barriers to emerging from this economic crisis.

When President Obama was elected, many felt change was afoot and that real diplomacy, tough decisions and transparent and rational decision-making was at hand. In the early days of his Administration, his style has arguably been more effective on issues of foreign diplomacy than on domestic policy. The financial crisis requires a strong hand, a strong stomach and avoidance of interference from entrenched and conflicted parties in both Government and the private sector. Unfortunately, too many of these people have garnered influence within the Administration, leaving us with an approach that is engineered to placate, pacify and perpetuate existing institutions. This is the wrong way forward.

Last year I had proposed the creation of an independent Stabilization Oversight Council (SOC), a group with the expertise and perspective to suggest the tough prescriptives while obtaining the support of the President and Congress. I believe now as I did then that the current policy team is not sufficient to make the difficult yet necessary decisions. When items as arcane yet as important as accounting rules become politicized, something needs to change. And it is incumbent upon our elected leaders to make these changes not for the good of their popularity, but for the good of their citizenry. And this doesn't mean the lobbyists. It means their voting constituents.

The right approach has not changed that much over the months since the crisis moved into full swing. And as the issues have been addressed in bits and pieces over this time period, I will seek to offer a step-by-step prescriptive of how we can get our financial system on the path to recovery rather than merely deferring the day of reckoning:

• Impose strict mark-to-market standards on financial institutions' balance sheets. If assets are classified as "held to maturity," confirm that the financing is in place to carry these assets to term. Intention to hold to maturity is very different than the ability to do so, and the rules need to change to link these two principles. This exercise will quickly flush out the solvent from the insolvent, and create a regulatory capital surplus (deficit) for each and every bank, broker/dealer and insurance company.

• If firms are in a deficit position, and within a pre-defined distance from solvency, they can have a 60-day window within which to raise private capital to fill the deficit. If the required capital cannot be raised, then the firm is eligible for seizure by the Government. This also applies to firms in deficit positions that are not granted a 60-day capital-raising window. These firms are then taken over and reorganized in a pre-packaged bankruptcy, with obligors paid off with available capital. The courts will be closely involved in this process. Many will be out of luck. Common stockholders. Many if not all unsecured debtholders. Incumbent managements.

• After the window has expired, each firm's bad/illiquid assets, now marked down to market values, are segregated from the healthy operations. These "bad" assets are held in a central repository administered by agents of the US Government on behalf of the US taxpayers. They will be warehoused and liquidated in a rational, non-fire sale manner over time. The healthy operations, including bank branches, core deposits, performing loans and liquid assets will be available for investment by private institutions, with the US Government potentially retaining a stake (with the intention of being sold as quickly as practicable). The "Good Banks" will be offered publicly almost immediately, with new managements, clean balance sheets, strong capital positions and a willingness and ability to lend. No longer will these banks have to hoard capital to cushion persistent losses from their troubled asset portfolios. Taxpayer capital will finally be put to good use; creating good banks that can make good loans to help good businesses emerge from the crisis.

• Rules governing financial disclosures will be modified to ensure full transparency, and financial accounting practices will be reviewed to ensure their consistency with new disclosure requirements. Further, off-balance sheet financial transactions will be sharply curtailed, simplifying both balance sheet presentation and footnote disclosure. Investors will no longer have to engage in time-consuming and costly forensic accounting reviews to get a true picture of a financial institutions' health. It will all be there in the financial statements.

• Over-the-counter (OTC) derivatives transactions will be pushed to exchanges. This will enhance transparency, liquidity and collateral management in this opaque, multi-trillion dollar market. Transactions will no longer evidenced by customized firm-to-firm agreements whose terms are invisible to the marketplace, but by notional amounts of standardized contracts with collateral balances that are "trued up" at the end of every trading day. This will sharply reduce the risks of a replay of AIG, where a firm with a high public credit rating was allowed to accrue hundreds of billions of dollars in potential liabilities without having to post collateral until it was too late. The movement towards exchanges will both demystify and de-risk a huge part of the derivatives industry, one which has been maligned for complexity and the inappropriate behavior of certain of its participants. But the value of derivatives as a risk-management tool is unquestioned and its ability to serve as a vehicle for speculation is also important for enhancing market liquidity and price discovery. But only if the risks can be dynamically managed via collateral posting and disclosures are straight-forward easy to understand.

• Boards' fiduciary obligations will be clarified and strengthened and anti-shareholder friendly provisions such as staggered Boards will be eliminated. The Government has started to get involved in discussions around corporate governance and executive pay. This is not the Government's job; it is the job of company Boards as elected by its investors. Everyone has failed on this score. Boards allowed executive pay to spiral upward without reason, and shareholders neither objected strenuously enough nor had the easy ability to impact directors' behaviors. Boards, plus their investor fiduciaries - the pension funds and endowments - all are resopnsible for the massive disconnect between executive performance and compensation. If Boards act as if they are in the pocket of the CEO, they should be replaced by vote. Right now Delaware state law is the big stumbling block to reform. Make it a Federal issue. This is where the Government should be spending its efforts; not on how executives should be compensated.

The Government's approach to addressing the root cause issues of the financial crisis has thus far been inadequate. Market realities have slowly been forcing it towards the prescriptives I have described, yet at a glacial pace. We have no more time - or money - to waste. Issues of politics, perception and partisanship have to give way to pragmatism before it is too late. If only our legislators could shed the shackles of short-termism we as a country, and as a people, would be far better off.