naked capitalism

Before I raise your expectations unduly, I am not saying that Ben Stein’s entire “Everybody’s Business” column today is intelligent. However, this week’s piece, “It’s Time to Act Like Grown-Ups,” had some sensible moments, and I want to give Stein his due on those infrequent occasions when it is merited.

I am not parsing the entire article; I’ll just point to what I found to be the low and high points. First, the goofy part:

Here is a simple truth: As we know, Merrill Lynch, Citigroup, Bear Stearns and other financial entities have taken immense charges on their holdings of bundles of subprime mortgages, collateralized debt obligations and loans made in connection with mergers and acquisitions and for general commercial purposes.

But these deals did not just come out of the blue. Someone sold these debt instruments to these huge banks and investment banks. The someone might have been a borrower who was not qualified, or another player in the financial field like a hedge fund or a mortgage originator.

If the buyers are now realizing that these instruments are worth tens of billions less than they paid, someone else must have booked a roughly corresponding gain. Now, it’s true that the seller might not have realized that he had the gain. He might have sold at what he thought was fair value at the time. It may be that only when the credit correction started was the asset in question marked down to problem levels.

When Stein is off kilter, it’s hard even to know where to begin.

Let’s start with the most obvious problem: If X sells something to Y, and the price of the good sold falls later so Y suffers a loss, X had a gain.

That sort of thinking puts both parties on a mark-to-market footing, and that has the effect of treating opportunity gains and losses as real gains and losses. But whether X really gained depended on what he did with the proceeds, If he exited the market and took cash, then yes, he did better than if he continued to hold the asset. But if he instead traded into another asset whose value fell even more, he could have come out even worse.

It may be easier to see the point if we talk about appreciating rather than depreciating assets. It’s common for investors to sell part of an appreciated position to take profits. Even though they recognize the security may keep going up, they decide to risk losing some additional profit to reduce their downside. An investor, such as a retiree, may also sell part of their holdings to fund consumption in accordance with a financial plan. Similarly, an institutional investor may sell a certain type of asset because he has asset allocation guidelines and changes in the values of various asset classes have put him outside his objectives.

Yes, you can say they would have done better in narrow profit and loss terms to have held on, but in all these examples, profit maximization wasn’t the only consideration. So again, the idea that they “lost” is specious.

That is perhaps a long-winded way of saying that decisions to sell assets aren’t simply about maximizing financial market returns. Investors have different preferences, so a trade in line with their preferences, risk tolerance, and liquidity needs isn’t a loss in the way Stein characterizes it.

The other problem is that Stein misses what drove the fixed income mania. It wasn’t the the opportunity for trading gains that Stein alludes to. It was the fees.

In the old days, banks and investors held assets and realized spreads over funding costs over time. But new-fangled financial structures have promised to deliver investors all kinds of great new paper (example: creating enough AAA rated paper to meet previously unsatisfied demand). The product designers and other participants in the product creation chain have managed to find bagholders of various sorts and have managed to suck fees out of them. Why the bagholders got snookered is the subject of a much longer conversation, but there were chumps a plenty.

So what happened to the investment banks, ironically, isn’t Stein’s model that they wound up on the losing side of the trade. No, at least in Merrill’s and Citi’s case, they were hoist on their own petard.

Merrill’s former CEO Stan O’Neal got rid of his head of structured products in 2006 because he did not want to increase the size of the business. He knew the market was getting saturated. O”Neal put a new chief in who was willing to commit to growth targets. So Merrill kept creating new structured investment product but was unable to place the full amount of the transaction with investors. They kept the rest on their balance sheet. (That, by the way, is incredibly bad practice. Merrill should have taken the price reduction needed to unload the rest of the deal). And they kept originating more deals and winding up with more unsold portions. They rationalized that they were a good risk and learned otherwise.

In a like vein, Citi was originating and selling similar structured products (collateralized debt obligations), but Citi’s wrinkle was that they had changed the design (of course to increase their profit) so that a tranche (the “super senior” tranche) was commercial paper. CP only goes out to a maximum of 270 days, but the CDO entities have longer lives, so Citi would have to find new CP buyers whenever CP matured.

Starting in August, investors started shunning asset-backed commercial paper, including Citi’s CDO-related CP. Cit could have let the CDO entities sell part of their assets to reduce their funding needs, but that would have created a lot of havoc, both in the CDOs and in the market. So Citi instead bought the CP itself. And that CP has fallen in value.

So if we use Stein’s win-lose model, the investment banks were losers because instead of selling paper (which they were selling only to generate fees) to third parties, they effectively sold it to themselves. These were tantamount to internal trades, self-inflicted wounds.

Now to the sensible part of Stein’s article:

….much has been made of the failure of officers and directors to notice that something was amiss at these big banks. Why didn’t the directors ask the chiefs, “Gee, how can you continue to earn a far higher rate of return on debt than the market rate? How are you defying gravity this way? Can it last?”

Why were the questions not asked?

Possibly because the directors might have been chosen with an eye toward political correctness instead of an eye toward what they knew about finance and accounting. I was staggered when I read about the backgrounds of the Merrill directors. It is nice to have leaders of colleges and universities on boards (as Merrill does) but wouldn’t it have been better to look for accounting expertise? Was the idea to conform to P.C. principles and not have anyone asking tough questions? What about fiduciary duty?….

Next, when I saw that Citi had taken a bath in collateralized debt obligations and subprime, and saw that Robert E. Rubin had been on the board in a major position and had failed to stop the train wreck, I was staggered. And now he has been named chairman. He couldn’t protect Citi’s stockholders, and now he’s in charge? And let’s remember, he was Treasury secretary when we had the first part of one of the worst bubbles in stock market history. What on earth are the Citi directors thinking?

Stein is absolutely correct to point to both the lack of deep enough expertise and enough tough-mindedness among investment bank directors. A dated but still relevant example: Richard Gelb, who turned his family’s business, Clairol, into an industry leader and became CEO of Bristol Myers when it bought Clairol, was a director of Bankers Trust. Now a man like Gelb would seem be unsuited to be a director of a financial services firm, particularly one that was a cutting edge derivatives player. But Gelb was a self made man, and not shy about asking pointed questions. He made himself hated by the Bankers Trust management, but in the end even his forceful inquiries weren’t enough to keep BT from getting into insurmountable trouble. And that was when the industry and the products were vastly simpler than they are now.

Gelb’s ultimate failure, despite his determination, proves out Stein’s point about political correctness, that board members chosen for how their bios will look in an annual report are unlikely to have the expertise to enable them to provide effective oversight of an investment bank.

I’ll take the argument one step further. Investment banks should not be public companies. We will put aside the most important reason, namely, that investment banks were far more prudent when they were putting partnership capital, rather than other people’s money, at risk, and the costs of having investment banks play with other peoples’ money are turning out to be awfully high. They can and are creating messes whose costs extend well beyond their shareholders and employees.

Investment banks are composed of multiple businesses with demanding requirements for managing them. Historically, the businesses have been overseen by people who grew up in them and knew them intimately.

It isn’t acceptable in a modern public company to have a board composed largely of insiders, but that’s what you need to have effective oversight of securities businesses, although that also puts the foxes in charge of the henhouse (the whole point of having external directors is to act as a check on insiders). And the few recent high profile retirees, or say heads of institutional investors that might some relevant knowledge would often be perceived to be cronies rather than independent.

But to Stein’s point about Rubin’s failure to act: it seems likely he chose not to know about the trouble spots. With Sarbox, I would not want to be on the finance or audit committee of a sprawling financial institution like Citi. And Rubin wasn’t.