The Mearsheimer View: Business & The Economy, Explained

The Future of Sarbanes-Oxley

2010-02-11T08:54:00.000-08:00

This week we have a post by a guest author:

Scott A. McPherson, CPA, CFE, CVA

Ah, Sarbanes-Oxley. It’s that albatross that has hung around so many business owners’ necks since it was unfurled in 2002. No wonder one of the top questions I’m asked is, “Scott… what do you think the future of SOX will be?”

Since I’m not gifted with the powers of 100% accurate prognostication, I can only speculate as to where the Sarbanes-Oxley Act will head in the coming years. However, based on the current economic climate, the intense debate surrounding the regulations and the media it’s been getting, I’ve put together a few predictions:

1. Small Businesses Will Continue to “Rage against the Machine”

For small businesses that are publicly owned, Sarbanes-Oxley has brought larger financial ramifications than it has for monolithic corporations. Thanks to the fixed costs associated with SOX compliance, those smaller businesses are forced to spend a larger percentage of their revenues on SOX-related measures.

Of course, the SEC has granted several SOX extensions to small public companies, namely those dealing with Section 404. The next is scheduled for June 15, 2010. However, no one is jumping for joy at the news. This constant pushing back of SOX deadlines is akin to being on death row and receiving a stay of execution. Sure, you’re glad that you’re not going to the electric chair right away, but you’re still on death row.

Fortunately, unlike a prisoner, small businesses are free to fight back politically and legally. I think you’re going to see plenty of that as the next Sarbanes-Oxley deadline for small businesses closes in.

2. SOX Will Undergo Revisions

The Enron scandal that created Sarbanes-Oxley is coming up on its 10-year anniversary, and the memory of the problems that precipitated SOX are waning in the minds of the up-and-coming generation of entrepreneurs and execs. Consequently, I think you’re going to see some minor – and perhaps even major – revisions when it comes to the way that Sarbanes-Oxley will shape the future of the business world.

Currently, many politicians and business leaders have set their sights on reshaping SOX. Truly, not a day goes by that financial bloggers around the world aren’t discussing Sarbanes-Oxley. Some find it praiseworthy, others find it loathsome. But all find it highly interesting and relevant, and that keeps SOX in the public’s eyes and minds.

Though this may sound like great news, it’s important to be realistic… so I have to say that…

3. SOX Is Probably Not Going to Significantly Change for Many Years

Given the fact that laws are tough to change, the chances of SOX going away tomorrow are nil. That means that all businesses – especially public small businesses – need to be prepared.

Last year we notified small public clients of procedures that should be taken. Most said “Let’s wait and see before incurring unnecessary costs given the economic climate.” The SOX audits loom over these businesses again this year and most are expecting another reprieve. Again we will reiterate last year’s notification of procedures that should be taken, and again we will probably wait on the enforcement ruling.

So will my Sarbanes-Oxley forecasts come true? I don’t know. But I do know that it’s absolutely critical for any publicly-owned business (or business that’s considering going IPO) to stay up to speed on the direction of SOX today and tomorrow.

About the Author: FinancialFutureCFO.com is a division of McPherson, CPA, PLLC and serves all 50 states. The firm provides an inexpensive alternative to hiring a full time person. All services offered are overseen by Scott McPherson, CPA, CFE, CVA. Visit http://www.financialfuturecfo.com/ for more information.

IRS Circular 230 Disclosure: Any tax advice in this communication is not written or intended by McPherson, CPA, PLLC to be used, and cannot be used, by a client, entity or other person for the purpose of avoiding penalties that may be imposed by the Internal Revenue Service.

King of the World, Again

2010-02-02T06:23:00.000-08:00

This week Ronald Grover, Tom Lowry and Michael White of BusinessWeek report on Avatar, the phenomenon which is not just a movie, it’s a game-changer for the entertainment industry. By now we all know that Avatar has broken box office records: it’s the highest grossing movie of all time. The movie to hold this title before was Titanic, another James Cameron film.

BusinessWeek says “Cameron is the most important commercial force in modern film, and his vision for the future of the movie business is rapidly demolishing anything that gets in its way”. Sounds like quite a vision. But Cameron is the guy who brought us Aliens, The Terminator and The Abyss, so don’t underestimate him.

Not only is the sheer magnitude of revenue impressive, but how that bucket of cash was achieved is unprecedented. The movie business will never be the same. BW points out that Titanic hit $1 billion after a few months, and it took Avatar only 17 days to reach the same milestone. And no, inflation was not the cause. What did help is ticket prices 30% higher for 3D. Cameron said, “I decided, let’s make a movie they can’t ignore”.

In spite of Cameron’s past success with so many films, Twentieth Century Fox was not about to put all its eggs into Cameron’s basket. Not when Cameron was asking so much to begin with. James Cameron has been called not just a director, but also an entrepreneur. He developed the camera that would be indispensable to the film, using his own funds. Now with other movie makers lining up to use his technology – for a fee, of course – that was his first big success with Avatar.

3D technology existed before, but not quite at the scale of Avatar. This movie proved that people will pay more to see something great, and I predict we will be seeing more. Cameron started to develop the script back in the mid 1990’s, before Titanic hit the theaters. But in the 1990s, the technology did not exist, so the six-legged creatures and blue princess had to wait.

Cameron paid $12 million of his own money to hire Vincent Pace to work on the 3D technology. BW says that Hollywood wisdom is to “never sink your own money into a movie”. But, Cameron proved conventional wisdom wrong, and came out ahead. Fox would not foot the bill for Avatar even though Cameron had proved himself to be a sure thing. Not to be deterred, Cameron went to the private equity industry (see my previous post on Private Equity 101) and persuaded two firms to invest in his gargantuan project.

Cameron worked with Jeffrey Katzenberg of DreamWorks Animation. They created an animated world and put real human characters into the dream world. BW says that rivals in the entertainment world often root against each other, but Katzenberg was a big supporter of the project.

Cameron had to agree to cut his fee in half, cut other expenses and he took a lower percentage of the film’s revenues. Given the blockbuster success, I’m sure Cameron has made up for any financial considerations he had to give up in negotiations.

Production started at Cameron’s hangar in Playa Vista, CA and word soon got out. Other directors began visiting, to see the possibilities of 3D. It is important to note that not all movies benefit from 3D. BW uses the example of a Woody Allen film not being appropriate for 3D. Yikes – Woody Allen up close on the big screen? No thanks. Some things are best in 2D.

BW points out the risk of incurring the extra cost for 3D can pay off. Vincent Pace, Cameron’s technology guy, has a “steady stream of inquiries since Avatar was released”. If you want to make a 3D movie, he’s the guy. There has been interest expressed in 3D commercials and 3D TV sports broadcasts. Now that sounds worthwhile – your favorite sport, truly happening live in your living room.

Pace and Cameron hold the patents on the 3D technology. Of course, anyone smart enough to do what they did, would know to claim a piece of future revenues. Now theater owners are investing in the capability to show 3D movies. They want a piece of the pie, too.

In short, what Cameron has done has completely changed the nature of the business. He has showed that big budget films can pay off, developed the 3D technology that will be the “in thing” for a while, and has made sure that he will be at the top of Hollywood’s A list for years to come.

Apple vs. Google

2010-01-18T08:38:00.000-08:00

This week Peter Burrows of BusinessWeek reports on the growing rivalry, and dare we say feud between Apple and Google.

As time goes by – and it always passes quickly in Silicon Valley – Apple and Google are becoming more alike and increasingly treading on each other’s turf. At the start of 2010, on January 5, Google introduced its smartphone, the Nexus One which runs on the Android operating system. This is a clear competitor to the ubiquitous iPhone. Apple, on the same day, announced the acquisition of Quattro Wireless, an advertising company that targets mobile phone users. In the past, before these moves, Apple was the shining star in the smartphone market, and Google was the leader in advertising. Now that the two companies have crossed paths, what will happen next?

BusinessWeek says “when companies start to imitate one another, it’s usually an extreme case of flattery – or war”. Eric Schmidt, CEO of Google, and Steve Jobs, CEO of Apple are the same age, and have known each other for years. As we all know, Jobs has been at Apple for a long time, since he founded the company in the 70s, with a little time off in the late 80s and early 90s before rejoining the company. Eric Schmidt was at Sun Microsystems and Novell, and has experience taking on Microsoft as a competitor. In 2006, Eric Schmidt joined Apple’s board. In August of 2009, Schmidt was off the board. Why? The two companies were overlapping more frequently, and Schmidt had to recuse himself more and more during meetings.

Why the growing overlap? Because the world has changed. Just a few years ago, we all used desktops and laptops for computing, and cell phones were a calling device. Then in 2002, Research In Motion(RIM) introduced the first smartphone, the BlackBerry. This market of smartphones soon grew, competitors sprang up and in 2007, the iPhone entered the market. Computing and internet access soon became something to do on a phone, and something you could do anywhere without lugging a laptop. Most people in the industry predict only a growth of mobile computing, and less of a dependence on desktop and laptop devices. Even the growth of netbooks turned the corner for consumers who want less computing power, not more, just access to the internet.

Apple and Google are strong players, and want to become stronger. But with two of them on the same turf, who will come out ahead? BW managed to get a statement from Apple, attributed to an internal manager. “Apple is a valued partner of ours and we continue to work closely with hem to move the entire mobile ecosystem ahead”. For now each company still need the other. Google dominates search(in spite of Steve Ballmer’s attempts with Bing) and for now it is still on the iPhone. The iPhone does not dominate the smartphone market, but it is certainly a key influence and Google needs more people to access the internet so it can sell advertising.

Mobile computing is clearly the wave of the immediate future, but how to make money off of it? This reminds me of the earlier days of the internet when various companies tried to gain customers regardless of profits. It took Amazon years to turn a profit. In this case, both companies make enormous profits in other lines of business, so they can afford to take a few losses in one area in the hopes of more profitability in the future.

BW says that Apple has the lead in this business. Currently the iPhone has 14% of the smartphone market and the Nexus One has 3.5%. One new wrinkle is that app developers are now starting to have a tough time earning money on their apps. But with more than 125,000 apps in existence, maybe that doesn’t matter.

And if anyone has the creativity to come up with a whiz-bang product, most of us would place our bets on Apple. From the iPod to the iPhone, and all the neat things in between, there seems to have no end to creativity and innovation. BW says that Jobs and company are trying to come up with a way to revolutionize mobile computing. If anyone can do it, I would predict Apple. Google may be brilliant with algorithms, but data manipulation and search just aren’t the same as the innovation we have seen from Apple. Apple’s acquisition of Quattro Wireless puts it in the driver’s seat going forward with mobile ads.

Google may have a problem because people don’t seem to use computing the same way when they are at their desks and when they are on the road. Mobile search has not taken off. The search bars are small, and people can bypass search by using an app, which is more direct, with fewer keystrokes. And Apple knows a lot about you. If you buy music on iTunes, subscribe to podcasts, watch videos and give your credit card number and home address, they have a lot of valuable information about your buying habits. This information is precisely the gold standard of market research that advertisers have been after for decades. Now Apple has a one-stop shop for targeted ads. In the past, Google had a significant head start by knowing search habits, but Apple’s hard data may be even more of an advantage.

It is interesting to note that the Android operating system was developed with the hopes that it would be used on devices not owned by Google. However, Google went ahead and purchased Nexus One, which indicate they may feel they can’t depend on other companies – they need to be a one-stop shop in the smartphone market just like Apple.

Here’s the key question: could Apple take Google off of its iPhones and computers? Sounds possible. Steve Ballmer is chomping at the bit to increase market share for Bing. In spite of the acrimonious nature of previous relations between Apple and Microsoft, BW predicts it is possible for them to come to a truce and start putting Bing as the default on Apple products.

What I hope is that the consumer will win out in this big battle. I don’t think any of us will complain if competition drives prices down, produces superior products, and generally makes life easier for those of us end users. I remember when people used to talk about Pepsi vs. Coke, now it is Nexus One vs. iPhone. Stay tuned folks – I’m sure we’ll be hearing more on this one.

The Disposable Worker

2010-01-15T19:41:00.000-08:00

Remember the movie “The Temp”? It came out in the 90s, when the economy was booming, which seems like eons ago. This week Peter Coy, Michelle Conlin and Maria Herbst of BusinessWeek report on “how companies are making the era of the temp less than temporary”.

If you have a traditional, old-fashioned job, thank your lucky stars. What am I talking about? The sort of job where the worker is classified as an employee, with full benefits such as health insurance and a 401k, promotion opportunities, paid vacation and just maybe, an employment contract. Those jobs seem to be going the way of the Dodo bird and the 8-track tape. (Remember those? The CD and the DVD are on their way out also).

The temp is here to stay, and it just may be you some day. That job you are not enamored of may be one you miss – at least you’ll miss the 401k and paid vacation.

I’ve read plenty of reports, and most seem to predict a rebound of employment to 2005 levels sometime in 2015, 2018 or even 2019. That’s a long time, folks. If you have a newborn baby now, that child may be in the fifth grade before this country is happy about employment again. Jobs are going overseas, processes are being automated, management techniques are changing, and good ol’regulation may be to blame. BW gave the scary example that because managers are now responsible for more people, and in a more detached way, it is easier for them to conduct layoffs because they have less of a connection to the people they supervise.

Even if you are an executive, you might find yourself as a “C-level to go” after a few years. What’s that? A C-level temp, willing to take skills and services wherever needed. The CEO of Kelly Services, a staffing firm, said “We’re all temps now”. Barry Asin of Staffing Industry Analysts also says that “The idea that any job is permanent has been well proven not to be true.”

Payroll used to be a fixed cost and it is becoming more and more a variable cost. We’ve all heard of just-in-time inventory, now there is just-in-time employment. The business risk is being transferred from the employer to the employee. When bad times come, the employer doesn’t worry; the brunt will be borne by the employee.

Chronic underemployment and unemployment have a lot of victims. Older people go into early retirement and younger people have a bad start to their career. Even 15 years out of school, that head start has a lasting impact. BW reports that people who graduated in a recession earn 2.5% less than if they had graduated in prosperous times.

Yikes. What’s a salaryman or woman to do? Have highly sought-after skills, that’s what. Get educated. Be in the right industry. The poorly educated and low-skilled fare the worst in this type of system.

Are there any consequences for employers? Do they just get off scot-free? Indeed, they are stuck with an “alienated, dispirited workforce”. That can’t be good for productivity. BW says “poor morale can devastate performance”. No kidding. UBS, Credit Suisse and American Express have all hired a Harvard psychology lecturer to train employees in positive thinking. How about a little decent treatment by the employer? That could work wonders for positive thinking in any organization. Used to work in the old days. And it seems to work for companies like Google and Zappos.

But, corporate profits have been good with a lower payroll. And most of us still hold stocks of some companies.

BW talks about a “trend toward a perma-temp world”. Companies that made big changes in the recession are sticking with those changes. It’s called “taking advantage of flexibility”. Microsoft, whose stock you might not mind holding, is a champ at using temporary teams. In spite of the bad things said about Steve Ballmer (some by me) they’re doing pretty well. The quality and pay of temps is no longer limited to “the girl from the agency” who comes in to file.

BW profiles a “temp exec” who does very well inside the C-level suite, albeit on a temporary basis. BW also mentions a lawyer with an MBA who is now on his own. More fancy degrees don’t necessarily translate into “sought-after skills” which would help the employer to justify hanging onto an employee.

At the bottom of the ladder, workers get the short end of the stick – nothing much they can do. Not surprisingly, depression and other mental health problems are on the rise. I think we would all agree with that. Career problems can be a prime source of stress and anxiety, as we all know. Better buy stock in pharmaceutical companies which sell sleep aids and anti-depressant medications.

Young people are losing out in the new world, unless they want to work as an unpaid intern. Even IBM, which seems like such a stalwart, old-economy company, had 71% of its workforce outside the U.S. in 2008. In 2009, it continued to reduce its workforce in the U.S., eliminating approximately 10,000 jobs.

When will it all stop? BW says that American workers will have to “swallow hard and accept lower pay”. The not-cheery statistic is that pay for 80% of the private workforce is 9% lower than it was in 1973, adjusted for inflation. So your paycheck may be larger in nominal terms (that’s the number on your paycheck) but the real term is lower (what you can buy with it is less). Consider the fact that GM was the largest employer in 1953, and today the largest employer in the U.S. is Wal-Mart. Something tells me the current Wal-Mart hourly wages and benefits don’t quite match up to what GM workers had in 1953.

BW proposes “rapid economic growth sustained over a long period” will fix the situation. Sounds great, but don’t hold your breath waiting. Clearly we could all use an economic stimulus – where will it come from? I wouldn’t bet on buying power from China – I’ve read enough reports that claim the Chinese economy is another bubble waiting to burst. India? Brazil – maybe they are building for the Olympics? Hmm. If anyone sees growth in a sector other than bankruptcy lawyers, let me know.

As usual, the political parties are sharply divided on what to do. Conservatives think the problem is too much government spending and involvement in the economy. Liberals, led by Paul Krugman, think there hasn’t been enough spending and job programs. At this point, I’m happy to see anything that works, regardless of the political affiliation.

BW points out in Europe, traditional jobs are much harder to come by and there is much greater use of temporary and contract employees. However, the big difference is that the temps and contractors receive full benefits, courtesy of the semi-socialist governments there.

One faint hope long in the future – if you are not a baby boomer – is that yes, the baby boomers will eventually retire, and someone needs to take those jobs. And take care of the baby boomers. So if you are starting medical school now, better specialize in geriatric medicine. In the nearer future, once the economy picks up all the employees who do not feel valued by their employers(that’s a lot!) will fly the coop when a better offer comes along. In the meantime, better keep that resume fresh, save for a rainy day and improve those skills.

Why the SEC keeps Backpedaling

2010-01-06T18:00:00.000-08:00

Jesse Westbrook of BusinessWeek has a great analysis of what’s going on – or not going on – at the SEC. After the Bernie Madoff debacle, Mary Schapiro, chair of the SEC was ready to crack down and show the backbone of the SEC. This was in contrast to the easier years of the SEC under former chair Christopher Cox. And I’m sure we all wanted to see Mary jump on her horse, ride off after the bad guys, and come back with a whiff of smoke rising from her six-shooters. At the time she said “Investors are looking to the SEC to assure the safekeeping of their assets. We cannot let them down” But this has not happened yet.

At first, Schapiro proposed inspecting almost 10,000 money managers. Somehow this number was reduced to 1,600 in December. Not surprisingly, this change in project scope came after Schapiro met with many executives of fund companies.

BW reports that there were several proposals which sounded great at first, that were then scaled back or delayed . Hedge funds lobbied, and short-selling rules were delayed. Corporate Beard rules were also delayed. Schapiro claims that the SEC is overworked, understaffed, and doing the best it can, which may be true. But why raise our expectations beforehand? The agency may be improving, but it still has a ways to go. Former SEC chair Richard Breeden says, “You get zero points in history for what you propose...you get points for what you get over the goal line.”

Schapiro is an old hand at financial regulation, having started out at the Commodity Futures Trading Commission, and after different assignments at the SEC and CFTC, ended up as CEO of FINRA, the Financial Industry Regulatory Authority. For those of you who read your brokerage statements, you should see the acronym “FINRA” somewhere on the statement. FINRA is a private organization which regulates brokerage firms and trading markets. In its own words, it is “the largest independent regulator for all securities firms doing business in the United States”. The unfortunate souls who invested with Bernie Madoff probably did not see the acronym “FINRA” on their monthly statements. So Schapiro was no slouch by the time she came to the SEC.

People who own stock receive those pesky proxy forms and annual meeting notices once a year. Most of the time, this doesn’t mean anything for the little investor, as the average guy on the street does not own nearly as much as either Warren Buffet or a large institution to actually make a difference. But Schapiro wanted to make it easier for shareholders to “wage proxy fights”. However, the U.S. Chamber of Commerce did not share her opinion and almost filed a lawsuit. Somehow this action – on both sides – was delayed until 2010.

Barney Frank, a politician himself, has noticed that Schapiro is under political pressure. He wanted the uptick rule reinstated, somehow this too is in limbo. Hmm… I’d like to see Schapiro get back on her horse and chase after the bad guys. After all, if the rest of us have to follow the rules, why not them? And if anyone can do it, Schapiro has the right background. However, don’t we all know about organizations which have grand plans, then fail to deliver? Wait and see… per my previous post, I wouldn’t bet much on regulation at this point.

Not So Radical Reform

2010-01-04T19:20:00.000-08:00

This week the BusinessWeek cover story is about the attempts – or lack thereof – of reform and regulation of the financial markets. BW starts out by describing the media following Barney Frank in the wake of the 2008 financial crisis, as if the media is paparazzi and Frank is a celebrity. Why Barney Frank? He’s the chairman of the House Financial Services committee, which became a key player in the political process last year.

In the fall of 2008 and the disastrous first few months of 2009, public opinion was calling for the heads of the “fat cat” bankers and other ne’r do wells who toppled our 401ks, jobs and the monetary value of our homes. The time was ripe for reform. Frank’s potential power multiplied overnight. The Federal Government jumped in to help with the TARP , the nationalization of Fannie Mae and Freddie Mac and various other involvement.

BW points out that rescuing the system is not the same as reforming it. When we had a crisis, there was a real chance for reform, and now the crisis has passed, the enthusiasm for making lasting changes has dissolved. Paul Volcker, former chairman of the Federal Reserve and chair of Obama’s Economic Recovery Advisory Board, says that bankers and regulators around the world “have not come anywhere close to responding with necessary vigor”. Volcker wants the big banks to be split up into smaller banks, but in fact they have only gotten bigger.

The stock market rose by a tremendous amount in 2009. Good news or bad news? For those of us closely watching our 401k balances, we wonder how the news could be anything but good. But to fuel the regulatory fires, good news has a way of placating people so they no longer see the need to change the system. The modest sign of recovery in the economy have also served to dampen the urge to reform. And now we have the health care bill, a major distraction.

What is really slowing down possible regulation is the New Democrat Coalition(NDC). What is this? A moderate group within the Democratic party, formed during the Clinton years. The Democrats believed they couldn’t win elections without a “strong moderate platform” The NDC has 68 “68 fiscally conservative, pro-business members” in the House of Representatives. Joseph Crowley of New York is the chair of the NDC and states that most of them come from business backgrounds. Crowley has even been on Air Force One with Obama – I’m sure that’s one flight he didn’t want to end.

The NDC has strong ties to Wall Street, both from Goldman Sachs, and from far less glamorous ( and lower-paying) jobs. Melissa Bean of Illinois, who I have heard speak, received the most donations from the financial industry.

The Obama administration and the House Financial Services committee was itching to implement change last summer, but the NDC “pushed back” and let it be known that they would not let such legislation go through. Derivatives trading – remember that? – is a hot issue. As it stands now, derivatives are unregulated, and often traded in less than transparent markets. JP Morgan Chase, Goldman Sachs and Bank of America earned more than $35 billion in the second quarter of 2009 trading unregulated derivative contracts. That’s a lot of clams, even for those big firms. So guess who wants to be Melissa Bean’s new best friend – you guessed it – the financial industry, to thwart regulation that would impede their sources of revenue.

Now banks have to report derivatives trades to regulators, but the trades themselves not regulated. Companies who use derivatives to hedge risk, such as airlines (fuel) energy companies and hedge funds are considered end-users of derivatives, as opposed to speculators, who use derivatives in search of profits. There will now be an end-user exemption in the new House Financial Services bill. But a representative from Cargill counters by saying that the amount of end-user derivatives will not make a significant impact.

Melissa Bean claims she “isn’t carrying water for Wall Street” as BW says, but it sure looks that way. The proposed Consumer Financial Protection Agency has been watered down as a result of Bean’s provisions. Barney Frank readily admits it is the “New Dems” who have lessened the regulation. Not surprisingly, he is not one of them.

The New Dems may have their fingers all over the House, but the senate seems to be still split. Clearly the Republicans will not want much in the way of regulation. Paul Miller, an analyst with investment bank FBR Capital Markets, says that “Wall Street is probably happy with the slowness of the process…because the slower the process, the more you can drag it out and water it down”.

At this point, it looks like we will get hardly any regulation at all. BW says the “onslaught” from the financial services industry on the legislators shows no signs of letting up. Which makes sense. From the perspective of Wall Street, why not take some of those profits, spend it on lobbyists, to ensure more profits in the future? There is an ad campaign called “no sleep”, about the worries of small business owners. But something about that seems wrong to me. Small businesses are generally not the ones using derivatives and requiring a lot of regulation.

Bonus season is coming up, and that will make a difference. Why? A lot of people are either unemployed, underemployed, or still in a bad economic way due to the great recession, and the lawmakers have a vested interest in appeasing some of the negative public sentiments toward big business. Senators McCain and Cantwell would like to reinstate the Glass-Steagall act. This act was instituted in 1933 to separate the public-utility like function of commercial banking from the casino-like function of investment banking. I read a recent interview with Paul Volcker who is not convinced that bringing back Glass-Steagall will fix our problems now. But don’t forget, Volcker is in favor of using this opportunity for reform.

2009: The Year of Living Furiously ... and a Few Predictions for 2010

2010-01-01T08:56:00.000-08:00

BusinessWeek gives an end of the year recap of 2009. They start by asking, was it a good year or a bad year? Well…By most counts better than the disaster otherwise known as 2008, but nothing like the good times of 1999. The S&P went up 23%, the Nasdaq went up 40%, but unemployment followed an upward trend also…up to 10.2%, and the budget deficit grew, like so many people’s waistlines. If your name is not Tiger Woods or Bernie Madoff, then 2009 was probably better than 2008. Even GM and Chrysler emerged from bankruptcy.

What did we miss? 2009 could have been a year for “real financial reform” in the words of Paul Barrett of BusinessWeek. Public opinion was strong enough to encourage politicians to enact real regulation, but not much happened. BW points out that 2008 was a “once-in-a-lifetime opening to overhaul the U.S. financial engine”. Well, we’ll have to wait for the next financial crisis. And – not to be dramatic – but back in the Great Depression in the 30s, it was only after the second fall in the economy that the new securities laws were passed.

President Obama, after a great 2008, showed us he is not as strong once he is in office. In fact, he seems like, dare I say – a politician! And so many people thought he was different. No, he’s like the rest of the men and women in office – beholden to the people who put him there, and subject to the political winds, wherever they blow. It almost seems like we caught him sweating as he gave one of his speeches. He has become more like our past presidents – not as effective in real life as he is in the idealized world of campaign speeches.

Do we really believe Lloyd Blankfein, CEO of Goldman Sachs, that he is doing “God’s work” ? Hmm... I’m the first to say that the world needs business services, but really, “God’s work”? Methinks he is taking the concept too far.

Did the bailout do enough, or was it too weak as described by Paul Krugman? We will never know for sure, but we do know things could have been worse. Then again, they could have been better. In January, Krugman wrote “this looks a lot like the beginning of a second Great Depression”. As much as I don’t like the idea of handouts, we can look to Japan to see what happens when a federal bailout is too little, too late. Let’s do what we can to avoid another lost decade – the “aughts” are a decade we don’t want to repeat.

Let’s put AIG to sleep once and for all. It is still limping along on life support, after all those bailout funds were swallowed up. Do we really need to hear about that company again?

Too Big to Fail: this problem has only gotten worse. Look at the size of the Bank of America, for heaven’s sake. It was big to begin with, then it acquired Countryside. After a big burp from ingesting that meal it acquired Merrill Lynch. I have seen Ken Lewis, the beleaguered CEO looking angry so much of the time, I would recommend he take time off for health reasons. All that stress can’t be good for him.

If an institution is too big to fail, it is too big to guarantee, and our tax dollars have already been spent. Paul Volcker is a big proponent of chopping up the banks into smaller players, so that when one of them goes down - which does happen sometimes - the event is not cataclysmic. Remember when Microsoft was being hounded for antitrust actions? Why not the big banks? Especially because our tax dollars are at risk – and the pile of federal income is so much smaller than it used to be.

Regulate derivatives. However, at the risk of giving you a sneak peak at a future post, I can tell you it’s not going to happen, due to shrewd lobbying and swayed politicians. We should all have listened to Brooksley Born a long time ago. Brooksley Born is a brilliant woman who recognized in the 90s what a problem derivatives could be if not regulated. Born is an attorney who was head of the Commodity Futures Trading Commission (CFTC) from 1996 – 1999. She warned Congress of the risks of derivatives, and ended up going against Alan Greenspan, Robert Rubin, Larry Summers and Arthur Levitt (of the SEC). These big names all pooh-poohed her legitimate concerns, and look at the mess we are in now. The one bright spot is that this year, in 2009, she received a Profiles in Courage Award for standing up to the naysayers. However, instead of an award, it would have been better had they actually listed to her and acted. Think of what we could have avoided!

The next future problem is climate change derivatives. If something is not done to regulate these I predict we will see derivatives fraud redux within the next five years. Combining financial fraud and the environment will really bring out the demonstrators – stay tuned for that one! I’ve heard there were so many crazies at the recent Copenhagen conference, and they will be looking for something new to do soon. Even George Soros is wary of this development, and that should tell you something.

And while we are on the subject of the environment, let’s revisit Cap and Trade. Cap & Trade is a wonderful idea in theory, but will it work in practice? It requires a strong central agency, and who is that? One of my future posts has to do with the loopholes in Cap & Trade. How about simple mandates? One bright spot in the last century of the United States is the development of the EPA and the environmental movement. And believe it or not, the government has done a few positive things which has kept our beautiful country from becoming a big asphalt parking lot. Maybe a combination of Cap & trade and mandates will be the answer, I would also like to keep tabs on the situation in California, a state with amazing natural resources, a huge population that needs those resources, and no money in the state coffers to help out. I welcome comments from readers on this issue – there is no easy answer.

The U.S. economy is fundamentally different at the end of ’09 than it was in ’07. The U.S. Government has truly become big brother, and now big boss. Now that they own so many companies, will they hang onto them? Government Motors? We’ll see how this does – hard to imagine it can compete against Toyota. Have you seen the ads for Ally? Wonder where this bank came from, and why you never heard about them before? Ally is the bank that GMAC created in order to become eligible for TARP funds.

Neel Kashkari, who worked under Henry Paulson to administer the TARP funds, is one of the smartest guys of all. He left D.C., and took time off to live in an idyllic setting in the woods. He was able to breathe fresh air, get some exercise and relax. Maybe Ken Lewis should follow the same program. Kashkari now works for PIMCO with Mohamed El-Erian, another respectable sort who seems to have his head screwed on right and can deliver a return.

Sarbanes Oxley – what will happen to this? It went to the Supreme Court in 2009, and we will see what happens in 2010.

Tim Geitner – what a tough job. But, he’s not a Goldman Alum, like so many others. So that is good. I predict he will be out by the end of 2010. Too many people are looking for a scapegoat, and he’s an easy target.

Ben Bernanke – he’ll stay.

Vikram Pandit at Citicorp – not looking so good, but he did pay back the TARP funds.

Some version of a health care bill will be passed, but costs will stay high. After all, these bills are about health insurance, not health care. We are still stuck with the same fraud, waste and duplication in the system that we all pay for in our high premiums.

My sympathies to Saturn and SAAB owners – may you always find someone to service your cars, long after the brands have been shut down. Cross your fingers – maybe with the dearth of those cars, they’ll rise in value, like antique cars. One can only hope.

That’s it for 2009! In spite of so many negative comments, I am looking forward to 2010 – who knows what will happen! And since we can’t predict the future, we might as well hope for a bright one, in the spirit of American optimism. Stay tuned, and I’ll keep writing about whatever happens in 2010.

Kohlberg, Kravis and Roberts: Can the buyout kings at KKR learn to be like Buffett?

2009-12-29T09:12:00.000-08:00

This week Emily Thornton of BusinessWeek reports on the new activity at KKR. You may remember them from a long time ago. For those of us who were reading the business news back in the 80s, we all remember the leveraged buyout of RJR Nabisco. That was the largest buyout transaction ever (at the time, and remained so for 17 years) and the subject of the book Barbarians at the Gate, by Bryan Burrough and John Helyar. For those of you who were paying attention to something else back then, KKR is Kohlberg, Kravis and Roberts, a trio who emerged from Bear Stearns, back when it was a great company. Henry Kravis and George Roberts are cousins. They went to college together in California, and worked at Bear Stearns, along with Jerome Kohlberg. Kohlberg was the senior statesman of the group. He eventually went his own way, and Kravis and Roberts carried the baton for the next twenty plus years.

Fast forward to 2009, and KKR is a leader in the world of private equity. TPG, Blackstone, Carlyle, Citadel and others are the other big players, but KKR has been around the longest. Who would argue with success? Well, looks like Henry Kravis would: he’d like to be more like Warren Buffett. BusinessWeek has a wonderful term for it: portfolio envy.

What does Warren Buffett and Berkshire Hathaway have that KKR might want? Berkshire Hathaway (BH) is a publicly traded company, and doesn’t have to go through the rounds of raising money to provide new capital for its investments. In the past KKR never had trouble, but the slowdown in 2007 made raising funds tougher for everyone. According to BusinessWeek, in the last two years 543 private-equity owned companies went bankrupt – ouch! That will slow returns, and all those institutions looking for a place to park their cash will be choosier in the future.

KKR will most likely be just fine and come out a winner on the other end, but being the bright people they are, they are using this slowdown opportunity to become a better player, ready to surge ahead when the economy turns around. For one thing, private equity has changed: it’s not just a world financed by debt anymore. For an explanation of private equity, see my previous post.

KKR now has a four-part plan which they divulged to BusinessWeek. The first part is an in-house investment bank to handle the underwriting, sales and other investment bank functions needed. Next, KKR is going public in the U.S. to have a ready source of investment cash. The third part is to take a greater number of smaller investments in the form of minority stakes and joint ventures. The last part is new management techniques in their own company.

John Canning of Madison Dearborn partners has also said that things are changing, and firms must change with the times. Will other buyout firms follow the lead of KKR? John Mack of Morgan Stanley, now a commercial bank, also predicts wider options different from the usual previous situations.

Blackstone and Fortress, two other private equity firms, went public in 2007. However, they had the misfortune of going public at the peak of the market, and now have to live with their reduced share price. KKR - if it goes public now – will do so in a more favorable market, with an upward trend line.

How is KKR different from Berkshire Hathaway? The green gecko for one. BH is mostly an insurance company. And BH financed its acquisitions with equity, not debt, which matters over time.

KKR will encounter all the usual challenges when its takes the plunge into being publicly owned – compliance and scrutiny. But they must also satisfy the institutions who have invested with them and are looking for continued returns. BW points out KKR could lose focus on its main business. Six companies owned by KKR may have financial trouble.

Kravis and Roberts are handing over more authority to other managers within their company, which is appropriate given their long tenure at the firm.

KKR has been creating an in-house financial services firm, part one of their four part plan. It has taken an effort to get it going and sell the idea to the rest of KKR, but it seems to be taking flight now. Merrill Lynch, Lehman and Bear Stearns are now out of the picture, resulting in less competition, and in 2009, KKR was the lead underwriter for an IPO(Dollar General) for the first time. The deal was shaky for a while, but due to 11^th hour intervention, all ended well.

Warren Buffet apparently has no affection for the private equity industry. He says the industry piles on debt and burdens companies with fees. But KKR still wants to be like them. KKR wants to be public, so they can use their own stock to buy companies. Henry Kravis says, “ We’re not just a private equity firm…we’re an asset management firm”.

But the investors who come to KKR for outsize returns are just as capable of investing in ordinary mutual funds, and if KKR takes too many small positions, they start to look a lot like a mutual fund. A mutual fund with outsize fees, that is. KKR has experimented with taking an active role in Kodak, without owning it directly. They’ve done this through providing needed financing, receiving seats on the Kodak board, and a role in management. But the Kodak stock price is still low, so the jury is still out on that one.

KKR has expanded, making it vulnerable to the challenges of a big, lumbering company. With a former McKinsey consultant on board, they are implementing changes to try to avoid this. Rajat Gupta, the advisor, says “The vision is to develop a premier global institution for alternative investments”. BW follows with “More than anything, Kravis and Roberts want to create a mature, meritocratic company that will long outlast them”.

This has all come a long way from the days of RJR Nabisco. I give kudos to them for lasting so long, so successfully, and for being innovators in a ruthless field. BW closes with a great quote from Henry Kravis: “The days are long gone when you just buy a company and hope that financial engineering will work. Our job today is to create value. Private Equity to me, is thinking and acting like an industrialist”.

Private Equity 101

2009-12-29T07:57:00.000-08:00

For those of you not familiar with private equity, here’s some background to help you understand the KKR post.

Private Equity is essentially that: equity investments which are not publicly traded. Equity investments are stocks, which represent shares of ownership, and debt investments are bonds, which represent lending. Over the past 20-30 years, private equity companies have multiplied. Generally large institutions invest in private equity firms. Other investors may be accredited investors, which are high-net-worth individuals who have met certain requirements for participating in alternative, higher-risk investments.

The Private Equity firms take the large investments (called “raising funds”) and make large equity placements in companies. Sometimes the placement is large enough so that the company is delisted, or taken off the public exchange and now privately owned either partially or in full by the private equity firm. Private equity firms usually prefer to take a majority stake so that they effectively own the company, and then put in their hand-picked management team.

Why invest in private equity? The institutions and accredited investors invest in private equity firms because they are looking for better returns than they can find elsewhere. They are sophisticated investors who understand the risks of alternative placements, and are under pressure to provide returns for their own investors. The institutions are usually pension funds, university endowments, insurance companies, banks and hedge funds to name a few.

Regulation D (Reg D) is an SEC regulation which means smaller privately owned companies can sell equity or debt on the private market without having to go through a public offering. Companies which sell securities must be either registered with the SEC or meet an exemption, and Reg D is one of them. Why avoid a public offering, also known as “going public”? Because of the enormous cost, hassle and ongoing compliance requirements of publicly owned companies. You can read my earlier post on Sarbanes-Oxley to see that a lot of smaller publicly owned companies – and even the largest ones – are not happy with the ongoing requirements of Sarbanes-Oxley.

For our last question, why the growth of private equity since the 70s? As with most developments, changed regulation led to changes in the marketplace. In 1974, ERISA was passed. ERISA is a comprehensive law regulating employee benefit plans and retirement plans. ERISA allowed corporate pension funds to invest in more risky securities, thus creating a supply of funds for investing and a demand for returns. In 1981, the Reagan tax changes went into effect, which lowered the capital gains tax and created new demand for investing in securities. Late in the 80s things slowed in the private equity market with the fall of Drexel Burnham and the S&L debacle. But of course, everything picks up again, and so it did in the 90s.

There was a temporary slowdown from the bursting of the internet bubble in 2000-2001 and then things rose again starting in 2002. Activity in Europe loosened up, providing even more supply of funds for investing and greater demand for alternative investments. The trend over time has gone from short-term benefits to long-term. In the 2000s many private equity firms hold their companies, put in a management team and plan for the long-term. This takes us up to the credit crunch starting in 2007 which put the brakes on debt financing and brings us to the following post on KKR.

What's going on at Dubai World?

2009-12-28T18:37:00.000-08:00

Wikipedia describes Dubai World as “an investment company that manages and supervises a portfolio of businesses and projects for the Dubai government across a wide range of industry segments”. Well said. Dubai World is new, existing only since 2006, but even in that short time it has become a major player in the global economy. It holds a variety of major businesses, including Nakheel, the real estate company that built the Palm development we all like to see from the air. When Dubai World sneezed in November 2009, the rest of the world felt it. Oil prices went down, and even the U.S. stock market was affected.

Dubai World is now in the middle of a mess. Rachel Ziembe, senior analyst at research from Roubini Global Economics, says that “Dubai World…is too big to fail but too big to guarantee”. Roubini Global Economics(RGE) is an impressive group. Nouriel Roubini, the founder, is one of the few economists who predicted the great recession we are experiencing now. Many refer to RGE’s website as one of the best news sources on economics. So Rachel Ziembe may know what she is saying. But some holdings at Dubai World need to be sold, and real estate and retail are possibilities.

Dubai World does not have a clear boundary between it and the rest of Dubai. Dubai World is still in the hands of the Sheikhs and their families who have ruled the area for over a hundred years.

I am most curious as to why the bankers loosened their standards when it came to lending to Dubai World. Eckhart Woertz, an economist at the Gulf Research Center in Dubai, said “lenders weren’t looking too hard into what entity was actually backing the debt”. The lending institutions believed all would go well, and seem to have been fooled by the aura of wealth lurking everywhere.

No one could figure out Dubai World, it is so complicated. And, Dubai World is ultimately owned by the Dubai government so it seemed safe. “Seemed” is the operative word. Most shocking of all, Chris Turner, a former director of risk and asset management at Istithmar World, says that “Western banks gave Dubai World at least $15 billion in 2006 and 2007 without looking at the numbers”. And, audited reports were not requested and not provided. Almost like being a “Friend of Angelo” at Countrywide! (Angelo Mozilo was the CEO of Countrywide mortgage, and his F.O.A. list had special privileges).

Chris Turner goes on to say, “being a risk officer there was like nailing jelly on a wall”. Moody’s reported a “limited availability of information” and yet the lenders kept lending. Lenders thought the debt was guaranteed by the Dubai government, and yet when times got tough, they found out it was not guaranteed at all. Lucky for all parties, wealthy Abu Dhabi came to the rescue, and the price Dubai has to pay is increased dependence in the future. Not unlike all the bailout situation in the U.S. where the bailee becomes more dependent on the one doing the bailout. Remember when you were a teenager and you had to ask your parents for a quick loan because you were out of cash? Made you feel sheepish and not so grown-up. Now you know how Dubai feels – trying to keep its dignity while receiving a handout from the next-door neighbor.

Because all the buying took place during the boom, assets were bought at top-of-the market prices. Now that cash is short, the assets must be sold at a discount. Buy high, sell low – not a good way to do business.

Both the European and U.S. stock markets took a hit when Dubai asked its financiers to “extend maturities” because presumably there are many companies and investors in Europe and the U.S. who are now left holding downgraded securities. This is yet another example of how interconnected the world economies are – when one goes down, there are ramifications on the other side of the globe.

But one entity’s downfall is another’s opportunity. Buyers are gathering, particularly private equity firms, looking to do deals in a down market. I predict in a few years we’ll be hearing about the next wave of investment opportunities in Dubai.

Why Dubai Matters

2009-12-22T19:16:00.000-08:00

What’s going on in Dubai? The week BusinessWeek put Dubai on its cover, and subtitled, "Why It's No Mirage". On December 14, Dubai received a lifeline from its neighbor, Abu Dhabi. How did it get to the point where it needed a lifeline? In late November Dubai hit its limit: it had to reschedule payments on $26 billion of debt. BusinessWeek describes Dubai as “the most dynamic business hub in the Gulf” and “a model for its neighbors”.

Dubai is unusual in the region because it is not dependent on the energy economy and has a more open economy than its fellow emirates. It is true that Dubai must be more innovative than its neighbors; it does not have the oil and gas reserves and must find other ways to be an important economic player.

Dubai experienced a real estate boom not unlike the one in the United States. Rules were looser, prices went up and the cycle fed on itself. Dubai first let foreigners buy real estate in 2003 and the buyers streamed in.

Nakheel, a subsidiary of Dubai World, suffered the most in the economic downturn. It created the iconic palm island development seen in so many photos. Nakheel currently has approximately $21 billion in debt.

The problems in Dubai have been simmering under the surface for a while. The ruler of Dubai is Sheikh Mohammed bin Rashid Al Maktoum. Sheikh Mohammed likes to protect the image that everything is okay. But Dubai is still tightly ruled. Finances are not transparent. Apparently, no one really knew the debt picture.

In spite of this, Dubai is still tolerant of foreigners, does not tax income and has some fun amenities. Many multi-national companies have located in Dubai because of the “open culture, top-notch infrastructure and hassle-free business climate”.

Dubai is home to the Dubai International Financial Center, just a few years old. Why have the investment banks chosen to locate here? The emerging market for Islamic Financial Services, now about $1 trillion worldwide.

Companies native to Dubai are doing well also. There are real estate companies, ports and airlines. The leading private equity firm is Abraaj capital. Qatar also has a financial center. Abu Dhabi has a joint venture with GE and Saudi Arabia is trying to get into the game.

BusinessWeek says that the Emirates region has provided wealth but few jobs. This is an issue of concern because it is important to employ young people. BW reports that young people “risk being drawn toward Islamist extremism if they don’t get it (a better life)”.

Abu Dhabi is apparently the financier of the Emirates region, but Dubai is the business center. Dubai needs to strengthen its infrastructure and is having trouble lining up bank credit. Because of Dubai’s dependence on Abu Dhabi, it may become more conservative socially and politically and may not be so independent in its foreign policy. If Abu Dhabi has the funds for a bailout that means the region will gravitate toward Abu Dhabi.

What does the future hold for Dubai?

Many think Dubai will land on its feet and do just fine. Many of the excesses will be tamed. Development will slow down. Dubai needs to “tighten up regulations” and “improve governance” according to BW. A major part of Dubai’s role as a business leader is its openness to foreigners. Other countries in the region do not want foreigners. BW cites Singapore as an “inspiration” to Dubai. If that is the case, we’ll be seeing more of it in the future.

Cap & Trade 101

2009-12-21T18:59:00.000-08:00

Back when Henry Ford was cranking up the assembly line and Pittsburgh’s steel mills were going full force, the air was still relatively clean and no one dreamed of the environmental fix we’d be in now. After years of spewing all kinds of things you shouldn’t breathe into the air, we find ourselves at a crossroads as to how to handle the question of who gets to pollute and how much.

Because there is no way we are going to give up our beloved internal-combustion engine or big factories in China, emissions trading seems to be here to stay. What is emissions trading? It is a way to control pollution by assigning an economic cost to polluting and then regulating the amount of pollution. In an emission trading system, a central agency sets a cap on the level of pollution that is emitted. If a company emits more than that level, they have to pay a central agency. If a company emits less than its allowances, it can sell the allowances, producing a trading market for those who exceed their limits. Hence the name “cap and trade”.

This system has been called “free market environmentalism”. However, that is a misnomer, because the entire system is dependent on central agency regulation – hardly a free market. Over time, the emissions limits are supposed to be reduced, and emitters will adapt with changing technology over time. The idea behind cap and trade is that it gives economic incentives to reduce pollution, and freedom to control how to reduce emissions and how much emissions.

Critics of Cap & Trade say that the central agency has too much power, may set the limits at an unattainable level, and the fees are not set by the market. The system also requires robust regulation to measure and regulate the amount of emissions. Otherwise, if a company decides to let out a few more emissions than it is paying for, who’s to know?

Supporters of Cap & Trade say that it is the only system we have, and we need a system so let’s go with it. The EPA says on its website “Successful cap and trade programs reward innovation, efficiency, and early action and provide strict environmental accountability without inhibiting economic growth.” Let’s hope all government programs work that well.

It seems that Cap & Trade works best on a large scale, and we hope resulting in large offsets. Paul Krugman however, points out the significant disparity between the efforts to reduce sulphur dioxide emissions in the United States and in Germany. The United States has a cap and trade program which hopes to reduce emissions by 35% over twenty years. Sound good? Compare that to Germany which has reduced sulphur emissions by 90%. Why the difference? In Germany, there was regulation which demanded the reduction of Sulphur dioxide emissions with stiff penalties for exceeding limits. Seems like regulation has worked in Germany. It’s debatable whether it will work in the U.S.

Sarbanes-Oxley: Could it be Eliminated?

2009-11-30T16:45:00.000-08:00

The world continues to change, and not always in the same direction. Just as we are moving to an environment of more regulation in the wake of the crises of the last two year, someone is trying to yank the wheel of the regulatory machine and pull it in the other direction, toward less regulation.

Michael Carvin and Noel Francisco are two Washington lawyers attempting to topple the mighty Sarbanes-Oxley Act, also known as Sarbox, or SOX. For an explanation of Sarbox, see my previous post.

Why attempt such a thing?

They are representing Brad Beckstead, a CPA in Nevada, who is not happy with the Pubic Company Accounting Oversight Board (PCAOB). The PCAOB was created under Sarbox to regulate auditors. The intent was to not have a rerun of the Enron scandal, when auditor Arthur Andersen performed a less than rigorous audit of Enron.

One of the intentions of Sarbanes-Oxley is to audit the auditors. Makes a lot of sense in theory. What Brad Beckstead says is that the Sarbanes-Oxley act was written for the big four accounting firms and Fortune 500 companies, and for smaller public companies the cost of audit and compliance is prohibitive.

No less than Ken Starr, the U.S. Solicitor General under President George H.W. Bush, makes the argument that there are many problems with Sarbanes-Oxley as it stands now. This call for adjustment of Sarbanes-Oxley does not come only from the political right. Senator John Kerry, a Democrat, introduced a bill in 2006 to reduce the regulatory burden on companies with a market capitalization less than $75 million.

Back to the BusinessWeek article.

The impetus for Beckstead to challenge Sarbox happened in 2004, when in a “grueling” audit in 2004, the PCAOB “picked apart his business”. He had to close his auditing practice because of the cost of compliance. Fortunately, this situation was noticed by the Free Enterprise Fund, an advocacy group aiming to reduce government and promote economic growth.

Carvin and Francisco argue that the PCAOB, currently appointed by the SEC, should be appointed by the President. The main problem is that the PCAOB is not under the control of the President; it is appointed by the Securities and Exchange Commission (SEC). Why does this matter? Because of the great economic impact of the PCAOB. It does not even have congressional oversight. Defenders of the PCAOB say it is not as powerful an organization as its detractors suggest.

But – if Sarbox is overturned, what about the post-Enron regulating spirit? Will it all fall? Former chairman of the SEC Harvey Pitt said that the Sarbanes-Oxley act was part of a national response to the accounting scandals in the early 2000s. Some have pointed out that if Sarbox is reexamined, what about other appointments? Sure enough in recent weeks, we have seen interest in reexamining the whole situation regarding the Federal Reserve.

In the wake of the Enron and other accounting scandals, the hope was that another debacle happening at publicly owned companies and affecting innocent ordinary people would not happen again. Instead, we ended up with the housing boom and bust, the subprime mortgage mess and the subsequent financial crisis affecting all of us in the United States, and extending far beyond our country’s borders.

There are some who argue that in this time of great recession, Sarbox is functioning as a giant drag on the economy for mid-size to smaller public companies. The cost of compliance has multiplied from the days before Sarbox, many public companies have chosen to delist, private companies have chosen to finance with debt instead of equity, and worst of all, the act has not prevented further wrongdoing.

But former Senator Sarbanes, former Representative Oxley and former PCAOB chair Mark Olson all defended Sarbox and argued that internal controls have strengthened, fraud has been prevented and investors were given more confidence. (Whatever confidence investors had, I’m sure has evaporated during the recent financial events!) Brad Beckstead, who prompted the Free Enterprise Fund to action, calls the Sarbanes-Oxley act a barrier to entry for small and startup companies because audit and compliance costs are so high. Even the Government Accountability Office (GAO) reported that the costs of compliance have increased by approximately eight times. Eight! Common sense tells us smaller companies must be having a difficult time in this recession; consider the result if they could cut some costs.

Unrelated to Sarbox, in Fall of 2009 a Democrat, Senator Dodd, is calling for a reexamination of the financial regulatory system. Seems like they always find some way to jump into action after a crisis, but never before. However, in true Democrat fashion he wants to put into place something even bigger and more powerful. Regarding the Federal Reserve, BusinessWeek points out the Fed governors have fixed terms and the President has limited ability to remove them. Somehow the American people don't seem to be bothered by that fixed system.

Should small companies be exempt from Sarbox? Beckstead certainly thinks so. Even John Kerry, a Democrat, thinks so. Carvin and Francisco seem to have their work cut out for them, decreasing regulation in a regulation-happy administration. Stay tuned for more news on December 7.

Sarbanes – Oxley 101

2009-11-30T15:30:00.000-08:00

Sarbanes – Oxley is a piece of compliance legislation that was enacted in 2002 after the accounting scandals at Enron, WorldCom, Adelphia, Tyco and Peregrine Systems. This act is intended to increase regulation of boards and management of publicly owned companies, and the accounting firms which audit those companies. The act is also known as the Public Company Accounting Reform and Investor Protection Act, and created the Public Company Accounting Oversight Board(PCAOB).

This act relates only to publicly owned companies.

There are 11 sections of the act, enforceable by the SEC. The sections cover corporate accountability and governance, and set in place stronger penalties for violations.

The act was designed to strengthen internal controls in publicly owned companies, improve transparency, bolster investor confidence.

Supporters say these controls have worked, and have been beneficial to cutting down on potential future scandals. Critics say the cost of compliance is too high and restrains economic growth.

Look Who’s Stalking Wal-Mart

2009-11-27T14:32:00.000-08:00

This Week BusinessWeek’s Michelle Conlin reports on Target, and how it changed strategy to survive the recession.

I’m sure we’ve all heard Target’s tag line, “Expect More, Pay Less”. In the past ten years, I’ve enjoyed looking at the innovative pop-art advertising with “fabulous people, wearing fabulous clothes, doing fabulous things”. Seems like a great way to run a store. Target was a leader in recruiting high-fashion designers to bring their wares down to the affordability level of everyday people. That’s how they came up with the faux-name “Tarzhay” indicating an exclusive boutique.

Then the recession hit. They still use their expression Expect More, Pay Less”, but BW points out they now emphasize the second part of the expression, not the first part. BW points out Wal-Mart may have been trying to follow Target’s style influence before, but now, Target is following Wal-Mart, through emphasizing low prices.

Target had a new CEO in May, 2008, Gregg Steinhafel. Steinhafel has a different management style that the previous CEO, says BW, but he didn’t bring much change in substance. The company did not expect him to bring about changes in strategy. However, the recession hit, and like so many other companies, Target was suddenly in a game of adapt or perish.

When the economy plummeted in Fall 2008, Wal-Mart was in prime territory with its discounts. Target’s stock price went south in the latter part of 2008, and needed to act fast. But, chasing price can be tricky for a retailer. When prices fall the customer is happier, but profits are smaller. The retailer can’t just keep lowering prices across the board as a strategy; no profits mean the end of the business. There needs to be a value proposition other than price to keep the business afloat and keep the customers walking in the door.

But somehow the beautiful people in the Target ads weren’t enough.

Target has identified their “target” shopper (forgive the pun), who is a working mother in her 40s. BW reports Target used to see this woman as a fashionista, now she is a “frugalista”. But somehow in real life she perceives Target to be more expensive than Wal-Mart. Target is fighting this perception, and in its new strategy, it emphasizes price. Target is now providing even more affordable fashions, and doesn’t miss an opportunity to show savings for the customer.

Groceries are an increasingly important part of this strategy. The grocery business is not easy: spoilage and razor-thin margins make it difficult for anyone and Target is no exception. But everyone needs groceries, certainly Target’s “target” shopper, and groceries bring people in the door. Dry goods which don’t spoil have been in Target’s stores for years now. One can sell boxes of granola bars as easily as a box of soap. When Target executive realized the average shopper was going to the grocery store twice a week and to Target only three times a month, they decided to overcome the obstacles to offer fresh and frozen items as part of new food marts within existing stores.

Target had a successful introduction of grocery items in Philadelphia, and results are good enough to implement the concept in 350 more stores in 2010. The only thing Target executives regret is not acting more quickly. Now we will hear more about grocery within Target, and more price messages in 2010; less of the fabulous people.

Is this the Target of the future? BW thinks the new price message at Target is “less like a strategy than a tactic to buy time”. One successful brander from an independent company believes Target has to “reinvent itself”. What will that mean? Sounds like if you want a discount, run out to Target now, and we’ll see about the future. BW ends the article with “The world doesn’t need a second Wal-Mart”.

Wall Street vs. America

2009-11-25T13:02:00.000-08:00

This week BusinessWeek reports on deals done between investment banks and local municipalities which, like so many other things in this economy, have gone bad, leaving the little guy in the lurch. The photo in the article is of an abandoned public school, indicative of the destruction these deals have wrought.

What happened? Cities, states and local municipalities have an ongoing need to raise capital to finance special projects and ongoing operations. To raise capital, they have historically issued municipal bonds, which are underwritten and sold by an investment bank. Investors like to buy these bonds because they are usually free of federal tax, are considered safe, and rated by a reputable agency. That system worked well in the past, and that’s how funds have materialized to build bridges, new roads, buildings and other large projects we need on a regular basis.

Like so many other things in the recent economy, this formerly working system changed in the past few years. Over time, investment banks have become more sophisticated about how to add fees, raise funds, and ensure something is still left for them if a deal should fall apart. The folks working in municipal governments haven’t experienced the same learning curve. During the boom, many municipalities signed on to deals which would protect the investment banks should things fall apart. The municipalities, not as sophisticated, thought good times would continue and did not think to build contingencies into their plans. BW reported on what has happened as a result of the economy going south.

Detroit as we know, is a city with more than just a few problems. Detroit last had a heyday in the sixties, and has never recovered. Recently, things have gotten even worse. Unemployment is 28%, home prices are down 39% since 2007, and they have a $300 million budget deficit, according to BW’s reporters. Not only that, they did some deals with investment banks during the boom which have returned to haunt them. When debt is issued, it is often customary for the issuer to include contingencies which require extra payments if the borrower(in this case, the city of Detroit) should have a fall in credit rating. Not surprisingly, Detroit’s credit rating dropped, and now they owe millions of dollars in extra payments to these financial firms.

Cities like Detroit are squeezed already – who isn’t? – so coming up with the extra funds would be difficult in good times, and next to impossible in bad times like this. Detroit has become a mere shadow of its former self, and basic services such as bus routes, education and even garbage pickup have been severely impacted. Detroit has to make a $4.2 million payment to the investment banks each month, which it is paying for out of casino revenue. Consider what would happen if this shell-shocked city had those funds to spend on basic services!

How did this come to happen?

As I explained above, historically cities such as Detroit have issued municipal bonds to finance their budgets and investment banks have underwritten and sold the securities. Nothing wrong with that – it was a system that worked. However, things became more complicated in recent years and derivatives were thrown into the mix. These were no longer plain-vanilla products, and the municipalities did not account for a future that would be less rosy. As BW says, “many of the transactions shared a striking similarity: provisions that protected the banks from big losses and left the customers on the hook for huge payouts”.

But investment banks know how to collect their fees. So when the deals went bad, Wall Street made sure the cities and local governments paid up, and the governments had even less room in their budgets to make the payments. BW reports that the New Jersey Transportation Trust Fund Authority has a $1 million payment to Goldman Sachs each month until December 2011. No wonder Lloyd Blankfein is often seen smiling these days. The Chicago Transportation Authority (CTA) had a sale-and-leaseback deal which could result in $30 million of termination fees.

Wall Street has had record success recently, and they must know there is a potential PR disaster brewing. No one likes to see the fat cats get fatter while the little guy suffers. But that seems to be what is happening. Politicians like to be seen standing up for the little guy, so there is new legislation in the works. One potential bill is to introduce a 100% tax on termination payments. Another bill will prohibit smaller governments from using derivatives.

In the meantime, it’s hard to see how Detroit will get back on its feet. But, the investment banks claim no wrongdoing. I agree that it is likely the municipalities entered into these legal agreements in a rational way, but given how successful the financial firms are, and in what bad shape the municipalities are in, something doesn’t seem quite right. One can argue that the financial firms have a duty to maximize return on investment for their shareholders and the municipalities participated on their own volition. Hmmm... A deal is a deal, but some deals seem less equal than others.

Unfortunately, the ongoing saga of Detroit may be just a beginning. There were many sale and leaseback deals struck in recent years, and they may be coming back to haunt the initiators of the deal. BW reports that 25 big municipal transportation authorities raised cash by sale-and-leaseback deals. There was an accident which killed nine people in the Washington metro area caused by old subway cars. The transportation authority ignored a recommendation by the NTSB to replace or retrofit older cars, most likely because they were trying to save money.

The Texas Teacher Retirement System has suffered an additional blow due to getting involved with investments it should never have considered, such as private equity and hedge funds. However, private equity firms and hedge funds are wonderful places to work at, because they keep collecting fees even in bad times. But, the retired teachers in Texas have not had a cost-of-living-increase since 2001, and probably do not appreciate these fancy investments.

I’ve listened to a lot of BusinessWeek podcasts, and I’m always impressed by the low-key, even-tempered manner of managing editor John Byrne. However, at the end of this one, he shocked me by saying “it’s a story that makes me angry”. His writer added, “there’s a high outrage factor”. Well said.

Steve Jobs: CEO of The Decade

2009-11-20T04:22:00.000-08:00

Fortune’s cover story this week is Steve Jobs: how he defied the downturn, cheated death and changed our world. There is so much to say, they have nine articles about him. Everything else in the issue is minor.

Where do I start? Fortune points out for many businesses, 2000 – 2009 has not been the best decade. Starting with the dot-com bust, Enron, and now the flurry of bad news in the last two years, we don’t have a lot of success stories.

But then there’s Apple. Who doesn’t have an Apple product? iPods, iPhones, and Mac computers are only three products, but most people between the ages of 7 and 85 have tried an Apple product at some point.

Fortune points out that Steve Jobs isn’t perfect. Like many wildly successful people, he can have a difficult personality and demands the best from everyone. But, he’s had both a cultural and business impact, not to mention a battle with disease and doing all he can in the context of a bad economy.

Steve Jobs is 54. This means he may still do more, and we’ll be writing a similar article about him 10 years from now. Fortune discusses other iconoclasts who have changed an industry: Henry Ford of ford Motors, Juan Trippe of PanAm, and Conrad Hilton of the eponymous hotels.

Jobs is a businessman and a celebrity. Apple has a higher valuation than Google. In this bad economy, Apple is sitting on $34 billion of cash or cash equivalents. The iPhone is a leader, the iPod is a leader and Apple stores are now the cool place to hang out for so many people of all ages.

Jobs’ current run of success started back in 1997 when he returned to Apple. I’m old enough to remember when John Sculley, recruited from corporate giant PepsiCo, was running Apple. One can only wonder what would have happened to Apple had Steve jobs not come back. Consider what would happen in a world without iPods!

2000 was a bad year for Apple. 2001 brought the debut of iTunes, to the chagrin of DVD sellers everywhere, although they probably did not recognize the impact at the time. Remember the original Napster, and the illegal downloads? iTunes debuted in 2001 and changed the purchasing of recorded music. The CD which was already in trouble, rapidly started to go the way of the Dodo bird.

In 2002, Jobs said, “we’re the only company that owns the whole widget – the hardware, the software, and the operating system. We can do things the other guy can’t do”. And so he proved that Apple can do things the other guy can’t do.

Apparently the Apple Board was not in favor of company owned retail stores, but Jobs forged ahead anyways. He is described as an incredible detail-oriented and had an enormous fingerprint on the design and development of the stores. Apple owns a patent on the glass staircase that appears in every store.

Jobs made deals with record labels back in 2002 before anyone realized the power of iTunes. Someone is sorry, I’m sure, they didn’t come up with a competing product.

When the iPhone came along in 2007 both Jobs and Apple were very circumspect about the new development. They fully understood that sometimes it is best to be quiet and let the world guess what’s happening. At Apple the media relations team reports directly to Jobs, to make sure he has complete control over messages to the outside world.

The one dark moment in recent history is the options backdating scandal. Jobs managed to apologize, make good with the SEC, and there have been no similar situations since then.

But Jobs is human, like everyone else, and health problems happen. He had a liver transplant, no small item. His recent illness has raised the question, what would happen to Apple without Steve Jobs? Jobs even has fans outside his company such as Larry Page, Sergey Brin and Jeff Bezos. Certainly those three are heroes to others, but to them, Steve Jobs is their hero. Marc Andreessen, the creator of Netscape and many other successful ventures, likes to ask “what would Steve Jobs do?” That’s a question we should all ask.

Why Wait for Health Reform? 10 Ways to Cut Costs Now

2009-11-16T19:27:00.000-08:00

This week Catherine Arnst at Business Week reports on “10 Ways to Cut Health-Care Costs Now”. Her point is that the health-care bill which is in Congress now is really all about covering the uninsured, not about reducing costs for health-care.

A few years ago Massachusetts opted for universal health-care. At the time they passed the bill, there was no word of cutting costs. Just like a diner at a nice restaurant who ends up getting a large bill after an enjoyable meal, Massachusetts is finding out after a few years it must do something about enormous costs.

BW asked the practical question, what can be done about costs right now? More importantly, they estimate that if half of all the waste, fraud and unnecessary spending were cut, it would be possible to provide health insurance for all. Thomson Reuters just released an extensive report about health-care spending in the U.S. which the BW article is based on.

What is the basic problem with the health-care system right now?

First of all, American health-care uses a fee-for-service plan. This means we pay for quantity of care, not quality. Doctors do not have any financial incentive to eliminate waste. In fact, if they do cut costs, they earn less. BW predicts that health-care spending will double over the next 10 years. Because Congress is doing nothing to cut costs in the current health care bill, we will all end up paying for it.

The private sector cannot wait around for costs to increase. Businesses are having enough trouble in this difficult economy and higher health-care costs are more painful to the bottom line than ever before.
BW emphasizes that the most impact will come from a comprehensive Federal health-care bill, but there are still some things that can be done right now to save real dollars.

1) Crackdown on Fraud & Abuse
The FBI estimates that 3% to 10% of total health spending is fraudulent billings to Medicare and Medicaid. That is $125 - $175 billion, a substantial sum. Law enforcement used to help out private insurers, but now they are taking matters into their own hands.
One common scheme is phony providers of medical equipment who are the recipients of claims. Anthem Blue Cross of California decided to investigate and found 10% of newly registered companies were non-existent, but still accepting reimbursement claims.

2) Develop a Healthy Workforce
Johnson & Johnson has offered comprehensive wellness programs since 1995, and saved $225 per employee from 1998 – 2002. Multiply that by 100,000 employees and the result is $22.5 million saved in four years. Even for a company the size of J&J, that’s substantial. In the past, conventional wisdom thought it would take decades for wellness programs to pay off, but J&J saved money after only three years.

3) Coordinate Care through Family Doctors
Uncoordinated care is a huge reason for unnecessary treatment. The U.S. does not have electronic healthcare records, which means duplication of treatment, testing and no cross-checking of prescriptions. BW estimates this costs $25 to $50 billion a year. They suggest a primary care physician as the center for communication and coordinator of care. North Carolina has implemented this kind of program resulting in $161 million savings in 2006.

4) Make Health a Community Effort
Haven’t we all heard about the benefits of exercise and eating right? The City of Rochester, NY has a number of large companies who have gotten together to set up a health & fitness program for the metropolitan area. Rochester may not be New York City, but it is still a fairly sizable area, so I view this as an impressive step forward. The program addressed fitness, eating fruits and vegetables and managing prescription drugs. Rochester’s health care costs went from 5% below the national average in 2005 to 15% below the national average in 2009.

5) Stop Infections in Hospitals
BW reports, “Every year 1.7 million patients develop infections while in hospital and 99,000 die as a result”. Sounds pretty terrible to me – we generally go to a hospital to get treated, not to pick up a new infection.
What can be done about this? Apparently, it’s as simple as washing hands, clothes and tools. John Hopkins Hospital in Baltimore has a five-item checklist to follow. The Keystone project is a collaboration of 77 hospitals. They followed the checklist and “reduced catheter-related infections to zero” saving 1700 lives and $246 million. Does your hospital use this checklist?

6) Get Patients to Take their Medicine
What happens when people don’t follow doctor’s orders? More doctor visits, hospitalizations, additional treatments to the tune of $177 million a year. The National Council of Patient Education did this study. Why don’t people listen? They think the drugs don’t work, they can’t afford the co-pays, they forget, and so on.
Various programs have been started to get patients to comply. These programs cost money, but deliver a solid return: for every $1 spent on a program can save $7 on diabetes, $5 for high cholesterol and $4 for high blood pressure. That beats most investments these days – and people get healthier, too.

7) Discuss Options Near End of Life
Most people don’t want to be poked and prodded with “unneeded test and futile treatments” when they are in the last year of their life. Instead they want more “nursing care, pain management and psychological support”. Given that one-quarter of Medicare dollars are spent in the last year of life, cutting down on treatments that patients don’t want could save some funds. What about the argument that anything should be done to save a person? Exactly, everything should be done, but note the word “unnecessary”. Dr. Elliott Fisher at Dartmouth Medical School says “this is about better care aligned with what patients want”.

8) Use Insurance to Manage Chronic Diseases
Not all diseases are created equal, and different diseases require different treatment plans. Value-based insurance design keeps costs down by giving patients financial incentives to manage their treatments. The estimate on this one is $174 billion a year.

9) Let Well-Informed Patients Decide
Patients need to know the risks and benefits of medical treatments they may or may not need. Sometimes they don’t need treatments they may insist on. BW doesn’t give a number, but emphasizes that “37% of health spending is wasted on unnecessary care” and this would go a ways toward reducing that figure.

10) Apologize to the Patient
“I’m sorry”. Such simple words, such powerful results. Laws can limit malpractice awards but it would be better not to have litigation in the first place. An attorney once said, “half of all lawsuits could be avoided with an apology”. Errors can and do occur, and in 2005 the SorryWorks! Coalition was formed by a man who lost a family member as a result of a medical error. The SorryWorks! Coalition has a policy that when an error is discovered by the hospital, the patient is informed and actions are taken.

The most dramatic example is at the University of Illinois Medical Center in Chicago, which started a formal apology program in 2006. Claims are down 40%, even though clinical activity is up 20%.

Overall, this BusinessWeek article is the most sensible approach to cost reduction I have seen yet. I’ll let Congress duke it out over the health care bill, and I wouldn’t be surprised if what emerges is so watered down it will be barely effective. Certainly I don’t expect Congress to cut costs; they are champs at spending money. Let’s hope that these sensible, practical measures which actually work are implemented further to cut costs.

The Commercial Real Estate Bust – “Extend and Pretend”

2009-11-09T08:21:00.000-08:00

BusinessWeek’s cover story this week is “Why the Commercial Real Estate Bust Looks So Scary”.

Goldman Sachs has been receiving a lot of attention recently for their big profits and mammoth bonuses – don’t you wish you were on the receiving end of one?

Some of Goldman’s investors aren’t so fortunate. BW opens with a report on the Arizona Grand Resort, a deal which Goldman securitized and sold to investors in 2006. It turned out to be one of the largest busts of the recent economy: the resort defaulted on a $190 million loan.

There’s a great story about lending. If you owe the bank $100,000 and you can’t pay, then you have a problem. If you owe the bank $1 million or more and you can’t pay, then the bank has a problem.

In this case, Goldman sold the loan to investors. Goldman kept its fees, and seems to be in pretty good shape now. What if you are one of the investors in the bonds backed by this loan? Too bad.

$190 million is only a fraction of the whole commercial real estate market, measured at $6.4 trillion. But this scenario has played itself out over and over.

Unlike many housing loans backed by the FHA, there is no PMI or Federal guarantee for these commercial loans. Most of the big loans were securitized. Who loses when the big loans go south? Investors, not the underwriters.

The next scary story BW reports on is the bankruptcy of the Yellowstone club in Montana, It’s a sordid story, complete with a rags to riches owner, an acrimonious divorce, and wild spending. I’m sure some people may enjoy seeing the owner suffer a reduced state, but I’m more concerned about the investors and the multiplier effect on the economy.

The Yellowstone Club is another large resort where Bill Gates and Greg LeMond purchased homes (must have the celebrity factor!) In 2005 Tim Blixseth, the owner, borrowed $375 million from Credit Suisse, $209 million of which was for his personal use. That’s where the wild behavior and spending come in.

An entity can hold only so much debt given a reduced cash flow, which is why we hear so much about capital structure these days. Yellowstone Club went bankrupt and I’m glad I’m not holding one of those worthless bonds.

BW also reports on another deal which would be laughable if it weren’t true: Piazza Blanca, an upscale shopping complex in Galveston, TX. Prudential Financial lent $13.9 million. The standard operating procedure in commercial real estate deals is that the property owner needs to report on future cash flow so the lender knows the loan will be paid on schedule. In this case, the numbers were made up, exaggerated, and the dog probably ate the homework too.

Aren’t the lenders supposed to verify numbers? In 2007, apparently they had better things to do. I remember back in the 80’s Mikhail Gorbachev saying “Trust, but verify”. Commercial lenders seem to have heard only the first part of the saying.

2007 was the peak year for bad loan origination, and we will be hearing about this for years to come. Kenneth Riggs, CEO of Real Estate Research, says the market won’t fully recover until 2020. This is especially bad because of securitization. The ripple effect of a bad loan is huge, because so many people invested after the loan originated.

The stories go on. As I always like to ask, what’s in it for us? How does this affect the average person on the street?

This will be an enormous deadweight on the economy while the economy is struggling to recover. Banks now have weakened capital structures (their ratio of debt to equity) and they are holding on to their TARP money to strengthen the capital structure, not to lend out. In today’s New York Times there is a piece about how Tim Geitner is wringing his hands trying to get banks to lend. Well, they won’t lend until they can sell their securities on the secondary markets (which have dried up) and when they have stronger capital structures to please the regulators who have now woken up after being asleep at the wheel. Even banks which have always been careful about lending now have a shakier loan portfolio. Because the economy is weaker, by definition all outstanding loans have a slightly higher risk of default even if it is the same outstanding loan from years ago.

I am also concerned about who or what these securities were sold to. Institutions hold most of the securities in this country, and in the previous boom times pension plans were willing to invest in all sorts of fantastical products. That’s what happens when rates are low – investors must hunt everywhere for higher returns which are difficult to find. Taking on risk is the only way to get a higher rate in such an environment.

It sounds like the defaults are going to keep happening. Just when we hit 10.2% unemployment rate, this doesn’t give any boost to consumer confidence.

My favorite part of the article was the BW podcast. In the commercial real estate market, there is a rush to renegotiate debt. The new operating phrase is “Extend and Pretend”. In other words, extend the term of the loan and pretend it is okay.

“Extend and pretend”. Such wisdom from an industry that never bothered to check the numbers…

End note: The BusinessWeek reporter, Mara Der Hovanesian, wrote another cover story in mid-2006, “Toxic Mortgages”. I vaguely remember that issue, but who was paying attention back then? That woman is brilliant!

The stress test for banks did not include commercial real estate debt – why, I have no idea – and with a move to fair value accounting, these assets are on the banks’ balance sheets at their previous valuations. In other words, the other shoe has not yet dropped on this one. More later!

The Apps Economy - Redux, Redux

2009-11-08T19:18:00.000-08:00

Thanks to one of my readers for alerting me to the New York Times cover article: “Virtual Goods Start Bringing Real Paydays”. This is my third post on this topic, so for a background, see the previous posts.

Claire Cain Miller and Brad Stone point out how rapidly “it is becoming commonplace” for users of social games to use real money to buy virtual products. I wrote about this before, saying how brilliant it is, and how profitable. Who wouldn’t want a 100% profit margin?

The NYT says the marketplace for these virtual goods is now $5 billion – yes, “billion” with a “b”.

Where do we sign up to invest?

“It is a fantastic business” says Jeremy Liew of Lightspeed Venture Partners. Yes, it certainly is. Lightspeed is a venture capital firm which has invested $10 million in virtual goods companies. Zynga, my favorite company, isn’t the only one. Playfish and Playdom are two others with “significant” revenue and profits. Asia is a place which has lead in many areas over the years, and it is no stranger to virtual goods, which are very popular there.

And, it is not just techies, everyday people cough up money for pixels.

One mother has a good point: “it’s cheaper than…Target where (the kids) will ask for a toy”. I agree – no boxes and bags to litter the house, no Legos left lying around. No clutter!

NYT raises the possibility that some might consider the exchange of real dollars for fake goods a “swindle”. Yet no one is complaining. Zynga claims that “less than 3% of people pay for something” and this year they will have earned around $100 million of revenue from games this year.

Consider the possibility if they went from 3% to something higher.

What does this mean for us, the end user? Look for more games, and more encouragement to play games. Then when you are in the game, inevitably you’ll be encouraged to buy these goods. If it makes you happy and you feel the value is good, the both the game creators and you will be better off at the end of the day. Just know: when there’s a product with 100% profit making $100 million for just one company, we’ll be seeing more of it.

This is only the beginning. Neither good nor bad, but be aware before you part with your hard earned dollars.

Now where do I go to invest in Zynga?

Green Energy Transmission

2009-11-05T17:31:00.000-08:00

I’m sure when most of us think of wind power, we envision a lot of windmills in a giant flat plain, with the wind howling away. However, all those plains are in the West, not the lumpy, bumpy eastern third of the United States where I grew up. Ever thought about what to do with the wind energy, or how to transport it to the East?

Next on the agenda of green energy is high-voltage transmission lines. John Carey at BusinessWeek reported on whether or not the U.S. should subsidize high-energy voltage lines for Green energy. Harry Reid – when he’s not working on a healthcare bill – likes the idea, and wants to expand the power line system to transport wind energy, and more importantly for a politician like Reid, to create jobs in Nevada, his constituent state.

Who pays for this?

We all do, through increases in our electricity bills. Liberals will like this one: collective cost sharing and more jobs. Governor Mark Parkinson of Kansas is pushing high-voltage transmission lines to transport wind energy from his flat state. Oregon is aIso a state hot on the wind energy bandwagon. I searched all over the Department of Energy’s website to find out about how the wind power will get to locations not near the supply of wind. Nothing yet.

What about the counter idea that every idea or new company pays for itself?

Believe it or not, there are wind and alternative energy companies in the East. But the power is more expensive to produce. Should we ship cheaper wind energy from the West via the new lines or build more sites in the East, where the unit cost is higher? Which way will this issue go? Usually, given a Democratic administration and the popularity of Green Energy, I’d place my bet on Uncle Sam picking up the tab for the new infrastructure.

But the Obama administration is starting to take heat for the mammoth sized budget deficits, troops are needed in Afghanistan, and there are only so many dollars to go around.

Even T. Boone Pickens put his wind farm on hold, so I’m willing to bet we’ll be waiting a while longer for the new green wires.

The GDP Mirage

2009-11-05T09:12:00.000-08:00

This week Michael Mandel, chief economist at BusinessWeek, reports on “The GDP Mirage”.

What is it?

GDP is a measure of all the goods & services produced by the U.S. economy. We use it as a benchmark. The change in GDP is what we are referring to when we discuss the perennial question, “how’s the economy?”

On October 29, The Bureau of Economic Analysis reported that GDP rose 3.5% in the third quarter of 2009. That’s quite a number! Especially when you consider we haven’t seen any numbers like that since Q2 of 2007, over two years ago.

Most media outlets and pundits are reporting that the recession is over. Mandel disagrees. How dare he issue such a contrarian viewpoint when we are all looking for good news? Because he’s probably right. Mandel’s argument is that the GDP as it is currently measured fails to track intangibles which are a necessary ingredient of the economy in 2009.

The intangibles he mentions are R&D, product design and worker training. Certainly those sound important to me. We would never have gotten to this stage of development if companies hadn’t spent on these things in the past!

So, why are the companies cutting these important intangibles?

The accounting system as it stands recognizes these categories as expenses, not investment. When a company wants to boost the bottom line, they cut expenses to look better to investors, creditors and everyone else. Since 1999 software has been categorized as an investment. In 2013 R&D will be an investment. But what happens before 2013?

Mandel is especially concerned about the reduction in employment of scientists and engineers, which has fallen 6.3% in the last year as compared to general employment, which has fallen 4.1%. Surely highly educated knowledge workers are important in the information age, are they not?

I keep hearing about how past recessions have given birth to new companies and innovation. It is possible the same results may not come out of this recession if companies are not investing. Mandel points out new product development is down, and the more highly educated workers are the first to be let go. In the past the U.S. has done very well investing in workers and spending on worker training. But now with huge cutbacks, will the U.S. worker maintain the same level of output?

BusinessWeek did some back-of-the-envelope calculations, and predicts that intangible investments are still decreasing.

We all know about the ominous outsourcing of R&D to China and India. It started with call centers. And now has moved up the chain to the really important development. It’s the big sucking sound Ross Perot used to talk about, now in a different part of the world.

If U.S. companies are getting more bang for their R&D buck by spending in foreign countries I suppose that’s not so bad. But the outsourcing of such a great range of jobs will help to keep unemployment high for a long time. What about those unemployed scientists?

Baseball statistics show us that what we track has a chance of improving. In fact, sometimes people will go to any length to achieve their numbers (Enron, anyone? McGwire and Sosa?) Sounds like we need to speed up directions to the BEA about what to track in GDP. Mandel states that the BEA does a good job with the numbers they have, but they “are using 20th century tools to track a 21st century economy”.

My opinion is Mandel is right. In a global information age, knowledge can be more important that property, plant and equipment. After all, what would you rather have, a dusty old building, or the knowledge of how to build a new and better one, on time and under budget?

The Apps Economy, Redux

2009-11-02T07:35:00.000-08:00

Zynga was not only the cover story in BusinessWeek, they’ve made it into Fortune. For an explanation of Zynga, see my previous post.

What is a social game? Fortune explains it as a free online application accessed through Facebook, MySpace and similar sites. They’re free! But Zynga has cleverly thought of a way to get you to pay for them.

They will sell you components – which you have to pay for in real money – to keep playing the free game. The game never ends and you can play it in a short stretch of time. Brilliant! And it’s not just young techies who do this. Fortune profiled a 37-year-old mother of three who is a devotee of Farmville. She spent $100 in the last few months on it. Someone restrain me from starting...

Here’s my question – why don’t other free sites follow the model and start charging for something?

Fortune points out that Twitter and Facebook either don’t have sales or are barely breaking even. For all that traffic, and the smart people at the helm, I’m sure they can do better than that.

Now that I’ve written about Google being the possible next victim of antitrust investigation, maybe we need to be on the looking for Zynga (just kidding – it will be a while!).

Interesting sidebar for the dog lovers out there: Mark Pincus, the company’s founder, named the company after his deceased, but beloved American Bulldog, Zinga.
My hat’s off to you Zynga, I wish I’d thought of it!

Junk Bonds - Back from the 80's

2009-10-30T19:37:00.000-07:00

They’re baack……

Remember junk bonds from the days of Michael Milken, big hair and Jacko before his transformation?

BusinessWeek just reported on the hot junk bond market. This was followed up by support from Bloomberg. com, Jeremy Grantham and Merrill Lynch reports – sounds like a critical mass of opinion. Why the rally?

Junk bonds are safer than stocks. Corporate bondholders are ahead of the stockholders to get a piece of the pie, in the event of a liquidation. Corporate earnings have been weak, to say the least, driving down the price of stocks. And interest rates are close to zero. We need returns somewhere!

You would think people would have learned their lesson about investing in below investment-grade debt, but how’s an investor to get some returns? Junk bonds are really not that bad, in spite of their name. After all, as I just mentioned, they are safer than stocks. But they may have already had their run.

BusinessWeek reports that in 2009 junk bonds returned 52%. In the same breath, they also report that the S&P 500 is up 19% since the beginning of the year, but of course that is after the collapse last fall. Over the last 23 years, stocks and junk bonds performed similarly, but this year the junk bonds have done better.

I don’t see corporate earnings turning up by large amounts anytime soon – we should not expect to see the Dow much above 10,000 anytime soon. There are even folks mentioning a possible “double-dip recession” which happened in 1937, just as the United States was trying to climb its way out of another great recession.

One analyst at Merrill Lynch describes the “flight up the capital structure”. This means that investors are looking for something safer than equities, while still investing in something issued by a corporation. And, for institutions, investing in bonds gives a longer maturity than bank debt. But, if we are really in a recovery, corporate earnings will strengthen, and the stock market will follow. But don’t hold your breath, that will take a while.

Check Bloomberg.com for a healthy debate on credit vs. equities – which is better to invest in now. This is why it is so important to follow an intelligent investment strategy and not to get caught up in the product dujour.

Obama & Google

2009-10-30T12:48:00.000-07:00

Obama & Google – The Fortune Cover Story October 30, 2009
Obama is not a fan of Corporate America, but he seems to have close ties to Google, a huge corporation. Google likes to portray themselves as Washington outsiders, yet they have a 20-person policy staff in their Washington office and their fingerprints on the Obama Administration.

Obama visited Google’s HQ in 2004 and again in 2007. During the first visit he developed two economic opinions, as Fortune says “support for more U.S. educated engineers and the expansion of internet services to poor and rural areas”.

Google donated $803,000 to the Obama Presidential campaign. This was third to Goldman Sachs and Microsoft. Christine Varney, Assistant Attorney General for Antitrust, alluded that Google might be looked at for antitrust. A Google representative says “what we offer is technological expertise…it’s a company that’s a think tank or a think tank that’s a company”.

Huh?

Eric Schmidt, CEO of Google, is on Obama’s council of Science & Technology advisors. Wikipedia describes him as “an informal advisor during the Obama campaign”.

The biggest “Hmmm” is Andrew McLaughlin. He used to be Google’s head of global public policy. Now he is Deputy Chief Technology officer in the Obama Administration.

Hmmm…any chance he still has his Google stock options?

Can anyone guess how old Google is? A mere 11 years old! Google is mostly a search engine but it is branching out into new fields. It wants to have a digital library, for example. However, it still holds 65% of the search market in the United States. Take that, Bing!

But – how much does Google know about you? Most of us use Google for search. Many of us have a Gmail account. Fortune describes the big brother situation of writing an email within a Gmail account to a friend about skiing, and having ads of ski resorts appear in the margins. That’s creepy, in my opinion.

Just how much do they know? Is it time for an antitrust investigation?

Google maintains that it is looking out for the little guy. It says that it is a “resource for technology issues in Washington”. What does Google want from Washington? Probably they want the government to stay off their case. But in addition to that, they want “net neutrality”. What is “net neutrality”?

Large phone companies such as AT&T, Verizon and cable companies own large networks. Because they own the networks, presumably they have some modicum of control as to what runs on the networks. An presumably, because they have invested so much to build and maintain the networks, they want to make a profit off of the network.

But Google wants to make sure that the network operators are not allowed to affect or control the content on their networks. This sounds like a good thing to me too – let’s support them here.
Did you know how much information your big brother Google has on you? Every time you send an email from a Gmail account that belongs to Google. According to Fortune there is a federal law which allows law enforcement (the guys in blue) to acquire email messages less than 181 days old. Yipes. Let’s keep Google happy – but don’t you think the Obama administration wants to keep Google happy? Don’t forget Google was their #3 corporate donor.

Hmmm….stay tuned for the soap opera.

Now that I’ve covered the Fortune article, I’ll give you my own take. I think we’ll be hearing about Google for the next few years, we may even see some antitrust action, and then it will all fade away. I’m old enough to remember the antitrust action against Microsoft, and before that, IBM. And how about AT&T/ Remember the Baby Bells?

Will the Obama administration be accused by anyone other than Fortune for being too close to Google? It is interesting, given the Obama administration’s anti-corporate stance, how deeply they’re enmeshed with Google.

Stay tuned, folks. I think we haven’t heard the last of this.

The Apps Economy

2009-10-26T14:00:00.000-07:00

October 26, 2009 Apps – The BusinessWeek Cover Story
They’re here, and they are growing. Apple launched its Apps store in July, 2008, and it has taken off. It took Google three years to turn a profit, but App developer Zynga is profitable now with $100 million in revenues.

How does an app developer make money? They can sell apps, they can sell ads within apps and they can sell digital goods used in the Apps. BusinessWeek tells us about Farmville, the virtual farm, where people pay real money to buy digital crops, cattle and farmland. Amazing! I’ll say it again: people pay real money to buy fake crops for their fantasy world. I wish I had invented that – sounds like the pet rock from the 1970’s, and some brilliant person convinced others to pay real money for essentially nothing. Let’s hope for Zynga, it continues.

The market for apps is predicted to grow threefold over the next three years. Anything growing in this economy is unusual, but to grow at that rate is truly unbelievable. The barriers to entry are next to nothing, so this will be a crowded marketplace in no time flat.

One company who hopes to be a big player is Yahoo. Yahoo will have apps on the Yahoo.com home page and may have its own apps store. The apps are a way to track data for its targeted ads. I suppose the trade off for everyday users like you and me is being subjected to more ads – we can never get away from them. You can learn a lot about a person by the apps they use, and I’m sure as we all venture further into the world of Apps, someone will be watching over our shoulder.

Even Research in Motion, and Verizon wireless and Kleiner Perkins – remember them? - the VC from the old dot-com boom days are getting into the Apps act.

What does this mean for everyday folk? More interesting things to do, and better ways of doing things, but alas, those pesky ads. And if you can develop an app, go for it – it may just be the next LinkedIn.

The First-Time Home Buyer Tax Credit

2009-10-23T15:01:00.000-07:00

October 23, 2009 – The First-Time Home Buyer Tax Credit
The First-Time Home Buyer Tax Credit – did it work? Yes – it did what a credit should do, it influenced behavior. What is it? The U.S. Government has offered a tax credit of up to $8000 for first-time qualified home buyers, if they buy a primary home before November 30, 2009. What are the qualifications? The buyer cannot have owned a primary home for three years prior to purchasing a home in 2009, they cannot buy from ancestors or a spouse, and income is limited to $75,000 MAGI for a single taxpayer and $150,000 MAGI for married taxpayers filing jointly.

The best part about the tax credit is that it is refundable. There is a big difference between non-refundable and refundable tax credits. Also, the tax credit goes directly on the 1040, eliminating the need for another form.

What will happen once the tax credit is no longer valid? The market will fall off, no doubt. However, getting new buyers into a home will have a ripple effect of spending – that’s what we call the multiplier in economics class. People need to buy furniture, spend on landscaping and improvements, and, as all of us homeowners know, the list goes on for years.

Is a tax credit the best way to use Federal funds? The National Association of Realtors seems to think so – they are lobbying for an extension of the credit. My concern – will this new crop of homebuyers be able to stay in their homes and pay the bills? Presumably with tighter credit standards, they’ve passed a higher credit hurdle than the folks who need only a pulse to qualify for a mortgage in recent years.

Important Sidebar: Tax credits explained
What exactly is a tax credit? It’s a reduction of the taxes you owe, after the amount is calculated. This is different than a deduction, which reduces the amount of taxable income before the final calculation. Credits are usually better than deductions, because they can be refundable, which means that if the taxes you owe fall to a negative number, the U.S. government will actually send money back to you. If you have a tax deduction which causes the taxes you owe to fall to zero, you won’t owe taxes, but you won’t get a refund.

Animal Spirits - Akerlof and Shiller

2009-08-20T14:58:00.000-07:00

August, 2009
I read a great book, Animal Spirits, by George Akerlof and Robert Shiller. This is a sample of what I learned.

Robert Shiller:
He specializes in behavioral finance, real estate and risk management topics. He was an early challenger of the Efficient Markets Theory.

George Akerlof:
He wrote the famous article “The Market for Lemons” about asymmetrical information. He also won the Nobel prize – how impressive!
Shiller is an economist at Yale and he is the Shiller part of the Case-Shiller Housing index
Akerlof is an economist at Berkeley. This book is essentially a rebuttal to the efficient market theory. They examine the current economy and explain that psychological causes – “Animal Spirits” helped to bring about the mess we are in.

First they define “Animal Spirits” and then formulate eight relevant questions and answer them. The five aspects of animal spirits are confidence, fairness, corruption, money illusion and stories.

Confidence: this brings us back to the multipliers we learned about in macro class, i.e. there is a ripple effect when people do or do not feel good about the economy and act accordingly
Fairness: this explains why wages and prices move slowly
Corruption: acceptance of corruption waxes and wanes in our society and the economy is affected
Money Illusion: people forget and/or do not take into account inflation when making decisions
Stories: we tell ourselves stories about what is going on in the world: they may or may not be true, but they become our perception

The eight questions are very good:
1. Why do Economies Fall into Depression?
2. Why do central Bankers have Power over the economy?
3. Why are there people who cannot find a job?
4. why is there a tradeoff between Inflation and Unemployment in the Long Run?
5. Why is saving for the future so arbitrary?
6. Why are financial prices and corporate investments so volatile?
7. Why do real estate markets go through cycles?8. Why is there special poverty among minorities?

The answers:

1. Economies from time to time experience fundamental changes in confidence.
2. They are the guardian of the money supply and the bank of last resort.
3. Wages are not efficient
4. Because of money illusion
5. Lack of a savings policy in the U.S.
6. Because of markets
7. The confidence multiplier in real estate
8. Lots of history to overcome

The real value of this book is to give us a reason why the financial crisis and subsequent downfall occurred. Then the logical conclusion is what we can do to prevent such a debacle again.

Important Sidebar: The Case-Shiller Index
What is it? Also known as the Case Shiller Weiss index. There are actually many indices. They are composites of single-family home prices in 20 metro areas in the United States. Fiserv now own the indices and publishes them monthly. There are options and futures based on the indices. Why is it useful? Just as the Dow and the S&P500 averages are used by many as a general indicator of the movement of the overall stock market, the S&P/Case-Shiller U.S. National Home Price Index can be used as a general indicator of the real estate market in the United States. When were real estate prices the highest? In Q2 of 2006. The index has declined ever since.

Good to Great - Jim Collins

2009-05-15T12:00:00.000-07:00

Spring, 2009
Good to Great – Jim Collins
Jim Collins may have a point, but he’s one of those consultants who likes to come up with his own terminology – Stages 1 – 4, etcetera. I read Good to Great, which was an entertaining and wise book, but the whole thing reminds me of the Reengineering fad from the early 90’s. Remember that? Michael Hammer and James Champy, and their book was simply titled” Reengineering”. That was all the rage back then, Reenginnering, Biotech, and remember the Stock Market phrase: “10,000 by 2000!”. Boy – I’d like to go back to those years, and let me tell you, my portfolio has already gone back to those years when the Dow was at 8,000. Or is that now? Can’t remember – it seems to me, I’ve been saving and investing for the last 10 years, but when I look at the news, I see the Dow is at 8,000. What gives?

Back to Jim Collins. In his previous two books, Good to Great and Built to Last, he talks about great companies who supposedly will always be great. Now that the economy has tanked, he is talking about companies that fail. He’s good at spotting a trend – or is he following a trend? There’s a difference.