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

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

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?

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

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

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?

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

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

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

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?

Steve Jobs: CEO of The Decade

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!

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

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?

The Commercial Real Estate Bust – “Extend and Pretend”

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.

The Apps Economy - Redux, Redux

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.

Green Energy Transmission

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?

The GDP Mirage

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 Apps Economy, Redux

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?

Junk Bonds - Back from the 80's

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!

Obama & Google

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?

The Apps Economy

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.

The First-Time Home Buyer Tax Credit

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.

Animal Spirits - Akerlof and Shiller

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.

Good to Great - Jim Collins

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.