Thursday, June 30, 2005

Memo to Mack

The prodigal son returns! After getting tossed from Morgan Stanley and First Boston one lesson should be clear this go around: you need to invest lots of time in cultivating good relations with your board members. But you have more immediate concerns:
  • You need to bring back the rainmakers such as Vikram Pandit and Joe Perella without losing co-President Zoe Cruz – accomplishing this will take all your diplomatic skills;
  • Once you stabilize the organization, you need to turn your attention to firing up the troops – giving them what they need to go out and win in the marketplace;
  • Only then can you turn to the issue of long-term strategy. Based on their performance and prospects I think now would be a good time to dump the Discover Card – look at today’s Bank of America deal with MBNA. Eventually Morgan Stanley should lose its brokerage business but prices today are in the bargain basement – wait till they rise; and
  • Ultimately you can add lots of value by investing the proceeds in expanding the traditional Morgan Stanley franchise – serving corporations and the executives they make wealthy.

Congratulations on your return. Morgan Stanley shareholders will be the beneficiaries!

Monday, June 27, 2005


The Dow Jones Industrials Average has lost 325 points, or 3% of its value in the last week. Meanwhile the price of oil ended the day at a record $60.47.

The proximate cause of today’s upward jolt in oil prices was the outcome of US policy to encourage democracy in the Middle East. After all, Iran’s new president elect, Mahmoud Ahmadinejad upped oil’s terror premium by claiming “It’s Iran’s right to develop nuclear energy.”

We should put the latest market jolt in perspective – after all last Thursday, the market dropped 166 points after oil hit $60 a barrel and FedEx announced that revenues were less than anticipated because it could no longer pass along to customers a fuel surcharge big enough to offset its rising fuel costs.

My conclusion is that what moves markets remains a big mystery. However, it is always disquieting when such a yawning gap opens up between what the government says and what actually happens. In his 2005 inaugural address, the President claimed that
our security depends on the spread of democracy. Iran’s latest announcement contradicts that.

Alan Greenspan’s comments on the economic impact of higher oil prices create a complex challenge in setting interest rates: Should Greenspan raise rates more to offset the inflationary effects of higher oil prices or will a rise in interest rates just add more pressure to high oil’s economic brakes?


Saturday, June 18, 2005

Slow boil

If you throw a frog into a pot of boiling water it will jump right out. But if you drop it in a pot of warm water and slowly turn up the heat, the frog will stay put until it perishes.

This cruel science experiment comes to mind as I think about the institutions that we have been conditioned to think are protecting us. Yesterday more evidence emerged of the frailty of our financial identities – as 40 million credit cards processed by CardSystems Solutions were hacked --
14 million of which were MasterCards.

The fundamental source of the problem, in my view, is insurance. Or more specifically, the notion of risk pooling which implies that all insured pay the same premium to cover the claims incurred by a subset thereof. How does this apply to MasterCard? If, say, 40,000 of those MasterCard holders find a total of $4 million in fraudulent charges on their July statements, MasterCard claims it will not require the cardholders to pay the charges. This statement, however, is not consistent with reality. What will happen is that MasterCard will shift the costs to the merchants whose goods are fraudulently purchased. And the merchants will raise their prices to consumers to cover the costs.

MasterCard will thus use the principle of risk pooling to shift the claims of a subset of its cardholders to all of them. According to a Gartner analyst Aviva Litan, MasterCard will not pay the price, “The sad truth is that the card companies could easily contain the potential damage by shutting down the affected accounts and issuing new cards. But of course they won’t do that because that would cost them around $10 a card. Instead, they will let retailers take most of the hit.”

MasterCard has cleverly disaggregated its functions. Processing is done by CardSystems, whose ownership includes Camden Partners, Equity Dynamics, Principal Financial Group and Edgewater Private Equity Funds. MasterCard is itself owned by its members to whom it licenses the right to issue cards or accept drafts from retailers. By outsourcing responsibilities for its business functions, MasterCard can shift the costs of its flawed security procedures – thereby eliminating MasterCard’s financial incentive to fix them.

Therein lays the fundamental flaw in applying insurance principles to institutions which hold portions of our lives in their hands.

And until society requires those responsible for such problems to bear the cost of fixing them, the incentives to keep things the way they are will continue to exceed the forces to make them better – slowly boiling our blood in the process.

Monday, June 13, 2005

The Passion of the Purcell

This morning CNBC announced that Morgan Stanley had decided to fire its CEO, Phillip Purcell. According to Reuters, “CNBC said the board's decision to fire Purcell was made at a meeting over the weekend and came after news on Friday that nine equities derivatives staffers had left the bank to join Wachovia Corp.. The departures were the latest from the bank's industry-leading equities division, where Purcell previously acknowledged poor employee morale was a concern. The departures appear to have the final straw for the board, coming after the departure of dozens of senior executives, investment bankers, and traders.”

While many speculated that Purcell’s stacking of the board would protect him, there were others – myself included – who thought that Purcell would eventually go. According to an April 1st article in Institutional Investor,

"If this happened a month ago, they would have had a stronger chance. Morgan Stanley just had its annual meeting and it won't be until a year [later] that shareholders can vote on this issue," said
Jeffrey Sonnenfeld, an associate dean at Yale School of Management. The annual meeting was held March 15. There are no provisions in the by-laws for shareholders to call for a special meeting before then, said Patrick McGurn, executive v.p. at Institutional Shareholder Services, a proxy advisory group. Under the bylaws special meetings can only be called by the firms' secretary at the direction of board members. Since the board, at present, is solidly behind Purcell, a meeting may not be called before next year.

My comment was included in “What Others Think” below

  • "The forces for dethroning are building faster than the forces to keep him. At this pace it could be a matter of weeks."--Peter Cohan, president of management consulting and venture capital firm Peter S. Cohan & Associates.
  • "If he does some things to make the dissidents partially satisfied, he has a decent shot of surviving over the next six months. However, if he takes a 'just say no' policy it probably isn't going to work for him."--Michael Holland, president Holland & Co., a money management firm.
  • "His credibility has been damaged...the odds are 100% that there'll be a change in Morgan Stanley but whether that means the departure of Purcell, I don't know."--Nell Minow, Corporate Library Chairman.

In the ensuing weeks I was particularly concerned with Purcell’s efforts to control the reporting on Morgan Stanley’s woes. But now that Purcell is out, the next step is to bring in a new CEO. I would be inclined to select one of the Morgan Stanley veterans who recently departed the firm. And once the new CEO arrives, there will be an opportunity to consider the best corporate strategy for Morgan Stanley.

With the stock price up 5% this morning in pre-market trading, the decision to oust Purcell comes as a short-term victory for Morgan Stanley shareholders. Whether it becomes a long-term victory depends on what Morgan Stanley’s next CEO does.

Monday, June 06, 2005

Market con(fidence)

Valedictories to expelled SEC Chairman William Donaldson make much of his success at restoring market confidence. If he has been so successful at restoring market confidence, why is the S&P 500 down 1% this year and under water 11% since January 19, 2001 when the current president’s term began?

This morning’s Wall Street Journal report of Goldman Sachs’s
overly close relationship with hedge funds reminds me that a big reason for the market’s muddle is that the word ‘con’ is a truncation of ‘confidence.’ Today’s report puts the basic problem in bright lights: Wall Street firms depend heavily on hedge funds and their own ‘proprietary trading’ for profits in an era when mass market demand for stocks is way down.

And as today’s article suggests, Wall Street firms are not always rigorous about keeping client trade intentions away from their own proprietary traders. The reason is simply: money. A March 2005 report published by Credit Suisse First Boston said that hedge funds were responsible for up to half of all activity in major markets, including the New York Stock Exchange and the London Stock Exchange. According to the same report,
Wall Street made $25 billion catering to hedge funds - lending them money, trading for them, helping to structure complex derivative transactions or lending them stock to bet against a company. That was one-eighth of Wall Street’s total revenues.

If a hedge fund or proprietary trader knows that a client is about to sell a big block of shares, they can profit from this knowledge by selling short in advance of executing the client’s trade. Such trades drive down the price of the stock – yielding lower proceeds for their clients.

Today’s article recounted how Phillip Hylander, chief of Goldman Sachs’s European stock-products group and head trader in Europe, set up one proprietary portfolio that traded in some of the stocks Goldman salesmen had recommended to hedge fund, Marshall Wace. The portfolio was called MW TIPS. After making a recommendation to the fund, a Goldman salesman would sometimes tell a proprietary trader what the recommendation was, saying, “I just tipped it,” according to people familiar with the situation.

Rather than restoring confidence, these kinds of reports make investors suspect that the market is a con.