Wednesday, June 28, 2006

Who's backing Mack?

Today’s congressional testimony from fired SEC hedge fund investigator Gary Aguirre is a reminder of the US’s dual system of justice. Those who pay the powerful are above the law. Those who don’t… as Jon Stewart would say, “not so much.”

If we compare last Friday’s
New York Times article with Aguirre’s congressional testimony today, it is hard to escape the conclusion that Aguirre – who was fired from his SEC job 11 days after getting a two-step merit pay raise -- believes that Morgan Stanley CEO John Mack tipped off hedge fund Pequot Capital Management’s Art Samberg of GE’s pending acquisition of Chicago business financier, Heller Financial.

Here are the relevant passages from the New York Times

..according to government officials, the trades Mr. Aguirre said had made the fund $18 million involved one of the biggest mergers in 2001: the General Electric Capital Corporation’s $5.25 billion buyout of Heller Financial, a Chicago-based lender to businesses. Heller's stock rose 50 percent the day the acquisition was announced.

Mr. Aguirre said the investigation was halted last summer when S.E.C. officials, bowing to political considerations, stopped him from taking testimony from the person he identified only as a former head of an investment bank.

Government officials with knowledge of the allegations say he was referring to John J. Mack, chief executive of Morgan Stanley, who was being considered to run the investment firm at the time and who had previously been chief executive of Credit Suisse First Boston. Mr. Mack, a long-time acquaintance of Pequot's founder and a major fund-raiser for President Bush, was chairman of Pequot briefly during June 2005; his family foundation has invested in Pequot funds, public records show.

And here’s an excerpt from Aguirre’s official testimony before Congress today
By May 2005, one of the insider trading matters dwarfed all others: the hedge fund’s trading in two companies just before the announcement of a cash tender offer by one for the other at a 50% premium over the last trading price. The hedge fund profited by $18 million in 30 days.

The evidence suggested that the hedge fund’s CEO acted on an unlawful tip in directing the hedge fund’s trades. But the question remained: who tipped him? In May 2005, Branch Chief Robert Hanson, directed me to spend all my time on the one matter and focus on finding the tipper. Accordingly, beginning in May 2005, I searched through millions of emails and other records for clues indicating who tipped the hedge fund CEO and, in June 2005, questioned the hedge fund’s CEO--the suspected tippee--on this issue.

By mid-June, growing evidence pointed to one person: the former CEO of a large investment bank. The suspected tipper likely knew about the tender offer, spoke with the hedge fund’s CEO just before he began to trade, profited by the trades, and had other personal and financial motives for tipping the hedge fund’s CEO. The two suspects trusted each other, did financial favors for each other, and exchanged stock tips. The evidence yielded no other viable

It doesn’t take a genius to figure out that Aguirre’s tipper is likely none other than John Mack. The $18 million profit and the 50% premium match the GE/Heller fact pattern published in the New York Times. In June 2005, Mack had been former CEO of First Boston. And Mack contributed to the current president’s 2004 campaign. According to, in 2004 Mack gave $45,000 to the Republican National Committee and $2,000 to George W. Bush.

And here’s the part where history – to paraphrase Mark Twain – may be rhyming. According to
The American Prospect, a single bank, Morgan Stanley’s predecessor, JP Morgan & Co., ruled the US capital markets from the late 19th century right through to the 1929 stock market crash.

J. Pierpont Morgan, the bank’s founder, exerted tremendous government influence, particularly with the Republican Party. During the presidential administrations of the 1920s, Morgan men represented the U.S. government at international monetary meetings. Moreover, an important source of Morgan’s government influence was its abuse of the securities markets. During the Roaring 20s, Morgan used its influence to promote its own stock offerings and profits at the expense of its investors' best interests.

This abuse came out in public during a May 1933, U.S. Senate Banking Committee hearing when the Committee’s counsel Ferdinand Pecora exposed how Morgan reserved shares at reduced prices for leading politicians and client executives – “giving guaranteed profits to former President Calvin Coolidge, Franklin Delano Roosevelt's sitting treasury secretary, the chairmen of the Republican and Democratic national committees, and the CEOs of General Electric, AT&T, and Standard Oil.”

To clean up such abuses, FDR signed the 1933 Glass-Steagall Act, which prohibited commercial banks from underwriting securities, and in 1934 signed the Securities Exchange Act, which created the Securities and Exchange Commission (SEC) to police Wall Street and prevent stock manipulation.

Today, no single bank rules Wall Street – although Goldman Sachs seems to be head and shoulders above the rest at the moment. And it’s a bit too soon to be calling the next Great Depression based on hedge fund shenanigans. Nevertheless, the SEC’s decision to fire the messenger, Aguirre, rather than investigating the suspect suggests that John Mack, or whomever Aguirre’s tipper might be, could be keeping secrets for some powerful people

Sunday, June 25, 2006

Is Ford running out of gas?

Goldman Sachs just made a big hire to run its newly created bankruptcy restructuring business. And one of Goldman’s big clients is Ford.

Is there a link between these two facts – e.g., is Ford soon likely to need Goldman’s burgeoning bankruptcy restructuring services? It could be shirtsleeves to shirtsleeves in five generations. As I pointed out three years ago in the
New York Times, companies are not required to report on where they stand with regard to terms of bank agreements which could help investors figure out the answer.

Ford stock has not been a good investment – it's tumbled 65% to $6.43 in the decade ending June 23, 2006 during which time the S&P 500 rose 90%. And its market share has tumbled from
24.8% in 1999 to 18.6% in 2005. With a $124 million loss in the last 12 months – a loss which would have been much bigger were it not for Ford’s vehicle finance profits -- and $12.54 worth of debt for every dollar of equity (compared to an industry average debt/equity ratio of 2.6), Ford has not escaped the notice of short sellers, who control 5.7% of its 1.83 billion share float, nor debt rating agencies, such as S&P, which rate its debt claims paying ability at junk levels.

I think the factors favoring a Ford bankruptcy outweigh the opposing ones. Here’s why:

Bankruptcy Pros

  • Near tripping covenants? I am appalled but not surprised that Ford does not report on the status of its compliance with bank covenants – terms of a contract between the company and its banks. This is important because if a borrower violates – or trips -- these covenants, the bank can demand immediate repayment of the loan and the company can file for bankruptcy if it can’t pay up. This comes to mind in considering that Ford carried a whopping $151 billion in debt (compared to a relative molehill of $21 billion in cash) as of March 2006 – up from $134 billion at the end of 2005. According to its financial statements, its contracts with lenders require it to maintain "certain debt-to-equity limitations, minimum net worth requirements and credit rating triggers." I have been unable to find details of the trigger levels -- e.g., Ford must maintain a debt/equity ratio below 14 – the violation of which would cause Ford’s banks to demand immediate repayment of its loans. However, the levels of the covenenant variables have deteriorated. For example, Ford’s debt/equity ratio has increased from 10.25 in March 2005 to 12.58 in March 2006; its credit rating from S&P tumbled from BB+ at the end of 2005 to BB- in January 2006 and its net worth has fallen from $15.7 billion in March 2005 to $12 billion in March 2006. Investors are in the dark as to how close Ford is to tripping its covenants;
  • Double digit bond yield. According to one former Wall Street banker, one way to tell whether the market thinks a company is about to file for bankruptcy is to look at its bond yield. Anything trading in the "high teens" is close to the edge. By that measure, Ford may have some breathing room, although at 10.6%, its bonds are yielding higher than ever in its history;
  • Negative free cash flow. Ford’s free cash flow – the cash available after capital expenditures – was a whopping negative $44.7 billion in the 12 months ending March 2006 – and in the most recent quarter its negative free cash flow was $2 billion. If Ford can’t generate positive cash flow, it becomes harder to pay back its debt;
  • Higher interest rates. According to Goldman Sachs analyst, Gary Lapidus, higher interest rates squeeze finance arm, Ford Motor Credit's profits. With the Fed raising rates and its credit rating declining, so is the spread between Ford's borrowing costs -- which are rising -- and the rate at which it can lend out money -- which is being slammed by competitive pricing and its own 0% financing gambit to regain lost market share;
  • Losing US market share. Ford’s North American operations, which lost $1.6 billion in 2005 and $1.2 billion in the first quarter, are losing market share. During the first quarter its US share fell to 17.6% from 18.2% the year before. This is a concern to ratings agencies and the lower the ratings, the higher Ford’s borrowing costs and the closer it comes to tripping a financial covenant; and
  • Insider selling. There are many reasons why an executive would sell shares of his or her company, not one of which is that the executive believes that the shares will rise in value. This maxim comes to mind in noting that there have been no insider purchases of Ford stock in the last six months – but 173,224 shares sold. While this does not pertain to Ford’s imminent bankruptcy, it does suggest a lack of confidence in the future of the stock by those who should know best.

Bankruptcy Cons

  • Newer models. Ford expects that by 2008 the average age of its fleet will be 3.2 years compared with 4.4 years today – including the Fairlane line which will be a more fuel efficient minivan line;
  • Small cars. Ford expects that by 2008 it will introduce three small cars selling for under $20,000; and
  • Ad campaign. Ford’s advertising campaign linked to American Idol is likely to generate goodwill.

The factors keeping Ford from bankruptcy appear to be a thin gruel. If my analysis is correct, Goldman’s James H. M. Sprayregen could soon be knee deep in axle grease as he helps Henry Ford’s great-great grandson take Ford out of bankruptcy.

Saturday, June 17, 2006

Break it up Bill

This morning’s Wall Street Journal [subscription required] advocates that Bill Gates should consider a breakup of Microsoft. I couldn’t agree more. In fact, I expressed my views on this last September on The Informed Observer, last October in Red Herring, and yesterday during my interview on CNBC.

Microsoft’s stock is down roughly 60% since its 1999 peak. While its revenues and profits are way up since then, I think the stock dropped because it missed two huge technology changes:

  • Open Source. The emergence of free operating systems, such as Linux, which enable companies to replace expensive servers running proprietary operating systems with so-called blade servers -- much less expensive servers that run this open source software.
  • Advertising-based software. Google has demonstrated that it can profit from giving away free software, such as that used to conduct searches, and generating revenue through advertising keyed to the search.

The two reasons Microsoft missed these changes spring from the management practices that led to its previous successes.

First, Microsoft’s traditional approach to getting into new businesses was to outexecute a successful innovator. During the 1980s and 1990s, for example, Microsoft was able to develop

  • Excel, a more widely purchased spreadsheet –-- after Lotus Development popularized 1-2-3;
  • Word, a word processing package, after Novell bought and promoted WordPerfect; and
  • Internet Explorer, the dominant web browser, after Netscape pioneered the browser.

Through subsequent versions of these programs, Microsoft came from behind, caught up and ultimately exceeded the incumbent’s market share – while linking these programs with its dominant PC operating system. In all these cases, Microsoft was able to charge money for its versions of the new products.

However, in the case of the two recent technology trends mentioned above, Microsoft could not use the outexecute strategy without cutting its own throat. In these cases, Microsoft’s competitors were smarter. They recognized that if Microsoft pursued its traditional approach to competition, it would cannibalize its core revenue streams. For example, if Microsoft competed with Linux by delivering customers a free operating system, it would rapidly lose its operating system revenues, which constituted 12% of its $40 billion (2005 fiscal year end) in revenue and 65% of its $14.5 billion in operating income. And if it gave away free applications software, as Google does, it would wipe out a portion of the $11.5 billion in revenue and $8.6 billion in operating income that it earns from applications software.

A second reason that Microsoft missed these new technology trends is that it makes decisions more slowly than its more focused competitors. As I commented last December in the
Washington Post, Microsoft’s OODA loop -- its ability to observe, orient, decide and act -- is slower than that of its competitors because it needs to integrate its new products with each other and with its earlier versions. As a result, decisions are made in long committee meetings which consume a lot of time and reduce the value that Microsoft’s products can generate for customers.

If Gates wishes to get Microsoft’s stock price back up, he should break up the company into autonomous units that can react quickly to industry changes because they are untethered from these creativity-sapping committees.

Tuesday, June 06, 2006

Five reasons why fear is winning over greed

In the last several weeks, the Dow has plunged 5%. Yesterday it lost almost 2%. What's behind the selling? If you're still holding onto your stocks how do you justify your decision? How much lower will the market need to go before you decide it's time to sell?

As I've said before, I don't believe anybody can provide a convincing explanation of why the market does what it does. While I liked Amey Stone's views on today's market move I think there are additional reasons to be concerned about the market's future.

I see five reasons why fear is winning over greed:
  • New Fed Chief. As Joni Mitchell once sang, "Don't it always seem to go, that you don't know what you've got till it's gone." When Alan Greenspan took his big yellow taxi out of the Fed Chair, his replacement lulled us into a temporary state of complacency. But Bernanke is no Greenspan. While he did well in school, he lacks Greenspan's real world experience. This experience matters because it gave Greenspan the ability to reach outside government statistics to find out what was really going on in the economy. Bernanke's "data driven" approach is scary to the market because nobody knows what data Bernanke is using; whether the data are accurate; or whether he's using early warning indicators or driving while looking in the rear view mirror. All this leads to massive uncertainty about whether Bernanke will keep raising rates.
  • Low presidential poll ratings. Recent polls suggest that the president's approval ratings are in the high 20s. Notwithstanding a few personnel changes, US troops are still in Iraq, the price of gas is still over $3 a gallon, real estate prices are falling, and the president is consumed with amending the constitution. As November elections approach, the chances of a change in leadership look pretty strong. This could throw the situation in Washington into turmoil -- potentially endangering the administration's tax cuts and industrial policies.
  • Geopolitical jitters. Iran still seems to be developing nuclear weapons. Will it be able to drop nuclear bombs on Israel and other places in the next five years? The fear that it might is leading western leaders to engage Iran in some kind of dialog. And today, this dialog led to fears that Iran would cut off its supply of oil if things did not go its way. While the US is trying to create a package of carrots and sticks to make Iran do what it wants, the markets may fear that US only has two real options for dealing with Iran: bomb it or do nothing. Neither option is reassuring to investors.
  • Return to economic reality. For years, whenever someone mentioned the rising Federal budget deficit or the enormous current account deficit, the falling dollar, the enormous debt burden carried by government and consumers, or the over-inflated housing market, Dick Cheney would give a speech saying "Reagan proved that deficits don't matter" and the markets would assume everything was fine. With the low poll numbers and high gas prices, investors are beginning to realize that stagflation might be the result. And the scariest thing of all is that raising interest rates might not be the right solution for stagflation.
  • Need for new solutions. Raising interest rates will certainly lead to higher mortgage rates and higher credit card interest rates. The higher mortgage rates will contribute to a decline in housing prices and an increase in mortgage defaults. The higher credit card rates will crowd out some portion of consumer spending that might have gone to purchasing clothing or toys. However, higher interest rates will have absolutely no impact on the price of oil which is acting as a tax on consumers and businesses. So Bernanke has a blunt instrument which will not solve the economic problems we face. This calls for new solutions and it's unclear who will deliver them.

I think investors should have stop losses in their accounts. If a stock declines more than 2%, I think they should sell. If your portfolio is comfortably above water, it may make sense to wait out this dip -- but it could be a long wait.