Why Paulson?

Today’s announcement that Goldman Sachs’ CEO Hank Paulson will become the next Treasury Secretary comes as a surprise. While it is no mystery why the White House would want Paulson, it eludes reason why Paulson would take the job.

The president is looking for a respected Wall Street executive to convince the world that the US economy is in great shape thanks to the administration’s economic policies. Paulson is certainly a respected Wall Street executive.

As to why Paulson would accept the job. Three reasons come to mind:

• This is what’s done at Goldman Sachs. Many Goldman Sachs executives – Robert Rubin (who was Clinton’s Treasury Secretary and Stephen Friedman (who was Bush’s head of the

National Economic Council) -- have left the top post to take an important role in government. Such a move is good for the Firm – since it can’t hurt Goldman’s business to have a former executive steering government business to Wall Street;

He wants to outdo Robert Rubin. Robert Rubin is clearly the most highly regarded former Goldman Sachs executive who moved to Washington. Clinton called Rubin the best US Treasury Secretary since Alexander Hamilton. Paulson would no doubt enjoy being remembered more fondly than Rubin; and

He wants to save the world from the coming financial crisis. The challenge is that if the global economy keeps chugging along as is Paulson will not be able to distinguish himself. The only way to do that would be to save the global financial markets from a crisis on the order of the Mexican financial crisis or the Russian financial meltdown in 1998. Recently appointed Fed Chairman Ben Bernanke, while academically brilliant, has yet to demonstrate that he has the real world experience to manage such a crisis. And his discussion of a “data driven” approach to interest rate policy seems to have unsettled the financial markets. Paulson’s experience and network of global contacts would help him make the right decisions.

Is such a crisis imminent? Cheap Foreign Capital Harks Back to '90s Crisis in this morning’s Wall Street Journal [subscription required] suggests that developing countries are becoming increasingly dependent on our cheap capital but that we are providing that capital with insufficient awareness of the risks. If developing country stock markets tumble too far too fast, these risks could become all too apparent. This would lead to a rapid withdrawal of the cheap capital – leading to a global growth slowdown.

This is just the kind of financial crisis that could test Paulson’s skills and put him in the history books.

Despite today's Enron convictions, the fox is still guarding the henhouse

This afternoon's guilty verdicts in the Enron trial of Ken Lay and Jeff Skilling are emotionally cathartic. But I doubt these verdicts will prevent future Enrons.

Public outrage over Enron resulted in the passage of Sarbanes Oxley (SOX). While SOX is intended to make executives more accountable -- it was not the basis for their conviction. Instead, Lay and Skilling were convicted on conspiracy to commit securities fraud, among other charges.

Unlike Starr Jones, I'm not a lawyer and I certainly don't know the technicalities on which such a conviction would be based. According to MSNBC, Lay's securities fraud conviction reflected juror's conviction that he "lied to employees, credit rating agencies and analysts with claims that Enron was healthy or that its books had been sanitized of problems when he knew otherwise."

But in simple terms, Lay and Skilling were convicted for inventing financial results that were at odds with reality and then sharing those false results with Enron's constituents. My interpretation is that their motivation was to meet, if not exceed, Wall Street's earnings expectations so they could get Enron stock to keep rising.

Every CEO of a publicly traded company has to be concerned about such expectations. And given the extreme complexity of the financial accounting for many public companies, some CEOs might view the complexity as an opportunity to exploit a gray area wherein they choose accounting policies that increase their odds of beating Wall Street expectations. Today's convictions will surely scare CEOs away from such a gray area.

The Enron conviction will fade over time as a deterrent. As I noted in Value Leadership, there is a more fundamental problem here. Allowing companies to prepare their own financial statements is analogous to allowing students to grade their own papers.

While there are accounting policies and auditors intended to keep companies on the straight and narrow, I don't think this fundamental problem can be solved unless a completely independent entity produces a company's financial statements. As I proposed in the book, such entities might be paid for from corporate fees. The quality of their work would be assessed and publicly graded by public shareholder watchdog groups.
Despite today's conviction, as long as the fox is guarding the henhouse, those hens ultimately won't be safe. It's time for the guardian of a company's financial statements to be completely independent of the CEO.

Wealth in the balance

Last Thursday and Friday, the stock market plummeted. Is this a temporary correction before bursting through to a new high, or a sign of more pain to come?

What makes the stock market endlessly fascinating is that nobody knows the answer. But every day people make their best guess. Mine is that the potential downsides outweigh the upsides.

Downsides

• Inflation. While official government statistics suggest inflation is creeping up at a mere 3.4% a year, the actual experience of consumers suggests otherwise. The effects of nearly $3 a gallon gasoline, record costs for heating homes, rising interest rates on credit card and mortgage debt, and record health care and education costs are squeezing consumers. Since consumers account for two-thirds of GDP, there may be less money to fuel future growth. This could have a negative impact on stocks;
• Weak dollar. The dollar has lost 5% of its value so far in 2006. And it appears that the US government is pursuing a policy of weakening it further. While this weak dollar policy might help the trade deficit, it will raise the cost of imports. With the price of gold hitting a 25 year high over $7o0 per ounce, somebody out there is clearly trying to hedge against a collapse in the value of paper money. The fear underlying this appetite for gold does not bode well for most stocks -- although gold stocks are likely to benefit;
• Government and consumer debt. Consumers and the federal government are carrying record debt loads. As interest rates rise, the portion of consumer and government budgets spent on debt service is likely to rise. This crowding out effect may limit growth and could lead to higher levels of consumer bankruptcies. Such bankruptcies might also harm stocks which depend on consumer spending for growth;
• Housing. The housing market has risen substantially since 2001; however, rising interest rates have capped the rapid price increases in housing. Insofar as consumers have been using the increased equity in their homes to pay their bills, a decline in housing values could diminish the amount of money available to consumers. Moreover, housing has accounted for many jobs in the last several years and a drop in housing prices could lead to slack in this sector of the economy. Housing stocks have declined recently in response to the lower demand; and
• Political uncertainty. There are several sources of risk in the current political situation. There is concern about a possible confrontation with Iran, an increased likelihood of significant political change in Washington after the November elections, and a simmering lack of market confidence in the new Fed Chairman Ben Bernanke who has yet to establish an effective relationship with the financial markets (by contrast to Alan Greenspan). These sorts of risk make investors less willing to commit capital.

Upsides

• Corporate balance sheets. With lower tax rates, a reluctance to shoulder heavy debt, a cautious attitude towards capital investment, and the use of outsourcing to limit employee cost inflation, corporate balance sheets are strong. This positions many companies to survive an economic downturn; and
• GDP growth strong. The first quarter 2006 GDP report suggested significant economic resilience. A 20.6% increase in durable goods orders was particularly notable in light of the 16.6% decline in the previous quarter.

In my view, these risks outweigh the upside -- potentially translating into a negative stock market outlook. What's your view?

Hedging the soon-to-be-broken-buck

Super investor Warren Buffett chose the wrong way to hedge what he sees as broken buck in waiting.

As he noted over the weekend, he still believes that the dollar is overvalued due to the US's current account deficit. Unfortunately for Buffett, and his investors, the way Buffett chose to hedge a drop in the dollar cost $955 million.

Buffett has the wisdom to admit his mistake. And since he still believes that the dollar is over-valued, he is still looking for ways to hedge a decline in its value -- including his $4B investment in 80% of Iscar, an Israeli manufacturer.

Another way for Buffett might be to buy gold which today hit a 25-year high. I have a somewhat painful personal experience with the shiny metal. Several years ago I was persuaded to buy into gold for the same reasons that Buffett is concerned about a potentially weak dollar. I decided to buy shares of a gold stock mutual fund. Within a few days it was up 15% over where I purchased it. Then it started ratcheting down -- 2% a day. Before I knew it, my investment was 2% underwater.

I took my loss and learned a lesson. Since I could not understand the reasons driving the fund to go up and down so much each day, I felt that I was sailing in stormy seas without a compass. Now I have mixed feelings about the investment. If I had held onto it, it probably would have increased in value given the longer term trend. But I was uncomfortable with volatility which I could not understand. Selling the fund's shares eliminated that discomfort. But it may have cost me money in the long run.

I wonder whether Buffett would come to a similar conclusion regarding the purchase of gold as a hedge against a decline in the dollar.

Colbert speaks truthiness to power

At Saturday night’s White House Correspondents' Dinner, comedian Stephen Colbert concluded the ceremony with a routine that spoke truthiness to power.

If you are not familiar with Colbert or his concept of truthiness, they are worth explaining. Colbert, whom Time recently anointed as one of 100 people who shape our world, is a comedian who got wide public exposure on the Daily Show with Jon Stewart. His recently started spin-off, the Colbert Report, skewers bombastic right wing pundits like Fox News’s Bill O’Reilly.

Colbert coined the term truthiness on his first show, which he defined as the quality by which a person purports to know something emotionally, without regard to evidence or to what the person might conclude from intellectual examination.

In Colbert’s performance Saturday night, which can be viewed here, he courageously delivered a blistering comic critique of Bush’s policies.

Here are some of my favorite excerpts from the performance:

"Now, I know there are some polls out there saying this man has a 32-percent approval rating. But guys like us, we don't pay attention to the polls. We know that polls are just a collection of statistics that reflect what people are thinking in "reality." And reality has a well-known liberal bias … Sir, pay no attention to the people who say the glass is half empty, because 32 percent means it's two-thirds empty. There's still some liquid in that glass, is my point. But I wouldn't drink it. The last third is usually backwash."

"I stand by this man. I stand by this man because he stands for things. Not only for things, he stands on things. Things like aircraft carriers and rubble and recently flooded city squares. And that sends a strong message: That no matter what happens to America, she will always rebound with the most powerfully staged photo-ops in the world."

"What incentive do these people have to answer your questions, after all? I mean, nothing satisfies you. Everybody asks for personnel changes. So the White House has personnel changes. Then you write they're just rearranging the deck chairs on the Titanic. First of all, that is a terrible metaphor. This administration is not sinking, this administration is soaring. If anything, they are rearranging the deck chairs on the Hindenburg."

"The greatest thing about this man is he's steady. You know where he stands. He believes the same thing Wednesday that he believed on Monday, no matter what happened Tuesday. Events can change ­- this man's beliefs never will."

What was most interesting in viewing the video on C-SPAN was that Colbert’s performance was clearly making the President and the audience very uncomfortable. Although he was standing just a few feet away from the President and despite the negative audience reaction, Colbert never lost his nerve.

The reaction in the room and in the mainstream media today and Sunday highlights the emperor-has-no-clothes nature of the Colbert performance. Washington is a one-company town and nobody wants to appear to be treating the chief with disrespect – such treatment could endanger the careers of those who work there. Thus the people in the room could not appear to enjoy Colbert’s performance nor could the mainstream media report on it. Instead we have been treated to fawning descriptions of the comic routine between the President and his doppelganger.

Fortunately we still live in a democracy. And recent polls suggest serious dissatisfaction with the current people in power. In November we will see how well that democracy works.