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Category Archives: Regulation

Below is the link to the 3Q12 Economic Report I wrote for a Colorado Bank’s Board of Directors and  (reproduced with permission):

http://www.QuantumRisk.com/PDF_Files/4Q12EconomicUpdates(2013-01-09)-Public.pdf

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Below is the link to the 3Q12 Economic Report I wrote for a Colorado Bank’s Board of Directors and  (reproduced with permission):

http://www.QuantumRisk.com/PDF_Files/3Q12EconomicUpdates(2012-10-12)-Public.pdf

Guan Jianzhong, Chairman of Dagong Global Credit Rating Co. Ltd

Bloomberg reports that China’s Dagong Global Credit Rating Co. reduced its credit rating for the U.S. to A+ from AA citing a deteriorating intent and ability to repay debt obligations.

Having worked on both sides of the world, I have come to associate such statements with shortsightedness. My past experience as a senior research analyst for a brokerage firm in Asia-Pacific would suggest that we are going to see problems in China by 2012.

In this blog post we take a look at how consumers could cope with the Mortgage Mess. Yes, we need strong banks otherwise the Dagong rating will be fulfilled, but this economy is 70% consumer driven. We therefore need stronger consumers, as strong consumers underpin the health of the banks, and not the other way around. Using China as an example, as China’s income per capita rises its banks and financial services companies become more confident of themselves, therefore the Dagong ratings comment above. 

I want to inform our readers that QuantumRisk’s CMBS Property Risk Analytics promotion ended September 10, 2010 per an earlier newsletter. The new pricing, valid until March 2011, is available here.

Home Prices Sag in August 2010

The State of the Housing Market
In my August 2009 blog post Have we hit the Housing Bottom? I had suggested that the house prices will bottom in 1Q 2010. Given the graph, I must say that this was a pretty good estimate of timing. 

The second question I had attempted to answer then, was home price recovery sustainable? My answer at that time was that it was more likely not.

The economic analysis presented by HiddenLevers (see picture) suggests that house prices are struggling to maintain an upward momentum. 

Why? There are two reasons. First the glut in foreclosed homes (1 in 4 for sale are foreclosed) will keep supply substantially greater than demand. Second, 1 in 6 homes in foreclosure translates into 1 in 6 homeowners who will not be able to participate in homeownership for at least 7 years or a 15% reduction in demand.

The graph shows that house prices are now hovering in the 68% to 71% range of their 2006 peak values.  From an economic cycle perspective, the housing industry collapsed before the commercial property industry. Given a 15% reduction in residential ownership capacity, it is very likely that commercial property sector will recover before the residential sector does. That is, the trough in the residential sector will be longer than that of commercials.

What is not reported in the news is the residential vacancy rates. A friend of mine who works for a utility company told me a few weeks ago, this utility is seeing 1 in 7 homes vacant. This is 50% more than reported by US Census Bureau for 2Q. That means rental incomes will not increase in the medium term. It also means that utility revenues will fall by 14%.

Some other bank just increased the difficulty of Chief Executive Officer Brian T. Moynihan 'hand to hand combat' over mortgage disputes.

The Next Big Wave: Legal Risk
Most of us are focused on market, credit & operational risks, but the next big wave will be legal risk.

I recently found out that banks are selling the second mortgage on foreclosed homes to debt collectors. Sure this maybe legally possible but lets weigh the pros & cons. The pros. Maybe banks think they can get back they principal in the second mortgage by selling the second mortgage to a debt collector. Sounds great, high fives to the managers who thought up this one. And at worst you don’t even have to write it off your balance sheet just yet. Kudos.

But wait. Does anyone really think they can get their money back from homeowners who could not even pay their first mortgage? Especially if they are unemployed? It also raises another question, what was the function and scope of collateralization?

Now the cons. What this action has done is to clarify that in the event of a foreclosure / repossession, the bank recognizes that collateralized debt survives ownership and can be put back to owner / originators. (Check with legal counsel for an informed opinion.) In the United States one cannot have one set of laws for one group of people and another set for another group of people.

Therefore, investors who bought RMBS bonds can now recognize that their securitized bonds survive any asset ownership issues, and banks are now liable for securitized bonds because they survive ownership.

I found out about a bank’s access to your personal funds some years ago. When I contacted the FDIC about it they said they could not do anything about it. Some mortgage contracts include a single sheet document that states that the bank has the right to move your funds around to keep your mortgage current. This I believe is antithetical to the securities law because securities law does not allow financial services companies to move funds around for a client for the benefit of the company.

The problem here is given such a ‘contract’ will or does the bank have the right to reach out to your 401(k) or similar funds?

Prime fixed rate foreclosures jump

How Consumers Can Protect Themselves
There are several ways consumers can protect themselves from future messy mortgage problems:

 1. House Pricing: The graph above (picture in State of the Housing Market, above) suggests that with today’s market conditions a home buyer should consider as an upper limit a purchase price of about 70% of the 2006 appraisal. If the housing situation deteriorates, this 70% number will drop. Looking at CMBS for guidance, this number can get to be as low as 54%.

 2. Appraiser Selection: Before purchasing, get an appraisal of the property by an appraiser who does not have links to banks as this minimizes banker bias.

 3. Mortgage Origination: If you are purchasing a foreclosed property, it is not recommended that you get your mortgage from the same bank that foreclosed the property. Why? At least in theory, in the event that there are ownership issues, you have a different bank behind you. 

 4. Safeguards: Given the state of the housing market, it would be prudent for the home buyer not rush into a purchase as the housing market is not likely to recover anytime soon. If you do so, you would need to have staying power. Therefore, before making a purchase, here are some points you should consider:

 4.1 Title Insurance: Don’t sign an S&P if you cannot get title insurance.

4.2 Deposit: Make your deposit conditional upon getting a clean title.

4.3 Indemnification: Require that the seller and/or the mortgage provider accepts liability for any future ownership claims in the event of the failure of the title insurance company. The lesson of 2008 was that many securitized bond credit enhancements (credit insurance) turned out to be worthless when the economy as a whole turned south.

4.4 Survival: Require that in the event of a foreclosure/repossession that all collateralized claims (1st, 2nd & 3rd liens) cannot survive the ownership.

4.5 Delinquency: Require that the mortgage provider cannot start foreclosure proceedings until the mortgage is at least 90 days past due. In the state of Colorado there are no laws to prevent a lender from foreclosing on day 2. Yes, even I was surprised by this, and know of at least one recent case where the foreclosure proceeding was started on day 50. 

4.6 Miscellaneous Contracts: Do not allow the mortgage lender have access to your other funds. Remove all such ‘subcontracts’ from your S&P agreement.

 5. Walk Away: If there are any doubts about the price, property or claims on the property, walk away. This market in not going to recover any time soon, and there will be plenty of second chances.

 There are many really good managers in banks, but as a general rule banks rotate their managers. So the great manager you see today could be replaced by a rogue manager tomorrow. Therefore do not feel ‘uncomfortable’ including these conditions in your S&P. You may even have to hire your own legal counsel to protect yourself. Remember it is wiser to walk away then to be burdened by a debt for a property you no longer own.

Summary
The real sad story is that we will eventually see 1 in 6 families homeless. To put things into perspective, James Fry, founder of Mean Street Ministry, reports that when he started this ministry about 10 years ago, there were 2 suicides per year, today there are 2 a week. We as a family have known James Fry, his family & his ministry for many years. Let us in Thanksgiving help someone in return.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational / educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk
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Real Problem versus Many Perspectives 
The perspectives reported on the Mortgage Mess varies very widely. From the political right is the Wall Street editorial “We’re not aware of a single case so far of a substantive error” to the political left Congressman Alan Grayson’s “the easiest way to make a buck is to steal it”. This one really shocked me, financial institutions and their mortgage servicing departments hired hair stylists, Walmart floor workers and people who had worked on assembly lines and installed them in “foreclosure expert” jobs with no formal training.

In my opinion these are details that subtract from the big picture. Without understanding the big picture we would not have a context in which to address this Mortgage Mess.

What is the big picture? It is, is our fiduciary responsibility to our shareholders or is our fiduciary responsibility to our customers? Correct picture but wrong perspective.

Our fiduciary responsibility is to our shareholders and that this fiduciary responsibility is derived from our fiduciary responsibility to our customers. We’ll discuss each perspective below.

Residential Mortgage Industry is Shrinking
First some context to this discussion. From the Wall Street reported data I estimate that 15.4% or about 1 in every 6 US homes are in foreclosure, and this does not include recent past foreclosures. That is a huge amount and bank troubles pale in comparison to this number. What does this number tell us?

It says that the mortgage market size will shrink by 15% as foreclosures are executed because foreclosed home owners will be barred for at least 7 years from participating in this market. The lowest estimate I was able to find was 10%. Therefore to remain profitable banks will have to lay off at least 15% of their residential mortgage staff.

Further, as reported in the New York Times, if title companies shy away from insuring foreclosed properties because they think those properties are vulnerable to claims, this will further depress the market, as investors too will shy away. 

Looking at the CMBS industry for clues, even though the reported commercial property appraisals are hovering in the 55% range, the anecdotal prices I have heard suggest purchase prices averaging between 10 to 20 cents on the dollar, and there are no reported foreclosure problems. Therefore, we can infer that the residential mortgage industry will experience similar appraisal versus selling price discrepancies and is therefore not out of the woods, yet.

Good News for Banks?
The Florida attorney general’s office says it doesn’t have the power to investigate banks but it has started an investigation into the law practices. To complicate matters, one needs to be aware that there is a difference between industry practice and actual mortgage regulation. There are also enormous variations from state to state with respect to foreclosure procedures. I found that in one state banks can start foreclosures on day 2 (1 day delinquent). This means that even though the 50 State Attorney General’s offices have launched investigations into the mortgage industry, in my opinion the banks don’t have to worry about them as these offices have no teeth. But some how this does not sound like good news, right?

First Fiduciary Responsibility
This Bloomberg article very nicely summarizes the current Mortgage Mess. That there are two fronts, “against U.S. homeowners challenging the right to foreclose and mortgage-bond investors demanding refunds that could approach $200 billion”. Of course this is an evolving situation and it is very likely many more fronts will open up.

The first fiduciary responsibility is to your customer. This is very clear in the many securities regulations since 1933. Of course banks are governed by banking regulations and in many instances are exempt from securities regulations as these exemptions are covered in the banking regulations.  Therefore I wonder if the banking regulations are any where nearly as concerned about protecting bank customers as the securities regulations require of investment advisors and broker-dealers?

Though the individual contracts appear to be in favor of the banks, investors are using every means possible to force banks to buy back bad mortgages. The final outcome, however, may play out in terms of power of buyers versus power of sellers, and not through legal means. That is investors in the future will seek assets from players who are amenable to buy backs than from those who are not.

This may be a good thing for the economy as insufficient principal protection may cause investors to seek alternative investments such as manufacturing, R&D driven technology licensing, and new materials, to name a few. Why? Because residential mortgages are no more safer than R&D.

Therefore, why did the residential mortgage market develop to the size it did? I can only conjecture that the existence of GSEs led to the mistaken belief that residential mortgages were one of the safest forms of investments.

Second Fiduciary Responsibility

The second fiduciary responsibility is to shareholders as this is a derivative of the fiduciary responsibility to customers. It is in this context that one would ask the question, how did this Mortgage Mess come to be?

In this context, given the Wall St. crash of 2008 and in the light of the Goldman Sachs hearings, the Wall Street editorial opinion that “We’re not aware of a single case so far of a substantive error” is difficult to justify as this would raise other questions.

As a general rule organizational seniority and salaries increase with fiduciary responsibility to shareholders. Therefore the questions, why did we did not have in place the systems and procedures to detect “substantive error”? Why were we paying managers so much if they did not know what was happening? What were these managers thinking?

Quite obviously operational risk and credit risk methodologies were insufficient. And may be they were ignored? A rethink of these methodologies and how risk committees are staffed and to whom they report to is in order.

Some Likely Future Outcomes

In the context of the First Fiduciary Requirement we can infer some future outcomes. 

Firstly, if there genuinely were mistakes in the foreclosure process, the second lien holder should now have a claim to the funds recovered from the sale of the property as the first lien holder did not conduct his fiduciary responsibility correctly. (Check this with your attorney as he may disagree.)

Second, title insurance fees may increase. Title insurers have two options either do not insure the title or substantially increase the fact checking required. The latter will increase title insurance fees. Assuming that Congressman Alan Grayson’s findings are correct, I believe that title insurance firms will choose not to insure as it would be more expedient to not insure than to dig up bad documents. Therefore, don’t expect title insurance for foreclosed homes unless the bank owns the title insurance firm, but this should raise questions of bias. My guess is that the title insurance problem is only going to get more complicated.

Third, future bank purchases will be structured more like an asset sale than an acquisition or merger. Why? First you don’t absorb the bad management team. Second by insisting only on asset purchases you put into place a screening process that substantially ensures that you are not purchasing a barrel of bad apples. Sure its a lot of work but that comes back to the banks’ fiduciary responsibility to its shareholders. An asset sale would allow the purchaser to include a clause that any future claims due to fraud, misstatement or omissions are the liability of the seller’s management team. Therefore one can infer that Bank of America’s purchase of Countrywide as a single company was not a good strategy, and that any subsequent M&A activity in the banking sector would require a rethink.

Fourth, further changes to securities regulation. Dodd-Frank indeed may turnout to be insufficient or in the worst case irrelevant as private action against mortgage industry participants further tighten regulation. For example if we assume that the alleged wrong doings were conducted by a handful of employees and not an issue of management culture, checks and controls, then we can expect changes to portions of the securities and banking regulations that would provide investors more time to seek recourse. For example Securities Act of 1934, Section 10(b), investors have two years from discovery of the fraud or five years from when it occurred to file their claim, while Sections 11 and 12(a)(2) claims against misstatements or omissions must be brought within one year of discovery and three years of the securities filing. These timing could be changed to 10 years or simply no statue of limitations for any fraud, misstatements or omissions.

Fifth, we would expect bond investors require,
1) A buy back clause in any future securitization, and that buy back clause is automatically transferrable to any and all future bond holders. At the very least in the event of the failure of the insurance provider.

2) That any third party providing a fee based opinion about a or soon to be securitized deal state that they have fully examined the collateral backing the deal.

Summary
This downside risk assessment of the residential mortgage industry suggest that an end to the industry turmoil is not in sight. Further, we can expect substantial private sector initiated changes to investment contracts that will provide both investors and home owners with better uniform protection.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational / educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk
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QuantumRisk looks at downside risk & lessons we can learn from industry failures. We don’t provide rosy scenarios of the future, that is better left to others. We neither negate nor advocate any persons, entities, products, services or political positions. Neither are we attorneys. Nor do we profess legal opinions on any subject.
 
However, as much as is reasonably possible we present opinions, information and facts that can be tested and verified by & for the benefit of our readers. In so doing, we explore downside risk, their consequences and how we could avoid these future scenarios. Sometimes, the conclusions arrived at may not be desirable but many times if we don’t look an undesirable outcome straight in the eye we usually cannot find a more amenable solution. 
 
An ideal outcome would be the rethinking of private & public policies that lead to a more secure future for all of us.

Goldman Sachs Senate Hearings
I had originally planned to write Part 2 of Loss Containment but realized that the Goldman Sachs Senate Hearings was more pertinent in this time frame. I will get back to Loss Containment next month, if something more pertinent does not surface.

On April 27 2010 the Senate Subcommittee on Investigations held a hearing in which current & former Goldman Sachs employees (including the CEO & CFO) testified. In all fainess we need recognize that many parties by ommission or commission share the blame for this financial crisis. I watched about 7 hours of the hearings, and have several observations:

1. More Main Street
Senator Carl LevinThe goals of these hearings (Goldman Sachs hearing was one of several) are threefold:
1. To construct a public record of the facts to deepen public understanding of what happened and to try to hold some of the perpetrators accountable.
2. To inform the current legislative debate about the need for financial reform; and
3. To provide a foundation for building better defenses to protect Main Street from the excesses of Wall Street.

Sen. Levin had repeatedly brought up the need to protect Main St. and therefore I infer that future regulation will be supportive of Main St. – Wall St. engagements and discourage Wall St. – Wall St. engagements. In this light, we recognize why Glass-Steagall worked at the operational level. It ensured that a substantial portion of the financial services industry was focused on the needs of Main St, and by use of barriers protected these segments of the industry from the influences of its more glamorous kin.

2. Discourage Non-Collateral Based Instruments
Senator Claire McCaskill“It’s gambling, pure and simple raw gambling” said Sen. Claire McCaskill.  This sentiment was echoed by Sen. Carl Levin and was repeated many times by the senators, suggesting that future financial regulation would some day discourage if not curb the development and use of financial instruments that are not directly identifiable with a real physical asset. That futures-like products are acceptable but synthetic-like products are not. This is going to be tricky to do but I infer that this will be the direction of future legislation.

With respect to Mortgage Backed Securities there are two possible requirements to ensure compliance with a possible collateral-based security requirement. First, that an analyst is able to follow the cash flow from the assset to the security, and show how a specific asset default, defeasance, or prepayment would affect the cash flow to a specific security. Second that the master or even the special servicer is able to do the same.

The first requirement is usually a given for straight forward/non-exotic deals, but the second is a problem even for some ‘basic’ deals as some of the data is missing. The MLCFC 2007 9 WF or GSMS 2007 EOP WF deals are good examples where the servicer has difficulty in providing some of the data. The slicing & dicing of some of the properties in these deals has no effect on the risk characteristics of the deals but has resulted in a breakdown in the servicers’ ability to provide current information right down to the property level.

3. Strengthening of Fiduciary Responsibilities
Sen Levin and his colleagues had repeatedly asked questions relating to clients’ interests versus company’s interests. Their focus suggest that future legislation will prevent a bluring of roles with respect to client versus company interests. Therefore we should expect a compartmentalization of financial services to protect the integrity of fiduciary responsibilities

Goldman Sachs Employees Testify (Fox News/AP Photo)

4. Individual Responsibility
Seven current and former Goldman Sachs employees including Chief Executive Officer Lloyd Blankfein testified at the Senate Hearings. First a disclaimer. My comments are based on my inferences as a management consultant working with teams and not as an attorney.

The fact that the Subcommittee required both current and former employees to testify before it suggests that individual employees cannot hide behind company policy or lack of, to defend themsleves against allegations of wrong doing. Further, everybody is doing it will no longer suffice as an acceptable defense or immunity for one’s actions.

Conclusion
History shows that financial regulation (Securities Act of 1933, Securities Exchange Act of 1934, Trust Indenture Act of 1939, Investment Company Act of 1940, Investment Advisers Act of 1940) spawned after the crash of 1929 took 11 years to formulate and implement. Similarly we can expect to see several more new or strenghtened regulations being formulated and implemented over the next 10 years. 
 
Future regulation will further compartmentalize both financial services (e.g. retail banking, investment banking, trading and public-type versus private-type fund management) and financial products (e.g. basic, middle and exotic products).   
 
There will be stronger, clearer guidelines as to how products can be structured. For example (and this is only a suggestion) basic products can be used to structure deals where AAA accounts for up to 90% of the deal. Exoctic products cannot have more than 25% AAA, and middle products cannot have more that 60% AAA

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice. 

Contact: Ben Solomon, Managing Principal, QuantumRisk
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Several news items (WSJ’s Tishman Venture Gives Up Stuyvesant Project, Control of Stuyvesant Takes Center Stage and the NYT’s Fallout Is Wide in Failed Deal for Stuyvesant Town, As Doubts Grow, U.S. Will Judge Banks’ Stability) got me thinking about stress testing.

Stress testing is an approach to evaluating how a deal or a balance sheet will behave when selected factors are changed to induce a loss. It is done to answer the question what is the downside financial risk should a bad situation occur?

Around February 2009, the Feds and the Treasury impleted stress testing of the largest banks. This illustrates that stress testing is used in both the private and public sectors. And for those who are not familiar with this methodology, it is not a Republican or Democrat issue, as we can see that Ben Bernake is a Republican and Timothy Geithner is an independent having been a Republican.

Figure 1 illustrates a single factor that is used to stress test the deal or the balance sheet. I purchased some structured finance models a few weeks ago and was reviewing them. My observations about 3 important failings of the stress tests are based partly on these models:

Figure 1: Factors Skewed Right

1. Right/Wrong Distribution: I realized that the inherent assumption behind one of the stress parameters, the loss statistic, is that it is Normally distributed, because it is based on average values. In this example the mean is the 5.0% dashed green vertical line.  Therefore, this factor should behave like the red-dashed Normal curve in Figure 1. However, losses are skewed right and fat tailed per the blue curve. The mean is still 5.0%, however, the mode is 4.6% (solid purple vertical) with a long tail extending out beyond 17.9%.

2.  Insufficient: Stress testing multiplies the loss number by 2x to 10.0% or 3x to 15.0%. In this example 15.0% is insufficient to cover 17.9% tail loss.

Figure 2: Factors Skewed Left

3. Irrelevant: In Figure 2, we see that the skew is to the left. As an example some returns distributions can be skewed to the left. Therefore, the stress test has no bearings with reality. The stress test stresses the loss statistic in a manner that can never happen because it is outside both Normal and Left Skewed distributions, and therefore, the results are irrelevant to the real world.

So take care with your stress testing.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position neither is it to be construed as investment advice.

Contact: Ben Solomon, Managing Principal, QuantumRisk

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This blog is in response to many readers comments about jobs moving overseas.

Example 1: A friend losing his job.
We have a friend here in Colorado who works for a services company. He has been asked by his American management to train his replacement in the Philippines and when that is completed he will be laid off. The conventional perspective is that many jobs are moving to India & China, but in this example my friend’s job is moving to the Philippines.

Lesson 1: The problem is with us. This example illustrates that the real problem is not the BRIC or other countries. It is that many American managers have found it easier to remain profitable by procuring cheaper overseas talent than expensive local talent.

Example 2: ICL in the 1970s.
Let me give another example. In the 70s, ICL was a very big computer company in the UK. They were losing money and brought in someone from Texas Instruments to turnaround the company. I forget his name. He did a good job and increased the profitability of the company, but in doing so he dropped ICL’s internally developed chip and replaced it with a Fujitsu chip.

After completion of the turnaround ICL shareholders wanted to sell the company. They found that even though the company was very profitable nobody but Fujitsu would consider buying the company. Why? Because ICL was dependent on Fujitsu chips, and from the perspective of value creation it was no long an independent company but an extension of Fujitsu.

Lesson 2: We are handicapping the value of our business: So all this outsourcing of talent is in reality working against the long term advantage of the shareholders, because who wants to buy a company with many expensive senior managers, many technology boxes and most of the talent 6,000 miles away? This in my opinion is short sightedness. But people have the right to make mistakes. Unfortunately these mistakes can be very expensive for other people, their employees.

Lesson 3: We cannot legislate good business decisions.

Example 3: Texas Instruments (TI) Daily Factory Starts (DFS) team in the 1990s.
I was the architect of Texas Instruments’ Daily Factory Starts (DFS) factory scheduling system. This program was TI’s worldwide top ranked project for 1991 and 1992. This system, built from scratch on a theoretical basis not found in other ERP systems, revolutionized capacity allocation in a 3,000 SKU factory capable of producing up to 6,000 SKUs. It reduced work-in-progress from 5 day to 3 days or a savings of $8.2 million for TI Malaysia and TI Philippines.

What happened? The only three people who designed, developed and implemented this project left within 12 months of completion. Imagine that! All 3 of us left. Needless to say even TI made some mistakes. TI did not sufficiently recognize any of us for the ingenuity & work we had put in. And because we reported to a third country management team, corporate had little say in the matter. I am told that the project was folded in 1994.

Lesson 4: Program discontinuity risk: One very substantially increases the risk of program discontinuity when talent is procured from third party companies, and even more so when procured from overseas. Unless you are a big company like Microsoft, GE, or IBM who can have multiple teams concurrently working on similar programs, procuring talent from outside the company is something you have to think through very carefully.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.

Contact: Ben Solomon, Managing Principal, QuantumRisk

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Here is another positive. My blog post TARP’s Possible Role in Jobs Growth was published by the syndicated news service RiskCenter.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.

Contact: Ben Solomon, Managing Principal, QuantumRisk

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I am very pleased to see that Michael Corkery of the Wall Street Journal’s Deal Journal has similar views to a blog I posted TARP’s Possible Role in Jobs Growth.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.

Contact: Ben Solomon, Managing Principal, QuantumRisk

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To get jobs growth going, maybe what is required is a business solution and not an economic solution.

The exceptions are people like Ben Bernake who did a marvelous job of reducing the severity of this recession. Even then Bloomberg reports (05/29/09) that Bernanke’s efforts to bring down borrowing costs to revive the housing market and help the economy are stalling.

Let’s review TARP to find some answers. TARP, issued as preferred stock in the banks’ balance sheet, is tax payers’ public funds used to cushion private shareholders bank balance sheets so that the difference between the banks’ assets and liabilities does not fall below a specific value (at best) or go negative (at worst); because Assets – Liabilities = Equity.

As reported by the Washington Post (07/20/09), the special inspector general overseeing the government’s financial rescue program said that “many of the banks that got federal aid to support increased lending have instead used some of the money to make investments, repay debts or buy other banks”.

What TARP was meant to do was to give banks time to fix the Asset side of the Balance Sheet. If banks had to mark to market, my guess would be that their Assets were about 25% smaller than on July 2007. This suggests that at the worst period during the recession some banks would have had an insignificant or negative equity on the Balance Sheets.

With hind sight this inference makes sense for 2 reasons. (1) There was a huge outcry around April 2009 by the banking industry to move away from mark-to-market rule. (2) The special inspector general report mentioned earlier.

Therefore, we see that the role of TARP was to ensure that bank Equity would remain positive and above a specific Asset % and nothing more.

Now what the banks did with TARP makes business sense too, because TARP increased some banks’ Equity in such a manner that they needed to adjust the Asset – Liabilities side of the equation; that meant reducing Liabilities or “repay debts” and increasing Assets or “make investment” and “buy other banks”.

Could we blame the banks for making “good” business decisions to secure their own safety having received so much cheap money with no strings attached? Let’s flip sides, would you as a banker give free money to your customers?

Let’s think about this some more. The only way banks are going to stay profitable in an underperforming economy is to (1) shed more banking jobs, (2) close more branches, (3) foreclose more properties & (4) reduce risk of lending by reducing lending. All are undesirable outcomes. I suspect that even banks forget that they too need a functioning economy to be profitable.

It appears that the previous Treasury Secretary Paulson’s primary objective was to save the banking system, not the economy, and therefore did not attach any conditions to the TARP funds. I believe the thinking was that this was to be a financial transaction only, to save some banks.

By the time Secretary Geithner took over, some of the initial panic had subdued. There did not seem to be the need to push for more conditions. Even if one wanted, what additional conditions would one attach to the TARP funds? This was a new situation and everyone was learning on the job.

Looking back we can clearly see that TARP’s weakness lay in not aligning the banks’ interests with the tax payers’ interests. Banks are the primary source of credit for a functioning economy, and if after they were rescued, they continued to withdraw credit from the economy then something is amiss. Fed’s Non Revolving Credit Outstanding shows that until recently non-revolving credit had been shrinking. But the recent blimp could be due to the clunkers and other such programs and not so much a revival in bank lending.

Do you remember “what is good for GM is good for America”? We should not make that mistake with the banks either.  Now this is our challenge, aligning banks’ interest with America’s.

The banks’ balance sheets provide an answer as to how to align the banks’ interest with America’s interests. Monitor banks’ business loans and mortgage assets and implement an additional TARP condition that banks cannot return their TARP borrowings until their business loans and mortgage assets have increased by 25% (or some percentage the economist feel safe with). By this rule the government does not tell the banks how to run their business. It tells the banks that the government only recognizes that the banks are healthy functioning members of the economy when they have shown that they can increase these critical assets by 25%.

This rule will immediately stop banks from adjusting their balance sheets by raising capital without growing their business. Raising capital is equivalent to substituting TARP dollars for private money and does not prove that banks will avoid previous mistakes. This rule will (1) cause banks to focus on their critical role of credit provider for the economy. (2) Buoy home prices because spatial correlations dictate less foreclosures will put less downward pressure on neighboring home prices. (3) Facilitate a greater tolerance for mortgage delinquencies for those who have lost their jobs for reasons beyond their control, and therefore fewer foreclosures.

We need to take into consideration that most banking practices are derived from experience in a functioning economy, when everything else is going good. This recession is the exception to those practices and needs to be viewed in a different light.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.

Contact: Ben Solomon, Managing Principal, QuantumRisk

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