Tuesday, November 25, 2008

Democracy in the selection of Board of Directors

By R Raymond May
1526 Reverdy Oaks drive, Matthews NC 28105 (tel) 704.847.0008

I was asked at a neighborhood get together in November 2008 for my opinion on what was the root cause of this fine mess we find ourselves in at the end of 2008. Interesting, everyone knows it was all caused by the collapse in house prices and the sub-prime mortgages debacle! or was it?

No I said, those were only the first symptoms; the root cause was the wholesale institutional culture of corporate theft that has taken hold. The most clear cut sign is the incredible levels of CEO pay, golden parachutes and most of all pay levels on Wall Street. 17 billion dollars for the 2007 Goldman Sachs bonus pool! Almost equal to the company’s current market capitalization.

One group of the stakeholder club – “management” holds all the cards. The others - Capital, employees, community take what management gives them. There are lots of “good” managements but there are no checks and balances and it is hard to see the good from the “bad” until it is too late.

The only check and balance on management is the Board of Directors. But how is the board put into place and who checks the board? Certainly not the shareholders, but no, it is the same shameless management.

In response to the corporate scandals in 2001-2002, the major U.S. exchanges came up with new director and committee independence requirements, which are intended to enhance board oversight. We use this regulation event to shed light on the effect of board structure on CEO compensation. We find a significant decrease in CEO compensation upon compliance with these requirements. The significant decrease in compensation is due to a decrease in the option-based portion of the compensation. The results suggest that board structure is a significant determinant of the size and structure of CEO compensation.1
None of these changes has addressed the key issue – how do we select and remove a board of directors? Other than having a yes vote to management’s selections for us.

Corporations are so big, and the amount of cash available is just too temping. I remember thinking out loud as a young trader on Wall Street "why are we paid so much?" My boss the future CFO of JP Morgan replied "it is because we are so close to all the money".

During my time on Wall Street I observed two types of people. Type 1 had the corporation, group or businesses interests in mind foremost. Type 2 only had their own interests at heart. Types 2 were definitely the majority and you hoped you did not have to work for one of them. The business seemed cyclical in terms of which type was dominant.

Clearly this mess was caused by the gradual prominence of type 2s. What is the purpose of owning stock in a company where all returns go to management? Why own a company where the number of shares increases at the same speed as profits just to be given to management?

As the US government agrees to bailout Citibank all the talk on the TV shows is on the removal of the Board! but even if we wanted to how would that happen? And how would a new board be selected?

We need real democracy in the selection of Board of Directors!

1. Chhaochharia, Vidhi and Grinstein, Yaniv,CEO Compensation and Board Structure(October 2006). Available at SSRN: http://ssrn.com/abstract=901642

Friday, November 21, 2008

Black Friday - the collapse of Citibank

November 21 2008

Seems to be another black Friday, Citibank shares trade below $4.00, Bank of America is on the verge of becoming a single digits stock, the once mighty JP Morgan has seen its stock tumble 50% in the last month.

Why is this happening?

One clear reason can be laid firmly at the door of Treasury Secretary Paulson. Lack of Confidence.

I have this picture in my mind of Fort surrounded by bad guys and on the verge of having to give up its defense, all hope rests in the arrival of a relieving force. But a smoke signal is seen in the distance from the relief force saying that they are going home! the Fort will just have to wait for another force to arrive in a few months. This is effectively what Paulson said this week in front of Congress. The TARP [troubled asset relief program] would no longer be used by the current administration to buy bank assets. Whoosh! Shock!

From the moment Paulson said this, commercial mortgage assets, credit card loans assets, auto loans assets on bank balance sheets have seen spreads widen, and once more raising the specter of bank failures.

History will judge Paulson once we have a better view of these events with the advantage of perspective. However Paulson is already trying to write his own version of history, his press conference earlier this week attempted to set out a defense of events surrounding the demise of Lehman as being caused by "insufficient authority" vested in Treasury and the Federal Reserve. This is a tacit admission that the demise of Lehman was a turning point in the crisis and a mistake, one in which ensured this would be a major crisis and one that would be difficult to arrest. For my two cents – history will not judge him kindly.

I for one believe Lehman could have been saved in some form. Lehman's demise taken together with the effective confiscation from equity holders that resulted from the Conservatorship of Freddie, Fannie and AIG has resulted in the equity markets collapsing - there are no buyers of equities. Why would you buy equity when you are unclear what you are buying and risk confiscation by the government?

As the equity market collapsed, holders of equities are forced to liquidate generating even more downward pressure. The final collapse has caused hedge funds that held equities as glorified mutual funds to report large losses and start a stampede of withdrawals from all hedge funds.

So what started as a housing crisis is no longer a housing crisis and those that say in order to fix this crisis the housing market must be shored up are no longer correct. The issues now lie in commercial loans, commercial mortgages, credit cards, auto loans, hedge funds, manufacturers or just about everybody. It is very difficult to see how confidence in balance sheets, businesses and our economy can be restored.

Management of Citi were right in saying that the share price should have no affect on the ability of the bank to operate normally. Oh how we wish this was true! Unfortunately Citi needs to continue to roll over its short-term finances! Who will lend Citi the money? As the share price falls, the price of funding increases, at some point the bank is no longer viable. We have seen this play out many times. But we are at a place now that the only buyer of Citi is the government and we all know the price of that is! So selling Citi shares at $4 seems very rational. Back to Paulson - he's been very inconsistent, very unfair and is provided no leadership - expect a bad weekend!

One last point - the administration has allowed huge financial corporations to be created! We are back to where we were in 1928! before the Glass-Steagall Act that resticted bank holding companies own other financial firms. Is this really a good idea?

Crossing the bridge!

November 21 2008

The doorbell just rang. It was the Chesapeake man coming to collect my wheelchair. Who would have thought that a manual wheel chair would cost $6000. Leaving hospital in June I had ordered a wheelchair but cancelled the order as it became clear that I would walk again. So instead of my own wheelchair I have relied on a loaner which came due today.
I did not know he would be coming to collect my chair today. Should I let him have it? It is very useful for anything stressful or long, like voting day or taking the dog for a walk - yes I take my wheelchair!

I let him have my chair!

Therefore I have no crutch any more and have to walk everywhere - what better signal is there.

Thursday, November 13, 2008

Derivatives, the starting of Blackbird

November 13 2008
By R Raymond May (c) 2008
1526 Reverdy Oaks drive, Matthews NC 28105 (tel) 704.847.0008

In 1986 I joined JP Morgan London as a freshly qualified accountant to be a junior staff member on a policy and procedures working team. Just six weeks into my career at JP Morgan I was sidetracked by the controller to help with the operations of the small business that was suffering growing pains - derivatives or in our jargon – Swaps. At that time only 5 business personnel and a single clerk, each trade tracked on a separte spreadsheet. I spent the next six years developing technologies covering operations, accountancy, risk management, valuation and more for what become a huge business. I can confidently claim to have first designed and developed systems that used mark-to-market accounting, value at risk and complex yield curve construction.

In 1992 I moved with my family to New York to take up a junior role on the trading desk. My first responsibility was to implement the risk management technologies I had developed in London. Secondly I took these models and arbitraged the long-term foreign exchange forward markets. In 1994 I took over responsibility for all U.S. dollar derivatives at JP Morgan.

At the end of 1996 I considered the methodology for trading in the swaps market to be inefficient and opaque. There must be a better way! Just that year a new trading platform had been introduced to trade foreign exchange. With my technology background and deep understanding of the swaps market I felt uniquely qualified to develop an electronic exchange for this huge growing derivatives market. In early 1997 I resigned from JP Morgan and set up camp in Charlotte North Carolina to commence the development of a new and complex marketplace, which we subsequently called Blackbird.

Over the next three years we raised $40,000,000 and developed the complex technology to allowed traders to trade between each other all forms of OTC derivatives. It was a major accomplishment.

The first serious challenge we faced came from the established Chicago exchanges in the form of regulation. Were we an exchange? And the challenge was launched by the CFTC. This was a complex question and one in which we could not afford to lose if we planned to have any clients. If we were to be regulated so to would all the Wall Street banks. With the help of the same banks and the top lawyers in the land we defended ourselves before six Congress committees. The final outcome was legal certainty on the regulation of derivatives. OTC derivatives would not be regulated providing that they were bilateral financial contracts and not fungible.

Our next challenge was to attract the banks to use our platform to trade OTC derivatives. This was a brick wall. This was a very profitable business, the larger banks generating more than a billion dollars a year, and the respective large bonuses. Under no circumstance would they countenance the risk that we've would spoil the party. The 10 largest created a consortium "Swapswire" each contributing $10,000,000 to develop their own version of a trading system and blocking our launch.

Since its launch in 2000 Blackbird has been unable to break down this brick wall.