Business Blog: Hoover’s Business Insight Zone

I’ve been meaning to post about this column, which recaps the 1980s-era spate of Wall Street innovation on behalf of middle-class investors, then decries the way that Wall Street now seems to have abandoned these same customers — or has, at least, left them much more to their own devices.

Wall Street doesn’t want you

. . . even the stunning size of these [recent] losses [e.g. at Citigroup] is not going to turn Wall Street’s attention back to the individual investor or saver. The best minds of Wall Street are going to continue to put their time and effort elsewhere, because Wall Street is still convinced that’s where the money is. Investors with a few hundred thousand or even a few million in assets, even if that represents the work of a lifetime, can’t expect more than a passing thought from the giants of finance.

That’s so profoundly wrong that it makes my hair — what remains of it — stand on end. That Wall Street would want to abandon financial innovation for the middle class just as the baby-boom generation hits its peak earning and saving years is beyond comprehension to me. And that it would call quits to a revolution in financial services and products for the middle class just halfway through signifies a profound failure of imagination.

Maybe Wall Street is just too intent on building ephemeral empires such as Citigroup and Bank of America (BAC, news, msgs) to care about these opportunities. But not everyone can be Goldman Sachs, nor should everyone aspire to.

Jubak’s suggestions for what financial services companies could be doing for middle-class customers are interesting, even if I differ with some of his points of focus. (E.g., I’m not sure how banks would help workers whom the global economy renders “permanently unemployable.”)

Bigger picture: there’s always room for innovation, and not just in the obvious areas (telecom, biotechnology, computing), but in all areas of business. It would be great if the financial services giants woke up from their collective/risk hangover and decided to serve the middle-class market better.

Clark Kent John Thain joins Merrill Lynch as its new CEO:

• MarketWatch
• Bloomberg
• NYT DealBook

I joke that Thain is Clark Kent because he looks like him (square jaw, black hair, glasses) and because he shares his quiet and strait-laced demeanor. But as CEO of NYSE Euronext, Thain was more like Superman, overhauling the Big Board (and merging it with Euronext) in the wake of the pay scandal around the previous CEO, Richard Grasso. The Bloomberg story linked above sums it up nicely:

During his almost four-year tenure at the NYSE, Thain, 52, orchestrated one of the biggest transformations in its 215-year history.

Thain took over amid controversy in January 2004 after Grasso was ousted when the exchange disclosed his pay package. In his first year, Thain unveiled plans for one of the most sweeping overhauls of the Big Board’s trading system in three decades.

By April 2005, he had hammered out an agreement to purchase Archipelago Holdings Inc., transforming the exchange into a for- profit company. A year later he was negotiating the $14.4 billion purchase of Paris-based Euronext NV, a deal that created the first trans-Atlantic stock exchange.

Not long after he had taken the reins at the NYSE, I got to hear Thain give a speech to an audience of business journalists. He came off as smart and sincere, but I wondered if there was “any there there” under that tax-accountant’s facade. Obviously, there is.

This represents Merrill’s first-ever outside hire for the CEO role. As my previous comments would indicate, I think that internal succession planning is far more important than the treatment it sometimes gets these days, but in this case I don’t know that Merrill could have done any better. Ex-CEO Stan O’Neal drove away just about anyone who might have succeeded him — another blot on his record as CEO, in my book. Given the situation, the Merrill board has done the best thing it could.

Thain is also making all the right noises, at least here in the early going. This comes from the MarketWatch story linked above:

Thain said his first job at Merrill will be to get to know the firm’s executives and other employees, while also dealing with near-term issues such as subprime mortgage-related exposures.

Merrill unveiled a write-down of roughly $8 billion when it reported third-quarter results, mostly from securities backed by subprime mortgages, including complex products known as collateralized debt obligations. Since O’Neal stepped down, investors and analysts have been worried that more losses may be disclosed.

Thain declined to comment on future Merrill write-downs, but he did say that there will likely be more losses for the banking industry from subprime mortgages and collateralized debt obligations over the next three to six months.

“I don’t think we’ve seen the bottom,” he told CNBC.

Precisely. Underpromise and overdeliver. Stress how important it is to get to know everyone and right the ship for the short term. It’s as cliched as when athletes say “I’m just in here trying to help the team win,” but the cliches can still comfort the markets and the troops inside Merrill, who are looking for signs of a level head. From what I’ve seen of him, Thain’s head is as level as heads get.

The DealBook piece linked above talks about how Thain is yet one more Goldman Sachs alumnus — along with Treasury Secretary Hank Paulson, his Cabinet predecessor (and the current Citigroup chairman) Bob Rubin, and New Jersey governor Jon Corzine, among others — to hold prominent positions in the outside of Goldman. Here’s the key bit:

What is it about the investment bank at 85 Broad St.? The firm apparently avoided the woes besetting its rivals by deftly betting against subprime mortgages. It is a perennial leader across the board of investment banking products and services. And it has earned handsome profits year after year, with current chairman and C.E.O. Lloyd C. Blankfein reportedly set to earn at least $75 million this year.

What is it about Goldman? They’re better than everybody else.

Now let’s see if John Thain can work that same kind of magic with Merrill.

This Whitney Tilson piece in the Financial Times touches on the work of Jason Zweig, whom we discussed a few days ago:

. . . Taking a proverbial deep breath before responding to short-term market moves goes a long way to avoiding panic-induced mistakes. This gives our “reflective” brain time to kick in and enable a more objective decision, says Zweig. Also important are regular disciplines or checklists to follow in making any buy or sell decision. Many investors institute formal reviews of any holding whose value falls a given percentage, asking what – other than the share price – has fundamentally changed in the investment thesis. This doesn’t ensure the right decision is made, but increases the likelihood that any decision is made for the right reasons.

Good advice. Sounds a lot like what Warren Buffett does at Berkshire Hathaway.

The more I read about what’s going on in the financial markets today and what has gone on to get us here — over-reliance on subprime debt etc. — the more I’m convinced that in practice the financial markets operate much less rationally than some would have us believe.

Well, who cares what I think? More to the point, Blackstone told you so. Back in June, when the private equity titan made its IPO, I said on CNBC that the stock was way too expensive because it had three premiums built into it:

1. The premium that comes with any non-horrible stock in a sky-high market. This I can live with.
2. The premium that comes with any ultrasexy IPO. This I wouldn’t want to pay.*
3. The Steve Schwarzman Premium. Schwarzman is one of the world’s very, very best appraisers of the market value of assets. He’s crazy-good at this, and he has tons of experience at it. He does not sell any asset he holds at less than the best premium he thinks he can get. In June I made the very simple assumption that he thought it was the best possible time to sell 10% of Blackstone. Guessing that he was more likely right than wrong, I figured that would imply that Blackstone shares — ahem, “common units” — were expensive relative to their long-term market value. We’re not into the long term yet, but so far my guess has been correct.

Mind you, I didn’t foresee how the big drop-off in real estate would impact Blackstone. But I did note their own pre-IPO SEC filings, which warned that it could be years before they turned a profit for the holders of their shares. (Common units, schmommon units — I’m going to call them shares from here on.) They’re doing what they said they would do, in other words, except that the given set of reasons is slightly different.

The result of all this: a looowwww share price relative to the price at IPO. David Gaffen of the Wall Street Journal has perceptive things to say about this here. You can witness the share-price decline from above $35 to below $23 in all its splendor here.

~

* If it need be said, I’m not a qualified financial advisor and I never give financial advice on this blog. I’m just sharing an opinion formed from some years of watching the markets.

I try not to get too “meta” with my analysis of what’s going on in the business world — no simplistic stories about stories about stories if I can help it. But it occurs to me that the recent binge of financial news (it’s been going on for many months, now) stems from at least two sources — and that it’s important to keep the two distinct as we read the business news:

1. The actual importance of news emanating from the financial markets. There’s no question that the “mortgage meltdown,” the “credit crunch,” and attendant phenomena are not just important but highly important for the entire world of business. They affect how companies finance their operations; rates of foreclosure and bankruptcy; mergers, acquisitions, and layoffs; big-time executive shifts; and on and on. These effects are real and they’re meaningful, and to that extent the floodtide of financial reporting is useful.
2. The sometimes envious, often adulatory, celebrity-style coverage of financial firms and moguls. This “finance pr0n” is not very different from what US Magazine or People does with stars from Hollywood or famous bands. In this world, what Steve Schwarzman does matters not because (or not primarily because) Blackstone is a big-time player in the world of commerce, but because he’s Steve Schwarzman, and we want to know what Steve Schwarzman is doing. This is not different, at bottom, from wanting to know what’s happening with Brangelina and their growing polyracial family.

Mind you that there’s nothing necessarily wrong with #2. Heck, I find myself reading character profiles on top athletes just because they fascinate me, not because I believe it has anything to do with following a particular sport. Personality journalism is a time-honored tradition; we just need to keep it separate in our minds from actual, substantive coverage of the financial markets if we want to avoid being so overwhelmed by the personalities of the finance world that we fail to see the structural, strategic, and tactical realities at play there.

It’s big, it’s obscure, it’s having a mondo IPO this week . . . that’s right, it’s Och-Ziff Capital Management, and here it comes barrelling down the pipe on our IPO Calendar.

Here’s the key quote from a post we did about Och-Ziff in July, when the IPO was first announced:

Och-Ziff is an asset management firm with about $27 billion of assets under management. It’s not a household name in the industry — it serves fund managers rather than individual investors — but it pulls down more than $1 billion yearly in revenue and has a broad portfolio of investments spread across the world. For a $2 billion IPO, expect this one to be on the quiet side.

Since then the IPO has been set a little bit lower — just north of $1.1 billion. Still it’s the biggest IPO to come down the pipe in a while. It will be interesting to see how the markets treat this company, given how badly the financial sector has gotten beat up lately.

~

* This is my homage to Monty Python. No special reason . . . but do we need one?

One of my long-term interests centers on how we decide, and in particular the sorts of neurological or psychological biases that affect our processes of making decisions. So you can understand my interest in this IndexUniverse interview with Jason Zweig, author of the recently released Your Money & Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich. A couple of tidbits:

Straight From The Source: Jason Zweig

. . . The brain has been built to make basic decisions about risk and reward. We don’t have financial circuitry in the brain. We haven’t evolved to make decisions specifically about money. That’s one of the really interesting things about neuroeconomics: It shows very clearly that when you make a decision about a profit, it’s processed in the same part of your brain that processes everything else that feels rewarding, like chocolate cake, Cheetos and drugs, sex and rock ‘n roll. When you make a decision about risk and losing money, that’s handled by the same kind of circuitry that responds when you face physical risk and mortal danger. There’s not much difference in the brain between having a rattlesnake slither across your living room carpet and having some stock you own go down 40 or 50 percent. Basically it’s the same response, which is, “I’m in trouble; how do I get out of here alive?” It’s very fast. It’s incredibly rapid.

. . . The really surprising thing is how little we know about how we think. J.P. Morgan once said that every man has two reasons for everything he does: the reason he states and the real reason. I think he meant something a little different by it, but what a neuropsychologist or a neuroeconomist would say is that most of us don’t even know why we do things ourselves, and we can often be in the grip of unconscious emotion or unconscious biases, feelings and inclinations that are in our mind but we have no awareness of. By definition, this is one of the hardest ideas you can ever get someone to admit.

It’s a very interesting read. Check it out.

The interview also puts me in mind of a lecture by Charlie Munger (vice chairman of Berkshire Hathaway). In the lecture, Munger details a variety of heuristic biases that tend to lead investors astray.

The Psychology of Human Misjudgment

…What happens when these standard psychological tendencies combine? What happens when the situation, or the artful manipulation of man, causes several of these tendencies to operate o­n a person toward the same end at the same time?

The clear answer is the combination greatly increases power to change behavior, compared to the power of merely o­ne tendency acting alone. Examples are:

- Tupperware parties. Tupperware’s now made billions of dollars out of a few manipulative psychological tricks. [...]

- The system of Alcoholics Anonymous: a 50% no-drinking rate outcome when everything else fails? It’s a very clever system that uses four or five psychological systems at o­nce toward, I might say, a very good end.

- The Milgr[a]m experiment. It’s been widely interpreted as mere obedience, but the truth of the matter is that the experimenter who got the students to give the heavy shocks in Milgrim, he explained why. It was a false explanation. “We need this to look for scientific truth,” and so o­n. That greatly changed the behavior of the people. And number two, he worked them up: tiny shock, a little larger, a little larger. So commitment and consistency tendency and the contrast principle were both working in favor of this behavior. So again, it’s four different psychological tendencies. When you get these lollapalooza effects you will almost always find four or five of these things working together.

Particularly interesting to me is this “lollapalooza effect,” through which various biases are piled atop one another, leading us badly astray. It happens all the time, and it can lead astray even the most brilliant and principled among us.

Though I’m not sure exactly where to start untangling the current mess in the credit markets, my hunch is that using Munger’s rubric would uncover multiple overlapping biases that have led large sets of investors astray. Food for thought, anyway.

Almost lost in the weekend shuffle as Chuck Prince departs Citigroup is this little gem from the company’s other Sunday press release:

Citigroup Inc. announced today significant declines since September 30, 2007 in the fair value of the approximately $55 billion in U.S. sub-prime related direct exposures in its Securities and Banking (S&B) business. Citi estimates that, at the present time, the reduction in revenues attributable to these declines ranges from approximately $8 billion to $11 billion…

Two things:
1. Whether the actual figures come in at the top or the bottom of the range, that’s a lot of money. A LOT — even for the mighty Citi.
2. It’s telling that, this “late” in the game, even a financial organization as sophisticated at Citi’s can’t draw a more precise bead on the figure than that. I mean “8″ doesn’t sound like it’s so far from “11,” right? And then you remember that we’re talking about billions.

Expect more bad news for all Wall Street firms. The subprime pain is not over, and it may be a long way from being over.

(Thanks to Management Turnover as Change Agent for pointing this out.)

Mid-morning update = more links:

David Gaffen of MarketBeat:

…Deutsche Bank’s Mike Mayo says management now appears to be in “a period of CEO-limbo,” which is “not only is troubling for morale but also unusual given that the outgoing CEO made several management changes in the investment bank only 3 weeks before his exit. Why did the board allow such changes to be made when there was a chance that the CEO would leave?”

(You’ll recall that Mike Mayo was the indignant analyst who grilled Mr. Prince during Citi’s last earnings call.)

Gregory Corcoran of Deal Journal:

…So too did Citi have to choose the right number, in this case, not too low to leave investors expecting more later but not too high to scare them either — and leave investors feeling that the bank didn’t have a handle on its own numbers. Clearly, the market didn’t expect a write-down as large as the one Citi disclosed….

Michelle Leder of Footnoted:

…With all of this other stuff going on, it seems interesting that Citi chose today to file its latest Q which used the word sub-prime 53 separate times in the 100-plus page filing. Compare that to 10-Q that Citi filed back in August, which only mentioned the S-word twice. Was it really not a problem worth much discussion only three months ago?

~~~

At least, that’s what intrepid Wall Street Journal reporters Sidel, Langley, and Zuckerman say:

Citigroup CEO Plans to Resign As Losses Grow

For all I know, Prince may be a swell human being — I hope he is. But it’s long been clear that he’s not up to the job of running Citigroup. Maybe nobody is; maybe the mega-bank has finally gotten too complicated to work.

In case you missed it, here is my argument from October 23rd explaining why Prince is the wrong person to lead Citi.

Enough with my Chuck Prince bashing — Citigroup’s problems may go well beyond who’s holding the top job:

Credit Crunch: More To Come

[Citigroup's] shares fell more than 7% at one point, after an analyst said Citi needed to raise $30 billion in capital, possibly by cutting its dividend, and raised concerns about the firm’s bloated balance sheet.

The note by Meredith Whitney of CIBC World Markets supports the argument that banks are maintaining inadequate capital levels given the risks they are assuming on their trading books, particularly in their out-sized exposures to the credit derivatives that have gone haywire in the recent market tumult.

The same story talks about the hocus-pocus “Level 3″ assets of Goldman Sachs and Merrill Lynch. For more on the kooky world of Level 3, I refer you back to this post from August, and especially its link to this bit from the estimable Marc Andreessen.

More details on Citi’s woes here:

Citi: That Sinking Feeling

We’ve got a long, long way to go — and, I’m afraid, many painful lessons yet to learn — before we get to the bottom of this credit crunch.