The Whipping Boy

Does Europe have its own Tim Geithner?

In January I asked rhetorically whether Jeroen Dijsselbloem was up to the task of leading the Euro Stability Group during these tumultuous times. It turns out we may have an answer, and it isn’t good.

To deal with its banking crisis, the President of Cyprus proposed taxing all deposits—even small deposits. Over Dijsselbloem’s objections, this plan was aired last week. After being voted down, it was back to the drawing table—this time directly with Europe’s “troika,” cutting Dijsselbloem out of the process.

Then, when the group came up with an approach that kept small deposits whole but could wipe out some large depositors, he called it a “template” for the future. Not good. If you want to maintain faith in the rest of Europe’s banks, telling large depositors that they might get nicked isn’t wise. He was immediately slapped down other leaders, who said flatly that his comments were wrong.

For years Tim Geithner was the whipping boy for the Obama Administration, taking flack when its policies failed to revive the US economy. With his clumsy comments and awkward negotiation style, Dijsselbloem may play the same role over there.

Douglas R. Tengdin, CFA

Chief Investment Officer

Acq-ward (Part 2)

So when are acquisitions justified?

We’ve all seen the compulsive, serial acquirer. Sometimes they’re justified—like when they’re in a disaggregated, fragmented industry with small, inefficient players. By rolling these up, the acquirer can offer better prices to customers, a simpler outlet for suppliers, and a growing revenue stream, earnings yield, and stock price. Such Borg-like M&A machines plow through an industry saying, “You will all be assimilated.”

But more often than not serial acquirers are serial value-destroyers, who need to be stopped before they kill again. In these cases the CEO gets rich, the acquired company cashes out, and stockholders get—nothing, or worse

But there are acquisitions that make sense. They’re the small bolt-on or tuck-in variety that adds new technology, or a new product, or a new service to the mother-ship. In these cases defections and culture aren’t an issue, since the parent is purchasing the boutique specifically for its people and products. In these cases, value is created as a strong offering gets distributed more widely.

But such an approach is a lot of work, and can’t be analyzed on the golf course between rounds. Maybe that’s why it’s so rare.

Douglas R. Tengdin, CFA

Chief Investment Officer

If you have questions or comments, please write to us at questions.

Acq-ward (Part 1)

Why do companies acquire other companies?

Imagine this: you’re CEO of a fairly successful company. Your cash-flow margin is solid, and your sales are growing. You’re hiring new people, integrating them into your culture, increasing your dividend, and gradually expanding. Life is good. You only have one problem: your cash-hoard keeps growing.

Normally, that’s not a problem, or at least, it’s better than the alternative. But eventually that cash calls to you, telling you that it wants a new home. What do you do?

If you’re like many CEO’s, a major acquisition might be in store. Buying someone else out can instantly expand your top line, promise you operating synergies, and—since you’re now CEO of a bigger company—expand your personal compensation as well. What’s not to like?

Consider: bought out firms usually lose their top engineers and sales people, because the new parent almost always favors its own people. Cultures are hard to merge; people do things for a reason, and they resist change. Big deals attract big competition, and often big scrutiny from government and industry watchdogs.

These are all reasons why the synergies from large acquisitions never seem to live up to the hype. But small acquisitions—they’re another story.

Douglas R. Tengdin, CFA

Chief Investment Officer

If you have any questions, please write to us at questions.

The Color of Money

Is gold money?

That’s the question Ron Paul asked Ben Bernanke a couple years ago when he testified before the House Banking Committee. Rather than lecturing the congressman on the proper role of a central bank in a modern welfare economy, Dr. Bernanke punted, feigning surprise at the question, graciously letting Dr. Paul pontificate on the manifold virtues of the yellow metal.

In any economy, money serves three functions: a store of value, a medium of exchange, and a unit of account. In the US the only tool that satisfies all three is our fiat currency, the dollar. But 90 years ago, that wasn’t the case. People regarded gold as money. If folks had a $20 bill, they’d probably take it to the bank to see if they could exchange it for “real” money—gold. Kind of like the way we look at a personal check. Now, we take a check to the bank and see if we can exchange it for “real” money—cash.

Money is the ultimate social network. It ties people together who might not have anything in common except a desire to effect a transaction. And our social fabric has changed. After a century of depression, recession, inflation, and regulations and executive orders, cash is king. There’s nothing more liquid.

Gold used to be money, but it isn’t any more. What it really is today is a symbol—of stability, value, and perhaps a bygone era.

Douglas R. Tengdin, CFA

Chief Investment Officer

If you have any questions, please write to us at questions.

Cyprus in the Caribbean

Could Cyprus happen over here?

Many folks look at their problems and say, “Nah.” We don’t have an outsized banking system mostly funded by foreigners, and we’re working with our worst problems. Meredith Whitney was wrong; the muni market didn’t see dozens of major bankruptcies with hundreds of billions of losses, right?

Well, maybe.

One glaring issue in an otherwise sound municipal credit universe is Puerto Rico. The Commonwealth has a population of 3.7 million, of which only about a million have jobs, and over 40% of which lives below the poverty line. Its public debt is enormous: almost $68 billion, or more than $18 thousand for every man, woman, and child. By contrast, the most indebted US state, Connecticut, has $5400 per person in debt.

But the main problem in Puerto Rico is the pension system. Many states have underfunded their pensions—New York by 10%; Massachusetts by 27%; New Hampshire by 42%, which is pretty bad. But Puerto Rico’s pensions system is 93% underfunded, and probably will run out of cash sometime in 2014. When that happens, look out!

Because Puerto Rico bonds are tax-exempt in all 50 states, they are widely held in many state-specific and national tax-free mutual funds. But the Commonwealth’s fiscal difficulties have them dancing with a downgrade. Both Moody’s and S&P have PR on the edge of a junk bond rating; if they do become non-investment grade, there will be a lot of soul-searching and forced selling by muni investors. Is Puerto Rico too big to fail?

Any default is unlikely—the Commonwealth is constitutionally required to satisfy their debt obligations before paying anyone else. The problem is that over 40% of the labor force works for the government. Are they going to stand in line behind Nuveen and Fidelity? And if the island does default, it will shock the financial world.

Think Cyprus can’t happen over here? Think again.

Douglas R. Tengdin, CFA

Chief Investment Officer

A Most Excel-lent Whale

Is there a whale in your future?

Recently JP Morgan released its internal investigation of what went wrong with its “London Whale” trade—the ill-conceived credit “hedge” that cost the bank between 5 and 10 billion dollars. Buried on page 127 of the 132 page document is this nugget:

Risk was monitored “through a series of Excel spreadsheets, which had to be completed manually, by a process of copying and pasting data from one spreadsheet to another.”

A couple of simple errors in this process led the bank understate its risk. Then the market turned against the bank and—poof–$7 billion gone.

Excel is perhaps the most important business software application of all time. It allows analysts to do sophisticated statistical analyses, create pro-forma financial statements, and format sweet-looking reports, all while letting you see what happens to the data as you manipulate it.

But its very power is its danger. Amateur hacks create quantitative monsters, with no sense of versioning, testing, or regression. There are millions of spreadsheet mavens out there who don’t know the first thing about programming in a methodical, well-documented way. They just start with a little model that grows and grows and grows.

Excel is everywhere. And who knows what it will blow up next?

Douglas R. Tengdin, CFA

Chief Investment Officer

The Bitter Lemons of Cyprus (Part 3)

Where do we go from here?

Is Cyprus another Greece, threatening the Euro? Or is it a special case, with an outsized banking system that needs propping-up from outside the system.

Like most things, it’s a little bit of both. Ironically, an answer can be found in the title to this commentary. The Bitter Lemons of Cyprus is a personal memoir of the author’s time on the island in the mid-‘50s during the run-up to violence between the Greeks, Turks, and British.

In the book normally friendly neighbors become hostile and violent, as outside pressures force trust to break down. Transactions that were a source of profit and pleasure become impossible, and the author’s colonialist attitudes—emblematic of the British Empire—undermine any good he tries to do.

In the end, the author sneaks out of the country, lamenting what was lost. As civil wars go, Cyprus was mild—nothing like the Greco-Turkish war on the mainland, with its hundreds of thousands of casualties. It was an outgrowth of a larger problem, but didn’t precipitate further problems in its own right.

Europe can only hope that Cyprus’s current financial problems will be similarly contained.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Bitter Lemons of Cyprus (Part 2)

So what’s the big deal?

The leadership of the EU has proposed that Cyprus dun its bank depositors by $5.8 billion in order to qualify for a bailout that will recapitalize their banks. And banking is a big deal in Cyprus. Because of lax money-laundering rules, it’s become the Cayman Islands of the Mediterranean

But 6.75% was too much of a hit on small deposits for lawmakers to accept. Never mind that bank deposits in Cyprus pay almost 5% and inflation has averaged about 2 1/2 % over the past 5 years. Bank depositors were seeing a positive real return from their holdings, unlike Germany or the UK or the US. As we all know, bank deposits rate here in the US have been paying less than the inflation for the past 4 years.

So savers in the US have been dunned by almost 10% in real terms since the beginning of the Financial Crisis. But there’s no sense of panic, no lines in front of ATMs, no protests at the Fed–just a steady drip, drip, drip of negative real interest rates.

So what’s the big deal, Cypriots? If you think a one-time charge punishes the thrifty, try investing in US Dollars. Because over here, what’s safe doesn’t pay, and what pays isn’t safe. Economists call it “financial repression.” I call it a “stealthy Cyprus.”

Douglas R. Tengdin, CFA

Chief Investment Officer

The Bitter Lemons of Cyprus

The Euro-crisis has reached a new level.

The country of Cyprus is tiny. Its $25 billion economy is smaller than Vermont’s, but it has bank deposits of $56 billion. In this it resembles Switzerland, whose $660 billion economy supports a banking sector with $1.2 trillion in deposits. The banking sector has grown because Cyprus has liberal money-laundering rules and extensive ties with Russia. It has been estimated that over a quarter of all bank deposits originated there. Limassol, the financial center, has three daily Russian-language papers.

But unlike Switzerland, Cyprus is part of the Euro. Due to losses on Greek government bonds, their banking sector needs to be recapitalized. Credit has dried up, but they can’t just print Cypriot Pounds. Cyprus needs to borrow Euros. Seventeen European finance ministers met over the weekend and decided that in exchange for a € 10 billion bailout package, Cyprus would need to dun all depositors for € 6 billion.

But apparently the leaders didn’t think breaching deposit insurance would cause a run on the banks. Now every ATM on the island is out of cash, and the banks are closed until Thursday. The implications of a deposit-tax are reverberating across southern Europe, wherever the Euro-crisis has been a prominent issue.

Europe has been searching for a solution to its currency crisis for years. Punishing savers seems unlikely to help.

Douglas R. Tengdin, CFA

Chief Investment Officer

Shoe-shines and Wunderkinds

Have we reached the silly season?

The news is filled with movie starlets discovering the stock market and 16 year-old actresses day-trading from their iPhones. Are these signs of a bubble?

An old market saying goes, “When even shoeshine boys are giving stock tips, it’s time to sell.” The market is a discounting mechanism that incorporates not only the latest news, but our sentiments about the news. So big, emotional events like Pearl Harbor, 9/11, Neil Armstrong’s walk on the moon, or the Lehman Bankruptcy tend to magnify what we’re already feeling.

But market buzz can permeate the culture, and encourage otherwise sensible people to buy and sell on a whim. Until Friday the market had risen for 11 straight days, something that hadn’t happened since 1996. And market volatility has fallen to the lowest level in six years. Complacency and momentum are a powerful cocktail.

I have nothing against bubbles. They can be profitable if you have the good sense to leave the party before authorities show up. But what the wise do at the beginning, fools do in the end. When the music stops, be sure there’s a chair nearby.

Douglas R. Tengdin, CFA

Chief Investment Officer