U.S. Companies Need to Get Real about Pensions Too
Corporate America ought to get real about pensions, too. As lawmakers wrestle over how to fix the nation’s ailing retirement plans, AT&T and Verizon took a whopping $17.2 billion of charges related to theirs in the fourth quarter. Return expectations remain too rosy and deficits are rising. The private sector isn’t leading the way on this issue.
The two telecom giants are among the leaders in companies saddled with pressured defined benefit plans. Four years of ultra-low interest rates have forced them to use a lower discount rate when calculating the net present value of long-term retirement obligations. That creates ever-bigger holes. The largest 100 U.S. pension funds were short by over $400 billion in 2012, up a fifth from the year before and the largest year-end gap since consulting firm Milliman started keeping track in 2000.
It’s tempting to shrug off such red ink as a temporary problem. Once the Federal Reserve tightens monetary policy, as it eventually must, the gaps should shrink. Such thinking informed a law passed last year allowing companies to contribute potentially $45 billion less to their funds this year than they otherwise would have, according to estimates by Credit Suisse. General Electric, for example, said it would inject only $500 million into its pension plan for 2012 and 2013 instead of the $3 billion originally intended.
The wait-it-out approach is hardly an exemplary model. For one, the Fed squeeze could last for years. If companies keep contributing less, their pension assets will need to earn more. Forecasts are already unrealistic. Some are recalibrating, but only at the margins. AT&T cut its expected returns from 8.25 percent to 7.75 percent, a still unrealistic hurdle in a zero-return world. It could spur an unhealthy use of leverage to supercharge returns on low-yielding fixed-income securities or an allocation of too much capital to riskier investments.
Plugging pension holes would be a better use of cash than allowing it to languish on balance sheets. Such contributions are also tax deductible. Voters may be resigned to politicians evading tough decisions on paying for future liabilities. Investors, however, can expect more from chief executives and boards of directors.
JPMorgan Flaws Should Ring Alarm Bells Everywhere
JPMorgan was supposed to be among the best managers of bank risk in the world. This week it published an internal report into the failings which led to $6.2 billion of trading losses at its chief investment office in 2012. If the mix revealed – conflicting mandates, discredited theory, inadequate checks and primitive technology – is really as good as it gets, financial watchdogs and investors everywhere should worry. There are plenty of lessons for regulators and bank executives who want things done right.
First, the controls should match the mission of a unit that manages excess cash, as the CIO did, and is trying to make money in the process. The report suggests JPMorgan’s supervision was set for the days when the CIO was a sleepier and much smaller operation which engaged in simple, old-fashioned hedging. Not enough changed when the CIO morphed into a trading operation that was a force in the market for complex synthetic credit default swaps. One trader was nicknamed the London Whale in press reports.
In particular, the CIO was under pressure to minimize reported risk. Models are used to calculate the measures of risk: risk-weighted assets (RWA), used to calculate capital strength, and value-at-risk (VaR), used to estimate likely losses. When the models suggested that some assets should be sold to keep the risk at an acceptable level, the unit’s traders sometimes just tried to change the models. But the bank’s senior risk staff did not summon up the necessary skepticism.
Second, the CIO’s VaR models relied on flawed theory. Credit default swaps simply don’t behave in line with the normal, or Gaussian, distribution typically assumed. The so-called tail risks, or the chances of extreme events, are bigger than that theory predicts. Ina Drew, who ran the CIO, referred to one day’s mark-to-market losses as an eight standard deviation event, according to the report. That translates mathematically into something that should only happen once every several trillion years. It makes no more sense than Goldman Sachs finance chief David Viniar’s famous remark as the crisis unfolded in 2007 about seeing 25 standard deviation events, several days in a row.
Third, not only was the VaR approach flawed, but JPMorgan did not calculate VaR correctly. At least one model was stored on Excel spreadsheets with formulae that hadn’t been properly checked. Inputs were supposed to be updated manually, but some numbers were out of date.
Someone in another part of JPMorgan even spotted an error in the CIO’s VaR calculation. For the person in question to take the time to identify the mistake, the VaR number must have looked badly off-kilter. Yet CIO managers dismissed it as a one-off. At best, the CIO’s systems last year look alarmingly amateurish. At worst, the managers didn’t understand or care much about the risks. Either way, these problems provide definitive talking points for regulators examining other companies.
Next comes the pricing of illiquid positions. It’s a fact of a financial firm’s life that when there is room for judgment or different answers, it is in a trader’s interest to provide the rosiest possible numbers. That clearly happened in the CIO. It did not follow best industry practice of asking outsiders to provide prices for illiquid positions. Managers should not rely on traders themselves, as the CIO largely did – but JPMorgan is surely not the only institution to do so.
Illiquid assets are also hard to shift, and for the CIO’s massive trades even accurate models would not have been reliable indicators of actual market prices. Other traders and financial media were already picking up on the CIO’s huge positions, but Jamie Dimon, the bank’s chief executive, agreed that these rumblings were just “a tempest in a teapot.” It was a big teapot: certain derivative positions may have had a nominal value of as much as $10 trillion, although there were other offsetting trades. Small mistakes about market prices could, and did, lead to large losses.
Dimon and his subordinates understandably wanted to believe that everything was indeed under control; unfortunately they believed it without first asking enough hard questions.
Lastly, JPMorgan’s report concludes that its compensation system wasn’t a problem. But it looks as though the incentive system didn’t help. Some traders were reluctant to unwind positions fully because it would crystallize losses, which would in turn normally hurt bonuses. Drew did nothing to reassure them. In any case, for bank traders, closing positions feels like housekeeping, which is never as well paid as making profitable trades.
Bank bosses and regulators alike need to ensure that measuring, managing and minimizing risk is part of the culture of any trading room. JPMorgan’s whale debacle shows how not to do it. Dimon has taken steps designed to change things. With luck, the lessons will help other banks avoid similar troubles.
Citi, BofA Give Investors Only Reason to Fret
Bank of America and Citigroup are giving investors nothing but reasons to fret. The two U.S. banks’ stocks were among the best performers last year – BofA’s doubled, while Citi’s jumped by 50 percent. But their fourth-quarter earnings, which both unveiled on Thursday, offer little to support further optimism.
Both of them had a messy final three months of the year, full of litigation costs and other charges. BofA Chief Executive Brian Moynihan had to book $5 billion of charges stemming from predecessor Ken Lewis’s attempt to build the nation’s largest mortgage lender and servicer with purchases like the disastrous Countrywide. It also took a $700 million accounting hit because improving credit made its own liabilities go up in value.
There were some offsets, like a $2.4 billion tax break. Stripping out all the one-offs bumps BofA’s fourth-quarter net income to around $2.2 billion, about triple the reported figure. But even that equates to a dismal 4 percent annualized return on equity.
New Citi boss Mike Corbat made a better fist of it. The bank set aside $1.3 billion for mortgage litigation and $1 billion to help pay for the restructuring Corbat announced last month. Back those out, as well as a $485 million accounting loss as Citi’s creditworthiness improved, and the bank earned $3 billion – also almost triple the official showing.
Yet even on that basis, Citi’s annualized ROE was only 6.4 percent, way below the rule-of-thumb 10 percent needed to beat the cost of capital. JPMorgan has been running above that level for a while and Goldman Sachs nudged its full-year 2012 return to 10.7 percent largely by setting much less aside for pay in the last quarter.
With rivals more solid, Moynihan and Corbat are under even more pressure to perform. Their costs are still way too high. BofA’s ratio of expenses to revenue, for example, was a whopping 86 percent last year, more than 25 percentage points higher than the average for institutions with government-insured deposits, according to the Federal Deposit Insurance Corp. U.S. Bancorp, meanwhile, is at 51 percent.
There are brighter spots. BofA’s deposits increased 4 percent to $1.1 trillion. When interest rates finally move higher, lending them out should boost margins. But that – and the end of BofA and Citi’s post-crisis hangover – could be a long way off.
JPMorgan Goes Soft On Jamie Dimon Over Whale
JPMorgan has gone soft on Jamie Dimon over the so-called whale trade. The bank’s 132-page report into $6.2 billion-worth of losses dishes out blame to several now departed managers. But it just echoes the chairman and chief executive’s own mea culpa. The more than $10 million docked from Dimon’s pay will sting, but the board could do more – like removing one of his hats.
To be fair, Dimon didn’t shy away from his and the bank’s failings. After initially calling news of the money-losing trades in JPMorgan’s chief investment office last year “a tempest in a teapot,” he faced up to them, defending the bank in front of the media, lawmakers and shareholders and accepting he had not paid enough attention. The lapse was a particular blow because JPMorgan had been considered the best managed bank on Wall Street through the financial crisis.
The bank’s task force report heaps a good portion of the blame on people who reported directly to Dimon, including former CIO head Ina Drew, ex-finance chief Douglas Braunstein and former Chief Risk Officer Barry Zubrow. Drew was bundled out, Zubrow is retiring, and Braunstein was replaced as finance chief. Yet when it came to Dimon, the task force said its views were “consistent with the conclusions (Dimon) himself has reached” about the firm’s and his own shortcomings.
The board has made a statement by paying Dimon only half what he pocketed for 2011 – though $11.5 million is still a pretty good living, and reflects the bank’s record profit in 2012. Yet when a big risk management failure occurs, directors need to consider options more radical than the mostly procedural and reporting changes that have already been made.
One could be to split the roles of chairman and CEO. A well-chosen chairman provides a check on a CEO’s powers. In one indication that this can work, GMI Ratings last year concluded that an executive pulling double duty can earn 50 percent more than the total pay of two people performing the top jobs separately. An independent chairman could galvanize and maybe refresh JPMorgan’s board. Perhaps most importantly at a complex bank, a chairman could also share the load as the bank’s figurehead, allowing Dimon to spend more time making sure the next whale trade doesn’t fall through the cracks.
Flu Epidemic Exposes U.S. Risk Management Flaws
In a typical year influenza inflicts about $90 billion worth of economic damage and kills about 36,000 Americans – and this year’s epidemic is shaping up to be worse. Yet Uncle Sam spends far more on homeland security than on flu prevention. Poor resource allocation can be a hard thing to cure.
The sprawling nature of the activity makes spending on domestic defense hard to unravel, but the proposed Department of Homeland Security budget for 2013 includes $33 billion to prevent and disrupt terrorist attacks. This includes functions like border patrol, customs and the coast guard which are needed anyway. But $5.2 billion alone is direct spending for “domestic counter-terrorism.” And the budget excludes the cost of the FBI and CIA as well as heavy military expenditure on overseas conflicts, some of which grew out of terrorist attacks or fears.
The government spends a lot less money preventing flu. The National Institutes of Health spent $272 million on influenza research in fiscal year 2011. Meanwhile, the Centers for Disease Control and Prevention spend about $160 million a year on influenza planning and response. There is the occasional budgetary windfall: the last epidemic resulted in a one-time shot of $8 billion to spend on everything from vaccines to hospital supplies.
Even so, the balance is off. The flu is costly for society – a CDC study pegs the annual total economic damage at about $87 billion. Some other estimates give higher figures. And the annual death toll calculated by the CDC is more than 10 times the number of U.S. citizens killed since 2001 by “terrorist action” according to the U.S. State Department.
Moreover, the worst-case flu scenario is horrendous, even compared to a rogue nuclear attack that might kill millions. The Spanish flu in 1918 killed 20 million people by low estimates – at a time when the world’s population was under 2 billion. The same probability of death now would kill nearer 70 million worldwide. Some known varieties of avian flu appear more infectious and dangerous than the 1918 strain and the world has become a more interconnected place, too.
Of course it’s more exciting and concrete to spend money on armed air marshals and wiretaps than programs to encourage hand-washing and flu shots – not to mention research that might take years to bear fruit. But in terms of protecting life, the government would get more bang for its buck with soap than with bullets.
Fiat Pegs Chrysler as Most Undervalued Car Maker
Fiat Chief Executive Sergio Marchionne seems to want Chrysler to be the most undervalued automaker. That’s the implication of his latest offer to buy a slice of the Motown manufacturer from the United Auto Workers’ retiree healthcare trust. Marchionne has put $198 million on the table for 3.3 percent, valuing 100 percent of Chrysler’s stock at $6 billion. It’s worth much more.
The Fiat boss says the offer follows from the agreement struck with the UAW trust in 2009 when the U.S. government divvied up ownership after bailing Chrysler out. Fiat took control, now owns 58.5 percent, and wants to fully integrate its American subsidiary. Marchionne’s price, though, assumes the deal contained a clerical error pegging any acquisitions from the trust to Chrysler’s performance. He says that should have referred instead to Fiat which, like other European automakers, is suffering.
The trust, which owns the other 41.5 percent of the carmaker, has rejected the offer and asked Fiat to prepare to sell up to 16.6 percent of Chrysler on the open market. If that’s a ploy to establish a higher valuation, it should work. Marchionne’s offer values Chrysler at just four times his own expectation of the company’s 2012 net income. General Motors, meanwhile trades above nine times expected earnings for last year, and Ford’s multiple is just over 10 times.
The Fiat proposal also pegs the enterprise value of Chrysler at $6.7 billion, scarcely more than the company’s $5.5 billion of potential EBITDA in 2012 if the first three quarters are anything to go by. Ford’s EV-to-EBITDA multiple is over five times; GM’s is just 2.6 times, partly thanks to $20 billion of net cash. That makes Marchionne look mighty cheap.
Granted, Chrysler’s two rivals are more profitable. Ford regularly cranks out a pre-tax margin above 10 percent in North America, with GM’s around 8 percent. Chrysler managed just 2.7 percent in the first nine months of last year. Both also have more cash than debt, allowing Ford to double its dividend last week and GM to buy back a chunk of shares from the U.S. Treasury. Chrysler, meanwhile, has $700 million of net debt.
But the Detroit number three is a purer play on the recovering U.S. market, and it isn’t burdened with a big money-losing European operation. And Chrysler is growing, with sales up 21 percent last year as it gained market share. Suppose, then, that Chrysler is worth at least seven times 2012 earnings, or $10.5 billion. That would mean Fiat needs to up its offer by 75 percent. Considering the European industry environment, the Italian group’s parsimony is understandable – but it’s misplaced.
Venezuelan Political Folly Is A Cue For Investors
The political folly in Venezuela is a cue for investors. Allies of ailing President Hugo Chavez seem to be taking even greater liberties interpreting the constitution than expected. There’s no inauguration, caretaker government or sign of a new election. If markets truly hate uncertainty, then animus toward Venezuela should be off the charts.
Just how sick Chavez is remains a mystery to most, though it’s obviously bad enough that he couldn’t get home from Cuba to be sworn in on Thursday. Venezuela’s government has coasted by with a series of cryptic messages about the recently re-elected president’s recovery from Dec. 11 cancer surgery.
For now, it’s easier to say what probably won’t happen than what will. A pro-Chavez congress and high court have shrugged off their obligation to form a medical panel to determine Chavez’s ability to rule. This means he won’t be deemed unfit to hold office any time soon, a needed precondition for the head of congress to usher in a caretaker regime. It also postpones - maybe indefinitely - a fresh national vote.
Time appears to be on the side of the Chavistas. A decision by lawmakers to grant the president an open-ended medical leave keeps his seat open as he fights to recover. It also provides his anointed successor, Vice President Nicolas Maduro, more exposure ahead of any eventual new election. Meanwhile, the opposition is weak after both national and regional losses at two different polls in the last three months.
The economy also isn’t likely to turn opinion against the government. Venezuela’s GDP grew by 5.5 percent last year and oil revenue continues to replenish Chavista-controlled coffers. An overvalued exchange rate is still a worry, but the incumbent team knows how to match partial devaluations with heavy spending to stay popular.
The new highs for Venezuela’s bonds almost certainly speak more to excess cash in need of a home somewhere in Latin America than confidence about post-Chavez reforms. Even so, it defies the old saying about investors despising ambiguity. They seem to love it in Venezuela, though may come to regret it when it becomes clearer that with or without Chavez, his market-unfriendly policies will live on.
Sprint and Softbank Forced into Tactical Warfare
Sprint and Softbank are being forced into tactical warfare. U.S. satellite-TV company Dish Network, run by the enigmatic Charlie Ergen, put forward a highly conditional $2.3 billion offer for Clearwire, a spectrum owner integral to the ambitions of Sprint and its Japanese buyer. Though the bid is unlikely to go far, it could pressure Sprint to pay more - or strike a deal with Dish.
The offer trumps Sprint’s $2.2 billion agreed deal for Clearwire. Though a board committee is considering the rival offer, it’s hard to imagine how it could possibly succeed. Sprint controls just over half of Clearwire’s votes and says it won’t accept. Part of Dish’s offer is to buy 24 percent of Clearwire’s spectrum outright for $2.2 billion, a proposal Clearwire has rejected before. What’s more, Clearwire can’t sell the spectrum without Sprint’s consent.
The Potemkin offer will nevertheless have consequences. Uppity investors already have come out against Sprint’s bid, which followed Softbank’s $20 billion deal to buy 70 percent of Sprint last October. Dish’s interloping at the very least lends intellectual credence to the idea that Sprint is trying to grab Clearwire on the cheap. That could tangle up Sprint’s deal in legal knots. Further, Sprint needs three-quarters of Clearwire shares for approval. Activists hold under 15 percent, but Dish’s offer could help them woo more investors to their plight.
Sprint may consider a sweetener, even if its bid is the only realistic one on the table for troubled Clearwire. Softbank is eager to tackle the U.S. market and to do that it needs additional bandwidth. Clearwire is the obvious source. Increasing the bid could clear the path for Sprint and Softbank to get down to business.
With the Clearwire shareholder vote months away, there’s plenty of time for Dish to make trouble. The company is sitting on a whopping 40 megahertz of spectrum it bought from two bankrupt firms. It’s probably worth three times the $3 billion Dish paid, after regulators allowed it to be repurposed from satellite use to cellular. That means Ergen could now be a seller and might explain why he’s positioning himself as a spoiler with Sprint. Until he explains himself, deal watchers will have to consult Sun Tzu instead.
Chuck Hagel Is A Good Choice For U.S. Deficit Hawks
Chuck Hagel, President Barack Obama’s pick for U.S. defense secretary, is a good choice for deficit hawks. He mixes dovish foreign policy views - at least for a Republican - with budget-cutting fervor. The combination could actually slash Pentagon spending. Reducing it to the proportion of GDP seen in the late 1990s would save Uncle Sam a quarter of a trillion dollars a year.
As a senator from Nebraska from 1997 to 2009, Hagel voted against government spending programs including the “No Child Left Behind Act” of 2001 and Medicare prescription drugs legislation two years later. On foreign policy, he backed the 2003 Iraq invasion but was an outspoken opponent of the so-called surge of 2007 to 2008. Before his Senate service, Hagel made millions in the cellphone business. Obama will set policy, but the nominee isn’t likely to object to military cuts and is equipped to find efficiencies, particularly in procurement.
Defense spending has increased in recent years, from less than 4 percent of GDP on average between 1998 and 2001 to an average of nearly 5.5 percent in 2008 to 2011. Within the defense budget, the cost of procuring everything from staples to fighter jets increased to an average 0.9 percent of GDP in the fiscal years 2008 to 2011 from 0.5 percent of GDP 10 years earlier. If Obama and Hagel could cut defense spending to the level seen around the turn of the century as a proportion of output, that would save around $250 billion annually. Even if cost savings were limited to procurement, they would still amount to $55 billion per annum.
Peace dividends of this kind have played a major role in past successful efforts to balance federal budgets - for example, the end of the Cold War helped reduce defense spending in the 1990s by 2.2 percentage points of GDP compared with the previous decade. Ongoing military efforts and other foreign policy requirements may limit the savings attainable now. Nevertheless, even spending in the 1990s, at under 5 percent of GDP on average, was far above that required for a truly isolationist policy: in the 1930s, U.S. defense spending averaged 1.32 percent of GDP. The current EU average is 1.6 percent.
Given U.S. lawmakers’ seeming lack of commitment to any other spending cuts, those looking for balanced budgets may need to focus on defense. Hagel could be their best hope.
Oil Barons and Tech Hipsters Share A Dark Side
Oil barons and technology hipsters seem very different. But they share a dark side. The chief executive of U.S. explorer SandRidge Energy and some of his peers jet around at shareholders’ expense, while at Facebook and Google founder-bosses are insulated from owners by super-voting rights. Clubby boards also feature in both sectors.
The U.S. oil and gas industry plumbs the depths of weak corporate governance and social responsibility, with 15 companies getting the worst F grade from consultancy GMI Ratings - far more than would be suggested by their weighting in the sample. Headline-grabbing offenders include Chesapeake Energy and SandRidge, whose founder Tom Ward kitted out the business with four corporate jets despite the fact that its wells are mostly within driving distance. Meanwhile James “Jim Bob” Moffett, chairman of Freeport-McMoRan Copper & Gold, recently engineered the purchase of McMoRan Exploration, which he runs and partly owns, for a whopping premium. Gold-plated CEO pay and perks also feature, along with generous remuneration for incurious directors.
Silicon Valley’s governance shortcomings aren’t so brash. Only a few tech companies are branded with GMI’s failing grade. Still by the consultancy’s count 41 of their number, including such leading lights as Facebook, Google and LinkedIn, have opted for multiple share classes that help bosses outvote other investors - a higher incidence than the average in GMI’s sample. Facebook’s Mark Zuckerberg holds just a fifth of the company’s stock but thanks to supervoting shares and other arrangements he commands over half of all shareholder votes.
Although it manifests itself in different ways, the two sectors thus share a certain disregard for regular owners. One reason could be that both abound with forceful entrepreneurs who started in complete control of startups and then sometimes struggled to adjust to the responsibilities of running public companies. That may help explain why Aubrey McClendon, the co-founder and CEO of Chesapeake, sold his personal map collection to the firm for an inflated $12 million before being forced to buy it back.
A tendency for boards to overlap and feature friends of executives may also owe something to the geographical clustering of the two industries. Oil and gas exploration companies tend to be centered in Texas and neighboring Oklahoma and Louisiana, while many tech firms call San Francisco and Silicon Valley home. When Freeport agreed to buy McMoRan, it also inked the purchase of a third company, Plains Exploration. As well as Freeport CEO Moffett’s dual role, other directors on the McMoRan board included the Plains boss. Cozy relationships are common in Silicon Valley too. Marc Andreessen, whose venture capital firm routinely sells smaller companies to tech giants, sits on the boards of Facebook, eBay and Hewlett-Packard.
For both energy and tech entrepreneurs, a peer group that includes still-private companies may also set a less than ideal example. Their bosses may not have the benefit of public shareholders’ money, but their chiefs can legitimately do as they please.
In the oil and gas patch, activist shareholders are starting to rattle the comfortable cages of some CEOs. Egged on by investor Carl Icahn, shareholders at Chesapeake ousted McClendon’s friendly board and replaced a system that allowed directors to be re-elected on a single vote with a majority requirement. And hedge fund TPG-Axon Capital has publicly challenged governance at SandRidge.
Entrenched managers and boards make these tough fights. But if enough votes can be mobilized, shareholders have the power to force change. Very few energy company executives hold supervoting shares that can prevent it.
Tech investors may not yet feel as abused as some in the energy sector. People like Zuckerberg at Facebook and Google founders Larry Page and Sergey Brin have achieved great things. But they won’t always get it right. If something does go awry, shareholders will often find there’s nothing they can do about it. Tech trouble, when it comes, could prove harder to clean up than the energy business.