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GPS: Reverting Back to a Simple One Factor Debate

GPS: Reverting Back to a Simple One Factor Debate


At this critical time of year for all retailers, GPS has but one factor we’re keeping an eye on.  The re-emergence of the Gap brand is key to the next leg of the story.  Can TV and better merchandising drive positive same-store sales?  We can’t be sure either way, but that’s where the debate is centered.


Over the past year or so we’ve gotten many questions about GPS and the sustainability of the company’s turnaround.  There is no doubt along the way we underestimated management’s ability to put in place a sustainable, multi-year cost cutting plan, inventory reductions, and substantial product cost savings.  Despite the profit improvements, sales have continued to decline.  Although, more recently Old Navy is certainly showing signs of positive momentum. 


GPS: Reverting Back to a Simple One Factor Debate - GPS 2 yr


All these efforts have resulted in a very consistent and respectable EBIT margin just shy of  12%.  In the absence of any real growth (square footage is pretty much flat) and with a substantial war chest of cash (no debt) on the balance sheet of $2 billion, the company is a cash generating cow.  Putting sales momentum aside, stable EBIT margins and a limited growth profile basically means GPS can produce $1.4-$1.6 billion in free cash flow annually.  And while there is still some skepticism as to how long this cash flow generation and exceptional EBIT control can continue in the absence of a topline pick up, the past three years should act as a pretty good base for which to judge the limited volatility in the company’s earnings stream.


With that said, GPS is now a critical point from a sentiment standpoint.  The turnaround is largely complete on the cost side.  The inventories have been cut dramatically along with $700 million in SG&A expenses that are now permanently removed from the P&L.  The company is moving to offense from defense.  There is simply very little “addition by subtraction” left in the model, and as such investments will need to be made to drive the next leg of the story.


This is where it gets a bit less quantitative and bit more qualitative.  The single biggest issue/topic/focus facing GPS the company and the shares is the ability of management to drive same-store sales back into positive territory.  The recent resurgence in positive momentum at Old Navy is clearly a positive first step in the process.  Merchandising, pricing, and marketing changes are all yielding positive results at a time when “value” means more to consumer than ever. The timing couldn’t be better as Old Navy regains its leadership in the world of low priced apparel/accessories sales with a fashion twist.  Product cost improvements (whether it be company or market driven benefits) are allowing Old Navy to take improved profits to the bottom line while at the same time taking unit sales up.  This is the ultimate recipe for success and sustained improvement, especially in the absence of a major consumer-led recovery.


But what about Gap, the brand?  This is where the risk/reward lies.  After years of fixing and cutting, it’s now crunch time.  The next leg of the story hinges on Gap’s effort to reemerge with relevance, which will ultimately determine whether or not those comps finally turn positive.  A lot is hinging on the company’s marketing plans for this holiday with the company’s return to TV for the first time in a few years.  The real test here is whether the marketing message and merchandise is enough to make the brand relevant (and ultimately much more profitable) again.  This is just the beginning of the process and the answer is unfortunately not known at this point.  Old Navy’s recent turn suggests that there is potential here, but the brand has been losing share for years.  On the risk side, these incremental marketing efforts are somewhat contained (y/y spend is forecast to be up an incremental $45 million this 4Q) which means there is no reason to be concerned that management has suddenly gone on a spending spree. 


However, the real concern is what if this effort doesn’t work?  Access to capital is not the problem with GPS.  It’s truly the ability of Gap brand management to reinvigorate a brand that has now produced 5 years of negative same store sales in a row.  I’d argue that even some moderate success is enough to keep investors interested.  The leverage is substantial if productivity per foot can begin to rise again.  The debate though, is now relegated to a simple one factor discussion, and unfortunately for some this debate is rooted in denim and wovens and “Holiday Cheer” and no longer in expense cutting and sourcing benefits.  This makes some investors uncomfortable.  Talking product is not what most investors like to do.  Ask McGough if Fair Isle sweaters are in this season and you’ll see what I mean.


All eyes are on the holiday for sure.  But in Gap’s case, the eyes are keenly focused on TV.  November same store sales will give a glimpse of the new marketing effort’s success, but December will be the true tell tale sign.  If results are positive, then there is likely a good reason to believe there are legs to the story.  If it’s a huge flop, then it’s back to the drawing board for management and all eyes revert back to cash flow generation and preservation.  In the near term though, there is now simply one thing to watch.


GPS: Reverting Back to a Simple One Factor Debate - GPS SIGMA



Chart of The Week: Unsustainable and Unreasonable

It is funny listening to people justify why they’d hold short term US Treasury Debt at these yields (i.e. negative real yields). Funny because any student of economic history will recall that this storytelling rhymes with what American stock and bond market investors thought heading into the waning days of 1938 (the stock market closed up +25% that year; as of today, the SP500 is up almost +22%).


In the Chart of The Week, Matt Hedrick and I show the context of free moneys. If you go all the way back to 1938, you’ll find a very representative period where an American President figured out the power of both currency devaluation and reflation, and abused it.


Yields on short term Treasuries have not been this low since the 2nd leg of the 1930’s economic Depression. Many economic historians blame the bear market in stocks from 1 on the Federal Reserve “raising rates.” I disagree. I blame it on the US Government pandering to the political wind of keeping rates unsustainably low for an unreasonable length of time.


*Note to Fed Heads who currently think Japanese on the perpetual policy front of issuing ZERO rates of return for both their creditors and citizenry alike: “exceptional and extended” is UNSUSTAINABLE and UNREASONABLE – for we, the citizenry of savers and risk takers, that is.


Yes, the math of pending equity returns works is in reverse relative to the duration that governments keep Piggy Bankers at the trough (borrowing short and lending long).


Again, in capitalism speak:

  1. Exceptional = ZERO rate of return
  2. Extended = widened duration

The longer you stay “exceptionally low for an extended period of time” (1938 or 2009), the more unreasonable it is to assume that the next move in rates (UP) is going to create a sustainable economic recovery.


If you disagree with everything I am writing, that’s fine. Most “economists” who didn’t call the 2008 stock market crash didn’t agree with me that plummeting US Dollars and Treasury yields were a leading indicator of negative equity returns to come either.


Look at this chart below again, then pull it back to 1938, and look at it again.




Unless we sign off on making the USA a glossier version of Japan, the next big move in short term rates is up. This is as low as we can go. There is a bubble in short term US Treasuries that’s getting ready to pop.



Keith R. McCullough
Chief Executive Officer


Chart of The Week: Unsustainable and Unreasonable  - 2Y


Taiwanese Export Inflection

Research Edge Position: Long Taiwan via the etf EWT


While Taiwan’s political status is complex, the signal sent by the reported export numbers from Taiwan are unambiguous.  Taiwan’s export orders climbed for the first time in 13-months, up 4.4% in October from the year ago period, which was an improvement over the -3.0% drop in September.  Export orders are a leading indicator for shipments for the next 1-3 months and bode well for the economic growth of the Island state in the coming quarter.  This growth in exports was likely driven primarily by China, which is Taiwan’s largest trading partner and grew 8.9% last quarter on a year-over-year basis.


The government also indicated today that industrial production rose 6.6% in October from a year ago, a sequential acceleration from September’s +1.7% year-over-year growth, which was revised upwards today.  The other positive data point released today was a slight sequential decline in the unemployment rate, from 6.09% in September to 6.04% in October.


Taiwan’s largest export industry is electronics and Taiwan Semiconductor, the world’s largest custom-chipmaker, recently said it expects to see a re-acceleration in its business and end markets.  Specifically, Taiwan Semiconductor is raising its capital spending budget to $2.7BN from a July estimate of $2.3BN, an implication that the company is expanding capacity in anticipation of future growth.


Interestingly, over time the Taiwanese have consistently diversified their export base away from the United States. In the early 1980s US-bound exports represented ~50% of its export base; that number is now less than 20%.   Additionally, it appears Taiwan is better positioning itself to take advantage of global GDP share by attaching itself to the market share that the Chinese will take in the coming decade.  Currently China buys ~23% of Taiwanese exports.


The negative impact of current U.S. fiscal policy as implemented by He Who Sees No Bubbles (Bernanke) is that the weak dollar and emerging bubble we’re seeing in U.S. dollar priced commodities (i.e. copper and oil) is actually quite negative for Taiwan as the country imports the vast majority of its energy and basic material needs.  Currently Taiwan uses about 2.2MM barrels per day (importing more than 98% of this), so it is clearly at the whim of the volatile global commodity markets.


Setting aside the negative potential impact of commodity inflation, the economic data points emerging from Taiwan are supportive of a continued economic recovery and support our long thesis.


Daryl G. Jones

Managing Director


Taiwanese Export Inflection - taiwan23


Early Look

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Here are our notes from the investor presentation aboard the new Oasis of the Seas



Internal focus is on cost culture, international expansion, and superior hardware to drive ROI and better pricing


40% of guests outside of USA

50% non USA by 2012

Average age: RCL 42, CEL: 51, AZ: 60


New ships are dramatically better economically


Solstice: 40% larger, 86% have balconies vs 57% of Millenium’s, inside cabins only 10% vs 20% on Millenium, energy is 60% better.


Oasis vs Voyager: 74% larger, 72% have balconies vs 49% of Millenium, inside cabins only 17% vs 40% on mill, energy 30% better.


40% of their capacity is Solstice class, Freedom, Voyager and Oasis - approaching 50%.


Projecting 1.1mm international guests by 2010.



  • Tough but market for consumer demand has been very stable.
  • Seeing people trading down and seeking value
  • Generating a tremendous amount of cash flow > $1bn this year
  • Environment has forced them to refocus on costs, lowered per unit cost by 10%


4Q09:  Pricing since January has been relatively stable and as they got closer to sailing (post June), volumes picked up materially and since Oct their prices turned positive on bookings in the Q for the Q y-o-y


2010: Preliminary indications are positive and anticipating yield improvement driven by newer hardware.  They have seen a little bit of expansion in the booking window - small though – and are anticipating more stability in pricing.  Goal of flat net cruise costs.  Diversified sourcing (from Europe) should help them (going into Asia and South America).


1Q2010 sailings: since late august the y-o-y booking volumes picked up materially and became positive.


Pricing so far through ‘09 for ‘10 looks better than the indications for pricing did in 2008 for the year forward.  However, some of that is influenced by the fact that Oasis is booked early.  The non-Oasis ships are looking down on a 1 year forward basis comp to 2008.


Costs: reduced work force, wage freeze, pension reductions, lowered costs from venders.


Fuel: they are 50% hedged for 2010, 2011 and 10% hedged for 2012.


Capex for 2011:  $2.1bn.


Focusing on improving ROI and returning to an Investment Grade credit rating.


Oasis of the Seas: December 1st is the first for pay cruise (training crew) and showing off the boat to the media and travel community.  So far they are having no problems.




Penetration in North America and Europe?

  • 17% of Americans have taken a cruise
  • One of the maturation indicators is if they are getting new guests - 40% of guests are still first time cruisers, hence they don't think that it’s saturated
  • Still think there is a ways to go
  • Europe is only 2% penetrated. UK and Scandinavia - much higher
  • Asia - penetration is tiny - less than 1%, rating from Asian and South American cruisers are very positive, suggesting room to grow
  • Question of whether to enter new international markets with a local or US approach


Doesn't think that this ship will cannibalize their other ships - rather think that it will grow the market.


Under what circumstances could they see themselves contracting another ship today? Deleveraging? 

  • Their goal is to equally pursue deleveraging and improve ROI (will do painful things like cancel dividend and issuing bonds earlier this year)
  • Think that in today’s world, companies need a less risky balance sheet
  • They are not looking to add any more ships to their order book at this time


How much cheaper would building a new oasis be today? Incremental ROI?

  • Scale and more efficiency costs/smaller percentage of less desirable rooms
  • More premium rooms (balcony) and they sell at a big premium than Voyager
  • Huge amount of onboard revenue opportunities
  • Also more energy efficient (Solstice is more of an efficiency play)


Azamara (super premuim brand). Top end was the hardest hit.  Are beginning to see very encouraging signs of life there but too early to be sure.


What is the corporate ROIC rate?

  • Don't have a published target
  • Right now their cost of capital is higher than their ROIC - view their current ROIC as wholly inadequate - their target is double digit.


What is RCL doing to improve the direct to consumer sales?

  • A lot depends on the individual brand. Their direct business has grown considerably
  • Aside from international investments, handling direct bookings is the other area of investment
  • 2010 direct business will still not be material enough to really move the needle - "evolutionary"
  • Still need travel agents to sell the experience -they've all been on the ships so that's pretty powerful


Hedges are on the balance sheet and recognized once the hedges mature


Cost of what they incurring on this ship will be expensed in the 4Q


They never fill ship during the first few cruises. They do this on purpose (toilet and air conditioning issues) need to be able to move people in the event on an issue.  This ship's pricing is also higher than expected (heard 40% higher than legacy inventory)


Premium that Oasis is getting over Freedom class is better than any other ship is getting over its immediate predecessor.


Would they be ordering more ships if they were investment grade?

  • Balance sheet is not the only reason why they haven't added new ships


Refurbishing old ships?

  • Under the right circumstances that can be an attractive investment. Cut one of their ships in half and added more amenities was a great investment but when they went to do the next one cost 60% so they passed on it
  • They can also sell old ships
  • They can also move ships to other brands where that ship is more consistent with another brand


What % of business is meetings and incentive?

  • 15% and a little more than half is a real "conference"






GMCR just made life miserable for PEET.    


After a competiting bid from Green Maintain Coffee (GMCR), Peet’s Coffee & Tea (PEET) was forced to raise its offer to buy Diedrich Coffee by 24% to approximately $265 million.  Peet’s increased its bid to $32 a share from $26. 


Green Mountain is offering $30 a share in cash.  Green Mountain has been consolidating its K-Cup licenses as it bought Tully’s Coffee in March and announced the acquisition of Timothy’s Coffees earlier this month.


In some respects, PEET management’s talking up the DDRX deal exposed a weakness in PEET’s long-term business model, although the company will be fine without it.  To justify the egregious purchase price (94% or $249 million is goodwill), management needed to signal how important the single-serve coffee market is.  When discussing the just announced DDRX deal on a conference call, senior management commented that “you've got to take a look at this single cup household penetration growth and what's happening, it's a very fast growing segment. It's here to stay and it's going to be a significant consumer segment and this isn't going to take five years.   This is happening now.”


There is no denying that the recent growth in the single-serve segment is astonishing.  Green Mountain’s Keurig brand holds 85% share of single cup brewer sales, with sales doubling over the last two years.  In 2010, Keurig brewers will approach penetrating over 4 million homes.  With approximately 90 million households with coffee brewers, Keurig’s share remains less than 5%, but it is growing rapidly. The increasing share base of installed Keurig brewers is the primary driver of K-Cup growth.  And, Peet’s management has now communicated the need to play in this game!


The acquisition of Tully’s last March gave GMCR a brand with manufacturing capabilities in the western part of the United States – PEET’s core market.  Without the ability to compete in the single-serve segment, PEET is facing the potential for significantly slower top-line sales trends as its market share erodes over time.


PEET now sits out there exposed; damned if they do, damned if they don’t.  If they do buy DDRX, the fact that the valuation of DDRX is so over the top is a big negative for PEET and we will not know if the acquisition has proven successful until 2011 (when it is expected to be accretive).  On the other hand, if they don’t buy it now, how is management going to explain away the urgent need to get into the single-serve segment. 


Clearly, the growth in the home brewer single-serve segment has benefitted from more people being unemployed and staying at home for their morning coffee.  That being said, it is not surprising that MCD and other QSR operators are talking about how challenging the breakfast day part is.  For PEET, as I said before, the DDRX acquisition is not expected to be accretive until fiscal 2011.  What is the likelihood the economy recovers and the U.S. economy starts producing jobs again in 2010?  If you think it is likely, then the timing of this purchase at such a high premium is all wrong.  As more people go back to work, more and more Keurig brewers will be sitting unused at home and K-cup sales will slow right when PEET needs them most!

Slouching Towards Wall Street… Notes for the Week Ending Friday, November 20, 2009

Cookie Monster On The Economy – Me Like… Recovery!!!


He Who Sees No Bubbles – That Not Good, Keemosabee


And: Goldman Apologizes.  Goldman Gives Back.  Goldman Cancels Christmas Party. 



The Shape Of Things To Come


This week Sesame Street celebrated its 40th anniversary.  Jim Henson, creator of the Muppets, is no longer with us, but he lived to see his handiwork change the world in ways television’s earliest proponents dreamed of.  Odd though it may seem now, television’s pioneers were of mixed emotions regarding the new medium.


Edward R. Murrow, the father of broadcast journalism, crossed over from radio to television with trepidation, fearing that the medium would stifle the imagination.  Still, early visionaries saw this invention as a tool that would educate the world.  CBS producer George Crothers created the weekly program Lamp Unto My Feet which, through its dramatizations and scholarly discussions, promoted religious understanding and tolerance.  The year was 1948, and tolerance was in short supply.  The next year Paul Tripp launched Mr. I. Magination, a weekly show that encouraged children to use their imagination and learn about the world.


Now we honor Sesame Street, a spiritual descendant of Tripp’s efforts to use television to stimulate children intellectually.  Sesame Street exemplifies all that is best about television.  It has taught generations of kids to spell and count, and has helped them to encounter a diverse world without sacrificing their own unique identity.


Speaking of the letters of the alphabet, here’s a group of people that could use an education.


We continue to be barraged by an alphabet soup of economic forecasts.  First there was the V-shaped recovery.  Then the concern of a double-dip recession led to the W-shaped recovery.  Some economists think the trough will last longer and the recovery lead off slower, leading to a U-shaped graph.  Others – not forecasting a double-dip, but less sanguine about the strength of the recovery – think the recovery will be L-shaped.


Into this mix, we would like to introduce the letter that says it all.  Today’s economic crisis is brought to you by the letter Q.  Indeed, we are calling for a Q-shaped recovery, in which the markets get pulled back into the endless cycle of boom, bust and Ponzification, while wealth keeps escaping out the tail, being siphoned off to the Usual Suspects. 


The average investor – which is most people in the world with cash in their bank account and a roof over their head – will be buffeted by the ups and downs of the market, spurred on by the self-dealing of the professionals who exhort them to buy each new investment product.

National governments will rush clunking down the corridors of power like knights in thousand-pound suits of chain mail, swinging the crushing mace of excess regulation at the marketplace, a weapon that lands with devastating force, though always wide of the mark.  Within three to five years after the consensus of Wall Street, Washington and the press announce themselves satisfied that the situation is under control (think “Mission Accomplished”) fresh bubbles will burst worldwide, sowing civil unrest and massive economic hardship.


It may pay to meditate on that next bubble – which neither governments nor financial pundits will successfully predict.  We do not yet know where it will originate, but the world it roils will be changed substantially from the world we saw trampled as we entered into the current bubble a mere two years ago.


By the time the next bubble pops, China will have reached an accommodation for its massive holdings in US Treasury debt.  This may take the form of forcing the US to establish a floor valuation for the dollar.  Secretary Geithner recently came out swinging – rhetorically, if not actually – in favor of a strong dollar, and his single biggest customer may decide it’s time for him to put up or shut up.  Our currency is, to use an unfortunate turn of phrase, no longer worth the paper it is printed on.  This is lost on no one.  Indeed, the more one’s wealth is tied up in dollars, the more painfully one recognizes this.  We foresaw the Fed sitting on its hands while other nations rushed in to prop up the dollar, for fear their own currencies would appreciate into crisis, and this has been happening everywhere but China. 


China and the US are locked in a Mexican standoff over the value of the yuan.  The Chinese will not stand down and have called us out on the obvious fact that the US has engineered the mother of all carry trades with our combination of a weak dollar and negative interest rates.  The Financial Times reports (20 November, “Short-Term US Interest Rates Turn Negative”) this week’s Treasury issue saw bidders pay a premium, meaning the buyers will actually give money back to the Treasury when these bills mature in January.  The inevitable result of this is that the Fed is beggaring-thy-neighbor into a global round of forcing everyone else to bail us out.


By the time the next global crisis strikes, the Chinese will have resolved this disequilibrium.  This may be as simple as forcing the US back onto the gold standard, or by making us acknowledge the dollar to be a Basket Case, and having the dollar pegged to a basket that includes the Yuan, the Euro, the Brazilian Real, and IMF Special Drawing Rights.  The consensus today appears to be that the dollar will not remain the world’s source of liquidity forever, but also that it is in no imminent danger of losing its place.  We think a transitional arrangement might evolve.  Clearly, the Chinese would push for one that will give them increased leverage as they continue to hold onto their Treasurys, meanwhile closing out those other pesky currencies like the Yen and the Ruble.


There is also the possibility of serious civil unrest in China, as those dissatisfied with their government’s policies grow bolder.  The error the West made in its analysis of Tiananmen Square was the self-satisfied notion that the Chinese wanted to be like us –where what they really wanted was the freedom to be like themselves.    


A Wall Street Journal Opinion piece (20 November, “The China President Obama Didn’t See”) claims there may be over 100 million Chinese practicing a secret form of Christianity, driven underground by their refusal to hew to the official policy that prohibits evangelizing and, of course, protest.  Christianity may be one of the most important hotbeds of a nascent protest movement.  The Journal piece says that “dissident intellectuals have been attracted to Christianity” as more and more “well-educated city dwellers turn away from Communist Party atheism.”


While we believe this will act as a destabilizing force in Chinese society, we caution against anyone thinking the embrace of a Western faith will draw its Chinese adherents any closer to our way of life.  Rather, this is likely to be a uniquely Chinese form of Christianity that has little truck with the west.  What, after all, have we done for them lately?


Religion forced underground has always been a catalyst for social upheaval.  While the façade of government might is incredibly sturdy, once it cracks even a little, the ensuing flood can be cataclysmic.  We have a scary vision of China, either returning to the harsh repression of Tiananmen, or falling victim to social revolution on a scale to dwarf what we have witnessed in Iran.  


Speaking of Iran, there will be another game-changer as well.  By the time the next financial crisis strikes, Iran will have nuclear weapons. 


Looking for a safe place to invest that battered 401K?  As you peruse those endless lists of mutual funds that all look mind-numbingly the same, don’t forget to factor in the precarious state of the dollar, the ascendancy of the Chinese-Brazilian economic and political axis, a billion unhappy Chinese, and a re-armed Hezbollah, implicitly backed by tactical nuclear weapons. 


To the cycle of Boom and Bust, now add Blam!!!


As you feel yourself being sucked into the vortex, remember that the politicians and bankers who doggedly persist in keeping us locked in this endless cycle will always continue to pay themselves.  This is a Zero Sum Game: they get Some, and we get Zero.  See that little curl at the bottom of the letter?  Underneath the endless cycle is that squiggly little tail where the money just keeps draining out and draining out…


Today’s economic forecast was brought to you by the letter Q, and by the numbers All, and None.




Unreservedly Fed Up


Philip Booth, editorial director of the Institute of Economic Affairs, writes in the Financial Times (13 November, “Ethics Alone Will Not Prevent Financial Crises”) “when the government signals that some banks are too big to fail… banks grow big.”  The “unintended” consequence of government meddling in the private sector is that it promotes the very activities it seeks to hinder.   Dead on the money, Mr. Booth.  In the old days, Capitalism used to mean that anyone could succeed – and that anyone could fail.  By coining the phrase “too big to fail”, the government de facto created a new category.  Is it any wonder that firms rushed to sign up?


The giant financial institutions’ problems were solved with the stroke of a pen.  They are all squealing with delight at the announcement that they are Too Big To Fail, like Moliere’s M. Jourdain, who is thrilled to learn that he has been speaking in prose all his life.


“Once governments interfere to the extent they have,” Booth observes, ‘we do not know what behaviour creates wealth and what behaviour feeds the boom.” 


The government does not merely tolerate this behavior, it actively fosters it.  The Wall Street Journal reports (19 November, “Pimco’s New Job Raises Concerns”) that the National Association of Insurance Commissioners has hired Pimco to “estimate losses in insurers’ holdings of residential-mortgage bonds, estimates regulators will use to determine for 2009 the capital insurers must hold to back these bonds up.”  Last week we learned the NAIC was planning to take this job away from the ratings agencies for fear of conflicts of interest, as insurance companies resorted to the old practice of shopping for the best rating for the distressed instruments languishing in their portfolios.


This week, the NAIC has hit upon the capital idea of taking one of the largest players in the world of money – a firm that manages funds for both insurance companies and state pensions – and making them the arbiter of credit worthiness. 


Pimco, needless to say, is tickled.  They have expressed themselves as being “extremely honored to have been selected by NAIC for this important assignment.”  Their rigid internal controls notwithstanding – they have assured the world their information barriers will prevent conflicts – it should be patently obvious that this has the potential to lead to trouble.


Pimco already works for the federal government.  It managed the emergency commercial paper program, and currently purchases mortgages for the Fed.  We do not question Pimco’s abilities, nor their integrity in forthrightly handling the new responsibilities.  But by asking Pimco to take on a job which creates such obvious potential for conflict, the NAIC is setting them up to be next on the list of firms to become a target of public ire, and Congressional investigation.  Pimco is clearly well suited for this task, and will no doubt execute with integrity.  But there are countless other shoes to drop in the asset-backed portfolios, and Pimco risks being vilified down the road for taking on what will, in retrospect, be called an unavoidable conflict.


Just in passing, we don’t for a moment believe the NAIC could be motivated by a desire to protect the industry they oversee.  We only mention this in light of the clearly unrelated item (WSJ, 16 November, “Banks’ Safety Net Fraying”) that reports on an apparent act of contrition by the major ratings agencies.  It seems that Standard & Poor’s has decided to treat banks that received government assistance much in the way baseball views players who have admitted to using steroids.  In awarding their asterisks, S&P may well be rocking a very large boat.  Says the Journal, “S&P gives Citigroup a single-A rating, but adds that it would be rated triple-B-minus, four notches lower, with no assistance.”  The article goes on to report that, thanks to government funding, “Morgan Stanley and Bank of America get a three-notch lift.  Even Goldman Sachs Group enjoys a two-notch benefit.”  Should such granular scrutiny be turned to the insurers’ portfolios, there’s no telling where it might lead.


Secretary Geithner was outed this week by none other than the SIGTARP – the Special Inspector General of TARP – who announced the bizarre finding that the Fed did not believe AIG’s tottering CDS posed a systemic risk.  What, then, was the rationale for paying them off in full, and not requiring the banks on the other side of those transactions to take a substantial haircut – or, indeed, to lose out altogether?


Congress’ response is, increasingly, to insist that Geithner must go, and many urge throwing in Larry Summers for good measure.  Secretary Geithner’s response is that it is very easy to criticize after the fact.  We accept that, but somewhere in the midst of all this, we keep coming back to the fact that AIG got $180 billion of our money, and that a lot of that was handed over to Goldman et al without asking for anything in return.  Oh well, we guess you had to be there…


While we are on the subject of government stoking conflict in the financial sector, we caught banking analyst Meredith Whitney on Bloomberg Radio this week.  She said the Fed’s balance sheet is now up to about one-third Fannie and Freddie-type paper – mortgage-backed securities that would be worthless but for the Mark To Market Of Last Resort.  At the same time, she says major bank balance sheets average some twenty percent holdings of just this type of paper which are counted in their capital.  To this we add our own Broad Street Irregulars who report seeing the same Cusip numbers of new Treasury issues appearing in less than thirty days of issue on the books of the Fed.  The nation’s entire financial system looks like a cycle of auto-Ponzification. 


Banking institutions classed as TBTF are sustained only by a Fed that stands willing to take their worthless paper onto its books at an artificial price.  If our Broad Street Irregulars are accurate, and the Government is buying back substantial chunks of its own newly-issued debt, then what percentage of the Fed’s own balance sheet has any actual market value?


Fed Chairman Bernanke gave a speech last Monday in which he remarked “It’s not obvious to me in any case that there’s any large misalignments currently in the US financial system.”


Will someone please show this man how to get to Sesame Street?




The Goldman, The Badman, And The Uglyman


I like big fat men like you.  When they fall they make more noise.

          - Tuco in “The Good, the Bad and the Ugly”


Realizing that they are now damned if they do, and damned if they don’t, Goldman Sachs has decided to do.  They are preparing to pay out record compensation to their employees, in recognition of a record year.


Suddenly they are getting flak from a most unexpected quarter: their own shareholders.  An as-yet anonymous group of Goldman investors have contacted Blankfein & Co urging them to exercise restraint.  We are not privy to their identity, but clearly they are important enough to make the front pages.  In fact, there is no better group to urge this.  Government, you may be shocked to learn, has neither the ability nor (harrumph!) the standing to legislate morality to Wall Street, or to anyone.  Like Rumpelstiltskin, Goldman has an uncanny ability to spin gold out of straw.  It is a given in their business model that profits are shared with those who generated them.  Indeed, Goldman is one of the few financial firms that fosters any kind of team spirit.  In an industry notorious for Lone Wolves, Goldman pays bonuses based on the overall performance of the firm.  For those who have never worked in the belly of the beast of Wall Street, it is not immediately obvious how unusual this is. 


Yes, Goldman is noted for ruthlessness, for obsessive pursuit of profits, for people whose entire lives mean nothing but the pursuit of money – and later, of power.  But let’s not put too fine a point on it.  Practically everyone who works on Wall Street wishes they could work for Goldman Sachs.  Goldman is hated, more than anything, because they consistently personify the pinnacle of success in the industry. 


Blankfein has been accused of having a tin ear where public sentiment is concerned.  But in fact there is nothing he can say to win approval.  By Wall Street standards, Goldman runs an ethical business.  They do not break the law, they do not purposely send widows and orphans to the poor house.  But they do capitalize on every advantage, and do not stop to weep if their competitors suffer.


It is not the job of Lloyd Blankfein to put a stop to this.  If anything, the shareholders are the proper agents of this transformation.  They actually own the company, and they are the ones both responsible for, and capable of demanding accountability on the part of management.  If they don’t complain to their CEO, who are we to kvetch?


If we can fault Blankfein for anything, it is his efforts to smooth things over.  As reported, for example, by the Financial Times (18 November, “Goldman Apologises For Crisis And Pledges $500m To Small Business”) the firm is taking steps calculated to burnish its public image.


To put it in perspective: $500 million over five years is not a lot of money for Goldman Sachs.  The stated target of these funds is “small business” – Main Street.  Goldman’s $500 million is small beer in context, both of its own finances, and of the magnitude of the problems facing America.  It is a major step, however, if other financial institutions fall in line.  We applaud Goldman for showing leadership, and we wonder whether any other firms will follow.  Goldman is already being taken to task for the paucity of its offer.  The FT article starts off by observing that the amount is “about 2.3 per cent of its estimated bonus and salary pool for 2009”.  They just can’t win.  And they won’t unless it becomes a movement.  We wonder whether the shareholders of any other banks will pressure them to follow Goldman’s lead.  With no other takers, Goldman’s gesture will be seen as cynical and criticized as too little, too late.


Oh, and a final word to Mr. Blankfein.  Forget the apology.  Apologizing went out of fashion earlier this year.  No one is listening.  You can beat your breast all you want, but you can’t hold a candle to the Apologizers’ Gallery that paraded across our television screens earlier this year.


In the month of February alone, John Thain apologized to Maria Bartiromo for his wastebasket; William Ackman apologized to his investors for Target; the heads of Royal Bank of Scotland and of England’s HBOS bank apologized to Parliament for their banks’ rotten judgment – the standout was Fred “The Shred” Goodwin of RBS who offered up this heartfelt plea: “I apologized in full and I’m happy to do so again.”


And of course, Mr. Blankfein, let us not forget the Apologizer-In-Chief who, after being caught with his Presidential trousers around his ankles over the succession of tax cheats he tried to name to his cabinet, bravely told the American people “I take full responsibility”.  Let’s face it, apologizing is done.  You can’t even win on that score.


What’s a Blankfein to do?


For our money, Mr. Blankfein, we think you just keep on doing what you are doing.  Cynical as we are – and knowing full well that, in the dirty, nepotistic and conflicted world of Washington and Wall Street, Timothy Geithner will probably be working for you by the end of President Obama’s first term –we think you are doing just fine.


Moshe Silver

Chief Compliance Officer


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