Banks: an Immodest Proposal

Jamie Dimon's shareholder letter inspired me to evaluate ways around another banking crisis. The primary reasons for our current economic crisis are as follows: one, too many banks had lax lending standards; and two, financial and corporate institutions were interlinked to such an extent that conservative behavior was not appropriately rewarded.

In attempting to fix our current problems, we may have sown the seeds for another banking collapse. Currently, too few financial institutions hold too much of consumers' assets. This problem has gotten worse as concerned consumers have withdrawn their assets from smaller entities and placed them in larger institutions. In addition, the government has allowed large banks to take over smaller banks' assets. This has benefited large banks by giving them more assets but has also increased systemic risk. Whenever fewer players exist in any game, power becomes concentrated and competition decreases, which hurts everyone on the outside, i.e. consumers. Right now, Wells Fargo (WFC) currently holds over a trillion dollars in assets. But in 1950, Wells Fargo's combined assets were less than $3 billion. In 1985, the number increased to $50 billion. Prior to the Wachovia acquisition, it held $610 billion, still well short of its current $1.5 trillion. JP Morgan (JPM), after its WaMu acquisition, is now the largest credit card issuer in the nation. There is some good news--after the recent financial turmoil, several investment banks, such as Goldman Sachs (GS), have become mere banks, falling under broad government regulation for the first time. Even so, with fewer financial institutions holding more assets and liabilities, it is unclear whether derivatives and other risky contracts have been sufficiently curtailed, or whether the new assets given to the larger banks have allowed them to maintain the previous system, which led to our current banking collapse.

In 2002, one bank, J.P. Morgan Chase, accounted for $26 trillion of derivatives all by itself. (Again, that's $26 trillion, not $26 billion.) Thus, it's fair to say that JP Morgan knew about the massive risk inherent in its derivatives in 2002--or at least five years before systemic risk spiraled out of control, causing our current economic collapse. Yet, JP Morgan survived through 2009 and appears to be one of the last standing well-managed banks. You can draw two conclusions from this result. One, derivatives or increased financial regulation is unnecessary. JP Morgan being able to extricate itself from derivatives to avoid collapse shows that individual decisions matter, not regulation. Or, two, even though JP Morgan and other banks knew about the massive danger of derivatives in 2002, the system allowed this massive risk to continue unabated for years. As a result, other banks continued to trade derivatives and caused the entire banking sector to suffer, leading to a recession affecting all banks, not just poorly-managed ones. Ergo, we cannot rely upon all banks having excellent CEOs, so we must strictly regulate banks to avoid systemic collapse.

Even if you ascribe to the second conclusion, you must still draft reasonable regulation. To this end, I offer the following:

1. No individual financial institution shall hold more than $75 billion of consumer [non-business individual] assets.

2. No individual financial institution that holds consumer assets shall have liabilities, including derivatives contracts, of more than $1 trillion.

3. Financial institutions may have liabilities of more than $1 trillion only if they meet two conditions: a) they must not hold any consumer assets or consumer loans, such as credit card debt or home mortgages; and b) they must buy insurance covering at least 75% of their liabilities. (This regulatory framework shifts the burden to insurance companies, not the government, to determine appropriate risk pricing. One problem with this framework is that the government must rely on Moody's (MCO) and other ratings agencies to act as ethical middlemen, but the government can more easily regulate ratings agencies than financial institutions. The government can also create its own financial ratings agency, like a "ratings USPS," while Moody's and S&P become FedEx and UPS. You're probably wondering how this framework would prevent another AIG bailout. It wouldn't, but if ratings agencies do their job and evaluate risk properly, an AIG won't ever happen again. The real issue is eliminating conflicts of interest in the ratings agencies, which probably shouldn't be publicly traded companies. Ratings agencies should be focused on prudent accounting, not increasing growth and profits per share.)

4. The FDIC insurance cap on all financial accounts (not investments) shall be raised from $250K to $650K permanently. (On January 1, 2010, FDIC deposit insurance for all deposit accounts—except for certain retirement accounts—will return to at least $100,000 per depositor.) This change may encourage Republican support, because it would help one of their core constituents, the rich. It would also help blunt cries of socialism, because again, this change helps mainly rich people. What rich person wouldn't want the government to insure all of his or her personal accounts up to 650K? This change may also cause the rich themselves to spread their wealth among different banks--increasing overall systemic health--instead of having their money with just one or two financial institutions.

5. Financial institutions that fall under these new regulations shall have five years to comply. The government stresses that there is no single way to comply with these new regulations. For example, financial institutions may spin off new entities to shareholders; they may sell assets to other entities to meet their new threshold; or they may use other methods to fall under the new threshold amount.

6. The Federal Reserve shall, in its sole and independent discretion, have the authority to raise the "trillion dollar" liability threshold once every calendar year, but if it wishes to increase the existing threshold by more than $750 million, it must receive Congressional approval.

Credit unions would benefit from this new legislation, and rightfully so. Did anyone notice that no consumer credit unions have collapsed? (Two corporate ones have collapsed, but these are different from credit unions that serve consumers.) Financial institutions which stayed true to their bread-and-butter business--making conservative loans and paying consistent dividends to shareholders--did well. Why not encourage them instead of the bad banks like Citigroup (C) and Bank of America (BAC)?

As for the inevitable lawsuits, the government would be acting under its anti-trust authority as well as its general welfare powers. No "taking" occurs here. Banks have five years to create a safer framework that maximizes shareholder value in any way they see fit. Most shareholders would end up owning shares in multiples companies and banks, not just one. There is no reason the value of their assets/shares must decrease--in fact, it may increase. As a result of the banks' complete discretion on how to spin off or create other entities and the long time period they have to do so, any "taking" is speculative and financial institutions cannot reasonably make such an argument under the 5th Amendment.

More specifically, the economic impact of the regulation is reasonable because a) the government is not violating or voiding any contracts, and to the extent it is doing so, such contracts may be re-negotiated in three to five years to produce a reasonable result; and b) the government is not taking anyone's property. It is simply ordering financial institutions to modify their own businesses to prevent massive systemic risk--it is not telling them how to do it. This is just like telling a restaurant it cannot have more than 1000 people dining in a certain square footage area. The government isn't taking the restaurant's customers--it's just telling them to modify their practices to prevent a fire hazard. The same principle applies with the proposed banking regulations.

The regulation's impact on investor-backed expectations is also negligible. No investor can reasonably argue he or she is entitled to create massive systemic risk when a) the government is not gaining any money whatsoever; and b) the investor does not necessarily lose any money if the banks handle the transition properly.

The more I think about it, the more I believe that "too big to fail" ought to be "too big to exist." Perhaps the government will come to this conclusion before the next financial crisis happens. I doubt it, though. The main people who would benefit from these new regulations would be average Americans. Unfortunately, Congress stopped listening to them a long time ago.

Bonus: another perspective, from Bob Wilmers:

At the shareholder meeting, Wilmers emphasized the performance of the "good" banks, the more conservative "community banks" that did not become players in the "virtual casino" of our financial markets. He also dissed the bank regulators, including the useless, dim-witted Office of Thrift Supervision. He calls OTS the "place to go ... if management of an institution wanted to be an aggressive player in the banking industry with a minimum of supervision."

Update: I can't believe I missed this Glenn Greenwald post:

Senator Richard Durbin (D-IL): "And the banks -- hard to believe in a time when we're facing a banking crisis that many of the banks created -- are still the most powerful lobby on Capitol Hill. And they frankly own the place."

JP Morgan's Annual Shareholder Letter

I don't know how I missed this. Jamie Dimon lays out a summary of the banking crisis so well, his letter should be required reading for all investors and business students:

http://investor.shareholder.com/jpmorganchase/annual.cfm

From page 23: We believe our nation can and should be able to provide health care coverage for all. It is the right thing to do, it will help us build a stronger nation, and, if done properly and efficiently, we believe it ultimately will be cheaper than the current course we are on.

I love the fact that Dimon is for subsidized health care coverage. Almost anything seems better than our current system, which has created massive future entitlements while failing to cover millions of Americans.

Let's not forget--according to most reports, Sandy Weill, the former CEO of the now-disgraced Citigroup, didn't get along with Jamie Dimon. Mr. Dimon should be quite happy how things have turned out.

More on how to avoid another banking crisis here.

My Facebook Debate on Torture

Here is an ongoing debate about torture I'm having on Facebook. Tom is from Dallas, Texas, the state that elected George W. Bush several times. Sean has an advanced physics degree and works for a government lab. I don't know Evan.

Sean: Mr. Obama claims the enhanced interrogation techniques are a "recruitment tool that Al Qaeda . . . used to try to demonize the United States and justify the killing of civilians." However, the 1993 World Trade Center bombing, the Khobar Towers bombing, the African Embassy bombings, the Cole, and 9/11 all happened before George W. Bush waterboarded Khalid Sheikh Mohammed, Abu Zubayda, or Abd al-Rahim Al Hashiri.

Evan: What an amazing perspective. So, you're trying to say that chronology matters when discussing these issues? Hmmm.... Bold. Very bold.

Me: The fact that some terrorists were anti-American years before 9/11 does not preclude the idea that our inhumane conduct towards prisoners increased the size and the intensity of terrorist threats. Look at it this way:

1. I've hated apples since 2001.
2. Yesterday, an apple truck dumped applesauce all over my lawn, causing me to pay 100 dollars to clean it up.
3. Now, I hate apples even more, and thanks to the apple company's negligence, it's easier for my neighbors to see why I hate apples, and also harder for pro-apple people to defend their product.

Under your theory, you would argue the apple company's negligence had no impact whatsoever on sentiment, credibility, and the safety of the next apple truck. Common sense tells us otherwise. And you're not seriously arguing that Abu Ghraib had no impact whatsoever on anti-Americanism and the terrorists' ability to influence more recruits, are you?

Evan: I would ask you, what did you do to Apple farmers to get the truck dumped all over your lawn? Did you, you know, go kill an apple farmer's whole family? Burn down his house? If you did neither, than your analogy falls apart. If you did either, or something similarly horrific, either your neighbors will see why it happened or are likely to also share your hatred and support your horrific acts.

I mean... seriously, neither 9/11 nor any of the actions and policies taken against Muslim extremists were accidents. But, one was first. And, actually, saying 9/11 was first is not even correct, as pointed by Sean in the original comment.

These extremists are not rational, either. So, using standard analogies on them is really fruitless as well. It just doesn't hold up. Next thing I bet we hear is the people who went after the financial funding of the terrorist orgs will be prosecuted, because the terrorists have kids too and those kids are hungry and the UN doesn't want kids being hungry.

Tom: Suppose you know the apples are coming for your lawn again. You have a senior apple in custody at a time when apple chatter is similar to the apple chatter that preceded the last major lawn event. You have reason to believe the senior apple has information that will save lawns. Shouldn't you squeeze that information out of the senior apple, if it is the best you can get and it will save lawns?

Me: Some radicals think they have plenty of support for a "blowback" theory--the overthrow of the Shah, support for Afghanistan fighters during the Cold War, "bribe" money to Egypt, Jordan, and Israel, etc.--but I wasn't referring to a "blowback" theory. Anyone can point to an event at a certain point in time and use it to further his or her agenda. Intelligent people look beyond chronology to determine whether an action or response makes sense.

Torture (squeezing the apple) has not been shown to produce viable information. The FBI has already said this (see Ali Soufan). Thus, if you are pro-"squeezing the apple," you're going against the current U.S. administration, the FBI, and the U.N.--in other words, you're on the fringe, b/c credible people with more information than you are telling you torture doesn't work.

http://www.nytimes.com/2009/04/23/opinion/23soufan.html

Me: Oops, meant overthrow of Mohammad Mosaddeq, not the Shah (see "Operation Ajax"). Anyway, on a separate note, check out the story of Iran Air Flight 655. Neither example is necessarily relevant to 9/11, b/c the 9/11 attacks were caused mainly by Saudi/German residents.

http://www.history.com/content/militaryblunders/iran-air-shot-down

Tom: Thanks for pointing out what intelligent people do and think. It is beyond consideration that anyone who disagrees with you might also be intelligent. Please pass the word that anyone who plans to think a thought should pass it by you before wrapping themselves in the mantle of intellect. Thank you, great one. Please continue to protect us from ourselves.

Sean: I don't believe for one moment that even a single Al Qaeda recruit ever decided on news of waterboarding at Guantanamo to pack his bags and head for the nearest training camp. They have a preexisting proclivity to hate us. They despise the United States for our culture and envy us for our power. The United States is a constant reproach to them: We are rich to their poor, strong to their weak, vigorous to their idle, can-do to their sit-and-wait. If we were weak, we would not be hated. If we were poor, we would not be hated.

Furthermore, this notion that the enhanced interrogation techniques applied to Khalid Sheikh Mohammed, Abu Zubayda, or Abd al-Rahim Al Hashiri didn't produce actionable intelligence and foil plots to kill Americans is a shibboleth of the left.

Did anyone else notice the Mr. Obama failed to rebut Mr. Cheney's point about what the enhanced interrogations yielded? All indications are that they were spectacularly successful.

Now that he has declassified and released details of the enhanced interrogations themselves, Mr. Obama should declassify and release the results of those same interrogations so we can all judge for ourselves whether or not they are worthwhile.

Tom: Furthermore, assuming Khalid Sheikh Mohammed was water boarded 183 times (as erroneously and repeatedly reported; there were up to 183 'pours' that occurred in about 20 sessions) I have a hard time finding a problem with it. If the first instance was the only fruitful one, and the rest were for sport, he was still a planner of the 9/11 attacks. I don't care if he was gang raped by giraffes 183 times. Don't try to mess up my cities.

Evan: The 'aggressive interrogation is not proven to get accurate information' is a tough pill to swallow. Interrogation is, really, an art, not a protocol. It is an extremely personal and emotional task, something that is difficult to actually study. And, when you mix in the counterintelligence that Bin Laden's followers have been trained to deploy, and it gets very murky. Show me a sample group for that study that matches up well to the Jihadists that we're up against. I'm going to guess that the 'aggressive interrogation doesn't work' data comes from po-dunk cops that went overboard. Our guys trying to get info to save our country from Jihad are so far beyond your everyday cop.

Also, remember, there are journalists who have volunteered to be waterboarded. They probably saw video of it and figured "wow... that's mean, but I could handle it"... you don't see journalists volunteering to have their eyes poked out or legs broken, repeatedly. Waterboarding is different.

Me: A couple of quick points--first, chronology itself is not meaningful without studying the actual details of the events themselves. For example, if I kicked you ten years ago, it may have nothing or everything to do with whether you kick me fifteen years later. More information is necessary to determine the relevance, if any, of the events, especially when reviewing events that occurred years apart. [i.e.,] Details of events themselves are necessary to determine the relevance of the dates of the events. This statement seems so clear, it is surprising anyone even tried to refute it. Tom, I notice you attacked me personally on the issue of chronology and didn't address the actual points I made regarding the actual issue--and no else did, either. Tom, I make no comment regarding your intelligence--your own failure to address the actual content of my statement speaks for itself.

Let's move on to Evan and Sean. First, I agree with Sean that the American people should be able to review the results of the interrogations at some point, hopefully soon. But Sean, your next statement--"All indications are that they were spectacularly successful"--is based on speculation. No one here knows whether the interrogations were successful or unsuccessful because we don't have evidence. We do know, however, that an FBI agent and our administration have told us torture does not yield good information, and the administration has access to the interrogation results. I also notice that no one commented on the NY Times article I linked to.

Evan, you make an excellent point; however, other countries have used torture against terrorists for years--just look at Egypt, Syria, and Israel. These countries haven't published/disclosed results of their interrogations. Without evidence, we cannot speculate. There is a reason speculation is inadmissible in a U.S. court of law. I agree that interrogation is an inexact science. But what we've done--waterboarding, dogs, insects, stripping, etc.--seems designed more to humiliate than to get information. That makes no sense to me. I want good information, and most interrogation experts agree torture doesn't work. Threatening torture against a weak, disconnected individual might produce some information--but there are miles between a threat and the actual torture itself. Here's a good article on interrogation--note the absence of waterboarding, insects, etc:

http://www.theatlantic.com/doc/200310/bowden

There is a diff btw torture and coercion. Where do we draw the line?

Sean: I'm pretty sure the line is drawn between what Syria, Iran, Saddam's Iraq and Egypt do and what we do. I think that's one way to tell the difference between torture and intense interrogation.

Tom: It was not a personal attack to simply note your arrogance. I didn't comment on chronology, as you seem to be arguing a specific point that is both simplistic and inconsistent with the original point of the status. Chronology is important. No claim was made that nothing else was important. Therefore, strenuous arguments about how chronology is not the only thing to consider are largely irrelevant. Consequently, my disregard was mistaken for the absence of a meaningful response.

Evan: I say +1 with Tom... And, about the FBI agent and the administration. The FBI is always straightforward, and the Administration, this administration, is obviously straightforward on everything. That's why the whole administration spent the day covering the disaster that is Biden's mouth... Yeah, that administration. I think there is proof that the... Read More interrogations were successful in the fact that we haven't been attacked since 9/11, even though we've been 'provoking' people to do just that with our 'horrible foreign policy' (I use quotes because I believe provoking is actually preventing, and 'horrible foreign policy' is actually a strong foreign policy) Once again, the chronology seems to add up.

Me: The American people have voted against Bush and the very policies you support. I am just sad it took eight years and an economic collapse to get there. At the end of the day, we are all Americans, and I think most Americans can at least agree that the last eight years have been torture :-) While I cannot understand people who advocate torture/waterboarding, I am quite pleased we are able to have a civil discussion that may, in time, cause us to broaden our horizons.

Update: the debate continues, and now it's reached 61 comments. I will include the most recent snippets:

Me: The next time an American soldier gets captured and tortured by foreign enemies, I will contact all three of you and ask you to write an apology to the families of the Americans. You ideology will hurt Americans. If I ever contact you, don't shirk away--man up and apologize for indirectly hurting Americans and for directly harming America's reputation, which has served us so well from Eisenhower until Clinton. Traitors don't know they're traitors. No traitor ever does. That's why it's important to analyze one's beliefs and evaluate whether they will harm the nation, its civilians, and its soldiers. Over 4,000 Americans have died in Iraq post-9/11, fighting in a country that had no connection to 9/11. We fought a war based on what we now know were speculative threats. We engaged in torture in Abu Ghraib as a result of Americans like you playing around with the definition of torture. Americans are now less safe, if only b/c the economic consequences of war have harmed us.

Evan: You are calling me a traitor? Unbelievable. You seem to have a very narrow definition of diversity. It's beginning to be very offensive.

Me: I did not call you a traitor. Read my comment carefully. It's a general comment, not a specific one, and it could conceivably apply to myself. There's at least one thing, however, that definitely separates us--the next time an American soldier gets tortured, waterboarded, beaten, and deprived of sleep, I will have the moral ground to protest--you won't. That doesn't mean you're a traitor--it does mean your beliefs indirectly endanger Americans by blurring the line between acceptable conduct and unacceptable conduct. Your refusal to condemn torture and its inevitable slippery slope during times of war means you have no standing to protest or condemn anyone when abuse of American soldiers occurs. You are consciously trading off America's right to condemn torture of its soldiers in exchange for having a pro-torture policy that *might* produce relevant information. I refuse to make that trade-off when no reliable study has shown that torture produces reliable results.

Restaurant Review: Chaat Bhavan

I really liked a new Indian vegetarian restaurant, so I wanted to share it with my readers. It is located at 5355 Mowry Ave, Fremont, CA 94538 (510-795-1100). Its website is www.chaatbhavan.com (the site loads slowly initially, so be patient). If you're vegetarian, you will love this place; if you're not, you will still love this place.

I ordered the following items:

Dahi Bateta Sev Poori, which is basically crispy noodles with yogurt and chutney.

Bateta Vada, which is potato balls with spices and chickpea flour.

Pav Bhaji with Papad, an orange-colored dish with steam cooked vegetables.

Raita, which is yogurt with different vegetables and spices.

With those four dishes, my friend and I left feeling full, all for less than 35 dollars.

Disclosure: I have no ties whatsoever to this restaurant and have not been given anything in exchange for this post.

Party Like It's 1931?

The CS Monitor's New Economy blog has an interesting post today. I'm not sure past comparisons offer much value today, but when no one knows the future of the market, all they can do is look backwards.

I am in mostly cash right now, even in my retirement funds. I may miss a rally, but real property and cash seem safer than stocks right now. Also, I don't have to keep my cash in low-yielding American dollars. I recently bought the Mexican peso (FXM) and will be looking to buy the Australian dollar (FXA) as well.

Founding Principles: a Majority Shall Not Engage in Tyranny

From Hon. Judge Michael W. McConnell's majority opinion, INITIATIVE AND REFERENDUM INSTITUTE v. WALKER, 450 F.3d 1082 (10th Cir 2006):

One of the Fathers' cardinal concerns was that democratic government not lead to tyrannical rule by a majority over a minority. "When a majority is included in a faction, the form of popular government . . . enables it to sacrifice to its ruling passion or interest both the public good and the rights of other citizens." The Federalist No. 10, at 106 (J. Madison) (Hamilton ed. 1868). The Founders did not think the problem of majority abuse of minorities was limited to those in government: they were particularly worried about the ways in which a majority of the people could impose their will impose on a minority. "The prescriptions in favor of liberty, ought to be levelled against that quarter where the greatest danger lies, namely, that which possesses the highest prerogative of power: But this is not found in either the executive or legislative departments of government, but in the body of the people, operating by the majority against the minority." James Madison, Speech of James Madison to House of Representatives (June 8, 1789) in Daniel A. Farber & Suzanna Sherry,A History of the American Constitution 227, 229 (1990).

Or, we can just quote someone who once said, "Democracy is two wolves and a lamb voting on what to have for lunch." I'll leave you with an amusing spinoff from that quote:

A Democracy: Three wolves and a sheep voting on dinner.

A Republic: The flock gets to vote for which wolves vote on dinner.

A Constitutional Republic: Voting on dinner is expressly forbidden, and the sheep are armed.

Federal Government: The means by which the sheep will be fooled into voting for a Democracy.

Freedom: Two very hungry wolves looking for dinner and finding a very well-informed and well-armed sheep.

Small Things (a poem)

Small Things

Swine flu is in the air.
CNN promises not to fear-monger as the word “pandemic”
flashes across the screen.
I think of the Mexican peso first, then of the Mexican people dying.
It occurs to me my priorities are screwed up.

But then I realize that’s the point--the constant scramble
to survive
to make money
to take care of your family,
It re-arranges everyone’s priorities,
forces people to think ahead, not backwards,
and it seems to work, until it doesn’t.

President Obama’s on the screen now,
talking about that flu again.
I think of the Mexican people first this time.
I think about the American schools shutting down,
and American kids happy to stay home.
I think of how a small thing can multiply into a big thing
and make its way up here without warning.

And then I realize a good thing can also multiply
And come here,
Something we’d never thought about before
until it came here
and changed our lives.

Small things, like six-year old Pierre Omidyar,
arriving in America from France,
his parents from Iran,
Not knowing their little boy would create eBay.

Small things, like Paul and Clara Jobs
adopting a little half-Syrian boy
born in Milwaukee
and bringing him to Mountain View, California,
where he would grow up and give us Apple Computers.

Smaller things, too, like 27 dollars loaned by a man in Bangladesh
who spoke at Stanford in 2003
and caught the ears of Matt and Jessica Flannery,
who then founded Kiva.org.
Soon came millions of dollars to help the poor.

Small things become big when they cross borders
undeterred by risk, failure, or fear.
They come, these small things,
flu particles, yes, but also the seeds of a bright future,
Burrowing their way forward.

(2009)

Wells Fargo Shareholder Meeting (2009): the Age of Uncertainty

I attended Wells Fargo's 2009 annual meeting today in San Francisco, California. Wells Fargo (WFC) did not seem to anticipate such a large crowd attending its meeting. It had to scramble to set up more chairs in an adjacent viewing area where shareholders could view the meeting on a large video screen. In a scene reminiscent of a Friday night club, some shareholders (including myself) had to wait downstairs before security allowed us to take the elevator to enter the meeting. Per its conservative image, Wells Fargo did not offer any coffee or refreshments. I asked an employee whether Wells Fargo had served coffee or refreshments at last year's meeting, and she said she didn't remember Wells Fargo serving food or drinks at any annual shareholder meeting.

Chairman Richard "Dick" Kovacevich spoke first and appeared in a good mood, making several well-received jokes. He earned my respect for being forthright in this earlier speech, where he stated, "We [the financial sector] really caused this crisis."

After the formal portion of the meeting had concluded, he turned the meeting over to President and CEO John Stumpf. First, let me give you some visuals. Mr. Kovacevich is a tall man who exudes confidence in a friendly way. Mr. Stumpf, on the other hand, is shorter, more intense, and much more brusque. I would almost compare them to Robert DeNiro and Joe Pesci (Goodfellas or Casino, take your pick)--effective men, each in his own way.

Mr. Stumpf delivered a short presentation. He began by rattling off all the names of failed financial institutions--AIG, Bear Stearns, Countrywide, Fannie Mae, Lehman Brothers, Merrill Lynch, and WaMu. These are "difficult times," he said. He went through some slides showing that Wells Fargo had made money and continues to grow. One slide was confusing--it showed WFC reporting $0.70 of diluted EPS, but had a shadow area that added $1.51 in EPS, which assumed the inclusion of credit reserves. Including the credit reserve build, the additional EPS would have brought the numbers in line with previous earnings. I did not understand what the additional EPS meant, and even after I asked Mr. Stumpf to explain it again during the Q&A, I still didn't fully understand it. (My current understanding is that Wells Fargo had set aside billions of dollars to cover expected future loan losses, especially due to the Wachovia acquisition, and had it not been forced to account for its expected losses, its earnings per share would have increased.)

Mr. Stumpf talked about the dividend and the "difficult decision" to cut it. He indicated WFC would increase the dividend when "practicable" to do so. Wells Fargo's cutting of its dividend signals a tectonic shift. If you go back to a time when banks were staid creatures, people would buy banking shares for the dividend. They expected that a bank would slowly and conservatively increase deposits and make more loans over time, allowing the bank to steadily increase its dividend. As a result of their consistent dividends, banking stocks were called "widows and orphans" stocks--held by husbands to protect their families when they died. That age is over. Banks have lost the public's trust, and with it, we have entered a new world of uncertainty. This change is shocking because even banks that acted conservatively, like Wells Fargo, had to cut their dividends, breaking their implicit promise to maintain steady payouts. If there is one unfortunate lesson to be learned from this crisis, it's that being good didn't pay off. As a result of widespread and creative financial engineering, the good banks got sucked into the morass created by bad banks like Citigroup (C) and Bank of America (BAC). Now, senior citizens looking for income have few places to invest. Even preferred shares are suspect.

Mr. Stumpf returned to his theme of consistent growth. He said that even during this tough time, WFC "grew revenues by 6%" while reducing expenses by 1%. He said the amounts loaned also increased, although most of that increase came from the commercial and wholesale areas, not the consumer. Deposits also increased as a result of the "flight to quality."

Mr. Stumpf then talked about Wells Fargo's two major events: Wachovia and the government's $25 billion investment in Wells Fargo. He said the Wachovia acquisition was going well, and Wells Fargo would pay back the government as soon as practicable. He said companies fail when they confuse their mission with the results. WFC's mission was to help people succeed financially, and the result was that "we make money." Bad companies, he said, mix these up and focus on making money over serving their customers. Mr. Stumpf ended his presentation by pointing out Wells Fargo's charitable contributions, which were impressive.

The Q&A session was longer than usual, and most shareholders had interesting questions. One thing about Mr. Stumpf, though--if he doesn't like your question, he'll give you a quick answer and expect you to move on. Several times, he avoided answering questions by using humor to deflect the question (Those of you who remember my Joe Pesci comparison can start visualizing him saying, "Funny? Funny how?").

One shareholder asked about Citibank's (C) lawsuit against Wells Fargo (which relates to the Wachovia acquisition). Mr. Stumpf said Wells Fargo would defend itself vigorously.

I asked whether the government forced Wells Fargo to take TARP money. After all, if Wells Fargo didn't need it, why didn't they reject it? Mr. Stumpf tried to avoid answering the question, so I asked Mr. Kovacevich directly for an answer. He said government negotiations were confidential, but added, "We did not ask for the money." He said he took the money because it was in the best interests of the company at the time.

Another shareholder talked about a personal issue. Apparently, Wells Fargo had increased his interest rate. The shareholder complained about Wells Fargo's customer service. At first, Mr. Stumpf asked whether the shareholder had a question. (At this point, I started thinking Mr. Stumpf might take a bat to this guy's knees.) After the shareholder meekly said, "I guess I don't have a question," Mr. Stumpf wisely turned on the charm. He said, "I'm sorry," and directed the shareholder to a specific Wells Fargo employee for further assistance.

Another shareholder praised the bank. He was a former employee who had held Wells Fargo shares since at least 1998.

Another shareholder talked about zombie banks and whether nationalization would be a good idea. Mr. Stumpf replied, "We are solvent" and "clearly not a zombie bank." He said his understanding was that the President and Congress had rejected nationalization.

Another shareholder asked whether Wells Fargo anticipated raising its capital base, thereby diluting its common equity shareholders. In a telling sign of how uncertain the current environment is, Mr. Stumpf refused to comment one way or another. When you strip down the optimism, no one really knows. Look at page 78 of Wells Fargo's 10K:

Under SOP 030-3 (Accounting for Certain Loans or Debt Securities Acquired in a Transfer), we recorded at fair value all credit-impaired loans acquired in the merger based on the present value of the expected cash flows...using assumptions about matters that are inherently uncertain.

Essentially, Wells Fargo itself admits its numbers are "inherently uncertain." The only thing we know for sure is that Wells Fargo's earnings received a boost from a recent loosening of the mark-to-market accounting rules. Still, regardless of any accounting changes, at the end of the day, no one really knows anything, because there are too many unknown variables. That's why Wells Fargo accepted $25 billion of our money--it doesn't really know, either, and if it did, it would have paid back the government already. [Update: some banks have already paid back TARP funds. See here.] So of course the CEO can't promise to avoid further capital injections. Of course the CEO can't promise to avoid diluting the common equity shareholders. Like everyone else, he doesn't really know what's around the corner. When historians study this current time period, the honest ones will admit no one really knew anything. It's sheer hope and faith that's driving many Americans, and, by extension, the banks to which they owe money.

I went up to the mic one last time. I told Mr. Stumpf some people think that "too big to fail" should be "too big to exist." I implied that we weren't addressing any of the root causes of our current problems and that this crisis could happen again. I said it was frightening to see the stock market go up and down based on the appearance of the banking sector's good or bad health. I indicated that banks, a relatively small group, had tremendous power over the average Joe's 401k. I said that Wells Fargo had spoken against some regulation, such as executive pay restrictions (see also 10K: page 78), but it hadn't talked about what regulation it favored. I asked Mr. Stumpf to talk about what regulations he favored so that we could avoid another crisis.

Mr. Stumpf had a two-part answer. He said that only 22% of financial assets are held in commercial banks. He said most financial assets are held by unregulated entities, such as AIG (and others who thought credit default swaps were a great idea). At this point, his answer became somewhat confusing. From what I understood (and discussed with an Aussie couple after the meeting), Mr. Stumpf implied that we should expand financial regulation, but without adding another government agency. He did not favor the current situation, where multiple regulatory bodies cover select financial entities while excluding other major financial players. (Or, according to the Aussie gentleman, "Don't go swimmin' without your trunks"--demand everyone have some covering if they want to play in the pool.)

Mr. Stumpf also suggested we should try to minimize systemic risk. He seemed to indicate that all of the banks' assets should come under one umbrella so that the overall risk of the banking sector could be easily ascertained. Again, I am not certain this is what he said, because Mr. Stumpf talks quickly. While he clearly understands complex financial terms and ideas, he seems to have a hard time communicating those ideas to the general public. (This is why WFC needs Mr. Kovacevich--his easygoing, amiable style balances Mr. Stumpf's abrupt demeanor.) From what I heard, however, it sounded like even the banking sector's head honchos acknowledged that greater transparency and governmental involvement were necessary to minimize systemic risk. Perhaps thinking he'd said too much, Mr. Stumpf stopped. That's when I realized the point and theme of the meeting was to project confidence, because at the end of the day, that's what America needs, especially from the banking sector. I think Wells Fargo did an admirable job at the meeting, but again, no one knows anything. Only time will tell whether America exits this banking crisis stronger.

The AP's Michael Liedtke's review of the meeting can be found here. As of the record date, I had 9000 WFC shares. I used margin and felt uncomfortable with the volatility, selling all my shares at around $14/share. Investors who bought Wells Fargo stock recently and had the fortitude to hold on have been rewarded. As I wrote here earlier, an investor could have made 46% had s/he timed the market properly.

Random fact: Warren Buffett owns approximately 7.4% of WFC common shares. See page 13 of Wells Fargo's 2009 proxy statement.

Bonus: The Economist has an interesting article (May 14, 2009: "Three trillion dollars later...") on banking:

http://www.economist.com/opinion/displaystory.cfm?story_id=13648968

Institutional Analysts are Almost Worthless

On December 18, 2008, I bought Maxim at 12.00/share and told my readers about my buy. Maxim is now selling for $13.70/share--a 14.1% increase in four months. The S&P 500 declined 3.1% during this same time period.

At the time I bought Maxim, JP Morgan disagreed with me. On December 16, 2008, JP Morgan's Christopher Danely downgraded Maxim stock to "underweight." In response, I wrote, "Almost all these these analyst downgrades come after the bad news has already been released. Consequently, when a major firm issues a 'sell' or 'underweight' rating, that's when contrarians and value investors should take a closer look at a stock."

My call was obviously correct, but what's really frustrating is that now, after the run-up in the stock price, several analysts are recommending Maxim.

On March 14, 2009, Canaccord Adams upgraded Maxim. Maxim's stock price was $14.05/share.

On March 15, 2009, Citigroup (C) upgraded Maxim. Maxim's stock price was $14.12/share.

If you had listened to these two analysts, you would be losing money right now. I don't disagree with the analysts' upgrades, assuming a long term horizon. I still think Maxim is somewhat undervalued, but I have considerably reduced my holdings and am waiting to re-enter at a lower price.

I continue to be skeptical of institutional analysts and their ratings. We need an independent website that ranks firms and their analysts based on their actual performance over three, twelve, and twenty four month horizons. The website should follow various analysts and rank them based on stock performance following an upgrade or downgrade. Hedge funds or well-off investors have access to such information, but the ordinary public is left in the dark when ascertaining analysts' credibility. That's a shame, because the public's relatively short term memory allows most analysts and their firms to avoid accountability. The Motley Fool has tried to create something along the lines of what I've suggested, but it doesn't track professional analysts.

I have been told that FusionIQ's proprietary software does rank analysts. I have been given complimentary access to the software, but have not had the time to actually sign on and evaluate it. I hope to provide a report on FusionIQ at some point in the future.

Disclosure: I own Maxim shares, and a family member works for Maxim.

Mexico Peso Devaluation

Holy cow, Mexico's currency declined 4.59% against the U.S. dollar in one day. That swine flu...

You can buy Mexico's peso through CurrencyShares Mexican Peso Trust (FXM).

Annual Reports: Part 2

I've been reading my annual reports and wanted to share the items I found interesting:

CME Group, Inc. (CME): this company generates revenues primarily from its clearing and transaction fees. (10K: page 31). In other words, it's a clearinghouse. [Update on 4/27/09: CME also "operates two self-regulatory futures exchanges" and offers information products--I did not mean to imply that CME is only a clearinghouse.] "Many clearing firms [CME's major customers] have expressed the view that...clearing houses should be operated as utilities rather than part of for-profit enterprises." (10K: page 41). Read that again--CME's customers are trying to lower their costs and will pressure CME on its margins.

Also, who's running this show? CME has 33 directors on its board. (10K: page 33) Of these 33 directors, 20--a majority--own trading rights on CME's exchange. CME is "dependent on the revenues from the trading and clearing activities of its members. This dependence may give them substantial influence over how we [CME] operate our business." (10K: page 33)

Duke Energy Corporation (DUK): Duke Energy's primary currency rate exposure is to the Brazilian real. A 10% devaluation in the currency exchange rate in all of Duke Energy's exposure currencies would result in a net after-tax loss on the translation of local currency earnings of approximately $10 million in 2009. (10K: page 31).

Interesting partnership with Walmart (WMT): "In a unique agreement with Wal-Mart, beginning in the second quarter of 2009 and for the next four years, our Texas facility will supply wind energy for a portion of the total energy used by more than 350 stores." (Shareholder Letter: page 7)

Goldman Sachs (GS): on the very last page of its 10K, Goldman Sachs lists its "Business Principles." Definitely worth a read, although I choked a little when I got to, "Integrity and honesty are the heart of our business." You can read the list of principles here.

Google Corporation, Inc. (GOOG):

International influence: "when Venezuelan broadcaster El Observador was shut down by the government, it started broadcasting on YouTube." (Shareholder letter)

Hear that, Microsoft?: More than one million organizations use Google Apps today. (Shareholder letter)

The future: "Computers will be 100 times faster still and storage will be 100 times cheaper." (Shareholder letter)

Holy cow, did Google just admit its P/E is too high?: "We believe our revenue growth rate will generally decline as a result of a number of factors including increasing competition, the inevitable decline in growth rates as our revenues increase to higher levels and the increasing maturity of the online advertising market. We believe our operating margin will experience downward pressure..." (10K, page 19).

Despite all its cool programs, Google is basically an advertising company: "Advertising revenues made up 99% of our revenues in 2006 and 2007 and 97% of our revenues in 2008." I wonder what caused that that 2% difference? DoubleClick?

Harvest Energy Trust (HTE): this stock is not a currency hedge. A lower Canadian dollar (relative to the U.S. dollar) actually helps the company's bottom line.

Jack in the Box, Inc. (JACK): first, kudos to JACK for maintaining its stock price. If you had bought and held JACK from January 2008 until now, you'd be about even. In a market where most stocks have dropped 30%-45% in that same time period, JACK and CEO Linda Lang deserve recognition. By the way, to those companies who claim they cannot find women to be on their Boards, how about Ms. Linda Lang? She's the closest thing to a miracle worker you can find right now.

Here's one reason JACK has done well: "Our focus continues to be on premium products versus deep value or discounting messages." (Shareholder letter)

Move towards franchising: "Jack in the Box transitions to a new business model comprised of predominantly franchised restaurant locations." "Our long-term goal is to increase the percentage of franchise ownership to the 70% to 80% range by the end of fiscal year 2013." (Shareholder letter) I hope this doesn't diminish JACK's brand. In my experience, franchisees tend to have worse customer service compared to company-owned locations.

Morton's Restaurant Group (MRT): Anyone with an extra invite to a Boardroom event, let me know: "Morton's continued to aggressively promote private dining for meetings and special occasion events in our private dining Boardrooms...Boardrooms generated approximately 19% of Morton's revenues in fiscal 2008." (Shareholder letter)

New York Times (NYT): "More than 40% of our full-time work force is unionized." (10K: page 11); "As of December 28, 2008, the underfunded pension obligation for our qualified pension plans was approximately $643 million." (10K: page 44).

Panera Bread Co. (PNRA): this one has nothing to do with PNRA's annual report. I just wanted to thank PNRA for its customer service. I recently lost a gift card at Panera Bread's Campbell, CA location. It had about 75 dollars left on it. I spoke to the local manager, who told me to call another PNRA representative. I got in touch with Robert J. and explained what happened. I faxed him my last two receipts (I keep my last two receipts to keep a record of transactions).

Robert told me PNRA couldn't track down the card without the full number on the back of the card, but he would see what he could do. He told me he'd get back to me within a few days. He actually did. Despite PNRA's and most companies' policies that the value of their gift cards will not be replaced if lost or stolen, he re-issued me the card. Now that's good customer service.

Word to the wise: whenever you get a gift card, write down and save the full number on the back, or register it online. Many companies allow an outside contractor to handle gift cards, so there's little communication in how to track the card. As a result, even with the most recent receipt, it's difficult to track down a lost gift card.

Customer service is important. In fact, it's the main way food retailers can differentiate their product. I used to go to McDonald's (MCD), because I really liked their coffee. Over time, some McDonald's locations got lazy. Some of its franchised locations would not offer half-and-half or sugar, or their half-and-half would be left on the counter, unchilled for hours. (This didn't seem to happen at non-franchised locations.) Anyway, when I wrote McDonald's customer service, they apologized and said they would fix it. After some follow-up communications, they contacted the supervisor at the location and copied my entire email to her. I was really upset--I had thought my complaint was anonymous--what customer in a food establishment wants the staff to know he's complained about them? Here is a snippet from my email to McDonald's, in case readers are interested:

The eggnog shake machine wasn't working, so I got a vanilla shake with gunks of yellow in it, rather than a smooth yellow shake. To the manager's credit, she allowed me to substitute another sundae for the eggnog shake, but she didn't seem to understand that my large shake was more expensive than a sundae. I know these are minor complaints, but McDonald's has more competition these days. You are competing against Starbucks and Panera, not just BK and Taco Bell. You are failing miserably in terms of service.

You need to analyze more why workers at Panera and Starbucks are more courteous than McDonald's and take action. Although your products and prices are competitive, you will lose market share if customers feel they can get better service elsewhere.

I've stopped going to McDonald's, even though I like their coffee. And I don't own McDonald's stock.

Pepsico, Inc. (PEP): Kudos to Pepsi for its colorful, descriptive 10K. After seeing page after page of different Pepsi products, I started wondering if Pepsi was the world's main supplier of food and drink.

Pepsi's motto: "joy, optimism and energy" (10K: page 6).

Walmart's influence: "In 2008, sales to Wal-Mart Stores, Inc. (Wal-Mart), including Sam's Club, represented approximately 12% of our total net revenue." (10K: page 45).

Playboy Enterprises (PLA): some interesting acronyms: PPM (per per month); VOD (video on demand); and SVOD (subscription package). Apparently, most companies are focusing on VOD. (10K: page 9).

Best summary of a company ever: "Playboy magazine is a general-interest magazine, targeted to men, with a reputation for excellence founded on its high-quality photography, entertainment, humor, cartoons, and articles on current issues, interests, and trends." (10K: page 9). Perhaps Playboy's corporate lawyers really do read Playboy for the articles.

Demographic of Playboy subscribers: median age is 35, with a median annual household income of approximately $59,000. (10K: page 9).

It's a small company: Playboy only has 626 full-time employees, at least as of February 27, 2009. (10K: page 12).

Also, in case you didn't already know, Hugh Hefner essentially owns the company. Mr. Hefner owns 69.53% of the Class A voting shares (10K: page 20). Class B shareholders--apparently, most of the shares owned by the average Joe--cannot vote, although they can come to the annual meeting in Illinois.

Wesco Financial Corporation (WSC): Charles Munger compares his company with Berkshire and basically tells the public to buy Berkshire instead of Wesco: "Business and human quality in place continues to be not nearly as good, all factors considered, as that in place at Berkshire Hathaway. Wesco is not an equally-good-but-smaller version of Berkshire Hathaway, better because its small size makes growth easier." (10K: page 7)

Wynn Resorts (WYNN): some internal family drama: "Elaine P. Wynn is married to Stephen A. Wynn, but an action to dissolve their marriage has been filed."

At least the nephew's doing all right: "Andrew Pascal is the President of Wynn Las Vegas LLC...Mr. Pascal is the nephew of Mr. and Mrs. Wynn." (page 8, proxy statement)

Macau is where it's at: "Macau generated approximately $13.6 billion in gaming revenue in 2008...making Macau the largest gaming market in the world." (10K: page 6)

SJM in Macau: "SJM, which is controlled by Stanley Ho, operates 19 of the 31 existing casinos [in Macau]." (10K: page 6).

Sharing the wealth: Wynn is charged a special gaming tax of 35% of gross gaming revenue and "must also make an annual contribution of up to 4% of gross gaming revenue for the promotion of public interests, social security, infrastructure and tourism." (10K: page 13) Is it just me, or does that 4% look like a source of kickback money to government officials and their friends? I also like the language of "up to" 4%. Who determines the actual percentage? Seems like a material point.

Bring cash, please: for purposes of the gaming tax, Wynn cannot include deductions for gaming bad debt. (10K: page 22)

A pet peeve from a former English major: does anyone at Wynn own a Strunk and White style guide? In some places, the period or comma was placed outside the quotation marks, instead of inside. (10K: pages 4, 6) This ain't the U.K., buddy.

Note: Part 1 is here.

Torture Still up for Debate, and a Bill Maher Joke

From "The Issue of Torture is not about its Efficacy":

http://www.cogitamusblog.com/2009/04/the-issue-of-torture-is-not-about-its-efficacy.html

I never really imagined in all of my 49 years on the planet that there would seriously be a debate in the United States about whether it is alright to torture a prisoner. I don't think of myself as naive or unjaded, but it just always seemed pretty clear to me that American political culture would not sanction the overt use of torture as a legitimate means of intelligence gathering or war fighting.

The NYT's Frank Rich talks about torture here. And he makes so much sense, you will ask yourself, "Where was he six years ago?"

Ah, the days of innocence.

Here's something funny to balance out the bitter. Bill Maher mentioned California's beauty pageant contestant, who may have lost the crown because of her opposition to gay marriage. (She said she favored "opposite marriage.") Here's what Bill Maher had to say:

She's extremely Christian, kind of hot, and she's dumb...It looks like the Republicans have a new Vice Presidential candidate.

I think the GOP might be considering it. Sigh. Where's a Barry Goldwater when you need one?

O'Neill on Social Security/Medicare: Ponzi Scheme

Paul O'Neill on Social Security and Medicare:

We've been spending money all along. It's a giant fraud; it's a giant Ponzi scheme. Every year we took the money and we spent it on other things.

There's a so-called famous lockbox in West Virginia I went to look at when I was secretary of the Treasury. You know what's in the lockbox? Actually it's a filing cabinet, and there are some pieces of paper that say, "We owe you." There's no money there; there are no investments there. There's nothing there but a piece of paper. That's a fraud.

People think, "Hey, I put money all my life in Social Security and Medicare." You didn't really. The government just took it and spent it on something else. There's no money there.

More here.

Rafat's Law of Diversity

Here is what I call "Rafat's Law of Diversity": 

1. One constant variable in life is that change will occur.

Jim Rogers, Street Smarts (2013)

2. The ability to keep up with change and adapt to changing environments provides a competitive advantage.

3. Entities and people who adapt the quickest to change will have an advantage and will be ahead of their competition. In economic terms, this is called the ability to adapt to "creative destruction" (See Joseph Schumpeter).

4. As of 2009, the world population is becoming and has become more and more inter-linked. Globalization is occurring rapidly, causing persons who would have never interacted fifty years ago to now interact and to engage in numerous economic and social transactions.

5. In short, due to globalization, countries and entities are becoming more diverse.

6. Entities that have the ability to interact on a positive basis with numerous cultures will have an advantage over entities that either lack this ability or have less of it.

7. Entities that lack diversity appear to be slower to adapt to change.

8. Entities lacking diversity as their surrounding local or non-local environment becomes more diverse show their internal culture is more resistant to change or that they are unable to gain talent from a diverse range of sources.

9. Entities unable to draw talent from a diverse range of places or resistant to change will be disadvantaged against more fluid, diverse entities.

10. As globalization increases, entities that are more diverse will have both tangible and non-tangible advantages over non-diverse entities.

11. Therefore, more diverse entities will be more competitive than non-diverse entities.

12. As of 2009, Asians are approximately 60% of the world population. As of 2009, persons of African descent are approximately 20% of the world population. As of 2009, the United States has only 5% of the world population. Mandarin and Spanish are more commonly spoken worldwide than English.

13. The United States is a consumer-based economy that relies on domestic and international consumption of its products to increase growth, profits, and influence.

14. To fully maximize one's successful interactions with worldwide entities, one must be fluent in more than one language and well-versed in several cultures.

15. Multinational entities that fully maximize their ability to engage with several cultures will maximize their ability to gain new customers and allies.

16. Entities that fail to maximize their ability to engage with several cultures will be disadvantaged against multinational entities.

17. Familiarity with different cultures and languages will maximize a multinational entity's ability to compete globally, providing it an advantage over entities that fail to maximize their ability to compete globally.

18. "Familiarity with different cultures and languages" may be called "diversity."

19. Multinational entities that favor diversity will be more competitive than entities that do not favor diversity.

© Matthew Rafat

Update on May 14, 2012: according to an April 2012 McKinsey Quarterly report ("Is there a payoff from top-team diversity?" by Thomas Barta, Markus Kleiner, and Tilo Neumann), U.S. companies with the highest executive-board diversity had returns on equity 95% higher and earnings margins 58% higher, on average, than those with the least executive diversity.

Bonus: Individuals or groups speaking on issues is not a free speech problem. Problems arise when individuals use their free speech to gang up on private individuals or politically-disconnected minorities. Such a "minority classification" will vary based on geography. A transsexual in SF would present a different analysis than one in rural Wyoming and still another in the college town of Bloomington, IN, depending on the reach and power of the group. To smooth out such differences in power, the fed gov may and should intervene when speech presents the likelihood of physical harm to an individual targeted by "gang speech." If physical harm is not likely but access to equal protection and provision of gov services is affected, there is still a role, albeit a lesser one, for the fed gov, though in such cases, a "restitution fund" allowing the individual to move elsewhere may be the best solution. "Gang speech" may take many forms, and may include unions, corporations, or any group of powerful individuals targeting a private individual because of the private individual's speech or non-violent but non-conformist behavior. If America is to continue building on diversity as one of its strengths, it must allocate resources to maintaining this unique advantage. Just as freedom is not free, neither is diversity.

Update on January 15, 2017: "When disagreement comes from a socially different person, we are prompted to work harder. Diversity jolts us into cognitive action in ways that homogeneity simply does not." -- Katherine W. Phillips

Update on June 2017: I have created another "law" here: https://willworkforjustice.blogspot.com/2017/04/rafats-law-inflation-elasticity.html 

Brocade Communications Shareholder Meeting (2009)

Brocade Communications Systems, Inc. (BRCD) had its 2009 annual meeting on April 15, 2009. The day after the meeting, Brocade announced closer ties to IBM. There was no informal presentation. 

Although the meeting itself was bare bones, Brocade's Shareholder Relations team did a fantastic job. I don't think I've ever praised a company's investor relations team before, but Brocade's team deserves special recognition. 

First, they used a portable miniature microphone. A company representative went around the room offering the microphone to whomever had the floor. You would be surprised at the number of companies which use no microphones at all, forcing shareholders to speak very loudly or requiring executives to repeat questions. Most large shareholder meetings have one or two standing microphones where people can stand to ask questions. This works well for larger meetings. For smaller meetings held in a conference room, a portable microphone works best. 

Second, the food was fantastic without being ostentatious. In these hard times, companies need to balance saving shareholder money with projecting a strong, healthy image. No food or coffee at the annual meeting indicates a company that either doesn't care about its shareholders or is trying to cut costs to the bone. Brocade had coffee and mineral water--the basics--but it also had some of the best chocolate chip cookies I've ever had. These cookies were so thick, they looked like scones. If my mother hadn't taught me basic manners, I would have stuffed about 20 of them in my pockets. I asked someone who made the cookies. She told me it was Gunther's Catering. 

I called Gunther's and confirmed they made the cookies. He said it was his mother's recipe, and they baked them fresh every day. The company has been around for 39 years and specializes in wedding receptions. If you like chocolate chip cookies, get thee to Gunther's. 

Lest you think it was just the cookies that won my heart, I assure you that's not the case. Shareholder relations personnel handled themselves professionally. They did not treat me or other shareholders like unwanted guests crashing an internal company party. You'd be surprised at how poorly many shareholder relations treat ordinary shareholders--read my Visa post, for example, where a shareholder relations person tried to stop me from taking a picture with the CEO, who was actually happy to have his picture taken, and then demanded my contact information. 

Lacking a presentation, the meeting would have been over had shareholders not asked questions. CalSTRS and CalPERS representatives appeared at the meeting to check on their shareholder proposals. Prior to voting, the company did not allow any comments to be made on their proposals. A shareholder attempted to make some comments, but Brocade's executives refused to allow him a microphone. Their refusal seemed unprofessional, because disallowing comments on specific proposals stifles the flow of potentially unbiased information to shareholders. Although most companies will tell you to make your comments at the end of the formal meeting, polls are closed by that time. Strike one against Brocade's management team. 

After the formal portion of the meeting concluded, the California representatives asked for a preliminary tally of the votes. Brocade didn't have one. I've never seen this happen before at any major company. Strike two against Brocade's management team. 

I asked a few questions. I asked how the company was managing the integration of Foundry Networks (FDRY). CEO Michael Klayko said the acquisition was going well. I asked what specific gap in Brocade's (BRCD) products the acquisition fulfilled. Many times, companies will acquire another company to boost revenue but will lack a real need for an acquisition. CEO Klayko said that Brocade found it cheaper to buy the company than to create the technology in-house. Foundry, he said, had "more connectivity products." Also, Foundry had just released a new chipset/product the prior Tuesday, showing that the acquisition was going smoothly. 

I asked what problems, if any, Brocade had discovered in the course of integrating Foundry. CEO Klayko said that Foundry Networks' distribution channels needed work, and its "marketing was suspect." Brocade's marketing, however, was very good, and that's why the two companies would work well together. 

I asked how Brocade expected to compete with Cisco (CSCO) and Nortel (NT). Here's where CEO Klayko shined. He said that Nortel might not be the best example to raise, because of its bankruptcy. As far as Cisco--Brocade's main competition--was concerned, CEO Klayko said that Brocade offers "cost advantages." In other words, Brocade offered similar products but at a lower cost. CEO Klayko also said the marketplace wants an alternative. Only near-sighted customers want to encourage a monopoly, because maintaining the status quo would allow Cisco to keep its high margins and relatively higher prices. Another shareholder, who worked for an investment firm, asked about analyst reports relating to IBM. 

CEO Klayko said there were lots of rumors out there and deflected the question. (The very next day, IBM and Brocade announced they would be working together on various products.) 

Another shareholder asked about Brocade's real estate strategy (buying vs. leasing property) and received a vague answer. 

Another shareholder was unhappy about the lack of a presentation. He also criticized the in-person absence of 50% of the directors. In what was the most memorable line of the day, he told Brocade's management, "Make us feel like you give a damn about us [small shareholders]." 

CEO Klayko responded that all the directors were present, but some were present by teleconference. He told this shareholder that he'd seen him present at various meetings throughout the year, so the company did communicate with its shareholders. I may have misheard the next response, but the shareholder responded that the only reason he was able to get access to those meetings was as a client of a brokerage firm. In my mind, if any company is restricting or selectively disclosing material information only to analysts or major shareholders, it would be violating Regulation FD. Please note: I do not have any information about whether any violation of Regulation FD is occurring, and I am not making any allegation of securities law violations. I would be very upset, however, if any company communicated relevant information only to major shareholders post-Regulation FD. 

I asked the CEO about complacency. I asked what the CEO was afraid of or concerned about. The CEO gave me a five item list: 

1. Access to capital. 

2. New technology (which makes current technology obsolete). 

3. Acquisitions that change the competitive landscape. 

4. Innovative quality (how to maintain quality). 

5. Cost (keeping costs low to attract customers). 

CEO Klayko also talked about the "entitlement mentality." He seemed to be channeling one of my favorite CEOs, Cypress Semi's (CY) T.J. Rodgers. 

I asked about various memorabilia in the room, which included a jersey from The City that Shall Not be Named (at least according to ESPN's Bill Simmons) and a signed Hootie and the Blowfish guitar. The CEO didn't know about the stories behind any of the memorabilia. 

Here's where things got a little interesting. I pointed out that Brocade had presented itself as an all-white, all-male company. All four persons at the front of the room representing Brocade appeared to be older Caucasian men. There's nothing inherently wrong with that, and diversity does not guarantee success. At the same time, almost all successful global companies present themselves as non-monolithic. (Pepsi (PEP) and Coke (KO) are way ahead of the game in this aspect.) I also said the executive team's lack of diversity was strange because the company was based in Santa Clara County, where 40% of the population is born outside the U.S. 

One of America's greatest attributes is its ability to project an open, tolerant image, which has attracted many ambitious, diverse people. As a result, we have the Blackberry (Canadian); Yahoo (Taiwanese); Google (Russian); eBay (French Iranian); and so on. Companies and countries that fail to project an open, tolerant image will be disadvantaged as world economies become more globalized, allowing talent and money to move elsewhere. In a nutshell, Brocade appeared to be violating Rafat's Law of Diversity. 

When I mentioned Brocade's appearance of having a 100% native-born Caucasian male executive team, the one and only female on the Board of Directors, Judy Bruner, raised her hand with a smile. Ms. Bruner is probably a great person. She received her MBA from Santa Clara University, my alma mater, and Santa Clara University strives to produce ethical, well-rounded graduates. However, when the only female on a company's Board happily raises her hand to demonstrate diversity, it's hard not to think that the corporate culture is irretrievably monolithic. From my perspective, having only one female on an entire Board is not cause for happiness or active disclosure. Even North Dakota's MDU Resources, Inc. (MDU) has more females on its board (25% of its directors are female) than Brocade. Thus, to me, Ms. Bruner's reaction--immediately identifying herself as the one and only non-male Director, instead of letting the CEO acknowledge the company's lack of diversity--felt strange. By the way, with the exception of perhaps three or four people in the entire room, everyone else present appeared to be native-born Caucasian also, which isn't an inherent problem, but still unusual in a diverse city like San Jose, California. 

CEO Klayko did not acknowledge his management team's lack of diversity. Instead, he said that we needed to create better educational opportunities here in the United States, and we were falling behind in science and math. He said Brocade was participating in the Tech Challenge, which encouraged children to pursue careers in math and science. In other words, Brocade was actively working at the local level to attract diversity. CEO Klayko joked that he was recruiting [minorities] at the 5th grade level. In response to my comment that we lived in a county that where 40% of the residents were immigrants, he said Brocade was a global company, not a local one. 

Unfortunately, his response confirmed my belief that Brocade's management culture is monolithic. Most studies show that Caucasians are only 20% of the world population. Assuming a 50/50 split in females and males, only 10% of the world contains Caucasian men--which indicates the CEO's response wasn't statistically sound. Again, there's nothing wrong with having 90% or 100% of any race on a management team. In fact, after the meeting, Investor Relations pointed out that of the 8 directors, one was a female and one was Indian--not a bad percentage. It's culture I am concerned with, not race. From what I saw at the meeting, Brocade's management team seems to lack cultural diversity. Strike three against Brocade's management team. After the IBM news was released publicly, I sold all but one of my shares. If Brocade works well with IBM, its shares may go higher in value; however, Brocade's relatively high debt load may inhibit its shares' forward progression. 

I really enjoyed listening to the CEO. He appeared energetic, strong-willed, charismatic, opinionated without being crass, diligent, goal-oriented, and knowledgeable--in other words, someone born to be a leader. I could immediately see why he ascended the corporate ranks. At the same time, passionate CEOs generally need a Board and executive team willing to speak up and provide a voice of caution. I'm not sure that's going to happen. Strong-willed leaders tend to unintentionally crowd out dissent, especially when their companies lack a substantial number of women in the upper ranks. With only one female and one Indian-American on the Board, I don't see Brocade's current management team as being sufficiently diverse. Perhaps I am wrong. On my way out, I passed by a room with many busy workers. Everyone in that room appeared to be of Indian descent. 

Note: Brocade has a blog. CEO Klayko's most recent post is here. The first line of his post is this: 

We are a nation and an industry curled up in the fetal position. 

It's hard not to like someone so direct, passionate, and intelligent.

Vampire Pensions

As if we didn't have enough to worry about, the FT's Charles Millard warns us about "vampire pensions":

http://www.ft.com/cms/s/0/5d8b4d42-2ac8-11de-8415-00144feabdc0.html

While economists worry about “zombie” banks holding back lending, vampire pension plans may soon be stalking a company near you. The underfunding of America’s corporate defined benefit pensions poses a daunting challenge, threatening not only their 40m beneficiaries but the entire US economy.

Oh, the many unfunded obligations.

Cash is King

Just keeping my readers posted. I sold most of my stocks and mutual funds today. Tomorrow, April 23, 2009, the government will release two sets of important numbers: one, unemployment claims; and two, Existing Home Sales. It is possible these numbers will be quite good. I doubt it.

On April 1, 2009, I told my readers that government action would make the market rise. As I predicted, it did. The S&P 500 rose from 811.08 to 843.55, a gain of 4% in just three weeks.

I still believe the S&P 500 will, sometime this year, hit my original target of between 920 and 950; however, I don't see much point in being in this market right this second. My personal risk analysis can't countenance holding mostly equities for a potential 10% gain over the next six months. I believe I will have another opportunity to jump back into the market.

If the numbers released tomorrow are good, the market will continue to rise, and I will have missed out on potentially major gains. That is a risk I am willing to take. Staying mostly in equities right now, without knowing the home sales numbers, seems too dangerous.

My short-term trading strategy has limited my losses. My retirement funds have declined approximately 14% from December 7, 2007 to April 22, 2009. (I don't know the exact percentage. Throughout the year, I deposit additional monies in my retirement accounts, which distorts the ultimate percentage even after accounting for the new deposits.) The S&P 500 has declined around 44% during this same time period. Perhaps buy-and-hold investors will laugh last, but for active traders, cash seems like a safer place to be right now than equities.

The information on this site is provided for discussion purposes only. Under no circumstances do any statements here represent a recommendation to buy or sell securities or make any kind of an investment. You are responsible for your own due diligence. To summarize, I do not provide investment advice, nor do I make any claims or promises that any information here will lead to a profit, loss, or any other result.

Ayn Rand's The Fountainhead

I recently watched Ayn Rand's film, The Fountainhead. Overall, the film was excellent. To get a view of Ms. Rand's philosophy, you can read Howard Roark's closing argument to the jury here.

I liked the film, but disliked Ms. Rand's character, Dominique Francon. Ms. Francon seems sexually and emotionally repressed, mostly because her existence seems geared towards achieving an absence of emotional attachment or passion. For example, she destroys a statute she enjoys, and she marries a man she does not love. Gary Cooper, on the other hand, does a fantastic job playing Rand's ideal man, Howard Roark. Part of this may be individualism's bias towards men. Men, more so than women, do well under an individualist philosophy. After all, most women, because of biology, have to think of children. Unsurprisingly, Rand never had children:

It was a responsibility that she was not interested in assuming. When she was writing Atlas [Shrugged], she would sometimes say that she was "with book." The only children she wanted were her books.

And therein we see the problem with too much individualism. Child-rearing is fundamentally a self-less act. It is true that many parents wish to live second lives through their children or have them for other selfish reasons, but at least for the first six years, there is a tremendous amount of sacrifice inherent in being a parent. Thus, when you factor child-bearing and child-rearing, Rand's philosophy doesn't translate well to a growing population or to one where mothers are given additional support.

Yet, it is true that most inventions and advancements have come from a few people. Without Galileo, Marie Curie, Einstein, and other famous scientists, it is unclear how advanced humankind would be at this point. Due to its rigor, science--like writing and other productive enterprises--requires a level of introversion that overwhelms a desire subjugate one's selfish enterprise to others' desires. We can look to the term, "mad scientist," to understand that scientists are generally misunderstood, because most people prefer to spend time with people, not abstract concepts. Indeed, almost every film about scientists depicts them as crazy or eccentric. So Ayn's basic point is true--scientists need to shut out the world and be intellectually independent to achieve results. Societies that protect the scientist and/or the independent intellectual's work create better opportunities for overall advancement (for example, attitudes towards stem cell research may be used as a test study of a society's willingness to allow scientific progress). It is unclear, however, whether selfishness and intellectual independence and progress are necessarily intertwined.

Regardless of the answer to whether selfishness is the sine qua non of progress, there is a balance that must be achieved, and Rand does not seem to know how to achieve it. In fact, there is no greater argument against pure individualism than Dominique Francon, who is made up to look like Rand herself in the film. To see Francon's internal writhing on her own forced island, torn between complete independence and submission to her desires, is to understand that Rand's philosophy is a recipe for unhappiness.

It is possible to have a society that protects mothers, that views child-rearing and child-bearing as honorable acts, and one that also respects the intellectual solitude/selfishness of the scientist or entrepreneur. It is also possible to argue that altruism has an important place in society and is not superfluous. Intelligent libertarians, for example, do not argue that no laws are necessary to protect selfish or independent behavior--just that the least number of laws necessary to achieve stability is desirable. In other words, society needs to establish a balance between selfishness and societal obligation by the least coercive mechanisms possible.

Rand's philosophy of pure selfishness doesn't do much for balancing generally desirable traits, such as altruism, with other desirable goals, such as freedom. As a result, Rand makes it difficult for reasonable people to support her absolutist views.

TurboTax Blog

TurboTax has a blog:

http://turbotaxblog.typepad.com/turbotax_blog/

Definitely worth a look-see.