Sunday, June 29, 2014

Lehman Valukas Report

While poking around on the internet in connection with the Valukas report to GM I was surprised to find that Anton Valukas was also the Examiner in the Lehman Brothers bankruptcy and had produced a long report about the firm's demise.  Since this is a subject of interest to me I went through the report.  I don't recommend this, the report is over 2000 pages long, full of legalese, sometimes repetitive and rather narrowly focused on who if anybody could the bankruptcy estate sue to try to recover some of Lehman's losses.  Still I felt it gave me a better idea of what had happened. 

Based on the report, the root cause of Lehman's failure was a disastrous 2006 decision by its CEO, Richard Fuld.  At a time when cracks were appearing  in the financial world, especially with regard to residential real estate, and other financial institutions were getting nervous, Fuld decided to vastly increase Lehman's exposure in the areas that were starting to appear shaky.  This involved making a lot of risky, illiquid investments.  (An illiquid investment is one which is expensive to sell, they tend to have the nasty habit of becoming especially illiquid (expensive to sell) at exactly the times you are most likely to need the money.)  Just the sort of poison a highly leveraged firm like Lehman doesn't need on its balance sheet in bad times.  The report calls this course of action a countercyclical strategy which appears to be an euphemism for a reckless gamble.  Of course as the report points out Lehman was in the business of taking risks.  However managing a firm like Lehman is all about limiting risk, trying to ensure that a little bit of bad luck or a single bad decision isn't catastrophic.   So Fuld's decision was bad in two ways, he misjudged the severity of the coming problems and less excusably he risked far too much on his judgment being correct endangering the firm.

Of course the initial decision wasn't fatal in itself, Fuld could have changed his mind and reversed course the next day and little harm would have been done.  But as the decision was implemented in 2006 and 2007 the risk to Lehman mounted. Eventually Lehman stopped adding to its exposure but didn't take any effective steps to reduce it.  When the markets moved against Lehman in 2008 bankruptcy (absent a government bailout) became inevitable.  It is unclear when the point of no return was passed.  Perhaps the Lehman could have survived (albeit severely damaged) if suitably decisive action had been taken early in 2008.  But this would have required Fuld to face up to the fact that he had made a horrendous blunder which seems to have been beyond him.  So instead Fuld seems to have tried to keep up appearances as long as possible while hoping for a market turn in Lehman's favor or a government bailout neither of which was forthcoming.

When Lehman did go bankrupt and its assets were liquidated there turned out to be a big gap between the value of the assets as recorded in Lehman's books and what they could actually be sold for resulting in large losses for Lehman's creditors.  I had been of the general opinion that this indicated some sort of huge fraud had taken place.  But according to the report this may be wrong.  There are several other potential explanations.  First fair market value for accounting purposes is defined as the price a willing buyer and willing seller would agree on.  It is not intended to reflect the price that could be obtained in a distress sale.  Nor does it reflect sales expenses.  This is fine if the asset holder intends (and has the financial capacity) to hold the asset indefinitely but means for illiquid assets there is likely to be a big gap between the value in the accounts and what can be realized in a forced sale.  That said it also appears that near the end when potential buyers were given access to Lehman's books they were not pleased with what they found although it is a little unclear whether this was just because they found Lehman's assets hard to value rather than definitely over valued.  It is inherently difficult to value illiquid assets with few comparable recent sales.   The report does acknowledge a few instances where Lehman's marks (values assigned to Lehman's assets in the accounts) were definitely inflated (outside even the wide range of possible good faith values for illiquid assets).  But this seems to have mostly reflected a failure to keep up with rapidly deteriorating market conditions rather than conscious deliberate fraud.

The rapidly deteriorating market also meant considerable loss of value could occur between the appraisal valuation dates reflected in Lehman's books and the dates Lehman's assets were liquidated.  Of course a substantial part of this loss of value was caused by Lehman's bankruptcy itself.

Another issue was winding up Lehman's derivative contracts.  A derivative contract is basically a bet between two parties about future events.  The parties post collateral to guarantee payment.  When one party goes bankrupt the other party is generally allowed to terminate the contract early and claim the current contract value.  This value can be hard to assess objectively so the initial claim will often be on the high side so as to establish a negotiating position.  This seems to have been the case with Lehman's contracts with the Lehman estate ultimately able to obtain more favorable settlement values than initially offered by its counterparties.  It seems possible there was still some loss of value though, the rules are not set up to favor defaulting parties.  

Finally Lehman as a going concern was an intricate web of relationships (with for example many legally distinct corporate entities some operating under foreign law).  Sorting out the mess when it all came crashing down was unavoidably expensive requiring millions in fees to be paid to people like Valukas, his law firm and the financial advisors he hired to help compile his report.

So perhaps the gap between the value of Lehman's assets in Lehman's books and what they realized when sold was not generally due to fraudulent books.  Still I would like to see somewhere a detailed explanation of how the gap arose.  This is not to be found in this report or anywhere else that I am aware of.

As the report explains under the business judgment rule the courts generally don't second guess business decisions even stupid ones which work out badly.  So the government couldn't prosecute Fuld for being an idiot.  But according to the report during 2008 Lehman attempted to make use of an accounting loophole to disguise how leveraged they were.  By performing a series of transactions (with no economic purpose) they could avoid listing some their debt on their balance sheet reducing the amount Lehman appeared to be leveraged.  It is unclear whether Lehman actually managed to satisfy the conditions of the accounting rule they were attempting to exploit but as the report points out it doesn't really matter, there is a general accounting rule that you can't report materially misleading accounts even if you are arguably in technical compliance with the more specific rules.  So it appears that high Lehman officials (including Fuld) could have been prosecuted for fraud (for deliberately reporting materially misleading results) if the government had chosen to do so.  But for political reasons I have never really understood the Obama administration gave Fuld (along with most everybody else) a pass for potentially criminal behavior in the lead up to the financial crisis. 

However this bad behavior wasn't a major cause of Lehman's collapse, it occurred after Lehman was already in big trouble.  Perhaps you can argue it was a contributing factor in that it was a form of denial without which Lehman might have been more likely to take the drastic painful steps needed to give it a chance to survive.   This seems pretty speculative however.  The misleading public statements did of course hurt anyone who relied on them to invest in Lehman which is all you need to prosecute.

In short this report fills in some of the details regarding Lehman's collapse but it is not a good big picture account for the interested layman.  As far as I know no such account has yet been written.

Friday, June 27, 2014

Account Numbers

Last night I logged on to my bank's website to pay my water bill.  For some reason I happened to notice that the account number on my bill didn't match the information on my bank's website (which I had entered several years ago when I added the water company as a payee after moving into my new townhouse).  Upon investigation I found the water company (New Jersey American Water) had changed my account number last November at the same time they changed the format of their bills.  An inconspicuous statement to that effect (advising that account numbers on bank bill payment systems should be updated) was included on the bill but I hadn't noticed.  The payments had been going through anyway but presumably would have started failing at some point.  So it seems that if you use bank bill payment systems you should check every so often that the payee information is up to date.

I also was a bit startled to see that my 2014 New Jersey tax refund had been electronically deposited earlier in the week.  I had filed a paper return and had been anticipating a paper check.  However upon checking I found TurboTax had included my bank account information on my return.  I don't remember telling it to do that but I was originally intending to file the New Jersey return electronically (like my federal return) but was then prevented from doing so for some reason I don't remember.  So I guess TurboTax didn't remove the bank account information when I switched to paper filing.  I suppose no harm was done and I did get the New Jersey refund a month earlier than last year.  Still very slow though, the federal refund took about a week. 

Sunday, June 22, 2014

The Caterpillar Way

I recently read "The Caterpillar Way" a 2014 book by Craig T. Bouchard and James V. Koch about the recent history (since 1980 or so) and prospects of the Caterpillar corporation.  I picked if off the new book shelf of my local library because I bought some Caterpillar stock last year without actually knowing much about the company.  If this largely laudatory book is correct I made a good investment.  Unfortunately the book isn't entirely convincing.

The authors were looking for a success story to write about and chose Caterpillar.  So it isn't surprising that on the whole Caterpillar performed well over the period covered by the book.  After bouncing around under 10 (split adjusted) in the 1980s the stock has risen to over 100 today. Of course the market as a whole was also up sharply from 1980 to 2000.  The authors' attribute Caterpillar's performance to a combination of good luck (in the form of favorable economic trends like a depreciating dollar) and excellent management.  The problem being of course this makes some regression to the mean likely.  Warren Buffett has been quoted to the effect that he preferred to invest in companies that were in such a good business that they could be successfully managed by an idiot (by which he means of course someone from the bottom portion of the range of CEO talent).  Expecting a company to always select above average CEOs seems a bit unrealistic. 

At the end of the book the authors make projections for Caterpillar's stock price in 2020 based on 3 scenarios which I will call no-growth, growth and hyper-growth to which they assign probabilities of 15%, 70% and 15% respectively.  Since they project (reasonably) that the stock will stagnate in the first case (no-growth) but do well in the other cases they judge Caterpillar to be a good investment.  However I would assign the probabilities more like 50% and 50% and 0%.  The authors believe the infrastructure and raw material needs of rapidly growing so called emerging economies will continue to increase demand for Caterpillar's products.  But I am less optimistic, such demand has already increased a lot in recent years and may not have much room for further growth.

Also as the authors acknowledge Caterpillar is in a cyclical  industry and will have bad years.  The stock dropped more than 70% in less than a year in 2007-2008 and similar drops cannot be ruled out in the future.  The stock may prove to be a good investment but it is hardly a sure thing.

The book wasn't officially sponsored by Caterpillar but the authors received high level access and appear reluctant to be too critical.  Caterpillar sells all its products through dealers and the authors portray this as a great and difficult to reproduce advantage for the company.  No doubt this is the company line but I doubt the case is totally one-sided.  The dealer networks of the domestic auto companies are widely seen as a burden that the companies can't easily get rid of (because of state laws protecting dealers).  So I expect there are downsides (or potential downsides) for Caterpillar also.

In summary I doubt this book will be of much interest to people who don't own the stock or have some other connection with the company.  

Monday, June 16, 2014


In my earlier post on the Valukas report about GM's ignition switch problems I questioned whether there was much difference between waiving a requirement and changing it.  Upon reflection I think this is wrong.  It is better to weaken a requirement if necessary than to waive it.  The problem with waiving a requirement is then you are left with nothing.  So the supplier no longer has any incentive to pay attention to that characteristic and performance may continue to deteriorate as the design is finalized and the part moves into production.   Also quality control problems which mean that some parts perform very badly may not get picked if that aspect of performance is not being measured.  The Valukas report didn't discuss how much the ignition switches varied, perhaps most of the problems were from switches with exceptionally bad performance.  Of course specifications ideally provide a safety margin so that even below average parts still perform satisfactorily.

Another advantage to not allowing a complete waiver is it might have caused the GM engineer to focus on the fact that there was a point where reduced effort to operate the switch becomes completely unacceptable.  In the process of determining where that point was he might have realized the switch was getting uncomfortably close.

Sunday, June 15, 2014

GM Valukas Report

I recently read the report (119 MB pdf download) by Anton R. Valukas to the GM board of directors about GM's recent recall of millions of cars with defective ignition switches.  Because of a poor design the torque (twisting force) required to turn the key and move the switch position from "Run" to "Accessory" is unduly small enabling unintended accidental shutdowns of the engine while driving.  This causes loss of the power assists to steering and braking although in most cases the car will remain controllable.  Less obviously it also means the airbags will no longer activate in a crash.  This long (325 page) report is by an outside lawyer tasked with determining why the mistake was made and why it took GM so long (10+ years) to realize there was a safety problem and issue a recall. I found the report interesting (although I just skimmed it in a few places) and think it raises a number points worth noting.

The first point is why GM thought it best to assign this report to a lawyer rather than an engineer.  This suggests that they feel the legal aspects are more important than the engineering aspects.  They are probably correct (especially going forward) but this means the report (in my view at least) somewhat neglects the engineering aspects.  The report also seems to avoid asking questions which might aggravate GM's legal problems.

The GM engineer responsible for the ignition switch design had inherited the design from another engineer.  When the first prototypes from the outside supplier (Eaton which was later purchased by Delphi) failed to meet the torque requirement he chose to waive it.  It appears he did so because he did not focus on the role of the requirement in preventing unintended operation of the switch while driving.  The report (and others) have emphasized the fact that the switch didn't meet GM's requirement but this seems just a matter of semantics to me.  GM could just as well have changed the requirement rather than waiving it.  The requirement doesn't appear to have been based on any sort of careful analysis of what was required to prevent unintended operation of the switch.  It would not surprise me if it had just been copied from an earlier design. 

After the car went into production it soon became apparent there was a problem.  There were numerous complaints about inadvertent operation of the switch while driving.  This seems to have occurred most often when the driver had a key ring with lots of things on it and bumped them with their knee.  This is not a rare situation, currently I have 8 keys (besides 2 car keys) on my key ring and they are normally in contact with my knee as I drive.  I have never had the impression for my current car (or any of my previous cars) that this was risking accidental operation of the switch and I certainly would be extremely annoyed if I bought a car where this was a problem.  In my case although I have a bunch of keys on my key ring there is sufficient space for the key ring to hang freely from the ignition key.  This limits the torque you can exert by pulling on the other keys (because the lever arm is so short).  I have vague recollections of seeing people with key rings so tightly packed with stuff that they might not hang freely which would greatly increase the lever arm and the potential for a problem.  The report does not discuss this apparently assuming the weight of the key ring is the only important factor.  Nor does the report perform any sort of comparison with other ignition switches, it would interesting to know how much of an outlier the switch really was.

At this point GM decided the problem was a customer satisfaction issue rather than a safety issue.  While it is true that inadvertent operation of the switch would not always (or even usually) cause an accident it obviously is potentially hazardous.  But there seemed to be a feeling that something wasn't a safety issue unless it contravened some specific government safety regulation and the government has neglected to specify torque standards for ignition switches.  Of course the government has specified standards for airbags but apparently no one was alert to the fact that shutting down the engine also turns off the airbag actuator.  This would not have been a major problem if inadvertent operation of the switch and serious accidents were uncorrelated rare events as in that case having both happen at the same time would have been extremely unlikely.  However there is no reason to believe these events are uncorrelated.  There is clearly potential for unexpected operation of the switch to trigger an accident although it is unclear how likely this is.  GM received numerous complaints about unintended operation of the switch but the report doesn't mention (as I recall) that any claimed that this had caused an accident.  Of course if the driver is killed in the accident he isn't in a position to complain but if accidents are being triggered I would expect non-fatal accidents to be much more common.  Another possibility is for the accident sequence to trigger unintended operation of the switch prior to the final impact.  This could occur for example if the driver lost control and ran off the road for some distance before hitting a tree.  The bumpy ride before the final impact could operate the switch, turn off the engine and deactivate the airbags (if there is sufficient delay prior to the final impact, the final impact itself should not deactivate the airbag actuator before it triggers).  Apparently this scenario is consistent with several serious accidents in which the airbags unexpectedly failed to deploy.

An issue here is the somewhat artificial distinction between customer satisfaction problems for which cost benefit analysis is deemed appropriate and safety issues which are supposedly fixed regardless of cost.  Since in reality cost will always be a consideration this encourages a hidden cost benefit calculation which results in classifying safety problems that don't seem to be worth fixing as customer satisfaction  issues.  While this may have legal and public relations benefits the double think involved is likely causing a misallocation of resources with some safety issues receiving too much attention and others too little.

Eventually GM started to be sued over serious or fatal accidents in which airbags unexpectedly failed to deploy.  It took GM a very long time to realize that this was likely a consequence of inadvertent operation of the ignition switch.  According to the report this was due in part to the fact that many of the people involved either didn't know or didn't appropriately consider the fact that switching off the ignition also (after a slight delay) deactivates the airbags. 

A complicating factor was the switch was modified after a few years in a way that alleviated the problem.  Much has been made of the fact that the GM engineer that approved the modification (the same one responsible for the bad design) didn't assign a new part number and later claimed (including under oath in a lawsuit) no changes had been made.  Perhaps this was all part of a conscious cover up by the engineer of his original error but I am not totally convinced.  Another report suggested the change was initiated by the part's supplier and the GM engineer just signed off on it.  In which case it is vaguely plausible that several years later he would have forgotten doing so.  The part number issue also doesn't seem totally clear cut, I expect parts are changed all the time in apparently minor ways without a new part number being assigned.  Suppose for example the part supplier had itself changed spring suppliers (a spring within the switch held the switch in position, the modification seems to have been basically use of a stronger spring).  Would this have required a new part number?  However it does appear clear the GM engineer was not eager to acknowledge his original error in waiving the specification.  In any case this delayed GM's recognition that the switch was the problem as the investigators didn't understand how the switch could be responsible for a problem that had gone away if the switch hadn't been changed.  Although perhaps they put undue weight on the GM engineer's claim that no changes had been made.  It seems like double checking with the supplier at least would have been prudent. 

An issue here is that it is impractical for car companies to initiate a recall without understanding the problem enough to have a fix in place.  It is not very feasible to provide millions of loaner cars while GM tries to figure out what the problem is and how to fix it.  However it is clear that GM didn't give this sufficient attention.

It is in fact unclear whether GM even now really understands the problem.  While GM contends the modified switch is safe they also have recalled hundreds of thousands of cars just because of a slight possibility that the cars may have had a repair in which the new switch was replaced with the old switch.  GM claims it is not practical to tell the switches apart (which is in tension with their claim that a new part number was clearly required).  But it should be easy to measure how much force is required to operate the switch.  Even if there is some overlap between the old switches and the new switches this should distinguish between safe switches and unsafe switches which is the important point.  However setting a cutoff point between safe and unsafe would involve the sort of cost benefit analysis that GM doesn't want to acknowledge conducting with regard to safety issues.  Even though no switch is going to be totally safe (incapable of inadvertent operation under all circumstances no matter how unlikely).

GM has reportedly fired 15 people in connection with this incident.  Based on the report this seems rather harsh in cases where as the report acknowledges the failures were largely due to systematic problems rather than individual lapses.  This doesn't apply to the engineer responsible for the design who (assuming the account in the report has some relation to reality) seems to have failed in multiple ways, approving a bad design and then failing to step up and get the problem fixed.  I was initially sympathetic for the top GM lawyer involved who seems to have been fired largely for failing to tell his boss about the issue as I doubt this would have made a difference.  But upon reflection Warren Buffett tells his managers that he hear wants to learn about serious problems in their domain from them and not by reading about them in the newspapers which makes sense to me so I suppose the lawyer did have a responsibility to recognize the potential magnitude of the problem and inform his boss (GM's general counsel).  However I have trouble with coming up with 15 people who deserved being fired.  Of course GM can claim that public outrage demanded some scapegoats and they have little real choice than to provide them.  Sufficiently generous severance arrangements (which haven't been made public as far as I know) could mitigate some of the unfairness involved. 

In summary this long report won't be of much interest to many people but I found some of the issues raised thought provoking.

Saturday, June 14, 2014

Irrational Exuberance

I recently read "Irrational Exuberance" by Robert  J. Shiller.  This was the 2005 second edition which added some material about housing prices to the 2000 first edition which was about the stock market.  Schiller's thesis in both cases was that prices were high by historical standards making expected future investment returns poor.  Unfortunately although Schiller proved to be correct I didn't find this book very interesting. 

One problem is that the book is dated.  Arguments about whether we are in a stock market or housing bubble are less interesting ten or fifteen years later when we know the answer.  There wasn't a lot in this book that was new to me.  Another problem is that Shiller sometimes makes his arguments in a somewhat simpleminded way.  For example he cites (p. 47-49) the rise of 401(k) plans as a factor increasing demand for stocks.  But of course traditional defined benefit pension plans also invested in stocks.  So it is not clear that shifting to defined contribution plans makes much difference. As another example Shiller claims (p. 177) that "... the efficient markets theory asserts that all financial prices accurately reflect all public information at all times."  But this is the most simplistic form of the theory, a more sophisticated version allows for some imperfections that can only grow to the point where they can be profitably exploited by the smartest best capitalized investors.  This deals with Shiller's later objection (p. 179) that without some profitable trades the smart money would not stick around to keep prices in line.

Shiller spends considerable time dealing with the objection that we can't be in a bubble because bubbles are impossible.  Apparently this isn't really a strawman as it seems there are reputable economists who believe something like this.  Still I find it hard to take this objection seriously and am not that interested in lengthy refutations.  In general I thought the book was too long, that the main ideas could have been presented more concisely.  I also found some of the advice unconvincing.  Schiller is big on hedging as a form of insurance.  But insurance generally costs money and may not be worth it.

In summary although Shiller is correct in his major claim that asset prices can get out of line I didn't find this book very compelling and so can't recommend it.   

Monday, June 2, 2014

Mad Men

On May 23, 2014 Elliot Rodger went berserk and killed 6 people before committing suicide.  For several reasons the incident received an unusual amount of publicity and various people with axes to grind have attempted to draw lessons from it.  However I think the main lesson is just that crazy people sometimes do crazy things. 

Most incidents like this are perpetrated by mentally ill people and this case doesn't appear to be an exception.  Of course there is some danger of circular reasoning when there is little independent evidence of mental problems prior to a killing spree.  However that was not the case here.

I would define mental illness as mental abnormalities which cause problems for the subject.  By this standard it was clear to many of the people around him that Rodger was mentally ill.  What was not so clear was that he was dangerous.  It may also be that his mental illness was not of a common type like paranoid schizophrenia but this does not mean he wasn't mentally ill at all.  He was obviously abnormal.

It is a mistake to ascribe too much meaning to the actions of a crazy person.  Their erratic random actions will sometimes by pure chance appear carefully planned.  This doesn't mean they were.  In this case Rodger achieved great notoriety in death but I am unconvinced that was his plan.

Sunday, June 1, 2014

The Buy Side

I recently read "The Buy Side", a 2013 Wall Street memoir by Turney Duff. Duff tells the story of his Wall Street career which was reasonably successful until he was brought down by abusing drugs. I didn't care for it. Much of the book is devoted to his struggles with drugs (especially cocaine) and I have never found drug fiends particularly sympathetic or interesting.

I am more interested by the business aspects of Wall Street and Duff doesn't offer much insight into them. Duff worked on the "buy side" (hence the title of his book) which meant he was employed by hedge funds to trade their portfolios, buying and selling stocks. Sometimes he was told what trades to make, at other times he had discretion to establish his own positions. In both cases for reasons that are unclear to me (and which Duff makes no attempt to explain) the hedge funds that employed him were willing to pay millions of dollars in inflated commissions. Naturally this made Duff a very popular man with his counterparties on the "sell side" as their incomes were directly tied to how much of his trading Duff chose to do with them. They showed their appreciation by extravagant entertaining which included in Duff's case supplying drugs. Duff proved unable to handle the drugs in the long run perhaps in part because he wasn't really happy with his job even when he was doing well (1.8 million in his best year by his account). Duff ended up in rehab twice when his drug abuse rendered him unable to perform adequately at (or even at times show up for) work. By his account he still had employment possibilities on Wall Street even after his second stint in rehab but chose to try and become a writer instead.

Duff worked for a time for Galleon Group which has since been brought down by an inside trading investigation which led to Galleon's founder, Raj Rajaratnam, being convicted and sentenced to 11 years. Duff didn't like Rajaratnam and depicts him as engaging in a variety of questionable behavior. But fortunately for Duff he had left well before Galleon got in trouble with the law. Duff himself admits to performing acts at work (at Galleon and elsewhere) of dubious legality. At times he is worried that this (or his drug use) is under investigation and will get him arrested but it appears these worries were unfounded (possibly just drug induced paranoia). Duff doesn't appear concerned that his book will cause him legal problems and as a practical matter having left Wall Street he is probably not a high priority for prosecution.

The main point I would take from this book is that there is a lot of extravagance and waste on Wall Street ultimately funded by excessive client fees. Fortunately these fees can often be avoided (or at least substantially reduced) if you are on your guard which I would certainly recommend when dealing with Wall Street.

While this book contained a few points of interest I don't recommend it. It is pretty long and I didn't find it compelling. Michael Lewis's Wall Street memoir "Liar's Poker" is much better and I also liked "A Colossal Failure of Common Sense" more although I didn't recommend it either.