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A Tale of Greed: How The Old BankUnited Fell Apart

2009-07-13T07:03:00.000-07:00

By Martha Brannigan

Published on Miami Herald, July 13, 2009

It took 25 years for BankUnited Financial Corp. to blossom into Florida's largest homegrown financial institution.

But it took just one type of loan to sink its Coral Gables-based bank and trigger its May seizure by federal regulators: The payment option adjustable rate mortgage, or option ARM.

A look at how things went bad at the thrift - now revitalized with fresh capital and under new ownership - offers a window into the real estate and banking debacle that has punished Florida's economy. But it is also a personal tale of greed and control.

Alfred R. Camner, the founder and biggest shareholder as well as the chairman and chief executive until October 2008, led the bank in an ambitious foray into option ARM - a produce many consider the riskiest mortgage ever created.

"The big question is why would Camner bet the bank on one product that turned out to be the most toxic," says Ken Thomas, an independent Miami banking analyst.

That is just one of many questions about Camner's tenure at the bank, a publicly traded company that he ran much like a family business, hiring family members and steering work to his law firm for years.

Camner - who still controls 45 percent of stock through special class B shares with super-voting rights - declined to comment for this article, citing pending litigation.

Camner's troubles came to a head on May 21 when federal regulators swept into parent company BankUnited Financial Corp.'s headquarters and seized its busted bank. Simultaneously, the Federal Deposit Insurance Corp. old the bank to a group of private equity firms led by New York banker John Kanas, that revived the bank with fresh capital.

The FDIC, which will shoulder the bulk of any loan losses, puts the cost to its insurance fund at $4.9 billion. That's the largest bank failure this year and the second most costly flop of a financial institution in the current downturn. BankUnited shareholders are likely wiped out.

How could thins go so wrong?

Camner, a lawyer by training, started BankUnited in 1984 on Florida's west coast. It paid good rates on deposits and bought home mortgages made by others.

Over time, as premier Florida institutions such as Barnett Banks were gobbled up by out-of-state giants, BankUnited became, somewhat by default, the biggest bank based in Florida. Going toe to toe with behemoths like Bank of America and Wachovia, Camner cast about for the right niche.

In 2002, he tapped Ramiro A. Ortiz, a respected banker who was president of SunTrust's Miami operations, as president to build BankUnited's commercial and small-business lending.

But as Florida's housing boom took off in 2004, BankUnited soon found a different forte - in option ARMs. Camner saw the success Marion and Herbert Sandler had in pioneering option ARMs as a highly profitable product that fueled growth at Golden West Financial in California.

Option ARMs, now discredited, give borrowers choices each month: Make a full payment of principal and interest, something in between, or a minimum payment that results in negative amortization, meaning the loan balance actually grows each month instead of shrinking.

It was just the sort of easy credit that speculators flocked to, fueling the rise in home prices between 2003 and 2006. Borrowers figured on making minimal installments for a little while and reselling a home at a quick profit or refinancing to avoid onerous terms that kicked in later.

Under the terms, when loan balances swelled to 115 percent of the original amount, or when the time came for the interest rate to reset, it spelled payment shock for borrowers. Monthly installments instantly skyrocketed, often to double or triple the original amount.

To be sure, BankUnited had plenty of company among large, prestigious lenders in its love affair with option ARMs. The same toxic loans dragged down Washington Mutual, Downey Savings and even Wachovia, which bought Golden West at its peak.

PLUNGING VALUES

What no one seemed to figure on at the time was what would happen when the housing boom ended. Rising mortgage balances and plunging home values conspired to put many borrowers under water, fueling a tidal wave of defaults.

The worst part was that many of BankUnited's option ARMs were based on a borrower's "stated income." These mortgages, sometimes called "liar loans," were approved based on how much customers said they earned, without documentation to back it up. Sometimes the bank didn't bother to verify a borrower's assets or employment either.

Camner's rationale was that borrowers had solid credit scores and many were required to buy mortgage insurance.

But that wasn't enough to skirt the catastrophe.

During the boom, BankUnited sold many of its loans to be packaged into securities, feeding a voracious appetite for this product on Wall Street. That made them someone else's problem - but ultimately everyone's as an overheated real estate market imploded, dragging the nation into its current economic quagmire.

With Camner doing so much business on Wall Street, the company bought an interval ownership unit at the St. Regis Hotel New York, five-star digs with butler service, to put him up.

But only Wall Street soured on mortgages, the bank had to keep the loans on its own books. And regulators allowed the risky loan concentration until it was too late.

With its portfolio of option ARMs burgeoning, BankUnited's profits soared at first. Earnings tripled to a record $83.9 million for fiscal 2006 from $27.5 million the prior year.

ACCOUNTING RULES

Under accounting rules, the bank could book the income for the full mortgage payments even when a borrower paid only the minimum. That boosted BankUnited's bottom line - and under Camner's compensation agreement, which was tied to asset growth and profits, it fattened his bonuses.

As its star was rising, BankUnited was getting generally good marks from federal regulators on loan quality, according to bank officials. And BankUnited's board - many of them Camner's friends - supported him.

"The regulators were giving the bank high grades, so where do you look to find problems?" asked long-time board member Marc D. Jacobson.

"When all the information you are getting from the regulatory people, the top accountants, external auditors, internal auditors - these are all credentialed people - when they're all telling you you're good and you can't point to any problems, where do you look?"

Jacobson added: "When everything is going smoothly, there are no red flags, and by the time the problems show up, it's too late."

A spokesman for the Office of Thrift Supervision, which has been widely criticized for lax regulation during the housing boom, declined to comment on the agency's oversight.

By 2007, with the housing market collapsing, the bank's problems began to fester.

Still, Camner shrugged off warning about the loan portfolio's risks, repeatedly insisting the bank followed conservative underwriting standards.

In a January 2008 conference call with Wall Street analysts, for instance, Camner stressed the bank wasn't like others that were getting into hot water, because it didn't make subprime loans, it didn't piggyback second mortgages along with first mortgages, and its loans were based on whether customers could afford the full monthly amounts, not the optional minimums.

But a recent federal class-action lawsuit by BankUnited shareholders, based in part on interviews with former employees, paints a picture of a bank that was anything but conservative. The suit accuses executives of engaging in reckless lending with shoddy underwriting and says the company made "false and misleading statements" - reporting big profits long after loan problems started to surface and failing to set aside enough reserves for the tsunami that was coming.

The company, however, blames the market. "The bank was brought down by adverse conditions in the residential market that affected the entire banking system," said C. Thomas Tew, the BankUnited attorney. "Some banks got bailouts. We didn't."

A net loss of $25.5 million in the fiscal first quarter ended Dec. 31, 2007 was eclipsed by a $65.8 million loss in the March 2008 quarter and a $111.7 million loss for the next one. After that, with so much uncertainty about its financial condition, BankUnited quit reporting earnings altogether.

In June 2008, BankUnited tried to raise $400 million in a public stock offering, but it flopped. The financial markets were collapsing all around. Camner's super-voting rights, which left public shareholders impotent, made the stock even less attractive. After the failed offering, Camner agreed to put his stock on equal footing with the class A shares that traded publicly.

By then the company was too deep in the hole to attract investors. A parade of investors and private-equity firms peaked under the hood, but no one could make the numbers work without government aid.

CEASE AND DESIST

In September, the Office of Thrift Supervision, which had been steadily stepping up pressure on the company amid alarm at its downward spiral, imposed a cease and desist order, sharply restricting BankUnited's lending and operations. But by then, the bank had already made enough option ARM loans to sink the Titanic.

The same month, a BankUnited shareholder filed a federal class-action lawsuit, since amended, alleging investors weren't warned about its risky loan portfolio and "sketchy appraisal process."

Soon afterward, the SEC's Miami office cranked up an informal inquiry into BankUnited's troubled loan portfolio and other matters.

Efforts to raise capital weren't going well either. Other banks that had bet big on option ARMs were similarly in a death spiral.

By October 2008, several BankUnited board members decided Camner had to go, according to people close to the situation. Faced with his ouster from a once-compliant board, he negotiated a retirement agreement and bowed out Oct. 20.

The retirement pact amounted to a pittance compared to his golden parachute, which was barred by the federal cease and desist order. Still, it called for one year of compensation and cash for his restricted stock. BankUnited agreed to give Camner the honorary title of "chairman emeritus." He and the company agreed in writing to refrain from saying anything disparaging about each other.

Camner's payout required regulatory approval. When BankUnited submitted the agreement to the OTS and FDIC, the feds sat on it. He never got paid. "The OTS did not render a final decision on the BankUnited request regarding Mr. Camner," said an agency spokesman.

His daughter, Lauren, resigned as senior vice president and director the same day as her dad. She too had ironed out a severance agreement. Regulators OKed a reduced amount.

The board promoted Ortiz to CEO.

With the bank's outlook darkening by the day, board members grew worried. The independent directors hired their own legal counsel. The bank bought a $10 million directors and officers liability insurance policy from Lloyds of London to top an existing $20 million policy.

"If BankUnited didn't have a good D&O insurance, half the directors would have resigned," said director Jacobson.

The board's key focus was finding fresh capital.

The Treasury Department's Troubled Asset Relief Program, or TARP, was taking shape as the nation's financial system teetered. But Treasury was reluctant to bail out a crippled institution that wasn't big enough to matter to the overall economy.

By early 2009, BankUnited acknowledged its capital had been wiped out. In April, regulators set a deadline for the bank to raise money. At the same time, they solicited bids from buyers.

"We continue to work on all avenues to recapitalize the bank," Ortiz said at the time. "That includes an equity investment. That includes open-bank assistance. That includes a capital investment on the part of the Treasury."

NEW OWNERS

The FDIC -led sale attracted five proposals from three groups. The winning bid came from a group of private equity firm led by Kanas. They agreed to invest $900 million in the bank, with the FDIC shouldering the bulk of any loan losses.

The FDIC put the cost at $4.9 billion. Only the failure of IndyMac has cost the FDIC more in the current downturn.

At the close of business on May 21, dozens of federal regulators, some wheeling carts, others wearing backpacks, filed in to BankUnited headquarters and seized the bank.

Camner's piggy bank was bust.

No one let the Camners know in advance what was coming. "You know how I found out? I got a phone call," Camner's wife Anne told The Miami Herald at a shareholder meeting the next day. "I found out yesterday at 5:15 p.m. the bank had been seized."

Warren Buffett's Investment Advice for You

2009-07-11T09:44:00.000-07:00

Billionaire investor, Warren Buffett, is never short of offering investment advice. On Friday, on ABC's Good Morning America, some advices were featured.

In the interview, Bianna Golodryga, asked for his top three pieces of advices for the average American who want to grow their money and keep it safe.

His response:

If it seems too good to be true, it probably is.
Always look at how much the other guy is making when he is trying to sell you something.
Stay away from leverage. Nobody ever goes broke that doesn't owe money.

In addition, he also finds important lessons drawn from his favorite game.

"In bridge, everything anybody does or doesn't do, you're drawing references from, including your partner and your opponents. You're working with a partner. If you don't work well with partners you're not going to have a winning bridge team over time. And everything you've learned from the past has some utility on the next hand you play. The next hand, you've never played it before and you'll never play it again in your life. But on the other hand, the problems you've solved in the past are useful in solving the problems there. And you have to keep paying attention all the time. You can't coast."

Asked if it is worth the high price for college education given the struggling economy. His response:

"Generally speaking, investing in yourself is the best thing you can do. Anything that improves your own talents. Nobody can take it away from you. They can run up huge deficits, the dollar can become worth far less, you can have all kinds of things happen. But if you've got talent yourself, and you maximize your talent, you've got a terrific asset. That doesn't mean everybody should go for college."

Basics for a decent investor/money manager

2009-07-10T02:03:00.000-07:00

What traits do Warren Buffett, Charlie Munger, John Niff, Bill Ruane, Philip Fisher, John Templeton, Jean-Marie Evaillard and other successful money managers possess in common? It is worth to examine the approaches and traits they have. My goal is to learn from their successes and equally as important, their failures. This involves two main ingredients: 1) The correct principle and 2) The correct person.

At the outset, I must point out that all that are written here do not guarantee you to be truly successful but it certainly can make you an over average, or at least, a decent investor.

The correct principle

Certainly, there are many ways to make money but this doesn't mean every way is the same. For long-term investment success, I strongly believe chances are enhanced when it embodies the following principles:

Think of investing as how you would purchase a business, rather than the trading of stocks. Investing today at a particular price is all about laying out cash today in exchange for all the cash flow a business will produce, discounted at an appropriate interest rate, in the future. The key is to pay less than what the business will produce in terms of the total present value over the business life time. Trading price will varies everyday, at times very wildly, but business value or rather, the intrinsic value of a business, hardly varies by much from time to time. Intrinsic value follows the fundamentals of the business while stock prices may or may not follow the business fundamentals. Many times, stock prices are priced to emotions rather than fundamentals. Well, that provides an opportunity for us to take advantage of.
Keep your eyes on the playing field, not on the scoreboard. If you invest in a business, it is what the business do, or equally as important, what it does not do, that really matters. If you focus on the stock price and not study the business, it is where most investors are done in. An example is the existing financial crisis, it is what the disciplined banks, like Wells Fargo and JPMorgan, did not do that set them apart from the rest. They did not pursue seemingly good and easy profits by abandoning an approach they understand and is effective for another approach which they did not understand and seemingly profitable business for the short-run, in exchange for long-term risk to the business. Now, we know these "good and easy profits" are nothing but a mirage.
Think independently. Do not rely on "expert" advice. Ignore the market, other than to take advantage of its occasional foolishness. We must be able to jot down our reasons for buying. If we buy Johnson & Johnson at $50 per share, we must be able to answer: "JNJ at $50 is undervalued because . . . . ." Ben Graham's dictum told us "the fact that other people agree or disagree with you makes you neither right nor wrong. You will be right if your facts and reasoning are correct."
Be flexible to the types of businesses you buy, but never pay more than the business is worth. To cater for errors, always purchase with a comfortable margin of safety unless you are very certain with your analysis. If the intrinsic value of JNJ is $70, do not purchase at $70, if it is selling at $50, buy it for you have a safety margin of 28.5%. As Warren Buffett says, "If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, [and] if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety."
Bull market creates a lot of temptations but it is also a test on the investor's discipline. Stock prices run up during a bull market and we know that as stock prices surge, the risk becomes higher and the margin of safety gets narrower. However, part of us, says, "Geez, we don't want to miss the train. There's easy profit to be made as price will goes yet higher." We know it is risky but yet we don't want to miss the train. It is thus imperative to be absolutely discipline in not abandoning an approach that works and is safe for another approach that tempts us with seemingly easy profits but highly destructive and risky. Controlling greed is important - not that we should not be greedy. But the right time to be greedy is actually counter-cyclical as Buffett says, "Be greedy when others are fearful and be fearful when others are greedy." Better be long-term greedy than short-term greedy.
Buy stocks as how you buy clothes - only when on sale.
There are only three options when we decide whether to buy a stock - in, out, or too hard, as Buffett told us. Accept it when you don't know something. We all have our limited circle of competency. As Thomas Watson, founder of IBM told us, "I'm smart in spots and I stay in those spots." It doesn't matter how large or small the spot or circle is, the important thing is to recognize the limitation of the circle and stay within it. We do not need to know everything. As long as we understand something better than others, we have an edge.
The pain of losing a dollar is double the joy of gaining a dollar. Focus on avoiding losses, especially permanent loss of capital, and then think about potential gains.
Find one-feet hurdle to step over rather than ten-footer to jump over. Businesses that require the least changes and are simple are superior over businesses that involve lots of changes, innovation and are sexy. Sexy business as in sexy ladies, get us in trouble. Buffett said, "We look for businesses that in general aren't going to be susceptible to very much change."
Invest only when the odds are highly favorable, and if you find it, you must be able to bet heavily. Investors at times have been overly sold on the idea of diversification or dollar-averaging, for fear of having too many eggs in one basket if the bet turns sour. The key here is how well you understand what you invest in. If you understand it perfectly, you need not diversify as it makes no sense to give up something that has a higher chance for a higher return for something that has a lower chance for a higher return. The depth of understanding also affects the degree of margin of safety you need. The more you understand, the less you need in terms of margin of safety and degree of diversification.
Do not focus on predicting macroeconomic factors.
Always be flexible. Be able to recognize mistakes immediately. There's no shame with being wrong. The only shame is being unable to recognize mistakes. Ability to question and discard your best loved ideas if it is proven wrong is not very common but it is certainly important.
Beware of technical analysis, momentum trading, or any geeks who focus much on mathematical modeling. The "quant" or "technician" tries to predict stock movement through the shapes on a stock's chart, without reference to value. When you come across someone who advises a stock at $50, "seems to be poised for a breakthrough to the $54-56 area, although a stop-loss order should be placed at $47," that is an antithesis to the principle of investing.

The correct person

We have identified the principles - by no means, exhaustive - necessary but yet insufficient for long-term success. The other ingredient is the correct person. The following provides some clues on the characteristics successful investors should have:

Patience is a vital virtue. Buffett constantly reminds that you should never buy a stock unless you would be happy with it if the stock exchange was to close for the next five years.
Having the right emotion is important because we are easily affected by the movement of everyday trading price.
High intelligence is not a necessity for successful investing. Buffett noted: "Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ." What you need is just a reasonable IQ and the right mentality and emotions.
A flair for numbers is important but do not be obsessive in it to the decimal. High advanced maths model is irrelevant.
Be humble and check your ego while staying confident with what you believe in. Almost all money managers have confidence in abundance but few are blessed with humidity. The moment arrogance creeps which is fairly easy when your portfolio is on the rise, you become overconfident. The worst kind of overconfidence is to assume success is due to skill rather than because of "when the tide raises, all boat raises." Always ask if your success is due to skills or market conditions. Overconfidence is the start of most disasters because it creates a potential to blind and hinder a person objectivity. They forget to question themselves and assume what was successful in the past will be successful in the future, which often isn't.
Be able to sit on your butt. "The game of investing is one of making better predictions about the future than other people. How are you going to do that," Charlie Munger said, "One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much."
Successful investors neither take any comfort in standing with the crowd nor derive pride from standing alone. Bargains are rarely - not never - found with the crowd. When most people head for something, it drives up the desirability of that something, which means also its price and thus, lower its margin for profit. This is simple economics of supply and demand. The more people want it, the higher the price. The less people want it, the cheaper it is. But beware of the value trap: the key is to identify which are truly cheap and good, not cheap and no good.
Always recognize it is hard, if not impossible, to find a bottom. If you find shares that are low in prices, they don't go up suddenly. Most likely, it will fall much further, at times, even 60% lower. But it doesn't matter. If you buy at $50, and it drops to $20, but in 5 years, it is worth $150, $150 is what matters, not $20.
Be as discipline as you are when you buy as well as when you sell. If you purchase any investment, say a house, at $100,000, for which you know for sure it is worth $600,000, and if someone comes by and offer you $200,000, you should not sell. And if you reject the first offer, and the next day, another buyer comes by and offer $150,000, you should not feel discourage and sell due to desperation, thinking that if you reject the second offer, the next offer may be lower. The key is to come to peace with your own valuation and reasoning. If you know perfectly well what you are purchasing and $600,000 is the intrinsic value, why sell at $200k, $150k, or even $400k? The only time to sell below the intrinsic value is: 1) if you do not know perfectly well what you purchasing, then you should sell at $400k or even lower; or 2) if you can find a better investment that is more undervalue than what you hold. Consider the opportunity cost of all alternatives.
Have passion and love what you do. In Buffett words, one must be able to "tap dance" to work.
Investing is a life-long education. He or she must be an avid learner. The moment we stop learning, we are one feet in the grave. Evolution is the only constant so learning is a must, not a choice. If you find yourself a little bit knowledgeable or smarter when you sleep as opposed to when you wake up earlier, you are partly successful.
Emotions are not part of decision making. Analysis of hard facts are.
For any money manager, three traits are must-have, they are: 1) Integrity, 2) Intelligence, and 3) Passion (as mentioned above). What is most important is integrity for which if it is missing, having the other two create more harm than good to investors who commit money with them. As Buffett says: "It is far easier to rob with the point of a pen than with the point of a gun." Unethical money managers will outwit unknowing investors - think of Bernie Madoff. He probably has both intelligence and passion but no doubt a lack of integrity. "Honesty is the best policy," as Ben Franklin told us.
Never allow greed to take possession of you so that you become in a hurry or afraid to miss the boat. Neither should you be too interested in money, you will kill yourself. However, if you are not interested enough, you won't go to the office. Instead, you must be animated by controlled greed, and fascinated by the investment process, i.e. to enjoy the game.
Possess the security and self-confidence that are backed by knowledge, without being rash or headstrong. If you lack confidence due to a lack of knowledge, fear will drive you out at the bottom. Nervous investors who aren't armed with the right facts have the habit of selling out when they go down.
Must be logical and think objectively.
Last but not least, ssk who is the idol of this person. Most successful investors have some common idols. Warren Buffett admires Benjamin Graham and Benjamin Franklin. Charlie Munger admires Benjamin Franklin. Bill Ruane admires Benjamin Graham. John Niff, Mario Gabelli, Michael Price and John Bogle are all influenced by Graham as well. If you draw a chart, you probably would be able to link a lot of these successful money managers back to the village of Graham and Doddsville.

The two main ingredients for a decent investing career are actually joint at the hip - not mutually exclusive. Some characteristics of the principles are also the characteristics the investor should possess.

Much of what have been written may seem obvious and common sense, but when it comes to putting to practice, majority of money is managed by people who neither have the correct principle nor the correct personal characteristics. After all, common sense aren't that common.

Not all investment managers who have a stellar records are good managers. If you have 10,000 monkeys throwing darts to select stocks, it is certain that a few of them will end up with stellar records due to randomness. This randomness applies to top-performing money managers as well but would they be able to outperform in the future? Of course not for they lack the right ingredients. The luck of these random few will certainly run out as long as they are willing to play the next round continuously till the game ends. Luck, as the dictum says, only "favors the prepared mind." The ingredients mentioned here are part of the preparation.

Thus, these traits are not only useful for evaluating professional money managers but also invaluable in helping you decide how to pick stocks for yourself.

Readers, what do you think? I am as eager to learn from you too if you have any thing good to add.

Warren Buffett's Complete Interview and Transcript at Sun Valley Media Conference

2009-07-09T20:19:00.000-07:00

Warren Buffett spoke with CNBC'c Julia Boorstin today at Herb Allen's Sun Valley Conference. This is the video and transcript of Julia's conversation with Buffett.

JULIA BOORSTIN: Warren Buffett, thank you so much for talking to us here in Sun Valley. I want to start off with a question about what happened today. We got some same-store sales numbers. And Costco's numbers were down despite some of those rebate checks, and I was wondering, you have a lot of consumer-facing businesses, what's your take on the consumer economy? Is it as bad as it seems?

WARREN BUFFETT: I think it is. I haven't seen the figures you're referring to but I had heard ahead of time, not from Costco, they were going to be very poor. Over Father's Day, I don't know whether America's families rebelled against their fathers that day, but sales were bad. Apparel sales were bad. We're in the underwear business. We see how they're moving every day and, wives are not buying underwear for their husbands. (Laughs.) It's still very, very soft.

JULIA: The underwear indicator is bad.

BUFFETT: Yeah, right, underwear is going down. (Laughs.)

JULIA: Looking across the consumer businesses you own, do you have a sense of when the consumer economy will pick up?

BUFFETT: No. I will know when it does. I get very, very contemporaneous figures on it. So when it happens, I'll know. But there's nothing in the figures today that tells me what's going to happen tomorrow. What they do tell me is that today it hasn't picked up yet.

JULIA: The global economic downturn is a big topic of conversation here. Yesterday I know there was a big panel discussion on it. From everything I've heard, it sounds like the mood was very glum. I've heard somber. I've heard glum. It was not a positive mood. Do you agree with that sentiment?

BUFFETT: Well, I would say that right now we're in a very, very tough period. We've been in it - it really took off last September, mid-September, when it hit the financial world like nothing we've ever seen, and that's gotten spilled over into the economy. And it's a tough period now. On the other hand, this movie will have a good ending.

JULIA: Now, good ending over what sort of time period?

BUFFETT: (Laughs). I don't know how long the movie will be. I know the ending will be good but I don't know whether its a two-hour movie or a four-hour movie.

JULIA: Well, you've said that the stimulus has done little, not enough, to get the economy moving. Do you think that people here agree with you on that?

BUFFETT: Well, I don't know about people agreeing with me, but yeah, I think they probably, generally. But the stimulus was never designed to act fast. People hoped it would start trickling in. In general, I think, and this is no criticism of the administration because I believe in the stimulus and would probably believe in another one, they may be overrated in terms of their ability to end the recession fast.

JULIA: But if you're advocating another one, are they overrated?

BUFFETT: I think they're useful, but I think that anybody who looks on them as a panacea is making a mistake. But they're useful, they're useful.

JULIA: What do you think should be done now in terms of, do you think there should be another stimulus right now?

BUFFETT: I think there probably should be. But I wouldn't expect miracles out of it.

JULIA: But so little of the 800-billion dollar stimulus has already been spent. Does it make sense to do another stimulus now, or do we want until some of that money, or more of that money, is out there?

BUFFETT: Well, I would. If you had another one you'd try to load as little on the Christmas tree as possible for specific constituencies, and you would try to get it spent fast. But the President said that originally, let's try to go with the shovel-ready projects. And then Congress got into the act and I think watered it down some.

JULIA: So if the stimulus is, a stimulus is, multiple stimuli, not a panacea, what is the solution?

BUFFETT: There is no silver bullet. I mean, the original cause of this was the housing bubble. Now a lot of things were contributing to it and flowed out of it and all of that. We built a couple million housing units a year. We formed a million, three-hundred thousand households a year, surprise, we had too many houses at a point. You can't work that off in a day, or a week, or a month. The best thing we can do is not to be building a lot of new houses now. I mean, we will work off the excess inventory faster. If you want to end the recession as soon as possible, you do nothing to encourage new housing construction. Very tough on the home builders but that is the prescription for getting supply and demand back into balance.

JULIA: And so what does that mean in terms of interest rates?

BUFFETT: Well, you want low interest rates. The more affordable houses are, I mean people have to have a job too, but low interest rates are a boon to housing in that they mean people qualify for owning housing of a given type that wouldn't otherwise. But we still have too many houses. And the only way to do that, we can either form more households, get all the 14-year-olds to start living together, which they would probably like, (laughs), or we can blow up a bunch of houses, which I don't think any of us would like, or we can produce more than the household formation and we will use up the inventory and we will get back to a vibrant economy.

JULIA: You supported President Obama -

BUFFETT: 100 percent.

JULIA: And what do you think of his behavior, his decisions since he's been in office?

BUFFETT: He's been terrific. I think it's very important that the people in the country, just as in the 30's, that they have a leader they believe in. And they've got good reason to believe in him. Plus he communicates extraordinarily well so they can understand what he's doing and why he's doing it and what the timetables may be and all that sort of thing. So we have the right person in the White House.

JULIA: But you feel like the stimulus hasn't done enough, so do you agree with the way he's handled the financial crisis?

BUFFETT: Well, the Congress wrote the stimulus bill. Yeah. (Smiles.)

JULIA: You've mentioned that you're not worried about inflation right now. You're concerned about inflation down the line. What can the government and the Fed do right now to minimize that risk?

BUFFETT: Well, right now they're pouring the medicine on. Unfortunately the medicine will have an after-effect, and it will be inflation, and the question is how much and how extreme? We're going to apply a lot of medicine, and we're likely to get a lot of inflation down the road. But it's better to have the patient recover than to sit there and say I'm worried about the after-effects of the medicine so we'll just ignore it.

JULIA: Oil prices have come way down over the past six weeks. I think they're now around 60 dollars. Will that help the situation?

BUFFETT: Well, it always helps. I mean, we are importing 10-million plus barrels a day of oil and that's a tax that the rest of the world imposes on us. We give them goods and services that we produce, or IOUs, in exchange for that. And the cheaper we buy oil, the better off we are.

JULIA: And where do you think oil prices are going to head in another year?

BUFFETT: (Laughs.) If I knew it, I wouldn't tell you, but I don't know it. (Laughs.)

JULIA: So President Obama spent a lot of time recently overseas dealing with international relations. Obviously he has a lot of issues on his plate. Is that where he should be focusing his attention?

BUFFETT: Well, it's important that he do that, obviously. The number one job is the economy but that doesn't mean you ignore the rest of the world. Plus he has this, he is favorably regarded by the rest of the world and he should take advantage of that. He should establish relationships that are better with important countries than has been the case in the last eight years.

JULIA: So do you think the biggest issue that Obama is facing right now is the U.S. economy?

BUFFETT: For sure. I mean, if you're unemployed, your most important job is to get another job, and get an income. And the country is becoming unemployed to a degree. And it's very important the economy gets, comes back. It will come back. Government has less influence on how fast that happens than a lot of people would like to hope that it would. But government is a player, but it has no silver bullet. The economy will come back, though.

JULIA: It seems like one of the big issues facing the economy, and also a big topic of discussion here, is health care. I know that there were a number of panels on health care here today. How grave a problem do you think is, do you think the U.S. health care system is, and what do you think the solution is?

BUFFETT: Well, (laughs), I know how big a problem it is but I don't know what the solution is. If I knew the solution I wouldn't hesitate to offer it. But I don't bring anything to that party that hundreds of thousands of other people don't know as much or more about it than I do. But it's obviously a huge problem when it's using up whatever it may be, some people say it's as high as 17 percent of GDP. But we can't go on with health care accelerating at a faster rate than GDP. We've done it for a long time, but we need a solution, and there are better people, people better qualified than I.

JULIA: One of the ideas that Senate Democrats are talking about is a surcharge tax on individuals earning over 200-hundred thousand dollars. What do you think of that as an idea to help address the health care cost issue?

BUFFETT: Well, I wouldn't do it in respect necessarily to the health care specifically, but I think that on balance the rich have been undertaxed compared to the middle class and the lower class. I mean, over the last decade in particular, the tax law has been tilted in favor of guys like me and we don't need any help. And there are plenty of people in this country that do.

JULIA: So what would you advocate in terms of the future of taxes?

BUFFETT: I would have something that hits guys like me harder and hits the people that served us breakfast this morning a little less.

JULIA: So where is that dividing line? Is it 200-hundred thousand dollars? Does that make sense as a -

BUFFETT: I think it should be more progressive the higher up you go. But I think it's ridiculous when my tax on capital gains is less than the payroll tax on what you're earning today.

JULIA: What do you think some of the other people here would say about that?

BUFFETT: Well, you'll have to ask them. (Smiles.) Some of them would agree. No, a lot of them would agree. They wouldn't like it. Nobody likes having their taxes increase. I don't like having my taxes increase. But on the other hand, we're raising 2.3, something like that, trillion. We may spend four-trillion. There's going to have to be some adjustment made someplace and I think it's better to adjust it, to some degree, on guys like me rather than on the people who gave me breakfast this morning.

JULIA: How long -- do you think taxes will go up in the near future?

BUFFETT: I don't know about the near future, but they will go up over time because we're not going to bring spending down from four-trillion to 2.3 trillion, and we're not going to take up revenues unless we -- it will be helped some when we get a recovery, but we'll need somewhat higher taxes someplace.

JULIA: So back to the health care issue. Speaking of taxes, one of the questions is whether to tax employer-provided health care. And this is a big issue of debate. What do you think?

BUFFETT: It will all be, there will be so many tradeoffs involved, it won't be a perfect bill. Nobody could design a perfect bill. So, you can't really look at one part of it until you're looking at other parts of it. So I don't have any magic answer on that.

JULIA: Another thing that we're hearing a lot about is the hospital industry has agreed to a lot of cost cuts. We've seen the pharmaceutical industry agree to a lot of discounts. Together, that amounts to hundreds of millions of dollars. How much are those kinds of compromises going to be to finding a health care solution?

BUFFETT: Well, they're going to be important. But they problem you have is you have a health care situation now where more than two-trillion dollars a year is being spent. That means two-trillion dollars is going to somebody, whether its doctors, nurses, hospitals, pharmaceutical companies, you name it. Everyone is going to look at that bill and they're going to say, 'Am I getting more or less?' It's like a tax law change. Every line in the tax code has a constituency. Well, every dollar in medical expenses has a constituency, and that's the tough thing at the end. It will take a lot of leadership and some statesmanship on the part of people to get something. But it is a question that needs to be addressed.

JULIA: Now, in addition to health care, this year digital media and distribution of media and monetization of media has been a big topic of conversation here. Last year we talked about the Kindle and you were really enjoying your Kindle. What do you think is the big topic this year?

BUFFETT: Well, I'm here as part of their outreach program. I'm the village idiot in terms of this stuff. So they try everything out on me, if it gets past me any three-year-old can do it. I'm the wrong guy to ask ..

JULIA: Have they tried to get you to use something this year?

BUFFETT: People are always trying to get me to use things. Like I say, I will be the last guy around using a landline phone and reading a newspaper and doing all those things.

JULIA: Have you tried Twitter?

BUFFETT: I have not tried Twitter, although I met the fellow who, one of the co-founders of it, he's from a little town in Nebraska called Clark and he went to the University of Nebraska for a couple of years. So can't be all bad. (Laughs.)

JULIA: It can't be all bad. Now one question, since we're hearing a lot about watching television on the internet, have you ever watched TV on the internet?

BUFFETT: I haven't watch TV on the internet, but I have used the internet a lot. A lot.

JULIA: So, here, talking to media CEOs, talking to CEOs from a big range of businesses, the CEO of Coca-Cola], American Express, they're all here, what is the sense you're getting from them about the state of the economy?

BUFFETT: Well, they would see it the same way. The economy, they would probably say that the decline has stopped, most of them would say this in their business, but there's been no rebound. Now that doesn't mean there wouldn't be a further decline. It doesn't mean the rebound won't start tomorrow. But what they are seeing in their businesses is sort of a flat line after a big descent.

JULIA: Is there anything that you've heard here from these CEOs that surprised you?

BUFFETT: No, I wouldn't say that at all. They're seeing the same things I see. We're in about 70 businesses ourselves, and I've got CEOs of every one of those companies , so I've already talked to a lot of them before I got here.

JULIA: So I have to ask you a question --

BUFFETT: Uh oh. (Laughs.)

JULIA: I know that you are friends with LeBron James. I know he's a huge fan of your's. Yesterday I was chatting with him and he said he'd be game for a game of pickup basketball with any CEO, anyone here who is interested. Are you going to play pickup basketball with LeBron James?

BUFFETT: I've already done it. I played him in basketball a couple of year ago. We played for hours, and maybe I'll even reveal the results of that --

JULIA: Who won?

BUFFETT: Well, I will play him any game he wants to play as long as I get to keep score. (Laughs.) But I won't tell him my scoring method ahead of time.

JULIA: So there's no match here that's been planned?

BUFFETT: We're going to play golf, but not basketball.

JULIA: Is he a good golf player?

BUFFETT: He tells me he's never played. I've played 65 years and if you want to place a bet on either one of us, bet on him. (Laughs.) He's got a special set of clubs, though. Phil Knight at Nike gave him this special set of clubs, so who knows what it's going to be like.

JULIA: Maybe he'll be a big pro. Well, thank you so much for talking with us. I really appreciate it.

BUFFETT: It's been a pleasure. Thanks.

NY Times: No Recovery in Sight

2009-07-09T10:13:00.000-07:00

By Bob Herbert

Published June 26, 2009

How do you put together a consumer economy that works when the consumers are out of work?

One of the great stories you'll be hearing over the next couple of years will be about the large number of Americans who were forced out of work in this recession and remained unable to find gainful employment after the recession ended. We're basically in denial about this.

There are now more than five unemployed workers for every job opening in the United States. The ranks of the poor are growing, welfare rolls are rising and young American men on a broad front are falling into an abyss of joblessness.

Some months ago, the Obama administration and various mainstream economists forecast a peak unemployment rate of roughly 8 percent this year. It has already reached 9.4 percent, and most analysts now expect it to hit 10 percent or higher. Economists are currently spreading the word that the recession may end sometime this year, but the unemployment rate will continue to climb. That's not a recovery. That's mumbo jumbo.

Why this rampant joblessness is not viewed as a crisis and approached with the sense of urgency and commitment that a crisis warrants, is beyond me. The Obama administration has committed a great deal of money to keep the economy from collapsing entirely, but that is not enough to cope with the scope of jobless crisis.

There were roughly seven million people officially counted as unemployed in November 2007, a month before the recession began. Now there are about 14 million. If you add to these unemployed individuals those who are working part time but would like to work full time, and those who want jobs but have become discouraged and stopped looking, you get an underutilization rate that is truly alarming.

"By May 2009," according to the Center for Labor Market Studies at Northeastern University in Boston, "the total number of underutilized workers had increased dramatically from 15.63 million to 29.37 million - a rise of 13.7 million, or 88 percent. Nearly 30 million working-age individuals were underutilized in May 2009, the largest number in our nation's history. The overall labor underutilization rate in May 2009 had risen to 18.2 percent, its highest value in 26 years."

If it were true that the recession is approaching its end and that these startling high numbers were about to begin a steady and substantial decline, there would be much less reason for alarm. But while there is evidence the recession is easing, hardly anyone believes a big-time employment turnaround is in the offing.

Three-quarters of the workers let go over the past year were permanently displaced, as opposed to temporarily laid off. They won't be going back to their jobs when economic conditions improve. And many of those who were permanently displaced were in fields like construction and manufacturing in which the odds of finding work, even after a recovery takes hold, are not good.

Another startling aspect of this economic downturn is the toll it has taken on men, especially young men. Men accounted for nearly 80 percent of the loss in employment in this recession. As the labor market center reported, "The unemployment rate for males in April 2009 was 10 percent, versus only 7.2 percent for women, the largest absolute and relative gender gap in unemployment rates in the post-World War II period."

Workers under 30 have sustained nearly half the net job losses since November 2007.

This is not a recipe for a strong economic recovery once the recession officially ends, or for a healthy society. Young males, especially, are being clobbered at an age when, typically, they would be thinking about getting married, setting up new households and starting families. Moreover, work habits and experience developed in one's 20s often establish the foundation for decades of employment and earnings.

We've seen what happens when you rely on debt and inflated assets to keep the economy afloat. The economy can't be re-established on a sound basis without aggressive efforts to put people back to work in jobs with decent wages.

We also need to consider the suffering that is being endured by these high levels of joblessness, including the profound negative effect on the families of the unemployed. Lawrence Mishel, president of the Economic Policy Institute, warned about the consequences for children. "What does it mean," he asked, "when kids are under stress because there is no money in the household, or people have to move more, or are combining households, or lose their health insurance? I believe this is going to leave a permanent scar on a generation of kids."

The first step in dealing with a crisis is to recognize that it exists. This is not a problem that will evaporate when the gross domestic product finally begins to creep into positive territory.

Bill Gross July 09 Investment Outlook: New Normal Equals Slower Growth, Narrower Profit Margin & Lower Return on Asset

2009-07-09T09:25:00.000-07:00

Here are some notes from Bill Gross's July 09 Investment Outlook.

Umpire John McSherry died during a baseball game because he couldn't stop eating.
Franz Kafka wrote a story 100 years earlier of a man who starve himself to the point of extinction because he "couldn't find the food" he liked.
The two individuals mentioned are not about food but life itself. The stories tell us human we need to change the way we think, act, or we will end up like John McSherry or the Hunger Artist.
In the past, U.S. and many global consumers gorged themselves too much financed with credit, which cannot be sustained. A new normal will set in in future.
The "new normal" means growth will be slower, profit margins narrower, and return on assets smaller than in decades past based upon the delevering and reregulating of the global economy, which in turn should substantially inhibit the "gorging" of goods and services that consumers grew used to in decades past.
Forecasts based on econometric models miss these secular/structural breaks in historical patterns because it is impossible to quantify human behavior. Human beings do not make decisions by chance or independently of each other, but in many cases in reaction to one another, for which charts nor forecasts can help to predict.
The supersizing of financial leverage and consumer spending in concert with the politicizing of deregulation describes our most recent brush with irrational behavior and inefficient markets.
Greed will come again. But for now, the trend is the other way and it promises to persist for a generation at a minimum.
Fact is American consumers have suffered a collapse in wealth of at least $15 trillion since early 2007. Result is potential spenders feel less rich by that much, the only model one can use to forecast the future is to logically predicts higher savings, lower consumption, and an economic growth rate that staggers forward at a new normal closer to 2 as opposed to 3.5%.
High unemployment will not lead to a return to the "old normal."
Many unemployed are untrained for the demands of a green-oriented, goods-producing future economy. Imagine a welding rod in the hands of an investment banker or mortgage broker and you'll understand the implications quicker than any economist using an econometric model.
Profit will likely settle at half of the absolute peak profit levels of 2007 and grow slower because of the rise of saving rates from 0 to 8% or higher.
Investor are likely to see less share of the pie (profit) because of the huge deficits, the recent reinitiation of PAYGO government programs and the health care program, which are likely to lead to higher tax rates. Therefore, new normal will not be friendly to investors.
Short-term policy rates will be kept low for longer than cyclical norms, and risk assets - stocks, high yield bonds, and commercial and residential real estate will involve just that - risk.
Investors should stress secure income offered by bonds and stable dividend-paying equities.
Over consumption is a relic of the past.

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Why Companies Fail (Part II)

2009-07-09T08:58:00.000-07:00

By Gary Hamel

Published June 08, 2009 on WSJ

In my last post I identified three things that can turn leaders into laggards: the practical difficulties of sustaining above-average performance, the natural obsolescence of once-vital strategies, and the corrosive impact of discontinuous change. Now let me add a forth: success corrupts.

The seeds of failure are usually sown at the heights of greatness - that's why success is so often a self-correcting phenomenon. The dynamics work like this:

Once a company becomes an industry leader, its employees, from top to bottom, start thinking defensively. Suddenly, people feel they have more to lose from challenging the status quo than upending it. As a result, one-time revolutionaries turn into reactionaries. Proof of this about-face comes when senior executives troop off to Washington or Brussels to lobby against charges that would make life easier for the new up and corners.

Years of continuous improvement produce an ultra-efficient business system - one that's highly optimized, and also highly inflexible. Successful businesses are usually good at doing one thing, and one thing only. Over-specialization kills adaptability - but this is a tough to trap to avoid, since the defenders of the status quo will always argue that eking out another increment of efficiency is a safer bet than striking out in a new direction.

Long-tenured executives develop a deep base of industry experience and find it hard to question cherished beliefs. In successful companies, managers usually have a fine-grained view of "how the industry works," and tend to discount data that would challenge their assumptions. Over time, mental models become hard-wired - a fact that makes industry stalwarts vulnerable to new rules. This risk is magnified when senior executives dominate internal conversations about future strategy and direction.

With success comes bulk - more employees, more cash and more market power. Trouble is, a resource advantage tends to make executives intellectually lazy - they start believing that success comes from outspending one's rival rather than from outthinking them. In practice, superior resources seldom defeat a superior strategy. So when resources start substituting for creativity, it's time to short the shares.

Finally, success breeds arrogance. Caretaker executives who've never been entrepreneurs and have never built something out of nothing are prone to view success as an entitlement, rather than the result of innovation, gut-wrenching decisions and perseverance. Isolated from the breeding edge of change by subservient minions, they start believing their own speeches. Unlike Andy Grove, Intel's former CEO, they aren't perpetually paranoid. Instead, they're naively confident, and therefore prone to underestimate threats and discount new competitors.

These aren't the only things that can turn leaders into also-rans, but they're the ones I've encountered most often.

In future blogs, I'll share some ideas about how a company can inoculate itself from these dangers. One quick suggestion: Treat every belief you have about your business as nothing more than a hypothesis, forever open to disconfirmation. Being paranoid is good, becoming skeptical about your own belief is better.

Why Companies Fail (Part 1)

2009-07-09T00:07:00.000-07:00

By Gary Homel

Published June 1, 2009 on WSJ

I grew up in Michigan, so the bankruptcy of General Motors strikes close to home. There was a time when GM made more than half the cars sold in the United States. But now, what was for decades the world's largest industrial company, is a ward of the state. GM's failure isn't the result of one spectacularly ill-conceived decision - the company didn't jump off a cliff. Instead, it meandered into mediocrity, one small short-sighted step at a time. Like a two-pack a day smoker, GM committed suicide in degrees.

Dodgy quality, a toxic labor environment, incoherent brand identities, clunky power-trains, adversarial supplier relations, and subterranean resale values - these were the chronic symptoms of a management model that regarded profits as the game rather than the scoreboard, that valued financial finagling more highly than inspired engineering, and elevated MBA-types to rule over the car guys.

A scan eight months ago, GM's then-chairman, Rick Wagoner, boasted that his company was "ready to lead for 100 years to come" - a comment that only could have been made by someone who was either naively optimistic or hopelessly delusional.

Ever since I can remember, GM's defenders have been arguing that the company was making progress; and they were right. GM has been getting better for a very long time - but it's been 40 years since it was the best. The Chevrolet Malibu and Corvette ZR1, the Buick Enclave and Cadillac CTS-V: these are exceptional cars by anyone's standards. Problem is, they are even more exceptional when judged against the persistent ordinariness of GM's other products. For years, excellence at GM has been an occasional aberration, rather than an all-consuming passion.

A company can coast for a long time when it starts with a dominant share of an enormous and hard-to-penetrate market in the world's largest economy - but given enough time, and enough incrementally myopic decisions, and it will eventually run out of momentum.

GM is not the only company that's sputtering right now. Motorola, Citi, NASCAR, Starbucks, Sony, United Airlines, EMI, Kodak, Alitalia, Sprint Nextel, the New York Times, Unilever, AOL and Chrysler - these are just a few businesses that seem to have lost their mojo. Truth is, every organization is successful until it's not - and today, there are a lot that are not.

How does this happen? How do yesterday's icons become today's also-rans? How does excellence degrade? What are the causes of corporate dysphoria? These are important questions. When an organization stumbles badly everyone loses: shareholders, employees and customers. Through the years, I've seen a lot of companies lose their way. Here's how it happens.

First gravity wins. There are three physical laws that tend to flatten the arc of success. The first is the law of large numbers. We all know that it's a lot harder to grow a big company than a small one. To grow a $40 billion company by 25% requires the creation of ten new billion-dollar businesses. To grow a $40 million company by the same percentage requires only one new $10 million business. In business as in biology, big things grow slower.

Then there's the law of averages. No company can outperform the mean indefinitely. During the last five years of Jack Welch's tenure at GE, the company's market value grew from just under than $140 billion to more than $400 billion. To maintain that torrid pace, Jeff Immelt, who took over from Welch in September 2001, would have had to grow GE's value to more than $1.2 trillion dollars by August 2006 - but that was never going to happen. As you lengthen the relevant timeframe from one year to five and then to ten, the probability of out-performing the average rapidly approaches zero. In the long-run there are no growth companies.

Lastly, there's the law of diminishing returns. The pay-off to any program focused on revenue growth or margin enhancement tends to shrink over time. Top-line growth slows as markets mature, and productivity growth slows as the knife scrapes closer to the bone. Over time, it takes more and more effort to produce less and less in the way of incremental returns. While these three laws aren't as unyielding as gravity, they're tough to overcome - and few companies manage it.

Second, strategies die. Like human beings, strategies start to die the moment they're born. While death can be delayed, it can't be avoided. Autopsies reveal three primary causes of death.

Clever strategies get replicated. Hewlett-Packard ultimately learned how to make computers as cheaply as Dell. JetBlue took a chapter out of Southwest Airlines' playbook. Cialis and Levitra intruded on Viagra's turf. And Facebook built on the social networking model pioneered by MySpace. While some strategies are harder to imitate than others (particularly those that yield network effects), most can be decoded by dedicated rivals.

Venerable strategies get supplanted. Digital cameras made firm obsolete. Downloadable music deflated the market for CDs. Skype allowed its users to sidestep expensive tariffs. And online news aggregators hollowed out newspaper profits. Sometimes newspapers improve on an existing strategy, but occasionally they shoot it out of the sky.

Profitable strategies get eviscerated. The internet has produced a dramatic shift in bargaining power - from producers to consumers. Armed with near perfect information, customers are able to batter down prices on just about everything. For many companies, well-informed customers are now a bigger threat to margins than well-armed competitors.

In life, death can come as a shock. In business, it never should. With the right metrics, strategy decay is largely predictable, though few companies bother to track it. And while a doddering granddad can't abandon his decrepit body for a young and vital one, a company can - at least in theory. Companies die when they can't escape the grasp of a dying strategy.

Third, change happens. Think of the number of things that have been changing at an exponential pace: the number of genes sequenced, the number of devices connected to the internet, the number of mobile phones in the world, CO2 emissions, the amount of bandwidth available globally, and the production of knowledge itself. In the past, there were many things that protected incumbents from the gale-force winds of creative destruction, including regulatory barriers, technology hurdles, distribution monopolies, and capital constraints. But in most industries these bulwarks have been crumbling. Discontinuities undermine old business models and create opportunities for newcomers. So not only do strategies die, they die quicker than they used to - and that's a fact. Over the past few decades, product- and technology-based advantages have become more fleeting. At the same time, the correlation between current and future earnings performance has become progressively weaker.

Fact is, most businesses were never built to change - they were built to do one thing exceedingly well and highly efficiently - forever. That's why entire industries can get caught out by change - industries like big pharma, publishing, recorded music and major U.S. airlines. In a world where change is shaken rather than stirred, the only way a company can renew its lease on success is by reinventing itself root and branch, before it has to - a feat that even the smartest companies have trouble pulling off.

Without doubt, the greatest threat to success is success itself. So next week: how success corrupts.

Why Companies Fail CEOs offer every excuse but the right one: their own errors. Here are ten mistakes to avoid.

2009-07-06T09:21:00.000-07:00

By Ram Charan and Jerry Useem Reporter Associate Ann Harrington

Published May 27, 2002 on Fortune

1) Softened by success

"Those whom the gods would destroy," Euripides wrote nearly 2,500 years ago, "they first make mad." In the modern update, the gods send their victims 40 years of success. Actually, it's a proven fact: A number of studies show that people are less likely to make optimal decisions after prolonged periods of success. NASA, Enron, Lucent, WorldCom - all had reached the mountaintop before they ran into trouble. Someone should have told them that most mountaineering accidents happen on the way down.

Consider the case of Cisco Systems. While by no means a faiure, Cisco suffered a remarkable comedown in the spring of 2001 - remarkable not only for its swiftness (its shares lost 88% of their value in one year) but also because Cisco, more than any other company, was supposed to be able to see into the future. The basis of this belief was a much vaunted IT system that enabled Cisco managers to track supply and demand in "real time," allowing them to make pinpoint forecasts. The technology, by all accounts, worked great. The forecasts, however, did not. Cisco's managers, it turned out, never bothered to model what would happen if a key assumption - growth - disappeared from the equation. After all, the company had recorded more than 40 straight quarters of growth; why wouldn't the future bring more of the same?

The rosy assumptions, moreover, persisted even when evidence to the contrary started piling up. Customers began going bankrupt. Suppliers warned of a coming dropoff in demand. Competitors stumbled. Even Wall Street wondered if the Internet equipment market was falling apart. "I have never been more optimistic about the future of our industry as a while or of Cisco," CEO John Chambers declared in December 2000, still projecting 50% annual growth.

What was Chambers thinking? In the Challenger Launch Decision, her definitive book on the disaster, Boston College sociologist Diane Vaughan notes that people don't surrender their mental models easily. "They may puzzle over contradictory evidence," she writes, "but usually succeed in pushing it aside - until they come across a piece of evidence too fascinating to ignore, too clear to misperceive, too painful to deny, which makes vivid still other signals they do not want to see, forcing them to alter and surrender the world-view they have so meticulously constructed."

For the perpetually sunny Chambers, that "piece of evidence" did not come until April 2001, when cratering sales forced Cisco to write down $2.5 billion in excess inventory and lay off 8,500 employees. Chambers may have been operating in real time, but he wasn't operating in the real world.

2) See no evil

With $6.5 billion in cash and a strong competitive position, Cisco will live to fight another day. Polaroid may not be so lucky. Like its fellow old-economy stalwart Xerox, Polaroid was a once-highflying member of the Nifty-Fifty group of growth stocks that lost their luster over the years. Eventually the question "What does Polaroid make?" became a latter-day version of "Who's buried in Grant's tomb?" Polaroid, that is, made Polaroid cameras - period.

Time had passed the company by, you might say. Not exactly. Think about another company that once seemed doomed to fail: Intel. Back in 1985, competition from Japan was turning Intel's memory chips into cheap commodities, and observers were all but writing the company's obituary. Instead of going the way of Polaroid, though, Intel decided to exit the memory business entirely and become a maker of microprocessors. The key insight occurred when Intel founders Andy Grove and Gordon Moore sat down and asked themselves some tough questions. "If we got kicked out and the board brought in a new CEO," Grove asked Moore, "What do you think he would do?" Get out of memory chips was the answer. From there, they said later, it was just a matter of doing what needed to be done.

Polaroid and Xerox, by contrast, were slow to confront the changing world around them. Executives at both companies repeatedly blamed poor results on short-term factors - currency fluctuations, trouble in Latin America - rather than the real cause: a bad business model. By the time Xerox President (and now CEO) Anne Mulcahy came out and spoke the truth - the company had "an unsustainable business model," she told analysts in 2000 - Xerox was flirting with bankruptcy.

Jim Collins, author of the influential management books Built to Last and Good to Great, has spent years studying what separates great companies from mediocre ones. "The key sign - the litmus test - is whether you begin to explain away the brutal facts rather than to confront the brutal facts head-on," he says. By forcing themselves to think like outsiders, Grove and Moore recognized the brutal facts before it was too late. Polaroid and Xerox didn't.

3) Fearing the boss more than the competition

Sometimes CEOs don't get the information they need to make informed decisions. The main reason, says Daniel Goleman, a psychologist and author of the book Primal Leadership, is that subordinates are afraid to tell them the truth. Even when a boss doesn't intend to quash dissent, subtle signals - a sour expression, a curt response - can broadcast the message that bad news isn't welcome. That's why, according to a study by Goleman and two associates, higher-ranking executives are less likely to have an accurate assessment of their own performance.

Fear can have its uses, of course; Andy Grove has long espoused the value of competitive paranoia. But in unhealthy situations, employees come to worry more about internal factors - what the boss might say, what management might do - than about threats from the outside world. Certainly this was the cause at Enron, where even alarm-ringer Sherron Watkins chose to express her concerns anonymously rather than hazard one of CEO Jeff Skilling's famous tongue-lashings. And she was one of the brave ones.

The same problem hampered Samsung Chairman Lee Kun Hee in 1997 when he decided to take Samsung into the auto business. Knowing the car industry was a crowded field plagued by overcapacity, many of Samsung's top managers silently opposed the $13 billion investment. But Lee was a forceful Chairman and a car buff to boot. So when Samsung Motors folded just a year into production, forcing Lee to spend $2 billion of his own money to placate creditors, he expressed surprise: How come nobody had spoken up about their reservations?

During World War II, Winston Churchill worried that his own larger-than-life personality would deter subordinates from bringing him bad news. So he set up a unit outside his general's chain of command, the Statistical Office, whose primary job was to feed him the starkest, most unvarnished facts. In a similar vein, Richard Schroth and Larry Elliott, authors of the forthcoming book How Companies Lie, suggest designated "counterpointers," whose function is to ask the rudest questions possible. Such mechanisms take information and turn it into information that can be ignored.

4) Overdosing on risk

Some companies simply live too close to the edge. Global Crossing, Qwest, 360networks - these telecom flameouts chose paths that were not just risky but wildly imprudent. Their key mistake: loading up on two kinds of risk at once.

The first might be called "execution risk." In their race to band the earth in optical fiber, the telco upstarts ignored some key questions: Namely, would anyone need all of this fiber? Weren't there too many companies doing the same thing? Wouldn't, uh, most of them fail? "People seemed to say 'Maybe - but it's not going to be us,' says Darrel Rigby, a Bain & Co. consultant who studies managing during times of turbulence. "Everyone though they were immune."

On top of execution risk was another kind, which we'll call liquidity risk. Global Crossing - run by Gary Winnick, formerly of the junk-bond house Drexel Burnham Lambert - loaded up on $12 billion of high-yield debt. This essentially limited Winnick to a cannonball strategy: one shot, and if you miss, it's bankruptcy.

Bankruptcy it was. Given the utter violence of the telecom shakeout, you might say it was inevitable. But other telcos did manage to escape the carnage. BellSouth, dismissed as hopelessly conservative during the Wild West years, emerged with a pristine balance sheet and a strong competitive position. Its gentlemanly CEO, Duane Ackerman, was guided by a radical idea: "being good stewards of our shareholder's money." What a concept.

5) Acquisition lust

WorldCom founder Bernard Ebbers liked to eat. He ate MCI. He ate MFS and its UUNet subsidiary. He tried to eat Sprint. Wall Street helped him wash it all down with cheap capital and a buoyant stock price. Pretty soon WorldCom was tipping the scales at $39 billion in revenues. But there was a problem: Ebbers didn't know how to digest the things he ate. A born dealmaker, he seemed to care more about snaring new acquisitions than about making the existing ones - all 75 of them - work together. At least Ebbers was up front about it. "Our goal is not to capture market share or be global," he told a reporter in 1997. "Our goal is to be the No.1 stock on Wall Street."

The results were frequently chaotic. For a time, sales rep from UUNet competed head-to-head with WorldCom sales teams for corporate telecom contracts. Smaller customers complained they had to call three different customer-service reps for their internet, long-distance and local-phone inquires. If there is such a thing as negative strategy, WorldCom may have discovered it.

Not that acquisitions are always so bad. General Electric combines its acquisitive nature with an impressive ability to break down acquisitions and integrate them into existing operations. But too often CEOs succumb to an undisciplined lust for growth, accumulating assets for the sake of accumulating assets. Why? It's fun. There are lots of press conferences. It's what powerful CEOs do. And like Ebbers, whose WorldCom stock had lost 98% of its value, few wonder if their eyes might be bigger than their stomachs.

6) Listening to Wall Street more than to employees

No one likes a good growth story better than Wall Street. And in the late 1990s, no one was telling a better one than Lucent CEO Rich McGinn. He knew how to give Wall Street what it wanted - explosive top-line growth - and in return, Wall Street turned McGinn and his team into rock stars. For a bunch of former Bellheads, it was intoxicating stuff.

But while McGinn was busy performing for the Street, there were at least two groups he wasn't listening to. The first was Lucent's scientists, who feared the company was missing out on a new optical technology, OC-192, that could transmit voice and data faster. They pleaded in vain for its development, then watched as rival Nortel rolled out OC-192 gear to thunderous success. At the same time McGinn was neglecting Lucent's salespeople, who might have told him that his growth targets were becoming increasingly unrealistic. To meet them, employees were pulling forward sales from future quarters by offering steep discounts and wildly generous financing arrangements, largely to dot-coms. "As we got further and further behind," Chairman Henry Schacht later explained, "we did more and more discounting."

It could only last so long. After Lucent stock had lost more than 80% of its value and he had replaced McGinn as CEO, Schacht sat down with FORTUNE to ponder some hard-earned lessons. "Stock price is a byproduct; stock price isn't a driver," he said. "And every time I've seen any of us lose sight of that, it has always been a painful experience." Top management needs to understand what the folks on Wall Street want - but not necessarily give it to them.

7) Strategy de Jour

When companies run into trouble, the desire for a quick fix can become overwhelming. The frequent result is a dynamic that Collins describes in Good to Great: "A&P vacillated, shifting from one strategy to another, always looking for a single stroke to quickly solve its problems. [It] held pep rallies, launched programs, grabbed fads, fired CEOs, hired CEOs and fired them yet again." Lurching from one silver bullet solution to another, the company never gained any traction.

Collins calls it the "doom loop," and it's a killer. Kmart is another victim. In the 1980s, and early '90s, Kmart was all about diversification, shifting away from discounting to acquire stakes in chains like Sports Authority, OfficeMax, and Borders bookstores. But in the 1990s a new management team divested those stores and decided to revamp Kmart's supply chain by investing heavily in IT. That lasted for a while, until a new CEO, Chuck Conaway, decided that, actually, Kmart would try to beat Wal-Mart at its own game. This unleashed a disastrous price war that in the end proved to be one mistake too many." When you look at companies that get themselves into trouble," says Collins, "they're often taking steps of great, lurching bravado rather than quiet, deliberate understanding." Did somebody say AT&T?

8) A dangerous corporate culture

Arthur Anderson, Enron, and Salomon Brothers were all brought down, or nearly so, by the rogue actions of a tiny few. But the bad apples in these companies grew and flourished in the same kind of environment: a rotten corporate culture. It's impossible to monitor the actions of every employee, no matter how many accounting and compliance controls you put in place. But either implicitly or explicitly, a company's cultural code is supposed to equip front-line employees to make the right decisions without supervision. At Salomon Brothers the culture did just the opposite. The transgressor there was Paul Mozer, a trader who in February of 1991 improperly overbid in auctions of U.S. Treasury bonds. While it was another improper bid on May 22 that finally did him in, the critical event occurred in April, when Salomon Chairman John Gutfreund learned of the February overbid by Mozer and failed to discipline him Mozer evidently took Gutfreund's lack of action as a green light.

Salomon's culture of swashbuckling bravado encouraged risk taking without accountability. Enron's culture encouraged profit taking without disclosure. Andersen's culture engendered conflicts of interest without safeguards. Rotten cultures produce rotten deeds.

9) The new-economy death spiral

Alan Greenspan has his own theory on failure. Testifying about Enron in February, he noted, "A firm is inherently fragile if its value-added emanates more than conceptual as distinct from physical assets . . . Trust and reputation can vanish overnight. A factory cannot." The speed of some recent crackups would seem to confirm his thesis. The first domino falls when questions are raised, sometimes anonymously. Wrongdoing is suspected. Customers delay new orders. Rating agencies lower their debt ratings. Employees head for the exits. More customer defect. And voila, you have what former Enron CEO Jeff Skilling has called "a classic run on the bank."

Is it possible to halt one? Yes, but only if you stop the spiral from building up speed. Salomon broke the cycle by hiring Warren Buffett as interim CEO - essentially a giant credibility infusion. By waiting several months to step down, on the other hand, Arthur Andersen CEO Joseph Berardino lost whatever chance he had to avoid disaster. Once started, the spiral can bring a company whose main assets are people and ideas to its knees with breathtaking finality.

10) A dysfunctional board

What was Enron's board thinking? Of all the infamous moments in the company's demise, perhaps the least explicable was the board's decision to waive Enron's code of ethics to accommodate CFO Andrew Fastow's partnerships. "A red flag the size of Alaska," says Nell Minow, founder of the board watchdog group Corporate Library. Even Enron directors belatedly agreed with this assessment. "After having authorized a conflict of interest creating as much risk as this one," the board's special investigation committee wrote in a February report, "the board had an obligation to give careful attention to the transactions that followed. It failed to do this . . . In short, no one was minding the store."

Despite a decade's worth of shareholder activism, Enron's board was not an anomaly. The sorry fact is that most corporate boards remain hopelessly beholden to management. "I was never allowed to present to the board unless things were perfect," says a former senior executive at Xerox, whose board includes Vernon Jordan and former Senator George Mitchell. "You could only go in with good news. Everything was prettied up." At many boards, the CEO oversees meeting, hand-picks directors, and spoon-feeds them information. "Directors know relatively little apart from what management tells them," says John Smale, a former CEO of Procter & Gamble and onetime chairman of General Motors.

Unless, that is, the board demands more. "The CEO is always going to want to turn the board meeting into a pep rally," says Minow. "You've got to say to him, 'Look, I'm a busy person. I don't have time for the good news. What I need for you to tell me is the bad news.' It's like what Robert Duvall says in the Godfather: 'I have to go to the airport. The Godfather is a man who likes to hear bad news immediately.' That should be emblazoned on every corporate governance policy sheet."

Paul O'Neill may have been wrong about his assessment of Enron, but he was right about something else. "The great companies don't make excuses," he said recently, "including excuses about how they didn't do well because the economy was against them or prices were not good. They do well anyway." It's true. And it's something to think about the next time you hear a CEO railing at the gods.

Ram Charan is co-author with Larry Bossidy, of Execution: The Discipline of Getting Things Done.

Six Lessons for Investors: Be Diversified and Don't assume past performance will continue

2009-07-05T08:50:00.000-07:00

By John C. Bogle

Published January 8, 2009

There is almost no limit to the ability of investors to ignore the lessons of the past. This cost them dearly last year. Here are six of the most important of these lessons:

1) Beware of market forecasts, even by experts. As 2008 began, strategists from Wall Street's 12 major firms forecast the end-of-the-year closing level and earnings of the Standard and Poor's 500 Stock Index. On average, the forecast was for a year-end price of 1,640 and earnings of $97. There was remarkably little disparity of opinion among these sages.

Reality: the S&P closed the year at 903, with reported earnings estimated at $50.

Strategists aren't always wrong. But they have been consistent, betting year after year that the market will rise, usually by about 10%. Thus, they got it about right in 2004, 2006 and 2007, but also totally missed the market declines in 2000, 2001 and 2002, and vastly underestimated the resurgence in 2003.

Ignore the forecasts of inevitably bullish strategists. Bearish strategists on Wall Street's payroll don't survive for long.

2) Never underrate the importance of asset allocation. Investing is not about owning only common stocks. Nor are historical stocks returns a sound guide to future returns. Virtually all investors should keep some "dry powder" in their portfolios in the form of high-grade short - and intermediate-term bonds. Investors who failed to learn that lesson felt on especially hard times in 2008.

How much in bonds? A good place to start is a bond percentage that equals your age. Although I don't slavishly adhere to that rule, my bond position accounted for about 65% of my personal portfolio in early 2000. Because returns on my bond funds since then have totaled 50% and returns on my stock funds were negative 25%, bonds are now about 75% of my portfolio, still close to my advancing age.

With all the focus on historical returns that greatly favor stocks, don't ignore bonds. Consider not only the probabilities of future returns on stocks, but the consequences if you are wrong.

3) Mutual funds with superior performance records often falter. Last year was an extreme example. With the S&P 500 off 37% for the year, Legg Mason Value Trust fell by 55%. Fidelity Magellan Fund, after a good 2007, was off 49%. Funds managed by proven long-term pros felt the pain - Dodge and Cox Stock down 43%; Third Avenue Value down 46%; CGM Focus down 48%; Clipper down 50%; Longleaf Partners down 51%. (Full disclosure: Four of Vanguard's actively-managed equity funds also lagged the market by wide margins.)

Only time will tell whether the disappointing shortfalls experienced by these and other funds will be recovered in the future, whether the skills of their managers have atrophied, or whether their luck has run out. Whatever the case, chasing past performance is all too often a loser's game. Managers of funds seeking market-beating returns should make it clearer to investors that they must be prepared to trail the market - perhaps substantially - in at least one year of every three.

4) Owning the market remains the strategy of choice. Such a strategy guarantees a return that lags the market return by a minuscule amount, and exceeds the return captured by active equity-fund managers as a group by a substantial amount. Why? Because the heavy costs incurred by investors in actively managed equity funds can easily amount to 2% to 3% annually. Typical expense ratios run from 1% to 1.5%; the hidden costs of portfolio turnover often come to 0.5% to 1%; a 5% front-end sales load, amortized over a holding period of 5 to 10 years, adds another 0.5% to 1% per year in costs.

As a group, investors are by definition indexers. (That is, they own the entire market.) So indexing wins, not because markets are efficient (sometimes they are, sometimes they are not), but because its all-in annual costs amount to as little as 0.1% to 0.2%.

Indexing won in 2008 by an especially wide margin. Low-cost, low-turnover, no-load S&P 500 index funds outpaced nearly 70% of all equity funds, and (admittedly a fairer comparison) more than 60% of all funds focused on large-cap U.S. stocks. This continues the pattern - with some variations - that goes back to the start of the first index fund 33 years ago. The bond index fund did even better. Its return of 5% for 2008 outpaced more than 80% of all taxable bond funds.

In sum, active management strategies as a group lose because they are expensive. Passive indexing strategies win because they are cheap.

5) Look before you leap into alternative asset classes. During 2006-07, equity mutual funds focused on developed international markets and emerging markets provided strong relative returns to U.S. stocks. During that period, U.S. investors made net purchases of $285 billion in mutual funds investing in non-U.S. stocks, and liquidated on balance some $35 billion from funds focused on U.S. stocks.

This extreme example of "performance chasing" at its worst is hardly defensible. But, disingenuously, it was touted by fund marketers as adding "non-correlated assets," or "reducing volatility risk." In 2008 - with non-U.S. developed market funds falling 45% and emerging market funds tumbling by 55%, we learned once again that, just when we need it the most, international diversification lets us down.

Commodities were no different. As the global recession developed, commodity funds sank, the largest such fund tumbled 50%. Always keep in mind: When the investment grass looks greener on the other side of the fence, look twice before you leap.

6) Beware of financial innovation. Why? Because most of it is designed to enrich the innovators, not investors. Just think of the multiple layers of fees to the salespersons, servicers, banks, underwriters and brokers selling mortgage-backed debt obligations. These new products (credit default swaps are another example) enriched their marketers during 2005-07, only to impoverish the clients who held them in 2008.

Our financial system is driven by a giant marketing machine in which the interests of sellers directly conflict with the interests of buyers. The sellers, having (as ever) the information advantage, nearly always win.

We can't say that we haven't been warned about the perils of ignoring the past. More than 2,000 years ago, the Roman orator Cato noted that, "there must be a vast fund of stupidity in human nature, or else men would not be caught as they are, a thousand times over, by the same snare . . . while they yet remember their past misfortunes, they go on to court and encourage the causes to what they were owing, and which will again produce them."

While the events of 2008 reinforced that message, perhaps these stern and off-repeated lessons of experience will help investors avoid similar mistakes in 2009 and beyond.

Mr. Bogle is the founder and former chief executive of the Vanguard Group of Mutual Funds. He is the author of a few books including "Common Sense on Mutual Funds" and "Enough: True Measures of Money, Business and Life."

WSJ Deal Journal: Coca-Cola Director on How to Fail in Business by Trying Really Hard

2009-07-05T01:58:00.000-07:00

By Heidi N. Moore

Published July 25, 2008.

Look at a list of stock tickers. You'll find a pretty decent group of companies that were once heroes and now are, according to the cliche, zeroes. (General Motors, anyone?) Don Keough, the former president of Coca-Cola and current director of the company as well as chair of media-industry investment bank Allen &Co., just wrote a handy book about how other companies can achieve such feats of disappointment, of they dare. Keough's upcoming book, "The Ten Commandments for Business Failure," takes a slightly opposite tack from most business books, which provide prescriptions for success. Keough, instead, decided to dramatize the dangers of the alternative: how to screw up. (Remember: he saw New Coke).

His commandments: Quit taking risks; be inflexible; isolate yourself; assume infallibility; play the game close to the foul line; don't take time to think; put all your faith in experts and outside consultants; love your bureaucracy; send mixed messages; be afraid of the future; and lose your passion for work - for life.

Deal Journal talked to Keough to find out more (or in the Keoughian world, does that actually mean less?) An edited version of our interview is below.

Deal Journal: "The 10 Commandments" is a title that has the threat of biblical wrath around it. Why did you decide on a title like that?

Don Keough: I've always hated the word success because it contains the twin viruses of arrogance and complacency. I think that these two viruses are linked to individuals, to companies and to countries. A few years ago I was giving a talk to the food industry and the issue was how to be a winner. I said 'I don't know how to be a winner but I know how you can be a loser.' I gave a talk about the 10 commandments for losing. And that led to my convenient list of 10 ways to fail.

Deal Journal: That's interesting that you say that you don't like success. In other countries, including England, they think the American focus on success is obnoxious.

Keough: If you look at human activity, it's like Wimbledon - it's the unforced errors that decide who will be the winner. If you look at CEOs, for instance, it's hard to have bad news filter through your staff. A lot of people don't want to upset the boss. If you look at Hitler in his final days, he was in his bunker.

Deal Journal: With the success of advice books, why did you want to write one with a focus of failure?

Keough: There are more failure traps. Once good things happen to a person, you get to a stage where you think, 'I've sort of made it, I've had my neck out on the line, I'm going to stop taking risks.' It's easy when you think things are going well and you're a bit of success. But once you quit taking risks, things happen and failure is not far behind. There are a few examples. Coca-Cola had built its entire business on the fountains. In 1939, a guy came out with a package that twice as big as their regular bottle for the same price. They were inflexible about it and wouldn't change, and that was a mistake.

There's also a tendency in the business hierarchy for the top officer to be isolated. They live in a very narrow world, they go to lunch with their close staff, and they rarely go on a commercial airplane and see people tough it through a travel environment. It's easy to isolate yourself, get no bad news, and have good PR to see to it that you get all the credit. That leads to failure.

If you look at all the annual letters written, the reason why Warren Buffett's annual report is such a bestseller is that he will point out the mistakes that he made. Usually the way it works in American business is that executives will say 'we had a challenging year' or 'mistakes were made.' The way these things work is sort of assuming infallibility. I remember when I was involved in Coca-Cola, the East Germans were about to open. They wanted a huge amount of money. I didn't think we should do it. The guy spearheading the move into East Germany was getting ready to leave the company because, he said, I never listened to the opportunity. He said, 'You've never been to East Germany.' We made a $1 billion investment because we saw his courage.

The age we live in now is that we're surrounded by data. It isn't information. It's data, a series of bits and pieces that flow into us. Paper is increasing by the carload. We're surrounded by data. Some of us are almost wedded to the BlackBerry. We put ourselves into situations where we are so flooded with little pieces of information that we don't have time to think, and then bad things can happen.

Deal Journal: Which are the most important commandments for failure?

Keough: One is to be afraid of the future. There is almost a malaise in the country right now about the future. All through the years we're confronted by things that will destroy our future. It's the killer bees one year, and the bird flu the next year. If you look at Malthus, he had us all drowning in a sea of flesh. Right now there are going to be fortunes made and there are those who see the future as a tough time but an opportunity.

Another is to love your bureaucracy, because it has a way of preserving itself. If you put male and female animals into a pasture, there will be more animals. If you put middle managers together, they will create more bureaucracy. Don't put your faith in experts and bureaucracy.

Deal Journal: But aren't you the chairman of an investment bank? They provide outside expertise.

Keough: Unless we have something important to add, people are damn fools to use it.

Deal Journal: What comes next?

Keough: If you look at the next 12 to 24 months, there's going to be a lot of interesting activity, and I'm an absolute optimist. Everything will be okay.

Dear Journal: That's in marked counterpoint to the message of your book, but it's comforting to hear.

Acid Test for Hiring

2009-07-04T20:31:00.000-07:00

In his book "Winning," former General Electric CEO Jack Welch says he starts with three acid tests: for integrity, intelligence and maturity - this is not very far from Warren Buffett's own test for integrity, intelligence and passion.

Mr. Welch writes: "People with integrity tell the truth and they keep their word." "They take responsibility for past actions, admit mistakes and fix them." On intelligence, Mr Welch left no doubts that he's not necessarily looking for education, but rather "a strong dose of intellectual curiosity, with a breadth of knowledge to work with or lead other smart people in today's complex world." As for maturity, Mr. Welch says it has nothing to do with age, rather it's a sense that the person "can withstand the heat, handle stress and setbacks, and alternatively, when those wonderful moments arrive, enjoy success with equal parts of joy and humility."

Only if candidates possess those three traits would he then begin to further evaluate what he calls "the four Es." They are:

Positive Energy: Does the candidate have the ability to thrive on action and relish change? Will the person be able to start the day with enthusiasm, and end it that way, too? "People with positive energy," writes Mr. Welch, "just love life."
The Ability to Energize Others: "People who energize can inspire their teams to take on the impossible," he says. That needs the right combination of knowledge and skills of persuasion.
Edge: Mr. Welch defines this as the ability to make tough yes-or-no decisions. "Anyone can look at an issue from every different angle," he writes. "Some people can - and will - analyze those angles indefinitely. But effective people know when to stop assessing and make a tough call, even without total information."
Execute: The ability to get the job done. Mr. Welch says experience has taught him that some people can do well on the first three Es, but not have what it takes to get a job over the finish line. He looks to hire people who can make things happen.

David Novak: The Education of an Accidental CEO

2009-07-04T07:55:00.000-07:00

David Novak, chairman and chief executive of Yum! Brands Inc, isn't your typical corporate chieftain. Any doubt about that should have vanished when he wore a yellow foam cheese head on the floor of the New York Stock Exchange in celebrating the company's initial public offering 12 years ago. These days, Mr. Novak, in his occasionally goofy but effective efforts to motivate associates, may opt for rubber chicken feet.

Mr. Novak views himself more as coach and cheerleader rather than as The Boss. He oversees one of the world's biggest restaurant companies, with some 36,000 outlets in over 110 countries and more than a million associates - Mr. Novak refers employees as associates. Four of its brands - KFC, Pizza Hut, Taco Bell and Long John Silver's - are the global leaders of the chicken, pizza, Mexican-styled food and quick-service seafood categories.

How Yum! Brands got to be so big, and successful - its stock has quintupled since going public - is laid out in "The Education of an Accidental CEO." The book guides readers through Mr. Novak remarkably steep and smooth career path. It focuses on the proper way to treat people and the rewards that can come for doing so intelligently and, if possible, service with a smile. Mr. Novak, with co-author John Boswell, makes clear that, to a large extent, Yum! Brands is a company to emulate.

The book's subtitle, "Lessons Learned From the the Trailer Park to the Corner Office," is sort of misleading. The words conjure up all sorts of negative stereotypes that Mr. Novak grew up poor and even, perhaps, in dissolute circumstances. Nothing can be further from that but neither did he live a charmed life. He spent much of his youth moving around the U.S. in a trailer, but the reason was that his father, who worked for the U.S. Coast and Geodetic Survey, was frequently reassigned to different parts of the country to gather data for maps. By his seventh grade, Mr. Novak had changed trailer parks thirty-two times and live in twenty-three states. His family was one of fifteen families on the survey team. He recalls whenever he moves, "it was like a circus caravan without the elephants."

However, Mr. Novak looks back on his nomadic upbringing as a major plus in his career and personal development. As a youth, he learned quickly how to adapt to new situations, interact with strangers and size them up. Going to a new school, meeting new people every few months wasn't always a snap for Mr. Novak. There was a lot of anxiety involved, but he learned how to walk through the anxiety and fear. Fears are "almost always about the future, even if it's the very near future, and I feared rejection as the new kid on the block," Mr Novak says. It has been his experience that "90 percent of the things we fear never happen and the other 10 percent don't happen the way we envision. But that doesn't make fear any less real." Fear will always be in human nature, but as Franklin Roosevelt says: "The only thing we have to fear is fear itself."

While he terms himself an accidental CEO, the reader can conclude that his ascent was anything but. Throughout his advancement - from advertising agency to PepsiCo Inc. division president to head of a listed corporation with sales in excess of $11 billion - his superiors saw in him effusive enthusiasm, passion, hardwork and an obvious talent to lead. He had a strategy from early on. Mr. Novak knew he was extremely competitive. He looks at everything relatively, be it business or climbing the corporate ladder. Regardless of what position he is in, he looks at his peers and decide if they're are better than him or not. Then, as he notes, "if you're as competitive like me, you work to become better than them. Once you are, then you look at your boss and think, 'Does he have something I don't have?' Then you work to become better than him, too. That's how my career always worked." That is a very shrewd strategy.

The sentence "Love what you do" goes a long way because it is the first rule of advancement, Mr. Novak writes. In his youth, Mr. Novak did a bunch of odd jobs, one of which is selling encyclopedias. The first time he went out, he sold two sets of encyclopedias, which was a very good start, and not to mention, good payday too. But he realized right away that he didn't feel good about the accomplishment. The problem was, he sold them to people who didn't need them. One was sold to a little old lady who didn't have any kids but was just delighted to have someone to talk to for a while. Mr. Novak thought that she bought the books to thank him for spending time with her. Within two days, he made $225, which was for him a lot of money. But on the third day, he quitted. He felt he was hustling people which was not the right thing to do. He knew he was good at selling but he notes, "I have to believe in what I sell."

There are many takeaways in "The Education of an Accidental CEO." It is chock-full of insights, axioms and wisdoms: "Love what you do," "You never know what you are capable of," "Keep a lid on your ego," "Stereotypes are poison," "It's never too early to find a mentor," "Play to your strength," to name a few.

Much of the worth of Mr. Novak as a CEO, as he notes, is doing "whatever it takes to get people fired up." One example is to motivate with praise. As Mr. Novak says, "You can never underestimate the power of telling someone he's doing a good job." As a leader, "the higher up the leader you are, the more important it is to give credit rather than receive it," he asserts. Celebrating the achievements of others is a huge part of Yum! Brands' culture. Mr. Novak often sends congratulatory handwritten notes to associates, signing them with a smiley face. Predictably, Yum! Brands is a company awash in employee awards - engraved silver pizza pans, rubber chickens and even $100 bills. "Thank you" is perhaps the most important thing a leader can say, Mr. Novak writes.

At the same time, he also sets the bar high. If you want to get noticed and promoted, he says, it isn't enough to do just what is required. You must do more. As for where you do it, that is insignificant. "If you are happy with and challenged by your work," Mr. Novak writes, "you will be happy doing it on the moon." Yum! Brands, by the way, is headquartered in Louisville, Kentucky - think Berkshire Hathaway which is located far from the epicenter of the financial world.

While having self-confidence is commendable, listening is a vital check on it, in Mr. Novak's view. He constantly remains himself that, despite of his "infectious enthusiasm," he needs to be "ever vigilant to remain open to other people's points of view." Otherwise, he notes, "I could enthusiastically lead everyone right over the cliff."

He had done nearly that at times. In the early 1990s, Mr Novak while in PepsiCo's beverage operations, zealously pushed the idea of a clear soda - called Crystal Pepsi - that ended to be what Time magazine called one of the worst product ideas of the 20th century. Mr. Novak blames himself for not paying attention to in-house skeptics. As a marketing executive at Pizza Hut when it was still part of PepsiCo, in the late 1980s, he was certain that a sunglasses promotion tie-in with a "Back to the Future" movie sequel would be a "slam-dunk." He should have checked first with his young daughter then, who pronounced the glasses "dorky." It took months to unload nine million pairs of shades, Mr Novak sheepishly recalls.

Among his successes was the transformation of Diet Mountain Dew from a shunned stepchild soda into a winning brand extension. Later, he presided over a turnaround at KFC - an accomplishment that "pretty much made my career," he says. The KFC success positioned Mr. Novak as the logical person to co-lead the restaurant group that Pepsi intended to spin off.

One reason for KFC's turnaround can be attributed to Mr. Novak's willingness to cooperate with and listen to franchisees, many of whom had their nest eggs on the line. Franchisees act "like entrepreneurs," Mr. Novak writes, "because that's what they are, and we'd have to be crazy not to listen to them." Their advice was to concentrate on product quality, new menu items, and better personnel training. Working together, Yum! and the franchisees, developed an action plan. One result was the crispy chicken strips, a franchisee's creation which became the most successful new product since the Colonel's original recipe, Mr. Novak says.

As talented an individual as Mr. Novak might be, he did not invent any new breakthrough technology or product that causes his ascension. "The truth of the matter is, there is no reason to try to reinvent the wheel," he says, "most good ideas are already out there, and to learn about them, all you have to do is ask the right people." The right people is not only restricted to people who are still alive. Sir Isaac Newton, once said: "If I have seen further, it is by standing on the shoulders on giants." It is to be noted that neither Sam Walton nor Thomas Murphy, former CEOs of Wal-Mart and ABC/Cap Cities (both extraordinary successes), respectively, invented nothing new. They simply copied what others have done smartly and improve on them. To put it plainly, from Chapter 16 of Mr. Novak's book, is to "steal from the best" in order to accelerate learning. Upon the spin-off of Yum! from PepsiCo, Mr. Novak was determined to learn the best practices from some of the top companies. In 1999, he visited some of these companies, when these companies were at the top of their game. Mr. Novak learns from: 1) Wal-Mart - "The more you know, the more you care;" 2) Home Depot - "I'm an owner" for which many of their front-line people have a skin in the game; 3) Target - "Differentiate yourself;" 4) UPS - "Make what matters a science;" 5) General Electric - "Relentless drumbeat for performance."

And probably, besides learning on the best practice of operating business, the best practice in dealing with Wall Street is equally as important for a public company. To this end, he consulted Warren Buffett. One of the questions Mr. Novak wanted to know was how to handle Wall Street. Mr. Buffett gave an answer that was both brilliant and simple, he says: "Don't romance Wall Street. You don't want investors who are only concerned about the quarter, or who are working on their exit strategy from day one. You want shareholders to own you forever." However, in order to get the right shareholders takes time, as Mr. Buffett notes. To achieve that end, Mr. Buffett advises, "it happens by communicating well, by being up-front about your company - its successes and its failures - and what your strategies are to keep it on track," and "talk to your owners." Mr. Novak still makes it a point to see Mr. Buffett every year and he brings along a couple of Yum!'s high performers partly as a reward for them and for them to learn.

The book deserves to be read in its entirety for its humorous yet earnest take on getting ahead using compassion, common sense and showmanship rather than bravado. In Mr. Novak, Warren Buffett says: "If CEOs were selected like NFL quarterbacks, David Novak would be a first-round draft pick. I would certainly like to have him running a Berkshire company. After you read this book, you will know why." I guess you can't get any better endorsement than that.

NY Times: Treasury's Got Bill Gross On Speed Dial

2009-07-04T00:00:00.000-07:00

By Devin Leonard

Published June 20, 2009

Every day, Bill Gross, the world's most successful bond fund manager, withdraws into a conference room at lunchtime with his lieutenants to discuss his firm's investments. The blinds are drawn to keep out the sunshine, and he forbids any fiddling with Blackberrys or cellphones. He wants everyone disconnected from the outside world and focused on what matters most to him: mining riches for his clients at Pimco, the swiftly growing money management firm.

Mr. Gross, 65, has long been celebrated for his eccentricities. He learned some of his lucrative investing strategies by gambling in Las Vegas. Many of his most inspired ideas arrived while he was standing on his head doing yoga. He knows he has to be well dressed for client meetings or television - but instead of keeping his Hermes ties neatly knotted, he drapes them around his neck like scarves so he can labor with his collar open.

With the collapse of Wall Street, Mr. Gross has emerged as one of the nation's most influential financiers. His frequent appearances on CNBC draw buzz, as do his wickedly humorous monthly

investing columns on the Pimco website. Treasury secretaries call him for advice. Warren E. Buffett, the Berkshire Hathaway chairman, and Alan Greenspan, the former Federal Reserve chairman, sing his praises.

"He's a very individualistic person. He doesn't come at analysis or investment judgment in the words, terminology or ambience that I have seen to over the decades," Mr. Greenspan says. "That may be the secret of his success. There is no doubt there is an extraordinary intellect there." Mr. Greenspan, it should be noted, now works for Pimco as a consultant.

Amid all of this, Mr. Gross and his firm are trying to shape the government's response to the economic crisis. He is one of the most fervent supporters of the Obama's administration's plan to enlist private investors to help bail out the nation's ailing banks and try to revive the economy.

That effort, known as the Public-Private Investment Program, or P.P.I.P, has gained little traction so far. But Mr. Gross has energetically defended its architect, Treasury Secretary Timothy F. Geithner, against critics like the New York University economics professor Nouriel Roubini and New York Times columnist Paul Krugman - both of whom argue that the strategy is flawed and that it would be best for the government to temporarily nationalize so-called zombie banks to prevent a repeat of the Great Depression.

Such nationalization, Mr. Gross insists, would be an unmitigated disaster. "There are two grand plans," he said this spring at a meeting of his firm's investment committee. "One is the Krugman-Roubini plan. They think the banks have so much garbage they are beyond hope. The other side is the administration's side. That's the one we're on. If the other side should ever gain credence, then we'll have something to worry about."

Mr. Gross is hardly a disinterested observer. Pimco, owned by the German insurer, Allianz, is jockeying to be picked by Mr. Geithner to relieve the likes of Bank of America, Citigroup and other banks of an estimated $1 trillion in soured mortgage debt so they can start lending freely again. Mr. Gross calls the plan a "win-win-win" for the banks, taxpayers, and Pimco investors.

The government is planning to announce soon which money managers will participate. A spokesman for the Treasury Department would not say whether Pimco would be one of them.

In many ways, it is perfectly logical for the White House to turn to someone like Mr. Gross at such a time. Few investors understand the mortgage market better. As co-chief-investment officer, he personally manages Pimco's flagship, the Total Return fund, which has $158 billion in assets. As of the end of May, he had invested 61 percent of the fund's money in mortgage bonds.

Mr. Gross has always been partial to mortgage bonds. And why not? He has done fabulously well with them. In an October 2005 letter to investors, he made one of the most prescient calls of the last decade, warning of the looming subprime mortgage crisis. Almost everybody ignored him. Today, they wish they hadn't.

When the housing bubble burst and the financial markets fell apart, investors lost billions of dollars. Not Mr. Gross's clients. Class A shares of the Total Return fund, for individual investors, were up 4.3 percent in 2008, or nine percentage points ahead of comparable bond funds, according to Morningstar; this year through Thursday, the shares were up 5.4 percent.

In the midst of an economic crisis, those numbers are impressive. So is the longer-term record: In the 10 years through Thursday, the fund had an annualized return of 6.42 percent, beating its benchmark by 0.54 percentage points, according to Morningstar.

That's one of the reasons the government has courted him closely. Last fall, the Federal Reserve Bank of New York, run at the time by Mr. Geithner, hired Pimco - along with BlackRock, Goldman Sachs, and Wellington Management - to buy up to $1.25 trillion in mortgage bonds in an effort to keep interest rates from skyrocketing.

Last December, when it was pressing Bank of America to complete its ill-fated acquisition of Merrill Lynch, the Federal Reserve also looked for Pimco for advice. According to recently released messages that Fed staff members sent one another that month, Pimco evaluated the two banks and concluded that Merrill wouldn't survive without a capital infusion or additional government aid.

Today, Mr. Gross is eager to buy the same subprime loans he once refused to touch, as part of the Treasury's distressed-asset initiative. After all, the thinking goes, if anybody can figure out how much all this debt is worth, it's Pimco. But Pimco's investment in so many aspects of the bailout has made many other financiers and analysts uncomfortable. They say its proximity to the Treasury Department and the Fed may allow it to reap billions of easy dollars through federal contracts and preferential investment opportunities.

A frequent complaint is this: Why is the Federal Reserve paying Pimco to buy mortgage securities on its behald, when the firm is already a huge buyer and seller of the same bonds. "That's the equivalent of a no-bid contract in Iraq," fumes Barry Ritholtz, who runs an equity research firm in New York and writes The Big Picture, a popular and well-regarded economics blog. "It's a license to steal."

No one, of course, has actually accused Pimco of theft. But there is a larger question: Whose interests is the firm looking out for in the bailout? Money managers, after all, have a legal obligation - a fiduciary responsibility - to put the interest of their investors before anyone else. Even Mr. Gross acknowledges that Pimco's interests won't always be aligned with those of the government.

Mr. Gross points out that he has never even met Mr. Geithner. For its part, the Treasury Department plays down Pimco's influence. "We speak with a number of market participants and believe seeking out a diversity of perspectives is critical to our efforts," says Andrew Williams, a spokesman for the department. He says the Treasury takes conflict of interests "very seriously in all cases."

Mr. Gross is well aware of the criticism that has been directed at Pimco. During an interview at its headquarters in Newport Beach, Calif., sitting at his horseshoe-shaped desk on its 4,200-square-foot trading floor overlooking the Pacific Ocean, he brings up the topic of perceived conflicts of interest himself.

He almost never personally buys and sells bonds. Pimco has dozens of traders who do this for him here. "There's the mortgage desk over there," he says, pointing to a group of well-scrubbed young people hunched over computers. "We've been buying some mortgages this morning. That's our baby, so to speak. That's our bag."

He immediately adds that this mortgage trading operation is completely separate from the one on the floor below, where traders are working on behalf of the Fed. He says he can't even visit that floor himself without a company lawyer at his side. The last time he did was in December, when he wised the traders happy holidays.

"I said, 'Merry Christmas,' " Mr. Gross recalls. "The lawyer said, 'Mr. Gross says Merry Christmas.' Right then and there, I knew that communications were basically severed. That's the way the Fed wants it."

He says he assumes that Pimco traders working on behalf of the government don't talk to their peers trading for Pimco's own accounts. Then again, he said he doesn't know for sure what happens after hours.

"I don't drink beer with these guys; I have no idea what happens in the privacy of their own homes," he says. He says that when he encounters traders working for the Fed outside the office, he doesn't talk to them.

"I pass some of them on the way to the lunch shop," he says. "I just sort of wave. I don't know what to do."

Mr. Gross is fond of saying he is the antithesis of a Wall Street "alpha male." He is every bit the South Californian, with longish hair and a laid-back attitude. Most Wall Street executives won't talk to a reporter without a public relations person hovering around. Even then, they can be disappointingly bland. No one would ever say such a thing about Mr. Gross. He approaches an interview is almost like a therapy session: it is a chance for him to make confessions.

"I'll tell you an interesting story," he says at one point. "I shouldn't, but I will. It's like I'm taking truth serum every time I do this."

The tale is about "a very childish and immature" e-mail message that he sent Don Phillips, a managing director of Morningstar, the mutual fund research company, when Morningstar didn't select him as its fixed-income fund manager of the year in 2008. It is an intriguing story. But it's nowhere near as interesting as what he has to say about Pimco's role in the bailout.

He sounds genuinely pained by the economic collapse. "There was always a big part of me that thought the Depression was just something from my old American Heritage history books," he says. "I thought: 'This stuff can't happen really. I mean, this is just for the economic philosophers and the paranoid worriers.' Then, in the last 6 to 12 months, you go, 'God, this just might happen!' "

With the fate of the largest banks still uncertain, a heated debate continues about how to fix the problem. Mr. Geithner wants to enlist money managers like Pimco to buy distressed bank assets with financial backing from the government. That way, his supporters argue, they can offer such generous prices that banks can disgorge the assets without too painful a hit.

But proponents of bank nationalization say the Treasury's plan won't work because some banks can't afford to take any losses on asset sales. This camp believes nationalization is the best path because it will let the government clean up banks' balance sheets and restore their health.

Mr. Gross argues that this would completely destabilize the financial markets. "If you thought Lehman Brothers was a mistake, just stand by and see what nationalizing Citi or B. of. A would do," he argued in one of his monthly letters to Pimco investors.

His mood brightens when he talks about how much money Pimco could reap by participating in the Geithner plan. No wonder: the terms are deliciously favorable for participants selected as fund managers. Money managers like Pimco would be expected to raise at least $500 million from their clients. The Treasury would match that with taxpayer dollars. Then Pimco and the Treasury would create a jointly owned fund of at least $1 billion that would buy distressed mortgage bonds.

Government largess doesn't stop there. The fund will be eligible for low-interest financing from both the Treasury and the Fed that analysts at Credit Suisse First Boston estimate could be as high as four times the total equity in the fund. So if Pimco ponied up $500 million, the fund that it manages could borrow $4 billion.

Pimco would then negotiate with banks to buy their wobbly mortgage-backed securities. Mr. Gross says that some of these securities pay an interest rate as high as 14 percent and that even if default rates were 70 percent, Pimco and the government would still make a 5 percent return after covering their negligible borrowing costs. That means the government-Pimco partnership could make at least $250 million a year on a $5 billion investment fund. Of that amount, Pimco would get $125 million - a 25 percent return on its original investment.

But here's the part that makes Mr. Gross salivate. If things go badly, the government is responsible for repaying all that debt. "It's just like in blackjack," he says. "That puts the odds in your favor. If you don't bet too much and if you stay at the table long enough, the odds are high that you are going to go home with some extra money in your pocket."

Indeed, for all of Mr. Gross's anguished talk about the crisis, there's no escaping that fact that Pimco isn't exactly suffering. In November, the Total Return fund became the world's largest mutual fund with $128.4 billion in assets, according to Morningstar. Since then, its assets under management have climbed to $158 billion. The firm once had trouble luring prospective employees to Newport Beach. Now Pimco is being deluged with resumes.

Meanwhile, some of the most powerful people in the nation call Mr. Gross for advice. "Paulson will call, Geithner will call, and I'll be like, 'Yabba-dabba' or 'Blah-blah-blah,' " he says with a measure of self-deprecation - and an equal dose of pride. "I turn into a walking, talking idiot."

Mr. Gross has been through crises before. He nearly died - and briefly lost part of his scalp - in 1966 when crashed his car while making a doughnut run for his fraternity brothers at Duke University. He spent much of his senior year recovering in the hospital. He also became obsessed with blackjack after reading "Beat the Dealer: A Winning Strategy for the Game of Twenty-One," by Edward O. Thorp, an M.I.T. mathematics professor (who is not a very successful hedge fund manager).

After he got his diploma, Mr. Gross hopped a freight train to Las Vegas with $200 sewed into his pant leg. He played blackjack for 16 hours a day. "After a while it gets pretty boring and pretty stinky," he recalls. "People lose money. They don't win it. You're just watching the dealers."

Even so, in four months, he turned $200 into $10,000 and used his winnings to pay for his studies toward an M.B.A. at the University of California, Los Angeles. He thought he could apply the lessons learned at the blackjack table to the stock market. After getting the degree, he called all the big Wall Street brokerage firms. Nobody called him back.

Finally, his mother showed him a classified ad for a junior credit analyst in the bond department at the Pacific Investment Management Company, a subsidiary of Pacific Mutual Life.

Although Mr. Gross had no interest in bonds, he took the job as a steppingstone to stock-picking. Back then, the bond market was a sleepy corner of the financial world. Mr. Gross's job was to make sure that Pimco avoided buying bonds from companies that might go belly-up and burn their creditors.

By the mid-1970s, the market had become sexier as shrewd investors like Mr. Gross began trading bonds like stocks - and began earning outsize profits.

In short order, Mr. Gross also dived into the first mortgage-backed securities (which carried comfy government guarantees) and began studiously monitoring interest rates so he could placed bets on his own macroeconomic predictions. This was highly unusual for a bond fund manager - and still is.

"There are a lot of big bond shops that frankly don't feel confident doing this," says Lawrence Jones, a Morningstar analyst. "It's not part of their tool kit."

Mr. Gross played well on television. In 1983, he became a regular on "Wall Street Week" on PBS; he loved the attention, and his ubiquity gave Pimco a big boost. Four years later, Pimco rolled out the Total Return fund. Over the next 10 years, its assets soared to $24 billion from $165 million. Much of this was because of shrewd investing. But TV did wonders, too. "It doesn't do you an good to be good if nobody knows about you," Mr. Gross says.

In 1999, he warned in his monthly investment column that the dot-com bubble would soon burst. The next year, it did. Despite the market downdraft, Mr. Gross's fund ended 2000 up 12 percent, and that same year he and his partners sold Pimco to Allianz for $3.3 billion. Mr. Gross received $233 million for his stake, and Allianz also agreed to pay him $40 million in retention bonuses and seems to be giving him free rein.

Not that Mr. Gross was going anywhere.

Free from distraction in a gym across the street from his offices, Mr. Gross happily rides a stationary bike, followed by a half-hour of yoga. Toward the end of his routine, he stands on his head for a few minutes in a position called the Feathered Peacock. He wobbles so much that you expect him to lose his balance and fall over, but he says some of his best ideas have come to him while he was upside down.

One of those insights came in 2005, when - while standing on his head - he began to worry about the real estate bubble.

He'd watched the prices of homes climb into the stratosphere in Southern California, and he says he felt as if he were witnessing something out of "Alice in Wonderland." Was this happening all around the country?

Pimco dispatched 11 mortgage analysts to 20 cities to find out. They posed as prospective homebuyers and drove around with unsuspecting real estate agents and mortgage brokers who told them how easily they could get a home loan. "It was a little deceptive," Mr. Gross says. "I didn't feel good about that, but I didn't know how else to get the real information."

Mr. Gross says he thought it was obvious what was driving this madness: subprime mortgages. He was certain that the real estate would collapse and take the economy down with it, and he made those thoughts known in letters to his investors. Pimco steered clear of risky housing debt, which meant that, for a time, some of his competitors who stockpiled the briefly lucrative products outperformed him.

For a fiercely competitive man, it was an awkward time. "Bill takes it hard when the numbers aren't what he thinks they should be," his wife, Sue, confided by e-mail. "In 2006, he recommended a Pimco bond fund to the owner of a local doughnut shop, and when it didn't do well for a while, he could hardly go in the shop for his favorite coconut cake doughnut."

Fortunately for Mr. Gross, but not for the economy, this couldn't last forever. The housing bubble finally burst in 2007, and the crisis followed. He was vindicated. Yet this was only part of the reason for his success. He also predicted in one of his monthly columns that the government would have to pump billions of dollars into the economy to avery a total collapse. At the same time, he and his Pimco team came up with an audacious plan: invest in bond sectors that Washington would be forced to support - like government-backed mortgages guaranteed by Fannie Mae and Freddie Mac.

Mr. Gross whimsically calls this strategy "shake hands with the government." And he used his access to the news media to get the government's attention. In a CNBC interview on Aug. 20, 2008, he argued that Americans were putting "their money in the mattress" because the government hadn't rescued imperiled financial institutions like Fannie and Freddie.

On Sept. 7, Henry M. Paulson Jr., then the Treasury secretary, announced that the government was taking over Fannie and Freddie. The value of the Total Return fund rose by $1.7 billion in a single day.

Michele David, Mr. Paulson's former spokeswoman, says Mr. Gross's TV appearances had nothing to do with the decision: "There are $5.4 trillion of Fannie and Freddie securities around the world. Investors here and across the globe were worried and voicing the same concerns."

But some of Pimco's critics aren't convinced. "The Treasury Department watches CNBC all day," says Steven Eisman, a portfolio manager and banking expert at FrontPoint Partners, an investment firm. "I know that for a fact. He was putting pressure on them."

Mr. Gross says nothing could have been further from his mind. He says he goes on TV with "a disbelief that people will believe or act on what I say," adding that "people should think independently."

At the same time, Pimco tried to influence the direction of the bailout itself. In the spring of 2008, Pimco's chief executive, Mohamed A. el-Erian, a former policy expert at the International Monetary Fund, floated a plan in Washington for a public-private partnership similar to the P.P.I.P. plan that Mr. Geithner later unveiled. It didn't get much traction.

But then Lehman Brothers collapsed on Sept. 15. Mr. Paulson asked Congress to pass the Troubled Asset Relief Plan, better known as TARP, which would enable the government to spend $700 billion to buy mortgage securities from teetering banks. The Treasury turned to Pimco and others for help.

"When we first asked for the TARP legislation in September, we were looking at purchasing assets," says Ms. Davis, the former Treasury spokeswoman. "We definitely talked to Pimco and a lot of other asset managers. You had to find out how such a program might work and bounce ideas around to see how this thing would work."

In the midst of the crisis, in October, Mr. Gross's friend, Mr. Buffett, wrote to Mr. Paulson suggesting a plan similar to the one Mr. Erian had been pushing. However, Mr. Buffett says he came up with his idea independently.

"I call Bill Gross and Mohamed and said: 'I've got this idea. If it goes forward, I hope you guys would manage it and would do it on a pro bono basis,' " Mr. Buffett recalled in an interview. "Within an hour, they said they were on board and they were willing to do whatever was called for."

Mr. Gross publicly announced that his firm would do the job free. "I got call after call, e-mail after e-mail saying that Bill offered was right for the country and that he was a great American," says a Pimco spokesman, Mark J. Porterfield. At first, it looked as if the Treasury might take Mr. Gross up on the offer. But his hopes were temporarily dashed when the Treasury simply gave TARP funds to the banks instead of purchasing bad assets.

And at the same time, people began to wonder about Mr. Gross's motives. He made it clear that he was not afraid to put Pimco's interests ahead of the government's in the bailout. As part of its "shake hands with the government" strategy, Pimco had bet that the Bush administration would come to the rescue of the nation's banks and other financial institutions. So it bought a variety of those bonds, including those of GMAC, the financial division of General Motors.

In November, as the economy continued to weaken, GMAC asked the Fed for permission to become a bank holding company so it could receive TARP financing. The central bank granted GMAC's wish, with one caveat: GMAC had to swap 75 percent of its debt for equity, allowing GMAC to potentially buy back a big chunk of its bonds for just 60 cents on the dollar.

Mr. Gross balked at the arrangement because, as a GMAC bondholder, he would have been forced to take a big financial haircut. "We said: 'It doesn't look too good on us. We think we'll just hold onto the existing bonds,' " he remembered. Much to the amazement of many people on Wall Street, the Federal Reserve, which declined to comment, still allowed GMAC to become a bank holding company and the government later guaranteed all of its debt, meaning that Mr. Gross's GMAC bonds would be worth 100 cents on the dollar when they mature.

Mr. Gross is unapologetic about the outcome. "The government has a vested interest, and it's not necessarily aligned with Pimco's interest," he says.

Simon Johnson, a former chief economist for the International Monetary Fund and now a professor at the Sloan School of Management at M.I.T., says he isn't surprised that Mr. Gross is such a virulent foe of nationalization. As Professor Johnson points out, Pimco is a major bondholder in some of the biggest banks. Nationalization would hurt his portfolio.

"It would reduce the present value of his holding," says Professor Johnson, himself a proponent of nationalization. "Therefore, he is not going to look good as an investment manager."

What of Mr. Gross's predictions that nationalization would deepen the recession? Professor Johnson acknowledges that there are risks either way, but says he thinks that people should be skeptical when powerful financiers make doomsday predictions.

"I think we pay undue deference to people who are very rich and have been successful in the financial sector in this country," he says. "We think they are the gurus who think they have unique expertise, and if Bill Gross tells us there will be a panic, it must be true. Well, no, I don't believe it. These guys all say this kind of thing."

The twist, of course, is that the Obama administration has embraced the same public-private partnership proposal that Pimco has been pushing along and that Mr. Paulson briefly considered last fall. Mr. Gross says that the Geithner plan was better because the government provides such generous debt financing.

Pimco is proud of its partnership with the government. Mr. Erian points out that the firm's executives have been members of the Treasury Department's Borrowing Advisory Committee (along with many other Wall Street executives) for years. Its current representative, the Pimco managing director Paul McCulley, says part of his job is to ingratiate himself with officials at the Treasury and the Federal Reserve so Pimco can better understand impending policy decisions. He boasts that he is on a "first-name basis" with both Mr. Geithner and the Fed chairman, Ben S. Bernanke.

"We have a whole lot bigger profile now than we did years ago, but the fact of the matter is we've been doing the same thing in the last year that we've been doing for the last 10 years," Mr. McCulley says. "I'd like to think we're having some influence in the public policy arena. And I say that first and foremost as a citizen."

Citizen - but also investor. And some critics of the financial benefits that Pimco might snare if the P.P.I.P. gets rolling are quick to point out what Pimco stands to gain.

"The critics would argue that all the benefits go to Pimco," says Representative Scott Garrett, Republican of New Jersey, who is a member of the House Financial Services Committee and a skeptic of the Geithner plan. "Well, maybe not all the benefits. But they get the best ones right out the door. And the taxpayers are on the hook."

The Obama administration says it will soon select lead fund managers for P.P.I.P. It's almost certain that Pimco will be among them. "If you are trying to encourage investment from the private sector, isn't it only logical to involve the most successful asset management organization in the private sector?" says Thomas C. Priore, chief of ICP Capital, a boutique fixed-income investment bank.

And being selected by the government has other benefits, Mr. Priore adds. "If any endowment or public pension plan representative is looking for an asset management firm, he or she won't get fired for hiring Pimco because, well, the government hired Pimco," he says. "That certainly enhances your franchise value."

P.P.I.P.'s fate remains uncertain. When the Treasury Department put 19 of the nation's largest banks through a stress test, many passed the exam and their stocks prices rose. They have raised $50 billion in new capital. Now some of them are likely to hold on to their distressed mortgage securities in the hope that the housing market recovers - rather than face the pain of selling the assets at a loss now (a situation that may get dicey if housing doesn't, in fact, recover).

The Treasury now says that Mr. Geithner expects P.P.I.P. to serve as "backstop" for banks that find themselves in a pinch.

There's a darker scenario, possibly. If mortgage default rates do soar, some big banks may fail. Then the administration would have to seriously consider nationalization, which might devastate Mr. Gross's holdings. He is, of course, well aware of this possibility and says he's watching Mr. Geithner as closely as he watched the blackjack dealers in Las Vegas.

"We just don't want to flush it all down the drain," he says. "You want to shake hands with the government. But maybe it shouldn't be a super-firm handshake."

At a lunchtime meeting this past spring at Pimco, executives tell Mr. Gross that they're worried about the fallout the firm will face if it receives a financial windfall as part of P.P.I.P.

"The risk is that you have a Congress with a populist bug," Mr. McCulley says.

Dan Ivanscyn, another of the firm's managing directors, agrees. "I think there is a risk that we're going to get criticized," he says. "I think Pimco could get roughed up."

"I think there is a much bigger chance of us getting roughed up personally," says Scott Simon, head of Pimco's mortgage-backed securities team.

Finally, Mr. Gross weighs in.

"So what are you saying?" he asks. "If we fail, we'll get the shaft, and if we succeed, we'll get the shaft?"

Jamie Dimon speech at U.S. Chamber on 11 Mar 2009

2009-07-03T09:04:00.000-07:00

An insightful speech was given by Jamie Dimon to the U.S. Chamber in Washington D.C. on 13 Mar 2009. He touched on many of the issues that created the economic mess.

He started by saying that there's no silver bullet that can solve the crisis. He stressed that the economy faces a very different situation than in prior recessions. The run on bank was not a traditional one. He also confessed that not shutting down JPMorgan's mortgage broker business sooner was "the biggest mistake of my career."

Dimon read from the text of a note that he sent to former Treasury Secretary, Hank Paulson, and said he will send the same to Fed Chairman, Ben Bernanke. His quote was a Teddy Roosevelt gem, designed to give some measure of solace not just to Paulson and Bernanke, but everyone toiling in the beleaguered industry. He read:

"It is not the critic who counts, nor the man who points out how the strong man stumbled, or the doer of deeds could have done better. The credit belongs to the man or woman who is actually in the arena, whose face is marred by dust and sweat and blood, who strives valiantly, who errs and comes up short again and again, because there is no effort without error or shortcoming, but who knows the great enthusiasms, the great devotions, who spend himself for a worthy cause; who, at best, in the end, knows the triumph of great achievement, and who, at worst, if he fails, at least fails while daring greatly, so that his place will never be with those cold and timid souls who know neither victory or defeat."

Some of his thoughts on the future of the system are:

changes need to be done wisely with eyes open;
there should be a debate over better regulation;
companies need to start doing the right thing before a crisis;
need for a systemic risk regulator;
too-big-to-fail needs to be worked out;
regulation needs to be by product, mortgages, derivatives, etc.;
hedge funds and private equity need to be brought into regulation;
need to simplify the regulatory system;
need to fix Basel II;
regulation needs to be fairly applied;
in securitization, all parties need to have some skin in the game;
need to regulate entire mortgage industry;
need to stop letting real estate bring us to our knees;
need to get accounting under control, mark to market accounting is fine but it has come to a ridiculous point, certain marks create too much volatility. There is too much flexibility in accounting;
need for counter-cyclical policies;
High loan-loss reserves need to be kept at all the time - as a reminder that things can be bad.

With his closing volley, Dimon took his shots at Washington, calling on the President to lead and members of Congress to stay their partisan bickering and follow. "There's a silver bullet," he said though. "There's plenty of blame to go around, when the war is over we should go ahead and do that. But we need all of our soldiers, and we're all soldiers in this war, to get this problem fixed - Abe Lincoln said a house divided against itself cannot stand - We need now everybody, everybody to act in unison to accomplish objectives I'd put the House, the Senate, the Democrats and the Republicans in that category. This is not politics as usual; we cannot be a dysfunctional family. We have a commander in chief, he needs to lead us so we can overcome this, and if he does, we will prevail."

Jamie Dimon: The Future of Our Financial System

2009-07-01T03:19:00.001-07:00

By Jamie Dimon, Chairman and CEO, J.P. Morgan

The extent of the damage and the magnitude of the systemic problems make it clear that our rules and regulations must be completely overhauled. Such changes to the regulatory system could have huge implications on the long-term health, and strategies, of our business.

While unprecedented actions have been taken by both the Federal Reserve and the Treasury, my hope is that new policies are grounded in a thorough analysis of what happened and what we need to do about it. Political agendas or simplistic views will not serve us well.

Often we hear the debate around the need for more or less regulation. What we need is better and more forward-looking regulation. Someone has famously said that a crisis should not go to waste. But what is also true is that it shouldn't take a crisis to solve our problems. During a crisis, people panic. This can make it harder, not easier, to do the right thing. From our perspective, certain improvements would make a big difference. We would like to share with you some of our suggestions.

A. The need for a systemic regulator with much broader authority

We agree with our leaders in government that we should move ahead quickly to establish a systemic regulator. In the short term, this would allow us to focus attention on correction some underlying weaknesses in our system and filling the gaps in regulation that contributed to the current situation. It also is clear that U.S. policy must be coordinated with the proper set of international regulators. When the crisis emerged, the actions of individual countries had a critical impact on numerous other countries. International coordination is essential in resolving this kind of crisis.

There should be procedures in place to deal with systemically important institutions - failure is fine as long as it's orderly and controlled and doesn't cause systemic failure

Size is not the issue; rather it is when institutions are too interconnected that an uncontrolled failure has the potential to bring the whole system down. What we need is a resolution process that allows failure without causing damage to the whole system. In the case of Bear Stearns or Lehman - both investment banks - regulators did not have this protocol They do have it, however, for commercial banks. Even more important, regulators are going to need a resolution process for large, global corporations that operate in many jurisdictions around the world.

The first goal should be to regulate financial institutions so they don't fail. If they do fail, a proper resolution process would ensure that action is swift, appropriate and consistent. The lack of consistency alone caused great confusion in the marketplace. For example, when some of the recent failures took place, there was inconsistent treatment among capital-holders (preferred stock and debt holders were treated very differently in different circumstances). It would have been better if the regulators had a resolution process that defined, a priori, what forms of aid companies would get and what the impact would be on capital-holders. The FDIC resolution process for banks provides a very good example of how a well-functioning process works.

Various liquidity and "lender of last resort" facilities, like some of those put into place during this crisis, also could be in place on an a priori basis. These controls would reduce risk and maximize confidence.

Regulation needs to be administered by product and economic substance, not by legal entity

We have experienced the unintended consequences of redundant regulation; i.e., different agencies regulating the same product in the mortgage business, in the derivatives business and in lending overall. If, on the other hand, similar products were overseen by a single regulator, that regulator would have much deeper knowledge of the products and full information that extends across institutions. The "regulatory competition" that could have caused a race to the bottom would be eliminated.

Hedge funds, private equity funds and off-balance sheet vehicles must be included in our regulatory apparatus without compromising their freedoms and positive attributes

Certain vehicles like hedge funds and private equity funds need to be regulated but only to protect the system against risk. These vehicles do not need to be heavily regulated like a deposit-gathering bank. We should consider requiring hedge funds over a certain size (say, $1 billion of equity) to register, provide quarterly audited reports, disclose total leverage and certain risk attributes - like volatility and investment categories - and outline operational procedure. They also could be requited to show their regulators (not their competitors) any concentrated "trades" that could cause excessive systemic risk. This all could be done without compromising flexibility or disclosing confidential positions while allowing these vehicles to move capital - as freely and aggressively - as they see fit.

The systemic regulator needs the ability to anticipate risk and do something about it if necessary

There, undoubtedly, are financial products in the market today that - if unchecked - could have a destabilizing effect. A systemic regulator, had it been closely watching the mortgage industry, might have identified the unregulated mortgage business as a critical point of failure. This regulator also might have been able to limit the leverage of Fannie and Freddie once they were deemed to pose major systemic risks. Such a regulator might have been in the position to recognize the one-sided credit derivative exposures of AIG and the monoline insurers and do something about it.

A systemic regulator also should be on the lookout for new or potential structural risks in our capital markets, such as the structural flaw that grew in money market funds.

B. The need to simplify our regulatory system

Everyone agrees that the existing system is fragmented and overly complex. We have too many regulators and too many regulatory gaps. No one agency has access to all the relevant information. Responsibility often is highly diffused. This problem could be relatively easy to fix but only if we have the political will to fix it.

C. The need to regulate the mortgage business - including commercial mortgages - in its entirety

Many of the same gaps in regulation that helped lead us into this mess still exist today - for example, in the mortgage business. Mortgages are the largest financial product in the United States, and while we do not want to squelch innovation, the entire mortgage business clearly needs to be regulated. This is not the first time that mortgages and real estate have led this country and many of its financial institutions into deep trouble. Proper regulation would go a long way toward standardizing products, testing new ones, improving customer disclosure and clarifying responsibility.

D. The need to fix securitization

We believe that securitization still is a highly effective way to finance assets. But some securitizations, particularly mortgage securitizations, had an enormous flaw built into them: No one is responsible for the actual quality of the underwriting. Even mortgage servicing contracts were not standardized such that if something went wrong, the customer would get consistent resolution. We cannot rely on market discipline (i.e., eliminating bad practices) alone to fix this problem.

We have heard several reasonable suggestions on how the originator, packager and seller of securitizations could be approximately incentivized to ensure good underwriting. For example, requiring the relevant parties to keep part of the securitizations, much like we do with syndicated loans today, would help manage resolution if something were to go wrong and could go a long way to re-establish market confidence and proper accountability.

E. The need to fix Basel II - leading to higher capital ratios but a more stable system

As discussed earlier, Basel II has many flaws - it has taken too long to implement, it responds slowly to market changes and it is applied unevenly across global borders. Perhaps its worst failing is that, in its current construct, Basel II does not include liquidity, which allowed commercial and investment to buy liquid or illiquid assets and fund them short. While this practice did not appear quite so dangerous in benign times, it created huge issues for many financial institutions during the market crisis. Basel II also has relied too heavily on rating agencies and, by its nature, has been highly pro-cyclical in its capital requirement for assets. It would be easy to make these capital requirements less pro-cyclical and require Basel II to recognize the risk of short-term funding, particularly that of wholesale funding. Finally, Basel II should be applied consistently, reviewed continuously and updated regularly. The world changes quickly.

F. The need to get accounting under control

We at JPMorgan Chase are strong believers in good, conservative accounting. Accounting should always reflect true underlying economics, which actually is how we run the company. However, accounting practices are not widely understood, are changed too frequently and are too susceptible to interpretation and manipulation. Sometimes, they even inadvertently determine U.S. government policy.

We generally like fair value accounting

For assets that are bought and sold, fair value accounting creates the best discipline. Fair value accounting (often referred to as mark-to-market accounting) already provides for some flexibility if recent prices are under highly distressed conditions. In such cases, good judgment and sound fundamental cash flow-type evaluations can be employed to value certain assets. However, in our opinion, the application of fair value accounting for certain categories needs to be reconsidered. For example:

We now have to mark to market our private equity investments by using potentially artificial benchmarks. These investments, by their nature, are very illiquid and are intentionally held for several years. To mark them to market, proxies made up of comparable companies are used, and appropriate discounts and judgment are applied. Essentially, we write these investments up when markets are good and write them down when markets are bad. But I am fairly confident that this approach is not always right. In many instances, cost is the best proxy for fair value. We would rather describe our investments to our shareholders, tell them when we think these investments might be worth more and, certainly, write them down on our financial statements when they have become impaired.
A new mark-to-market rule addresses "debit valuation adjustments." Essentially, we now have to mark to market credit spreads on certain JPMorgan Chase bonds that we issue. For example, when bond spreads widen on JPMorgan Chase debt, we actually can book a gain. Of course, when these spreads narrow, we book a loss. The theory is interesting, but, in practice, it is absurd. Taken to the extreme, if a company is on its way to bankruptcy, it will be booking huge profits on its own outstanding debt, right up until it actually declares bankruptcy - at which point it doesn't matter.
It is becoming increasingly more difficult to compare mark-to-market values of certain instruments across different companies. While it's too involved to go into detail here, different companies may account for similar mark-to-market assets differently. This needs to be addressed by ensuring that companies adhere to consistent valuation principles while applying the rules.
Fair value accounting does not and should not apply to all assets. Investments or certain illiquid assets that are intended to be held for the longer term (like real estate or plant and equipment) or loans and certain assets that are shorter terms (like receivables or inventory) all could actually to marked to market. There are, in fact, markets for some of these assets, and others could be calculated based on reasonable assumptions; for example, a farm would be worth more when corn prices go up, and a semiconductor plant would be worth less when semiconductor prices go down. However, if we marked these assets in this way, they would have wildly different prices depending on the health of the economy or the swings in prices for their output. While accounting should recognize the real impairment in the value of assets, marking the aforementioned assets to market every day would be a waste of time. Under this scenario, it would be quite hard for companies to invest in anything illiquid or to make long-term investments.

New accounting rules that have the potential to inadvertently affect how the capital markets function or change fundamental long-term U.S. government policies should be made thoughtfully, deliberately and with broad input

For example, we all believe that companies should have fully funded pension plans; i.e., the actual assets in the plan should be enough to meet a fair estimate of the liabilities. Years ago, if this wasn't the case, companies were allowed to maintain a "deficit" and fund it over several years. That deficit was not recorded on the financial statement of the company.

A change in accounting rules dictated that the deficit should not just be a footnote in the financial statements but that it should be reflected directly in the equity account of the corporation. Clearly, in very bad markets, these deficits grow dramatically, thus depleting the increasingly precious capital that companies have. (This is just another example of a pro-cyclical force). When companies realized they were getting enormous volatility in their capital account, they began to curtail or eliminate their pension plans in favor of 401(K) plans (where the individuals bears all the investment risk). This was a rational, precautionary step. But it, in effect, transferred the risk from the company to the individual. No longer did the large corporations assume the risk of providing a steady income stream to retired employee. Instead, the risk was passed to the individuals - many of whom could not afford it.

This is a perfect example of how accounting inadvertently sets policy. And, in my opinion, this was probably the wrong policy for the country. There would have been many ways to be true to the economic purpose of accounting without making a detrimental policy change. There are countless other example, and we hope regulators and accountants will eventually find better ways to apply accounting principles.

G. The need for appropriate counter-cyclical policies

During this crisis, it became evident that our system created enormous pro-cyclical tendencies. In fact, I can't think of one counter-cyclical policy at all (other than emergency actions taken by the government). Accounting policies such as mark-to-market and loan loss reserving are pro-cyclical. Basel II capital requirements are pro-cyclical. Regulatory and legal requirements are pro-cyclical. Repo and short-term financing are pro-cyclical. The one pro-cyclical tendency we probably can never correct is that of the market itself (i.e., the cost of capital goes way up in a downturn or investors refuse to finance less liquid assets). I have heard many good ideas about how to create some counter-cyclical policies and will focus on three here.

Loan loss reserving can easily be made counter-cyclical

I find it absurd that loan loss reserves tend to be at their lowest point precisely when things are about to get worse. As things get worst and charge-offs rise dramatically, one must dramatically increase loan loss reserves, thus depleting capital rapidly. This problem would be solved if banks were allowed to estimate credit losses over the life of their loan portfolios. Reserves should be maintained to absorb those losses. This would enable banks to increase reserves when losses are low and utilize reserves when losses are high. Transparency would be fully preserved because investors and regulators would still see actual charge-offs and nonperformers. This would require a rational explanation about the appropriateness of the lifetime loss estimates. It also would have the positive effect of constantly reminding CEOs, management teams and investors that bad times, in fact, do happen - and that they should be prepared for such events.

Repo and short-term financing can easily be made counter-cyclical

All banks now have access to the standard financing facilities for securities and loans via the Federal Reserve (i.e., the Fed will lend a specific amount of money against specific assets). A suggestion is this: If an institution provides financing to clients in excess of what the Fed would lend to the bank for the same securities, it would have to be disclosed to risk committees and the company's Board of Directors. The Fed then would have two major tools to reduce leverage and in a way that is counter-cyclical - it could charge higher capital costs to a bank when the bank is lending more than the Fed would lend or the Fed could reduce the amount it would lend to the banks. Market players would still be free to provide credit and leverage as they see fit.

Banks should have the ability to implement counter-cyclical capital raising with rapid rights offerings

Banks and possibly other companies would be aided by having the ability to effect rights offerings at a moment's notice. Regulations should facilitate such offerings - with the proper disclosure - in a matter of days rather than weeks. This would allow a company to raise capital and repair a balance sheet that might have been stretched by unanticipated market events and to do so in a manner that is fair and does not dilute the company's existing shareholder base.

H. The need for policies in health care, pensions, energy and the environment, infrastructure and education that will serve us well over time

Beyond the financial crisis, there are several important issues that will dictate whether or not the United States will continue to thrive over the next century. 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. On energy, we now have experienced our third major crisis, and we, as a nation, still have not executed a sensible long-term energy policy. Again, we believe that done right, an energy policy could be economically efficient, create great innovation, reduce geopolitical tensions and improve our environment. Similarly, we need to improve our nation's infrastructure and develop an education system that befits our heritage.

We can't fall into the trap of institutional sclerosis - now is the time to act. In the past, this nation has shown the fortitude to work together to accomplish great things, and we need to do that again. For our part, JPMorgan Chase are doing everything we can to be helpful to our leaders on all these issues.

Interesting Article

2009-06-29T09:30:00.000-07:00

Ruth Faces Living Off a Scant $2.5 Million

by Brett Arends
Monday, June 29, 2009

provided by

How tough is it living off $2.5 million? Ruth Madoff is about to find out.

Bernie Madoff's wife has been left with a lump sum in that amount from her settlement with the Justice Department.

The first thing to note is that the cash doesn't come completely free and clear. She may still face claims from the Securities & Exchange Commission, the Securities Investor Protection Corporation, and the trustees liquidating her husband's business and estate. It is also unclear how much Social Security she will have to live on as well.

When you cast aside the sort of smoke and mirrors used by her husband, a conservative investment portfolio may only earn about 3% a year over inflation. At that rate, and if Mrs. Madoff wants to make sure she doesn't outlive her money, her $2.5 million settlement should give her an annual income of maybe $125,000 a year. That would make the money last all the way to age 100.

That's a pretty good income. It's a lot more than many of her husband's ruined victims will have. But it will hardly support her past lifestyle. Mr. and Mrs. Madoff, according to court papers, owned homes in Manhattan, Montauk, N.Y., and Palm Beach, Fla., along with millions of dollars in furniture, art, furs, and the like.

Sounds like she's going to have to do, on a bigger scale, what a lot of Americans are doing right now: Downsize.

If Ruth Madoff spends a third of her $125,000 a year on accommodation, that will come to about $3,500 a month -- enough perhaps for a (modest) two bedroom in Manhattan, but nothing glamorous. It will rent more in Florida. Especially if she moves inland from Palm Beach -- to somewhere like Sunrise.

The good news? There's an Ikea nearby. And lots of factory outlets. And in Florida she will be able to survive without her $36,000 Russian sable coat.

As for cars: Mrs Madoff has to give up her Mercedes-Benz E class and CLK. But a brand new Mercedes SmartCar only costs about $14,000.

As for investments: Mrs Madoff is 68. She will need income to live on for maybe 30 years or more. She's going to have to generate income to live on, and enough growth to keep up with inflation. That's going to mean a conservative mix of stocks and bonds.

Among bonds, Treasurys look expensive. Even inflation protected Treasurys, so-called TIPS, are starting to look fully priced. And Mrs. Madoff would do well to avoid very long-term bonds. They are at risk from inflation.

There are better opportunities in corporate debt, from investment grade to high yield. She might also look at tax-exempt municipals -- she can earn at least 3.5% tax-free without taking on too much inflation risk. She might even consider emerging market government bonds.

If she wants stocks paying good income as well, Mrs. Madoff should be able to earn yields of about 4.5% a year right now without taking too much risk. Closed-end funds -- special mutual funds that trade like regular shares -- can be a great way to get equity income. That's because the funds themselves can sell at a big discount, which means you get more income for each dollar invested.

The irony, of course, is that Mrs Madoff really needs right now a financial adviser she can trust to handle her money.

Jamie Dimon: The Future of Our Financial System

2009-06-29T07:56:00.000-07:00

By Jamie Dimon, Chairman and CEO, J.P. Morgan

A. The need for a systemic regulator with much broader authority

There should be procedures in place to deal with systemically important institutions - failure is fine as long as it's orderly and controlled and doesn't cause systemic failure

Regulation needs to be administered by product and economic substance, not by legal entity

Hedge funds, private equity funds and off-balance sheet vehicles must be included in our regulatory apparatus without compromising their freedoms and positive attributes

The systemic regulator needs the ability to anticipate risk and do something about it if necessary

A systemic regulator also should be on the lookout for new or potential structural risks in our capital markets, such as the structural flaw that grew in money market funds.

B. The need to simplify our regulatory system

C. The need to regulate the mortgage business - including commercial mortgages - in its entirety

D. The need to fix securitization

E. The need to fix Basel II - leading to higher capital ratios but a more stable system

F. The need to get accounting under control

We generally like fair value accounting

We now have to mark to market our private equity investments by using potentially artificial benchmarks. These investments, by their nature, are very illiquid and are intentionally held for several years. To mark them to market, proxies made up of comparable companies are used, and appropriate discounts and judgment are applied. Essentially, we write these investments up when markets are good and write them down when markets are bad. But I am fairly confident that this approach is not always right. In many instances, cost is the best proxy for fair value. We would rather describe our investments to our shareholders, tell them when we think these investments might be worth more and, certainly, write them down on our financial statements when they have become impaired.
A new mark-to-market rule addresses "debit valuation adjustments." Essentially, we now have to mark to market credit spreads on certain JPMorgan Chase bonds that we issue. For example, when bond spreads widen on JPMorgan Chase debt, we actually can book a gain. Of course, when these spreads narrow, we book a loss. The theory is interesting, but, in practice, it is absurd. Taken to the extreme, if a company is on its way to bankruptcy, it will be booking huge profits on its own outstanding debt, right up until it actually declares bankruptcy - at which point it doesn't matter.
It is becoming increasingly more difficult to compare mark-to-market values of certain instruments across different companies. While it's too involved to go into detail here, different companies may account for similar mark-to-market assets differently. This needs to be addressed by ensuring that companies adhere to consistent valuation principles while applying the rules.
Fair value accounting does not and should not apply to all assets. Investments or certain illiquid assets that are intended to be held for the longer term (like real estate or plant and equipment) or loans and certain assets that are shorter terms (like receivables or inventory) all could actually to marked to market. There are, in fact, markets for some of these assets, and others could be calculated based on reasonable assumptions; for example, a farm would be worth more when corn prices go up, and a semiconductor plant would be worth less when semiconductor prices go down. However, if we marked these assets in this way, they would have wildly different prices depending on the health of the economy or the swings in prices for their output. While accounting should recognize the real impairment in the value of assets, marking the aforementioned assets to market every day would be a waste of time. Under this scenario, it would be quite hard for companies to invest in anything illiquid or to make long-term investments.

G. The need for appropriate counter-cyclical policies

Loan loss reserving can easily be made counter-cyclical

Repo and short-term financing can easily be made counter-cyclical

Banks should have the ability to implement counter-cyclical capital raising with rapid rights offerings

H. The need for policies in health care, pensions, energy and the environment, infrastructure and education that will serve us well over time

Jamie Dimon: Fundamentals Causes and Contribution to the Financial Crisis

2009-06-28T01:19:00.000-07:00

By Jamie Dimon, Chairman and CEO of J.P. Morgan

After Lehman's collapse, the global financial system went into cardiac arrest. There is much debate over whether Lehman's crash caused it - but looking back, I believe the cumulative trauma of all the aforementioned events and some large flaws in the financial system are what caused the meltdown. If it hadn't been Lehman, something else would have been the straw that broke the camel's back.

The causes of the financial crisis will be written about, analyzed and subject to historical revisions for decades. Any view that I express at this moment will likely be proved incomplete or possible incorrect over time. However, I still feel compelled to attempt to do so because regulation will be written soon, in the next year or so, that will have an enormous impact on our country and our company. If we are to deal properly with this crisis moving forward, we must be brutally honest and have a full understanding of what caused it in the first place. The strength of the United States lies not in its ability to avoid problems but in our ability to face problems, to reform and to change. So it is in that spirit that I share my views.

Albert Einstein once said, "Make everything as simple as possible, but not simpler." Simplistic answers or blanket accusations will lead us astray. Any plan for the future must be based on a clear and comprehensive understanding of the key underlying causes of - and multiple contributors - to the crisis, which include the following:

The burst of a major housing bubble
Excessive leverage pervaded the system
The dramatic growth of structural risks and the unanticipated damage they caused
Regulatory lapses and mistakes
The pro-cyclical nature of virtually all policies, actions and events
The impact of huge trade and financing imbalances on interest rates, consumption and speculation

Each main cause had multiple contributing factors. As I wrote about these causes, it became clear to me that each main cause and the related contributors could easily be rearranged and still be fairly accurate.

It was also surprising to realize that many of the main causes, in fact, were known and discussed abundantly before the crisis. However, no one predicted that all of these issues would come together in the way that they did and create the largest financial and economic crisis of our lifetime.

Even the more conservative of us, and I consider myself to be among them, looked at the past major crisis (the 1974, 1982, and 1990 recessions; the 1987 and 2001 market crashes) or some mix of them as the worst-case events for which we needed to be prepared. We even knew that the next one would be different - but we missed the ferocity and magnitude that was lurking beneath. It also is possible that had this crisis played out differently, the massive and multiply vicious cycles of asset price reductions, a declining economy and a housing price collapse all might have played out differently - either more benignly or more violently.

It is crucial to understand that the capital markets today are fundamentally different than they were after the World War II. This is not your grandfather's economy. The role of banks in the capital markets has changed considerably. And this change is not well-understood - in fact, it is fraught with misconceptions. Traditional banks now provide only 20% of total lending in the economy (approximately $14 trillion of the total credit provided by all financial intermediaries). Right after World War II, that number was almost 60%. The other lending has been provided by what many call the "shadow banking" system. "Shadow" implies nefarious and in the dark, but only part of this shadow banking system was in the dark (i.e., SIVs and conduits) - the rest was right in front of us. Money market funds, which had grown to $4 trillion of assets, directly lend to corporations by buying commercial paper (they owned $700 billion of commercial paper). Bond funds, which had grown to approximately $2 trillion, also were direct buyers of corporate credit and securitizations. Securitizations, which came in many forms (including CDOs, collateralized loan obligations and commercial mortgage-backed securities), either directly or indirectly bought consumer and commercial loans. Asset securitizations simply were a conduit by which investment and commercial banks passed the loans onto the ultimate buyers.

In the two weeks after the Lehman bankruptcy, money market and bond funds withdrew approximately $700 billion from the credit markets. They did this because investors (i.e., individuals and institutions) withdrew money from these funds. At the same time, bank lending actually went up as corporations needed to increasingly rely on their banks for lending. With this as a backdrop, let's revisit the main causes of this crisis in more detail.

A. The burst of a major housing bubble

U.S. home prices have been appreciating for almost 10 years - essentially doubling over that time. While some appreciation is normal, the large appreciation, in this case, and the ultimate damage it caused were compounded by the factors discussed below.

New and poorly underwritten mortgage products (i.e., option ARMs, subprime mortgages) helped fuel asset appreciation, excessive speculation and far higher credit losses

As the housing bubble grew, increasingly aggressive underwriting standards helped drive housing price appreciation and market speculation to unprecedented levels. Poor underwriting standards (including little or no verification of income and loan-to-value ratios as high as 100%) and poorly designed new products (like option ARMs) contributed directly to the bubble and its disastrous aftermath.

Mortgage securitization had two major flaws

In many securitizations, no one along the chain, from originator to distributor, had ultimate responsibility for the results of the underwriting. In addition, the poorly constructed tranches of securitizations that comprised these transactions effectively converted a large portion of poorly underwritten loans into Triple A-rated securities. Clearly, the rating agencies also played a key role in this flawed process. These securitizations ended up in many forms; the one most discussed is CDOs. Essentially, these just added a lot more fuel to the fire.

While most people are honorable, excess speculation and dishonesty were far greater than ever seen before, on the part of both brokers and consumers

The combination of no-money-down mortgages, speculation on home prices, and some dishonest brokers and consumers who out-and-out lied will cause damage for years to come. This, in no way, absolves the poor underwriting judgements made by us and other institutions, and it certainly doesn't absolve anyone who mis-sold loans to consumers.

B. Excessive leverage pervaded the system

Over many years, consumers were adding to their leverage (mostly as a function of the housing bubble), some commercial banks increased theirs, most of the U.S. investment banks dramatically increased theirs and many foreign banks had the most leverage of all. In addition, increasing leverage appeared in:

Hedge funds, many using high leverage, grew dramatically over time. Some of that leverage was the result of global banks and investment banks lending them too much money.
Private equity firms were increasingly leveraging up their buyouts. Again, some banks and the capital markets lent them too much money.
Some banks (and other entities) added to their leverage by using off-balance sheet arbitrage vehicles, like SIVs and leveraged puts.
Nonbank entities, including mortgage banks, CDO managers, consumer and consumer finance companies, and even some bond funds, all increased their leverage over time.
Even pension plans and universities added to their leverage, often in effect, by making large "forward-commitments." Basically, the whole world was at the party, high on leverage - and enjoying it while it lasted.

C. The dramatic growth of structural risks and the unanticipated damage they caused

I believe there are four structural risks or imbalances that grew and coalesced to cause a "run on the bank." But this was not a traditional bank run - it was a run on our capital markets, the likes of which we had never experienced. After Lehman's bankruptcy, many parts of our capital markets system stopped providing any capital to the market at all, If the crisis had unfolded differently, then perhaps the events that followed would not have occurred. Surely no one deliberately built a system with these fundamental flaws and imbalances. Clearer heads will understand that much of this was not malfeasance - our world had changed a lot and in ways that we didn't understand the full potential risk. But when the panic started, it was too much for the system to bear.

Many structures increasingly allowed short-term financing to support illiquid assets

In essence, too much longer-term, non-investment grade product was converted into shorter-term Triple A-rated product. Some banks, hedge funds, SIVs, and CDOs were using short-term financing to support illiquid, long-term assets. When the markets froze, these entities were unable to get short-term financing. As a result, they were forced to sell these illiquid assets. One of the functions of banking and the capital markets is to intermediate between the needs of investors and issuers. This triggers a normal conversion, either directly or indirectly (through securitizations) of longer-term, illiquid assets held by the issuers, who need to finance the business into the shorter-term, higher-grade product that most investors want. Clearly, over time, this imbalance had grown too large and unsupportable.

Money market funds had a small structural risk, which became a critical point of failure

Money market funds promise to pay back 100% to the investor on demand. Many money market funds invested in 30 to 180 day commercial paper or asset-backed securities that under typical circumstances could be sold back at par. In normal times, investors demanded their money in fairly predictable ways, and funds were able to meet their demands. Over time, money market funds grew dramatically to exceed $4 trillion. After Lehman collapsed, one money fund in particular, which held a lot of Lehman paper, was unable to meet the withdrawal demands. As word of that situation spread, investors in many funds responded by demanding their money. In a two-week period, investors pulled $500 billion from many money funds, which were forced to sell assets aggressively. To raise liquidity, these money funds essentially were forced to sell assets. As investors moved away from credit funds and into government funds, the banks simply were unable to make up the difference. This became one more huge rupture in the dike.

Repo financing terms got too loose, and too many illiquid assets were repo'ed

Over time, in those markets where financial companies financed their liquid assets, financial terms had become too lax. For example, to buy non-agency mortgage securities, financial institutions only had to put up 2%-5% versus a more traditional 15%-25%. The repo markets also had begun to finance fairly esoteric securities, and when things got scary, they simply stopped doing so. In the two weeks after Lehman's bankruptcy, more than $200 billion was removed from this type of financing, by both investors and banks. Once again, financial institutions had to liquidate securities to pay back short-term borrowing - thus, another rupture in the dike.

Investors acted wisely to protect themselves, but the system couldn't handle them all doing it at the same time

Individual investors, corporations, pension pans, bond and loan funds, money market funds and others - all acted in their own self-interest, and all individually acted wisely. But collectively, they caused enormous flows out of the banking and credit system. Regardless of whether the funds came out of a bank, a money fund, or a bond or loan fund, the fact remains that the cumulative result was a severe shortage of necessary credit that was removed from the system. Clearly things had changed. In the past, regulators had focused on preventing a systemic collapsed of the main intermediaries in the financial system; i.e., the banks. In this new world, however, we need to discuss how to protect ourselves not only from runs on banks but also from runs on other critical vehicles in the capital and financial markets.

D. Regulatory lapses and mistakes

With great hesitation, I would like to point out that mistakes also were made by the regulatory system. That said, I do not blame the regulators for what happened. In each and every circumstances, the responsibility for a company's actions rests with us, the CEO and the company's management. Just because regulators let you do something, it does not mean you should do it. But regulators have a responsibility, too. And if we are ever to get this right, it is important to examine what the regulators could have done better. In many instances, good regulation could have prevented some of the problems. And had some of these problems not happened, perhaps things would not have gotten this bad.

Unregulated or lightly regulated parts of the market contributed to the crisis

I've already discussed some of the flaws with money market funds and hedge funds - the latter were not regulated, and the former were lightly regulated. In addition, there are two large segments, among others, that - had they been regulated - could have helped the system avoid some problems.

Much of the mortgage business was largely unregulated. While the banks in this business were regulated, most mortgage brokers essentially were not. In fact, no major commercial bank that was regulated by the OCC wrote ARMs (possibly the worst mortgage product). A very good argument could be made that the lower standards of the unregulated parts of the business put a lot of pressure on those players in the regulated part of the business to reduce their standards so they could compete. In this case, bad regulation trumped good regulation.
Insurance regulators essentially missed the large and growing one-sided credit insurance and credit derivative bets being made by AIG and the monoline insurers. This allowed these companies to take huge one-sided bets, in some case, by insuring various complex mortgage securities.

Basel II, which was adopted by global banks and U.S. investment banks, allowed too much leverage

It is quite clear now that the second of the Accords by the Basel Committee on Banking Supervision (known as Basel II), published in 2004, was highly flawed. It was applied differently in different jurisdictions, allowed too much leverage, had an over-reliance on published credit ratings and failed to account for how a company was being funded (i.e., it allowed too much short-term wholesale funding). In 2004, the five independent U.S. investment banks adopted Basel II under the jurisdiction of the Securities and Exchange Commission (this was not allowed by the banks regulated by the Federal Reserve or the OCC, which remained under Basel I). The investment banks jettisoned prior conservative net capital requirements and greatly increased their leverage under Basel II. And the rest is history.

Perhaps the largest regulatory failure of all time was the inadequate regulation of Fannie Mae and Freddie Mac

The extraordinary growth and high leverage of Fannie Mae and Freddie Mac were well-known. Many talked about these issues, including their use of derivatives. Surprisingly, they had their own regulator, which clearly was not up to the task. These government-sponsored entities had grown to become larger than the Federal Reserve. Both had dramatically increased their leverage over the last 20 years. And, amazingly, a situation was allowed to exist where the very fundamental premise of their credit was implicit, not explicit. This should never happen again. Their collapse caused damage to the mortgage markets and the financial system. And, had the Treasury not stepped in, it would have caused damage to the credit of the United States itself.

Too many regulators - with overlapping responsibilities and inadequate authorities - were ill-equipped to handle the crisis

Our current regulatory system is poorly organized and archaic. Overlapping responsibilities have led to a diffusion of responsibilities and an unproductive competition among regulators, which probably accelerated a race to the bottom. Many regulators also did not have the appropriate statutory authority (through no fault of their own) to deal with some of the problems they were about to face. One large, glaring example revealed by the collapse of Bear Stearns and Lehman was the lack of a resolution process in place to deal with failure of investment banks. If commercial banks fail, the FDIC can take them over. This was not the case with investment banks. In addition, a resolution process needs to be in place for large, global financial companies that operate in many jurisdictions and use many different regulatory licenses.

E. The pro-cyclical nature of virtually all policies, actions and events

In a crisis, pro-cyclical policies make things worse. I cannot think of one single policy that acted as a counterbalance to all of the pro-cyclical forces. Although regulation can go only so far in minimizing the impact of pro-cyclical forces in times of crisis, we still must be aware of the impact they have. For example:

Loan loss reserving causes reserves to be at their lowest level right when things take a turn for the worse. Therefore, as a crisis unfolds, a bank not only faces higher charge-offs but also has to add to its level of reserves, depleting precious capital.
Although we are proponents of fair value accounting in trading books (a lot of the mark-to-market losses that people complained about will end up being real losses), we also recognize that market levels resulting from large levels of forced liquidations may not reflect underlying values. Certain applications of fair value accounting can contribute to a downward spiral where losses deplete capital, and lower capital causes people to respond by selling more, at increasingly lower values.
The rating agencies made mistakes (like the rest of us) that clearly helped fuel a CDO and mortgage debacle. They also, in the midst of a crisis, continually downgraded credits. Lower ratings, in turn, required many financial institutions to raise more capital, thus adding to the vicious cycle.
In bad times, the market itself demands both an increase in capital and more conservative lending. We may not be able to change this phenomenon, but there are steps we can take to ensure that the system is better prepared for it.
Financial arrangements allow the most leverage in good times, but they force a dramatic reduction in leverage in bad times.
As capital markets volatility increases, Basel II capital calculations and many risk management tools, like Value-at-Risk, demand that more capital be held to own securities or loans.

F. The impact of huge trade and financing imbalances on interest rates, consumption and speculation

I suspect when analysts and economists study the fundamental causes of this crisis, they will point to enormous U.S. trade deficit as one of the main underlying culprits. Over an eight-year period, the United States ran a trade deficit of $3 trillion. This means that Americans bought $3 trillion more than they sold overseas. Dollars were used to pay for the goods. Foreign countries took these dollars and purchased, for the most part, U.S. Treasuries and mortgage-backed securities. It also is likely that this process kept U.S. interest rates very low, even beyond Federal Reserve policy, for an extended period of time. It is likely that this excess demand also kept risk premiums (i.e., credit spreads) at an all-time low for an extended period of time. Low interest rates and risk premiums probably fueled excessive leverage and speculation. Excess consumption could be finance cheaply. And adding fuel to the fire, in the summer of 2008, the United States had its third energy crisis - further imbalancing capital flows.

There have been times when large imbalances - such as those in trade - sort themselves out without causing massive global disruption. However, it is bad planning and wishful thinking to assume that this will always be the case. These imbalances shouldn't be allowed to get that large - they create too much potential risk.

Many other factors may have added to this storm - an expensive war in Iraq, short-selling, high energy prices, and irrational pressure on corporations, money managers and hedge funds to show increasingly better returns. It also is clear that excessive, poorly designed and short-term oriented compensation practices added to the problem by rewarding a lot of bad behavior.

The modern financial world has had its first major financial crisis. So far, many major actors are gone: many of the mortgage brokers, numerous hedge funds, Wachovia, WaMu, Bear Stearns, Lehman and many others. Some of the survivors are struggling, particularly as we face a truly global, massive recession - and it still is not over.

Robert Wilmers: Regaining Confidence

2009-06-26T00:10:00.000-07:00

By Robert Wilmers, Chairman & CEO, M&T Bank

My focus, above, has been, as it must be, on M&T own situation. But no discussion of an individual bank's results nor strategy can ignore the extraordinary time in which we find ourselves, a time in which there has developed a crisis of confidence in the financial services industry. It is a crisis which has already prompted unprecedented forms of government intervention but calls for more - much more - action to ensure the long-term health of our capital markets. Regulatory reform will simply not be sufficient nor effective if its focus is confined to historically "covered" financial institutions such as banks. Put simply, nothing we do to "fix" our banks will be enough to allow investor and consumer confidence to return. That is so because, over the course of the past three decades, there has been nothing less than a sea-change in the world of lending, a change which has helped create the sorts of risk - and need for regulatory reform - we face today. Indeed, despite the well-publicized problems of specific banks, the so-called financial meltdown we've experienced over the past two years was owed much more to the investments of what can be call a new, shadow banking system - a system which has actually outstripped traditional banking as a source of credit and yet has been beyond the reach of the regulatory system's standards for safety and soundness. At the same time, it influenced the business approach of traditional banks. Yet regulatory has remained stuck in the past as the world has changed around it.

Consider the fact that, in 1978, commercial banks and thrifts held 71% of all private, non-governmental U.S. loans. Since then, the amount of credit extended not by banks but by other parts of the private sector has grown more than three and a half times as much as that provided by the banking system. Indeed, as of the end of the third quarter of 2008, commercial bank loans accounted for just $6.9 trillion of the estimated $20.3 trillion in private U.S. financial sector loans outstanding. This reflects the fact that throughout the 1980s and 1990s, a new idea about lending took hold and grew. Securitized credit outstanding grew nearly 50-fold from 1980 to 2000 - compared to a mere 3.7 times for commercial bank loans over the same period. Its essential idea: that loans could be sliced, diced and packaged in large groups, to serve as the basis of debt to be sold in the securities markets. This new approach began with mortgage-banked securities, but grew to include a variety of assets. The concept was little short of revolutionary. It meant that bank deposits would no longer be the only - or even the chief - funding source for credit. Instead, loans of all sorts would effectively be financed by the capital markets - and packed and sold by Wall Street. In the watershed year of 1998, bank lending was, for the first time, surpassed by what some call synthetic products sold in the capital markets.

Who was responsible for this huge new universe of lending? The answer to this question is crucial in understanding what form new financial services industry regulation must take. The key actors were a vastly increased number of investment firms far outside the purview of federal or state regulators. The number of unique, identifiable hedge funds increased from fewer than 50 in the early 1980s to 22,650 in 2007. In that same period, their assets under management grew from less than $1 billion to $2.1 trillion. The securitized debt in which they were investing proved, we found out too late, to be laced with risky mortgages, bundled into securities which rating agencies - with their own financial incentives to do so - gave their highest seal of approval.

This is simply not clearly understood by the public - which continues to think of banks as the primary source of credit - and has not been well-explained by political leaders. Thus, regulators have continued to fix their gaze - indeed, to micro-manage - traditional financial institutions such as banks, even as the ground has shifted beneath the entire industry. Banks found themselves on an unlevel playing field compared to others under no obligation to make clear the extent to their debt nor its relationship to their liquid assets. Notwithstanding the need to deal with immediate problems, we must not, in the wake of our financial crisis, fail to review and update the rules of the game. Just as the Depression of the 1930s led to the establishment of the Securities and Exchange Commission and the Federal Deposit Insurance Corporation, so must this current crisis spur regulatory innovation. It is no special pleading on the part of a bank chief executive to assert we must restore the balance of regulatory oversight between commercial banks and other parts of the financial services industry. We should do so not in order to be fair to banks but because the nation's problems won't be solved unless solutions are directed at the entire financial system, not just one-third of it.

So it is that we need a new generation of regulation to extend the time-honored principles of safety, soundness and transparency to what has become a virtual casino of lending. All the players must be included. Investment banks, hedge funds, and other investment vehicles - who are the ones who sparked the securitization boom - must be overseen. The rating agencies which enabled the lending casino to operate by certifying as top quality what turned out to be high-risk bonds, must operate under a new business model: they must be paid by those who might purchase bonds, not by those issuing them. They, too, must be regulated. Complex derivatives, such as credit-default swaps - which ostensibly provided insurance for high-risk investments - must be brought out of the shadows, into a public clearinghouse, such that markets can know their magnitude and extent. (The market for credit-default swaps is estimated to have grown from $500 billion in 1998 to $54.6 trillion in 2008.) At the same time that huge flows of capital must come under a broader regulatory regime, so too, must all players. The activity of U.S. mortgage brokers, for instance - whose number increased from 9,000 in 1988 to 54,000 in 2005, played a key role in the subprime debacle and must have some sort of supervision.

We are neither fond of regulation nor quick to call for more of it. But it is neither consistent nor wise to subject banks to regulation that can only be called intrusive and excessive while the rest of the financial services sector operates in a Wild West environment. There is simply no justification for the exclusion from regulation of any major pools of capital which, if poorly managed, could threaten the smooth functioning of the financial system as a whole.

Apart from the extension of regulatory oversight to what has become a vast shadow banking system, so, too, must we bring common sense to accounting as it affects all financial institutions. This must include, first and foremost, the re-examination of the appropriateness of so-called mark-to-market accounting for balance sheet purposes, in periods of illiquid markets, The ability to reasonably determine the fair value of certain assets in times of economic uncertainty is, at best, severely limited - when those that previously made markets in such assets, for all practical purposes, have gone fishing. No serious observer, however, believes that the long-term value of securities which continue to perform is as low as mark-to-market rules would dictate.

The fact that we must "mark to market" current securities which were highly rated when we bought them, with the intention of holding them for the long haul and which, indeed, continue to pay returns forces us to maintain additional capital. Moreover, marking to market leads to a false picture of our health, as measured by the tangible common equity ratio. It is worth nothing that if such requirements were imposed on the loans we make each day to our customers the entire commercial banking system would have already collapsed, for a loan made today, to even the highest-rated borrower, can only be sold at a considerable discount to its face value, in today's dislocated markets. Such irrational rule making inhibits us from doing exactly what government asserts is the use to which it wants public funds it has injected into the banking system to be dedicated: lending. We will not, however, lend for the sake of lending, especially to those with poor credit histories. We know all too well the consequences of so-called well-capitalized institutions extending credit to borrowers without ability to repay. That's how we got into this mess in the first place.

It is important, moreover, to keep in mind that mark-to-market accounting has not, historically, been standard practice. Indeed, for more than 60 years after the Depression era, the Securities and Exchange Commission resisted adopting such "fair value" accounting, out of concern that such numbers were more subjective than reliable. Having seen its effects, we need not be adverse to reform out of fear that such change would undermine accounting integrity.

Similarly, it is past time to adjust the approach to loan loss reserve requirements imposed by the Securities and Exchange Commission - and which led the banking industry to enter a recession with the level of reserves close to an all-time low. Concern about such phenomena as earnings-smoothing, which preoccupied regulators earlier in the decade, are far removed from our present situation. Indeed, the idea that we should worry about banks putting too much into their loss reserves is hard to understand today. Regulators must recognize that loan loss provision is a matter of judgment; there is simply no way to assess a portfolio of loans and be able to know - with scientific precision - which loans will perform and which will not. Sound judgment will likely lead to a conservative approach - but it is just an approach which regulators have discouraged because of an exaggerated fear of earnings manipulation. It is worth keeping in mind that loan loss reserves are clearly disclosed - such that investors can make up their own minds about the judgment of management. Armchair quarterbacking by regulators has been ill-advised, never more so than now.

In light of the problems associated with mark-to-market-accounting and the formulaic approach to loan loss reserves - not to mention the regulatory failure which allowed a now-infamous $50 billion investment "Ponzi" scheme to go undetected - the time would seem right for a thorough review of the policies and procedure of the SEC. Regulators should take stock of their own performance - and, in that context, it is well worth nothing the concentration of problems which surfaced in the past year in institutions overseen by the Office of Thrift Supervision (OTS). A handful of major thrift institutions regulated by the OTS accounted for the lion's share of payments to depositors which had to be made by the FDIC. Indeed, just four large thrifts accounted for $355.6 billion or 95.6% by assets of the failures in 2008.

This poor quality of oversight has led to sharply-increased-premiums for FDIC member banks such as M&T; we anticipate paying an additional $37 million in such premiums in 2009 over and above those we paid in 2008. It is worth considering whether to abolish the OTS and fold its duties into the portfolio of another, more effective agency.

At the same time we consider long-term regulatory changes, we continue to be confronted by an immediate crisis. It is crucial to make sure that the extraordinary steps being taken to address that crisis do not actually make things worse. The record to date is not altogether reassuring. Consider the Troubled Asset Relief Program, or TARP, the so-called bank "bailout" through which the federal government has injected capital, in exchange for preferred shares in 364 commercial banks and thrifts, including M&T, whose FDIC-insured institutions hold two-thirds of all bank and thrift assets. TARP funs had brought with them to lend at a time when there is limited loan demand - and when we have already added $2.4 billion to our loans in the past year. Indeed, we have not been alone in doing so. For the 12-month period ending September 30, 2008, total loans held by U.S. commercial banks increased by $562 billion. In contrast, over the same period, credit provided by issuers of asset-backed securities, major players in the "shadow" banking industry, fell - by some $320 billion. It may appear that banks are not lending - but that impression is the result of near-collapse of what I have called the shadow banking industry.

It is, in other words, exactly wrong for public officials and the press to complain that the injection of government funds - through the TARP - has not solved our credit crisis because banks are not doing their part.

But when the public complains about banks and the TARP program, it may really be making a broader point. The emergency program was sold as a way to help the little guy - and the large number of homeowners who are in trouble are seeing precious little relief. Finding a way to provide that relief will not be easy, in substantial part due to the complex structure of mortgage-backed securities, on the one hand, and the way mortgages are serviced by independent institutions, on the other - not to mention the financial meltdown which has hit middle America. It's an imposingly complex problem whose solution will demand changes in rules, regulations and even laws - and both creativity and competence in the government approach to helping those in distress.

It's good to see the new Administration working hard, and with imagination, on the problem. As officials do so, however, we hope they keep in mind that the banking industry whose help they will need includes more than just a handful of large institutions. A quasi-oligopoly has emerged among commercial banks - indeed, the top four banks now have a larger percentage of total assets (52%) than all others combined. That's both impressive and distressing. And indeed, these four, together with two other institutions which were granted a fast track to bank holding company status, have received $165 billion or 54% of all TARP funds. Including three other, non-bank institutions that participated, the total increases to $229.8 billion or 75.3% of TARP funds distributed to date. It is these same few institutions or those that they acquired in the past year, or those that have gone bankrupt during the same period, that totally dominated the shadow banking market through their leadership and creativity. It is also their compensation policies that have sullied the reputation of the other 8,341 banks and thrifts in the U.S. that have done the right thing, day in, day out, in their communities. Indeed, one has to raise the question whether allowing the creation of a banking oligopoly is prudent public policy, particularly as it is logical to assume that by dint of size these same institutions would provide leadership to the industry. If past is prelude, one must question whether they will provide the moral tone that leadership demands and what our society expect of its banks.

The goal of public policy in this time of crisis must not be to preserve specific financial institutions - but to restore health to the financial services industry as a whole. We are optimistic that the team assembled by the new Administration in Washington can do just that. We all shape the hope that a thoughtful approach, one which recognizes the changes that have occurred over the past two decades and that revisits the structure and regulation of our financial system, will help restore confidence in our markets It is such confidence on which M&T - and all America - will depend.

Warren Buffett's Live Lunch Interview on CNBC with Becky Quick

2009-06-25T02:05:00.000-07:00

Warren Buffett appeared live on CNBC with Becky Quick today, Wednesday, June 24, 2009.

Buffett told us the economy is in a "shambles" with no signs of a recoveryanytime soon. He also criticized Apple for not disclosing earlier that CEO Steve Jobs had received a liver transplant.

Here's the video.

Warren Buffett Gives Advice to Girl Scouts at Dairy Queen

2009-06-24T01:46:00.000-07:00

Surrounded by a group of Girl Scouts in his hometown of Omaha, Neb., Buffett offered this tip for college students:

“The biggest suggestion I have is to avoid credit cards. Interest rates are very high on credit cards. Sometimes they are 18 percent. Sometimes they are 20 percent. If I borrowed money at 18 or 20 percent, I’d be broke… So if I had one piece of advice for young people generally it would be to just avoid credit cards.”

And what advice does Buffett have for a new investor?

“I would do a lot of reading before I invested. In other words I would prepare for it. I wouldn’t jump in the water until I know how to swim… I read every book the Omaha Public Library had about investing by the time I was 11.

On qualities Buffett looks for in employees?

“The biggest thing I look for is if they have a passion for whatever they are going to do.

Ingredients for greatness

2009-06-23T01:03:00.000-07:00

What makes Tiger Woods great? What made Warren Buffett the world's best investor? Each was a natural who came into the world with a gift for doing exactly what he ended up doing. Buffett was known to say, he was "wired at birth to allocate capital." It's a one-in-a-million-thing. You've got it or you don't. But well folks, it is not as simple. For one thing, you do not possess a natural gift for a certain job, because targeted natural gifts don't exist. No one is a born CEO, investor or chess grandmaster. You can only achieve greatness through an enormous amount of hard work over many years, at times, both demanding and painful. Buffett, for instance, is famed for his discipline and the hours he spends studying annual reports, reading 5 newspapers a day, and reading lots of books. The good news is that your lack of a natural gift is irrelevant - talent has little to do with greatness. You can make yourself into any number of things that you have a passion for and be great in it.

Scientific experts are producing remarkably consistent findings across a wide array of fields. Talent doesn't mean intelligence, motivation or personality traits. It's an innate ability to do some specific activity especially well. How can some people able to go on improving? The truth may lies by what is uncovered by scientists' observations on great performers across a diverse field.

NO SUBSTITUTE FOR HARD WORK

The first major conclusion is that nobody is great without work. It is nice to believe that if you find the field where you're naturally gifted, you'll be great from day one, but it doesn't happen. There's no evidence of high-performance without experience or practice.

Evidence shows that even the most accomplished people need around 10 years of hard work before becoming world-class.

The ten-year rule is a rough estimate, and most researchers regard it as a minimum, not an average. In many fields, like music, literature, elite performers need 20 or 30 years experience before hitting their zenith.

So greatness is not presented on a platter. It requires a lot of hard work but yet that isn't enough since many people who work hard for decades cannot even sniff greatness. What's missing?

PRACTICE MAKES PERFECT

The best people in any field are those who devote the most hours to what the researchers call "deliberate practice." It's an activity that's explicitly intended to improve performance, that reaches for objectives just beyond one level's of competence, provides feedback on results and involves high levels of repetition.

For example, simply hitting a bucket of balls is not deliberate practice, which is why most golfers don't get better. Hitting an eight-iron 300 times with a goal of leaving the ball within 20 feet of the pin 80 percent of the time, continually observing results and making appropriate adjustment, and doing that for hours every day - that's deliberate practice.

Do it regularly - like you would bath every day - not sporadically.

For most people, work is hard enough without pushing even harder. Those extra steps are so difficult and painful they almost never get done. That's the way it must be. If great performance were easy, it wouldn't be rare. Which leads to the deepest question about greatness. While experts understand an enormous amount about the behavior that produces great performance, they understand very little about where that behavior comes from. Some people are much more motivated than others but why - something yet to be answer.

David Novak, CEO and Chairman of YUM! Brands, says, "If it can happen to me, it can happen to you. I believe that you are only as good as you think you are, and that only you can hold your back, that positive thinking is self-fulfilling, and that you become what you think you can become. That in a nutshell is what will inspire you to know your stuff, give you real substance, and love what you do, which have always been the keys to success."

So the reality is that we are not hostage to some naturally granted level of talent. We can make ourselves what we will. Strangely, that idea is not well embraced or popular. People hate abandoning the notion that would coast to fame and riches if they found their talent. But that view is tragically constraining, because when they hit life's inevitable bumps in the road, they conclude that they just aren't gifted and give up.

Maybe we can't expect most people to achieve greatness. It's just too demanding. But greatness isn't reserved for a preordained few. It is available to you and about everyone.

The ten commandments for business failure by Don Keough

2009-06-21T10:41:00.000-07:00

Don Keough is a director of Berkshire Hathaway and chairman of Allen & Co, a New York investment firm. He is a retired president of the Coca Cola Company.

Applying the basic wisdom of what the rustic said (in the prior post), figure out where I will die and ensure I walk around it and avoid it at all cost. Learn from others' failures. So here are the 10 commandments for guaranteed business failures as prescribed by Don Keough.

1) Quit taking risk. He who is overly cautious accomplish little. Of course, risk should only be taken on a calculated basis. It's the management's major task to prudently risk a company's present assets in order to ensure its future existence.

2) Be inflexible. People who are inflexible are so set in their ways, so sure that they have the formula for success that they simply cannot see any other way of doing things (they cannot question and destruct their own well-loved ideas). Inflexibility is a crippling disease. A case in point involving a brilliant and legendary businessman, Henry Ford. Ford did not become the nation's richest man by inventing the automobile, or mass production. What made him a genius was his instinctive sense of mass marketing. He saw better than anyone at the time that if he could drive the cost down, the automobile could be transformed from a plaything of the rich into transportation for the masses. So to do that, he took two risks: 1) he kept reducing the profit per car in order to increase sales volume; 2) when the average wage for an automobile assembly-line worker was less than $2.50 a day, he announced in 1914 that he would pay his workers the unheard of wage of $5 a day. Ford had this idea that his workers could also be his customers - people who would both produce and consume the product. In paying $5 a day, overnight Ford increased the size of his market by paying his workers enough money to actually buy the product they were making. Yet in a few years, this genius who had been so visionary became so inflexible that he nearly ruined the company. He reportedly said, regarding the Model T, "They can have it in any color they want, as long as it is black." For a long time, that was just fine. But then people began to get tired of black. America was also roaring into the 1920s with bigger, faster, fancier, brightly painted automobiles. And Ford kept insisting that the Model T remain unchanged since 1908. He insisted that was what America wanted and needed and he was not going to change his mind. Inevitably, upstarts like Chevrolet and Dodge began to erode Ford's market and seriously challenge the company's dominant leadership. At last, more rational minds prevailed and Ford admitted the need to produce better vehicle. In 1928, he launched successful the Model A. But Ford's inflexibility had brought the company to the brink of disaster and cost it a competitive edge it has never regained. The story of failure of each company and industry is different. Some are more straightforward than others. It's obvious when you look back that in the early part of the 20th century that ice companies, no matter how they resisted, would have to find something else to do because they were going to be replaced by electric refrigeration. It is not quite obvious how the majority of more than 3000 bicycle companies just disappeared while others morphed into the automobile business, and even, as the Wright Brothers demonstrated, into the airframe business. Clearly some folks were more flexible than others.

3) Isolate yourself. There're just a few things you need to do to create your own executive bubble. Start with your surroundings. Build your own bubble. Get yourself a great big office in some remote corner of the most remote executive floor and then shut the door. Never walk around the HQ office and talk to people. Don't bother to learn of your employee's name. Always lunch with only a few close members of your immediate staff in the executive dining room. Put a big sign: "Don't make the boss mad. Bring me no bad news." Create a climate of fear. With power comes responsibility, and power includes hiring and firing. Just scream and throw tantrums. Dress down people who make istakes in front of other people. Be rude. Act like a 2-year old child. To completely isolate yourself further, put yourself first in everything. When there's credit to be taken, take all of it. When there is blame to be taken, take none of it. If the spotlight of public attention turns toward your company, leap into that light and leave your employees and associates and everyone else who might have a helping hand way off in the wings. After you have hogged the limelight, in the unlikely event that you harbor some feelings of guilt, you can assuage some of those feelings by sending your hardest workers a nice X'mas card or something. Hogging the limelight does not guarantee failure but it does make great success very difficult. Among most truly successful people, they possess a self-effacing quality - an avoidance of the spotlight. If you read Warren Buffett's annual letters, you can't help but uncover that he lavished praise and credit on someone else. Strangely enough, it is when things go wrong that Warren comes on centre stage to assume responsibility.

4) Assume Infallibility. Never admit a problem or a mistake. If something seems to be heading in the wrong direction, cover up, or better yet, wait until you have a full-blown crisis, then blame it on some external force - or blame it on someone else. Customers are frequently troublesome. You can always blame whatever goes wrong on them. Annual reports, particularly those to shareholders, is often a place you see CEOs shifting the blame to something or someone else. When a company had a disastrous year, the Chairman's letter is frequently an artful exercise in fingerpointing at any number of causes ranging from unforeseen currency fluctuations, to the unusually active hurricane season. You have certainly read, many times possibly, that "mistakes were made." Timbers were caving in, dust is in the air, and the person in charge of it all blithely asserts, "mistakes were made." Implied, of course, is, "But not by me." That's what sets Warren Buffett apart in his legendary annual letters. If in a particular year, performance is not quite up to previous years or what might have been expected, he is quick to say "It wasn't good and it was my fault." Despite his virtually unequalled record for profitably allocating capital, he lays no claim to infallibility. In his 1996 letter to shareholders, for example, Warren noted the problems with Berkshire's investment in USAir and commented, "In another context, a friend once asked me: 'If you're so rich, why aren't you smart?' After reviewing my sorry performance with USAir, you may conclude he had a point."

5) Play the game close to the foul line. If you play close to the foul line, you are not likely to inspire much trust on the part of your customers or employees and you will fail. Success is more permanent when you achieve it without destroying your principles as Walter Cronkite said. Trust is one quality Don wanted, not being loved or feared. Kmart and Wal-Mart were founded in the same year (1962). Yet Kmart filed for bankruptcy in 2002. Kmart had pursued a dangerous path, along the way, there were rumors and allegations of corruption and self-dealing on the part of executives. Indeed, a senior real estate executive with the firm was convicted of bribery. The truth is they played close to the line and in some cases, the court said they crossed it. One of the reasons corruption became more wide-spread, was because our whole social environment became less civil and more tolerant of bad behavior. In 1969, a famous experiment was conducted by Philip Zimbardo, a Stanford psychologist. Two cars with no license plate and the hoods up were abandoned - one in the Bronx, New York and the other in Palo Alto, California. In the Bronx, the car was stripped and trashed in a matter of minutes. In Palo Alto, something quite different happened. For more than a week, the car sat there unmolested. But one day the psychologist himself took a sledgehammer and began smashing the car. Soon, passerby were taking turns with the hammer and within a few hours, the car was demolished. This experiment led to the "broken window" theory of crime - the idea that if a broken window is left unrepaired in a building, soon vandals will break the rest of the windows. According to the theory, it says "No one cares. Break a window and nothing happens to you. Break more. It's ok." To a degree, the business environment was suffering a similar fate. Little cracks in the body of ethics were being ignored. Another reason why corruption became more widespread is that we began to spend an inordinate amount of time catering to our valued friends who help to make "the market" - the Wall Street analysts.

6) Don't take time to think.

7) Put all your faith in experts and outside consultants.

8) Love your bureaucracy. If you want to get nothing done, make that administrative concerns take precedence over all others. Leaders of complex organization walk a thin line. There must be rules and routines in every business to maintain the proper rhythm in everything. Over time, however, it seems that inevitably the rules and routines become more important than the ends they were designed to serve. The rules and routines become rigid, obsolete rituals and obstacles to the positive energy of the system. The bureaucrats who control these rituals guard them with their lives because any change undermines their own power or authority. Gradually, the bureaucrats simply can and often do become a major impediment to progress of any kind and guarantee failure. And they do look busy! They churn out internal reports and memos. They cover their backsides with trails of thousands of emails and memos in the file. They go home at night complaining of how hard they work and in reality no single productive event has taken place all day. In such enterprise, failure is guaranteed. In the cattle business, it was clear if you kept the right mix of male and female animals you would end up with a lot more animals. Bureaucracies multiply in the same way and here is how it works: You put a manager in place and within 18 months, he or she has an assistant. The assistant becomes a junior manager and guess what? Another assistant. The beat goes on. There are layers upon layers of people yet when the customer calls, nobody's home. They are all in meetings. These meetings generate more paperwork, more emails, more calls, more meetings. In fact, most often there are even meetings to plan meetings. Meetings are the religious services of a great bureaucracy and the bureaucrats are fervently religious.

9) Send mixed messages. Jack Welch had indicated that when he took over GE, the company was a jumble of mixed messages, with many longtime units on the brink of failure. At the Coca Cola Company in the 1970s, there were a number of situations where communication was, at best, misleading, especially to its employees and bottlers, but also to its retail customers. Like a parent who tells the child, "Clean your plate or no dessert!" The parent said it but didn't mean it. The child got dessert anyway.

10) Be afraid of the future. Most people find it sensibly to be prudently cautious regarding the future. It is not a crime to be cautious but when caution becomes the overriding modus operandi in a business, it can precipitate failure. You see it in football. Near the end of the game, the team with the lead begins playing it safe, cautiously protecting their lead. They quit taking the same kind of risks that gave them the lead in the first place. And too often they lose in the final minutes of the game. To quit taking risk is a serious risk!

Bonus commandment - Lose your passion for work and life. Nothing great in the world has been accomplished without passion. The old saying goes, "Tell me what you love and I'll tell you who you are." Love has been around a long time. The word comes from the ancient Vedic, or Hindu, word of the Sanskrit "lurb," meaning desire. A major component of happiness in the business world is finding something you love doing, whatever it might be, and then finding a way to do it. To have success you have to have a high level of unadulterated desire to get up and go to work. It's not that work has to be fun. That's a misconception promoted by some of the more giddy human resources people who like to talk about team spirit. Work, real work, is often very hard, exhausting at times. Rallying the troops is not telling people to have more fun. It's telling them to work harder because they are capable of doing better. They deserve for their own self-satisfaction to perform at a higher level. The hard work itself is what makes you tap-dancing into the office. It's that passion to solve the problems of the day. If you really want to fail, lose that passion for whatever it is you are doing. Get that spring out of your way. Say to yourself, "That's good enough." Or "That's not my job." Or "I don't care." Or "I'm retiring soon anyway." We all know people who have done this. They are the grey-faced automatons found in every workplace - the people who seem to stew in their own misery, cursing the darkness rather than lighting a candle. Even if they manage to make a good living, they are not successful - in fact failures - because they set such low expectations for themselves and those around them. All truly successful people express love for what they do and care about it passionately. They display such passion in their work so much so that if you asked them they'll tell you they can't imagine doing anything else. They seem almost so crazily focused on what they do. In recent times, it is common that one's career is span over many jobs at many different companies. It makes the notion of passion antiquated. How can you be passionate about anything that is going to last only a few years, and then you are going to move on to something else? What's the point besides getting more pay?

Charlie Munger's Prescription to Guaranteed Misery

2009-06-21T09:39:00.000-07:00

I learnt positivity builds well on positivity and conversely, negativity feeds on negativity. From Warren Buffett, I learnt about Charlie Munger and from Munger, I learnt about Munger's personal heroes like Benjamin Franklin.

There're so many things that I have learnt from Charlie. One of my favorites is a speech he gave in 1986 on his son's graduation day at the Harvard School. His speech was an extension of Johnny Carson's graduation speech years prior, in which Carson gave his prescription for a life filled with misery. Munger's speech is well worth to be read in its entirety, and here, it should be summarized.

In Carson's original speech, he could not tell the graduating class how to be happy, but he could tell them from personal experience how to guarantee misery. Carson's prescription for sure misery are:

1) Ingesting chemicals in an effort to alter mood or perception

2) Envy

3) Resentment

Munger went on to add on four more prescriptions to guaranteed misery.

1) Be unreliable. Do not faithfully do what you have engaged to do. If you will only master this one habit, you will more than counterbalance the combined effect of all your virtues, however great your virtues may be. If you like being distrusted and excluded from the best human contribution and company, this prescription is for you. Master this one habit, you will always play the role of the hare in the fable, except that instead of being outrun by one fine turtle, you will be outrun by hordes and hordes of mediocre turtles and even some mediocre turtles on crutches.

2) To learn everything you possibly can from your own experience, minimizing what you learn vicariously from the good and bad experience of others, living or dead. This prescription is to become as non-educated as you reasonably can. There was once a man who assiduously mastered the work of his best predecessors, despite a poor start and very tough time in analytical geometry. Eventually, his own work attracted wide attention, and he said of his work: "If I have seen a little further than other men, it is because I stood on the shoulders of giants."

The bone of that man lie buried now, in Westminster Abbey, under an unusual inscription: "Here lie the remains of all that was mortal in Sir Isaac Newton"

(This shows even genius like Newton learn from others. In the book Outliers, it argues that no one, even geniuses included can succeed solely on their own, example in point, Chris Langan - a person with an IQ over 190).

3) To go down and stay down when you get your first, second and third severe reverse in the battle of life. Because there is so much adversity out there, even for the lucky and wise, this will guarantee that, in due course, you will be permanently mired in misery.

4) To ignore a story told to the young Munger by a rustic who said, "I wish I knew where I was going to die, and then I'd never go there." Most people smile at the rustic's ignorance and ignore his basic wisdom. If you are bent on misery, ignore the rustic's approach at all cost. An example, if you keep losing on lottery, keep buying. If you keep drinking, keep on drinking and double up.

What Carson did was to approach the study of how to create X by turning the question backward, that is, by studying how to create non-X. Munger quoted the great algebraist, Jacobi who said, "Invert, always invert." Many hard problems are best solved only when they are addressed backward.

Munger thinks that Charles Darwin would have ranked near the middle of the Harvard School graduating class of 1986. Yet he is now famous in the history of science. This is precisely the type of example you should learn NOTHING from if bent on minimizing your results from your own endowment.

Darwin's result was due in large part to his working method, which violated all Mungers' and Carson's rules for guaranteed misery and particularly emphasized a backward twist in that he always gave priority attention to evidence tending to disconform whatever cherished and hard-won theory he already had. In contrast, most people early achieve and later intensify a tendency to process new and disconforming information so that any original conclusions remain intact.

The life of Darwin demonstrates how a turtle may outrun a hare (in business alike, turtle - like Walmart, Cap Cities/ABS in its early days - outrun hares - like Sears Roebuck, CBS), aided by extreme objectivity, which helps the objective person to end up like the only player without a blindfold in a game of Pin the Tail on the Donkey.

So minimize objectivity is another way to misery. If you minimize objectivity, you ignore not only a lesson from Darwin but also from Einstein. Einstein said that his successful theories came from "Curiosity, concentration, perseverance, and self-criticism." And by self-criticism, he meant the testing and destruction of his own well-loved ideas.

Munger signed off saying, "Gentleman, may each of you rise by spending each day of a long life aiming low."