The harder they fall

The revelation that Wells Fargo employees had opened millions of accounts without the knowledge of their customers has come like thunder in a bright blue sky.

Here was the most respected of the big US banks seemingly behaving as the reviled Wall Streeters, after it had touted its plain vanilla business and earned Warren Buffett’s confidence and admiration[1]!

Of course, not everybody cried, as Congressional critics were quick to point out that they had been right all along: big banks were out to trick their customers rather than serve them, and their staff would stop at nothing to earn fat bonuses.  It also provided a timely boost to the controversial Consumer Financial Protection Bureau which uncovered the problem.

Still, the bank has given them ample ammunition:

-         The scope of the fraud, close to two million accounts and credit cards,

-         That some 5,300 employees and managers were fired, hardly “a few isolated bad apples”,

-         That the leader of the unit where the shenanigans had taken place chose that time to retire with US$125 million in stocks, options and retirement benefits, a large chunk of which had been accumulated during her stewardship of the consumer banking unit,

-         Finally, that the bank CEO squarely blamed employees but didn’t name any high ranking executives among those responsible and was vague as to his own accountability.

At the same time, it should be noted that the actual financial damage inflicted on the bank customers was light: some 14,000 accounts incurred an average of US$28 each, and, in total, US$5 million was refunded which works out to less than US$5 per client[2].  This explains why, by today’s standards, the fine was a very modest US$185 million.

Nevertheless, I expect that the final cost to the bank will be much higher.

To begin with, the bad publicity will bite all the more so that Wells Fargo had such a good reputation.  Negative sentiment will weigh on the stock price.

The bank will need to spend hundreds of millions on better internal controls and training.  The decision-making will likely be slowed down as transactions will need to go through lengthier and slower approval processes.  Risk taking will probably diminish, and with it profits as staff will be wary of making career-ending decisions.

This scandal will likely take a bigger toll on top management than we have seen to-date.  Let’s face it, when thousands of employees feel so pressured to reach their goals that they resort to fraud, either (1) they were poorly trained and/or of uncommonly bad character, or (2) the top down pressure was so intense and widespread that it was no accident.  Either way, management is at fault.

Having worked for a large bank, I for one believe that corporate culture determines how business is conducted; it is critical in guiding managers’ and employees’ behavior and decision making.  In this instance, and from anecdotic evidence, I believe that there was a corporate cultural problem.  Setting the appropriate culture IS the responsibility of top management, under the supervision of the board of directors.

A key Wells Fargo strategy toward growth and profitability has also been called into question: the much advertised effort to deepen and broaden the relationship with customers by selling them ever more products.  Yet in recent years, while the goal had been set at 8, they had plateaued just north of 6.  If 6 rather than 8 is the effective ceiling, how will the bank make up for this setback, especially since cross-selling will be under closer scrutiny?

Some have compared this crisis to the JP Morgan “London Whale”.  JPM was punished much more harshly, even though its victims were its own shareholders rather than its customers.  With its “fortress balance sheet”, JPM recovered relatively quickly although it is likely that its future profitability suffered because of rising compliance expenses and lower risk tolerance.

Wells Fargo has in my view a bigger problem: besides incurring greater compliance expenses and dialing back risk-taking, it faces a greater strategic challenge and it may suffer from upheaval in its top management ranks.

For all these reasons, I wouldn’t be surprised if its stock price were to drift down toward book value, i.e. US$36 vs. US$47 today, reflecting a loss of premium valuation and lower future earnings.

Although it is no excuse, I think that the current financial context of quasi-zero interest rates keeps exerting ever stronger pressure on banks’ net interest margins, and Wells Fargo is the latest but by no means last victim.

---

[1]  Buffett’s Berkshire Hathaway owns 9.7% of Wells Fargo, a stake worth US$21 billion.

[2]  In the absence of further details, such average number is difficult to interpret.  My own hunch is that some customers were charged fees of about US$30 while others incurred no charges.

On the Cliffs of Marble

When I left France for the US in 1972, as it turned out never to come back, I packed a poster of the north wall of the Eiger and a copy of my favorite book of all times: Ernst Jünger “ Sur les Falaises de Marbre”[1].

This extraordinary book recalls the last days in an imaginary land before its invasion and destruction at the hands of the Great Forester, a cunning and ruthless tyrant who lived in the vast forests nearby.  Jünger started his book while staying in a small town on the shore of Lake Constance.  Years later while on a vacation, I visited picturesque Meersburg and Lindau, drove through the rolling hills behind Hagnau and watched the sun set over the snowy peaks of the Alps beyond the shimmering lake, and memories of the book and its magic rushed back to my mind.

Some have said it was a criticism of Stalinism, others of Nazism.  It certainly was a paean to freedom, to what makes life in harmony with friends, neighbors and nature so precious, and how quickly we can lose these and how painful it then is.

I don’t believe that we are living on the banks of Jünger’s vast Marina.  But I do feel that we are in danger of slipping into a period of greater tension, greater division and failure to address our most pressing problems.  Before too long, and unless we regain our senses, the time for a Great Forester could arrive.

For many reasons, we are left with four candidates to the presidency: a populist and demagogue and Forester apprentice, an aging career politician with truth telling issues, an ex pot entrepreneur, and an activist who spray-paints bulldozers of companies she disapproves of (sadly, the Democrat, Republican and Green VP candidates are probably better than the top of their tickets).

It is difficult to imagine how any of these candidates could unite the country.  Hillary Clinton is probably the one more likely to try and build consensus because she is the one who most lacks a committed base, but can she bridge the trust gap?

Meanwhile, Americans are more divided than they have been in decades.  It is both ironic and sad that they were most united when President Obama took office in 2008.  Responsibility for this can be spread wide, and because of that, redemption will be hard to reach: Tea Party extremists unwilling to compromise, main stream Republicans unable to deal with them and the opposition, Democrats in Congress and the White House enamored with diktat and income redistribution without GDP growth; most of all, politicians deaf to popular angst and aspirations.

Against this dreary political background, the economy and the financial markets have been operating with a high degree of wariness, where extreme monetary policies have attempted to offset the absence of fiscal reforms and pro-growth policies.  The fix has carried increasing risks: financial assets are overpriced, public pension funds are hugely under water, the insurance industry is at risk and even consumption is threatened by the need for households to save more when 10 year Treasurys yield a meager 1.7% p.a.  

So we have a divided political class, a divided nation, a subpar economy and stretched financial markets.  I might add that the same combination of slow growth and excessive indebtedness is pressuring governments and traditional parties and giving openings to populists of all kinds around the world.

As an investor, I would think that prudence is in order.  Sure, stocks are not as expensive as bonds, but does that make them attractive, as a class?  Not really.  There is nothing wrong in keeping stocks of steady performing companies, or in buying into carefully chosen turnarounds.  But if one keeps a large exposure to equities, buying some protection seems advisable to me.

Alternatively, cash does look like a good temporary alternative.  Another one is real estate.

History shows that people and countries don’t change until they have to.  In America, I don’t think we have reached that point, nor do I see anyone able to mobilize the nation.  History has also shown that it takes time for a large country or economy to change direction.       

Caveat emptor!

---

[1] On the Marble Cliffs.

“You will need a bigger boat!”

If you have read this blog for several years, you know that swimming, next to investing, is my favorite activity.  As the Olympic Games of 2016 are under way, we have seen some great racing already, like the 4x100 men free relay and both 400 free finals.

But we have also witnessed the controversy about doping rising to the point of nearly overshadowing the athletes’ performances and, at times, turning these Games into confrontations from a bygone era.  The Olympics are supposed to bring people together through sport, not to cause spectators to boo its actors.

As with all important issues, making an early decision, even an imperfect one, beats delaying; as time passes, problems get bigger and control over resolution timing is lost.

The German broadcaster ARD had long been leading the charge against doping at home and around the world, but it was their 2014 reporting on organized doping that set in motion a series of official investigations and the suspension of the Russian track and field federation.  The swimming federation (FINA) was much slower in responding, as was the International Olympic Committee (IOC). 

The result was a series of, literally, last minute decisions, often contradictory, which left everyone unhappy.  More importantly, it didn’t address three issues which are critical to public and corporate sponsors' perception.

-The “unlucky” doper:  Behind the relative tolerance of first time offenders is the impression that these were unlucky enough to have been caught just that one time when they cheated.  In reality, doping is never a onetime event; most drugs need repeated intakes to produce results; furthermore, athletes and their medical staff need time to adjust the dosage and strike a balance between effectiveness and detectability.  In reality, the unlucky doper is a repeat offender.

-The penalty box:  If you watch ice hockey matches, you see players commit a fault and skate towards the penalty box where they will spend a few minutes before resuming normal play.  Penalties are part of the games.  In swimming, doping and serving a time suspension is becoming the norm.  Now, if you are an unknown Peruvian flyer, you will incur a four year suspension, effectively ending your career.  But if you are a star, your federation will fight for you, assemble a top notch legal team if need be, and you will either go scot-free or stay a few months away from the pool.  So, for too many elite swimmers, the choice is between risking a slap on the wrist and winning a medal.  Tempting isn’t it?

-State organized doping:  We thought we had left that nightmare behind when East Germany collapsed.  Apparently not.  Most people will recoil at the thought of a state putting its might behind an organized effort to corrupt testing procedures and results.  Clearly, this would put competitors at a disadvantage.  But what if the top athletes from the country in question had little choice but to dope?  Not that they would be jailed if they didn’t, but they wouldn’t receive the kind of technical, medical, financial and logistical support that fulltime athletes can’t do without.  That would be even worse.

Procrastinating FINA and the IOC have dug themselves into a big hole.  So far, they have shown that they are incapable of getting out of it on their own.  The main factor is money, and I expect that, if we get to a solution, it will be because MORE money speaks again the status quo than for it; I mean the corporate sponsors and broadcasters.  This is how the Tour de France overcame its own scandals.  Unfortunately, the spirit and ideals of the late Baron de Coubertin have long been left behind by the very same people entrusted to uphold them.

Sister Souljah, Brother Judas?

Last March, I wrote a post about Republican presidential candidates’ Sister Souljah opportunities and how they had flunked them: Mitt Romney failing to take a budget deal that would give him 90% of what he wanted, the 2016 candidates failing to push back against Donald Trump’s insults.

Well, Ted Cruz was given a second chance yesterday and he grabbed it.  Except that he was immediately cast as a Judas.

The original Sister Souljah moment was Bill Clinton speaking as a candidate to Jesse Jackson’s Rainbow Coalition and rejecting a well known black activist’s call for black on white violence.  In the immediate aftermath, he suffered a drop in support from some quarters, but eventually more than made up for that with moderate Americans.

Yesterday, Ted Cruz refused to endorse Donald Trump, calling instead for Republicans to stick to principles and vote their conscience.  Today, at a breakfast of Texas delegates, he added that he couldn’t endorse a candidate who insulted his family.  What took him so long?

The party reaction was telling and frankly shocking:  the New York delegation screamed and booed; on CNN, a Trump official could barely control himself calling for Cruz’ party exclusion, Governor Christie was likewise furious and the general audience didn’t fare much better.

Ted Cruz took major risks with that speech and the fallout was immediate. Most political commentators accused him of careerism.  The party was exposed as more divided than it wanted to appear.  Party grandees who had fallen in line behind Donald Trump realized that they could be dangerously exposed in case the Trump candidacy failed come November.

Accusing Cruz of weighing in career considerations in such a major decision seems disingenuous to me.  Likewise, denying that he may have principles seems unfair.  What is undeniable is that he showed great courage and that he will be, with Donald Trump, the most memorable Republican figure of 2016. 

Whether this will have been his Sister Souljah moment, time will tell.  I believe that it will eventually strengthen his influence within the Republican Party: he will have warned about the Republican nominee’s shortcomings, he will have name recognition, and he clearly showed more courage than his peers.  But unless he moderates his views I don’t see him in the White House in 2020.

Watership up

In the 1970s British novel, Watership Down, a band of rabbits led by one Hazel escaped destruction and went on looking for a new place to live.  In the course of their odyssey, they come across a warren of well fed but depressive rabbits; these resplendent animals feed on mouth-watering lettuce planted by the local farmer, except that this farmer also sets up snare wires in his field to catch them, one by one.

Unable to resist the lettuce yet afraid of the wires, the epicurean leporids try to convince Hazel’s band to stay in order to lower their own chances of strangulation.  Showing both fortitude and wisdom, Hazel and his friends move on.

Moving on to Europe in 2016.

Last week, the human inhabitants of Britain voted to exit the European warren in search of a better life.

Unlike the rabbits, the British people don’t enjoy the support of a seer and his conviction that they will succeed.  But like the rabbits, I think that they made the right choice.  Europeans should take this opportunity to change course as well.

Originally set up as a customs union, the EEC included six founding members.  With the passing of General de Gaulle, the key opponent to federalism disappeared and the European institutions went on increasing their areas of competence.  By 1973 Denmark, Ireland and the UK had joined in. 

The 1980s set the seeds for real dissent by further enlarging membership (Greece, Spain, Portugal) and further increasing the powers of the European Parliament[1]. 

The 1990s brought the Treaty of Maastricht with expansion into foreign policy, criminal justice, the military, and of course financial matters with the creation of the euro.  The euro was a rushed job[2] and a highly political compromise: Germany was wary of the euro but eager to absorb East Germany; France was wary of German expansion but eager to adopt the euro.  And three new countries joined the European Union.  The Treaty of Amsterdam further built Brussels bureaucracy, to the point of making many of the new regulations unworkable.

The 2000s brought in twelve more members, such as the Baltics, Bulgaria, Cyprus and Malta but also created more conflicts between national and EU areas of competence.  The seemingly unchecked reach of Brussels in a 27 country union with GDP per capita ranging from $50,900 to $7,700[3] encountered growing resistance among the core countries.

In retrospect, it is amazing that such a transformative integration process as the EU was conceived and implemented with almost no popular consultation or approval.  Indeed, after the Dutch and French popular rejections of 2005, the EU Constitution was recast under the 2007 Treaty of Lisbon so as to avoid future popular referendums![4]

Suffering from a legitimacy deficit, the EU was at risk if its members faced serious difficulties, and this is what has happened with: 1) poor macro-economics in the aftermath of the 2008 global crisis, 2) recurring acts of Islamic terrorism, and 3) uncontrolled immigration from the Middle East.  Worse, being part of the Union didn’t seem to help.

I for one am fairly optimistic for the UK:

-The British Isles haven’t drifted towards the freezing Artic,

- The commercial, industrial, financial and touristic ties built with the EU countries over the last three decades are not going to disappear any time soon as they are mutually beneficial,

- The UK and London have always been open to the world; this culture, the skills and the soft infrastructure developed over the centuries will endure and should facilitate an international revival free from the cumbersome shackles of Brussels.

For the remaining 27 EU members, Breixit is also an opportunity to reform the Union.  Indeed, former President Giscard d’Estaing, of no-referendum fame, declared yesterday that the EU needed more democracy, less bureaucracy and more differentiation between big and small countries.

The EU is often made fun for silly rules such as the curvature of bananas, and why not?  But more serious rules stand in the way, such as those preventing Italy today from recapitalizing its ailing banks.

Prestige aside, the euro zone has disappointed.  Instead of bringing about stronger finances, it has incentivized its members to take advantage of lower interest rates to load up on debts.  Rich countries like Germany are now indirectly supporting the weak fiscal policies of others while the weakest ones, unable to devalue, must squeeze their workers to the point of endangering social stability.

Returning power to the states, limiting bureaucratic creep by cutting down the number of commissions and agencies, mandating sunset provisions in new regulations, tying national voting power to population and GDP size should count among the steps towards establishing a better union of so many members.

The UK has been the catalyst for change.  It is messy, jarring, worrying, yet necessary for survival.  Following in the steps of Hazel, Fiver and Bigwig, Britain is on the move again, and who knows, it may decide to join a reformed European Union?

---

[1]  Starting to cause the first serious frictions with a number of member countries, Ireland having to amend its Constitution to accommodate this power increase.

[2]  Common currency without fiscal integration or even harmonization as the so-called convergence criteria were soon disregarded by the major countries.

[3]  Austria and Bulgaria.  Luxembourg is excluded.

[4]   Former President Giscard d’Estaing candidly confessed to that in an op-ed in Le Monde on 10/29/07.

The Prisoner of (Mar al) Zenda, an exercise in fiction

On a balmy Florida morning, the mansion staff were tidying up the veranda and cleaning after the guests had finished their breakfast.  The dinner and recital of the previous evening had gone rather well considering the palpable tension which had pervaded the relations between the host and some of his most prominent guests.

But the atmosphere had relaxed considerably come morning, and the Majority Leader, who had maintained his habitual reserve since he had arrived, was almost bubbly by the time he had finished his croissants.  The Speaker had returned from an early two hour run and was engaged in a lively discussion with a Silicon Valley investor.

As limousines started to pull up and attendants were loading the luggage, the Host was amiably chatting with departing guests before sending them on their way.  In all the buzz, one could easily be forgiven for failing to notice that the famous hair of their host had turned a shade redder, or that a small blue van was silently rolling towards the service exit.

The bombshell exploded a week later when the Host told Wolf Blitzer on CNN that he had decided to pick former General and CIA Director David Petraeus as his running mate to set up the first co-presidency in US history.

Wolf’s eyes literally bulged out of their sockets, and for a few seconds, he was at a loss for words.  The Host gently let him gather his wits and proceeded to explain why this was a win-win strategy for the country, the Republicans and him:

-“Wolf, to make America great again, we need to revitalize the economy, rebuild our military and recast our foreign policy which have been TERRIBLE in the last eight years.  I am a very successful businessman, my friend Carl Icahn will pitch me his best ideas, and I will choose a FANTASTIC Treasury Secretary!  But look, as smart as I am, I have no experience in foreign affairs or in defense, and David is the best out there, and so I am so grateful that he accepted to serve our great country as Vice President with primary authority in these two areas as well as domestic security.”

-“Donald,---woah,…ah…this is so unexpected,.euh…

-“Wolf, you are a VERY sharp journalist, one of the very best in the business, as a matter of fact I think you may be the best, and surely you can see that this ticket is bringing the temperament and competence which I promised all along and which this great country deserves.  And we will win in November!”

Within seconds, somewhere in Kentucky, the Majority Leader clasped his hands, and, in a manner reminiscent of Dinah Lord’s at the end of The Philadelphia Story, simply uttered: “I did it!”  Somewhere in Chappaqua, NY, a blond woman sunk into her sofa, sobbing: “Not again!”  Five thousand miles away, in a small Amazonian forest clearing, a thin plume of smoke was twisting in the morning mist as a few women were grilling freshly caught fish from the Apaporis river.  The rest of the small Xurungawah tribe was sitting in rapt silence as a big fair skin man with a strange yellow-white mane was haranguing them:

-“Folks, this is one incredible place and you are an amazing people!  We will build here the most amazing ecological resort in the world!  I see you don’t quite grasp what I am telling you, but we will get it done folks, and by the way,..”

Unlike in the movie, we don’t know if Donald Trump has a perfect double.  But an opinion is starting to take hold: at his age, he is unlikely to change, and for a growing number of Americans (including me) he is unelectable to the presidency.

Republican Party leaders are realizing that, but they can’t ignore the votes of millions and nominate another candidate.  They can’t go to war with him although they can’t embrace his corrosive statements.  They openly worry that he doesn’t know enough about domestic or foreign policy to govern effectively.  Yet they are unwilling to leave the White House in the Democrats' hands without a fight.

Still, they hold two aces: one is money.  Effectively, they will control the bulk of the donor contributions and therefore how the campaign will be waged.  They also know that as a man with a large ego, Donald Trump will not want to face a humiliating defeat.

They could try and convince him to resign.  But while his poll ratings have weakened, they haven’t entered panic territory.  Until then, neither he nor his supporters will let go.

Or the party leadership could convince him to share a co-presidency with a respected professional heavyweight; somebody strong enough to make that project credible.  In 1976, Gerald Ford briefly offered a similar deal to Ronald Reagan.  It didn’t work because the two men were not complementary and believed that they could win on their own[1].

This is not 1976.  A co-presidency of the kind suggested above would have several key benefits for the Republicans: 1) it would wrong-foot a Democratic strategy focused so far on discrediting a personality, Trump, 2) it would prevent many Trump voters from bolting or abstaining, 3) it would force the Democrats to come up with a government program agreeable to both Clinton and Sanders factions, and 4) it would also force them  to do the same, giving them credibility.  Win or lose, the benefits for the country are obvious.

In truth, the options for the Republicans are very limited and risky, and they only have themselves to blame.  Our “Prisoner of Zenda option” is a long shot.  But hoping that Hillary Clinton is forced to retire would only bring in Joe Biden, and he would trounce Donald Trump (my opinion).  Allocating most of the money and efforts to the Congressional races at the cost of the presidential one is risky: it could divide the Party further and encourage Republican voters to stay home.

If only Ruritania were real!

---

[1]  Ronald Reagan believed he could win in 1980.

On the head of a pin

The Republican primaries are effectively over.  Donald Trump has won.  The Democratic ones continue, with Bernie Sanders hammering at the only Establishment figure left, Hillary Clinton.

2008 was the year Americans felt they had come together behind an historic candidate, Barak Obama.  Eight years later, they are angry, frustrated and more divided than ever since the Vietnam War.  So much so that they are betting on two outsiders who promise to bring the “corrupt” system down. 

Now what?  Reality is starting to dawn on Republican Party grandees that Donald Trump is not their candidate, rather that they are his supporting cast.  Who is the boss?  The question is being asked now and will be answered soon.

Republican mediators hope that Donald Trump will change his tone to unite the Party.  This is unlikely for several reasons.  Dumping a winning strategy has risks for Trump.  Besides, one of the most surprising sights of the primaries was to see prominent politicians taking little offense at being called corrupt, liars, weaklings or told to shut up on live tv.   

My view is that Donald Trump calculates that the Republican Party leaders lack courage and vision and that they will ultimately back him up in order to save their sinecures: better being tame courtiers than proud exiles.

A Trump president would likely go over the heads of Congress and the Senate to appeal directly to voters, make extensive use of executive decrees, and go for big targets: big infrastructure programs, NATO shake-up, big budget and spending battles.  He obviously believes that he would win most of these; he would enjoy the negotiating game;  but the US is not the NY real estate market, or even France, Germany or Russia:  Gamesmanship at the US level has far greater potential destabilizing effects.  Unpredictability may be a good negotiating tactic but it is not a strategy for the world leader[1].  Likewise, loading the US with debt – because if the economy rebounds it is easy to pay it off, and if it fails you just restructure – can’t be the best way to sell  hundreds of billions of US treasuries every year.

The Trump candidacy will have had some positive effects, such as exposing the dysfunctionality of the Republican Party, imbalances within NATO contributions and the not so hard nose negotiating abilities of the Obama administration.  But the negatives of a Trump presidency are difficult to fathom and potentially huge.

What about the Democrats?

Hillary Clinton is unloved and polarizing, but is the safe pair of hands among the last three remaining candidates.  Yet she has been pulled further to the left by Bernie Sanders than she wanted or expected (and her miseries are not over yet).  That Senator Elizabeth Warren is talked as a possible running mate makes that very clear.

She also has hanging over her head, as the Sword of Damocles, the inquiry into her use of a private server and the sharing of “classified” emails.  It is possible but unlikely that the Department of Justice pursue a criminal indictment against her; but if this decision were a close call, some disgruntled FBI or DOJ staff could leak embarrassing related documents; then, we would have a new ball game.

To succeed in the general elections, she would need to retain the support of Sanders’ voters while attracting independents and non-Trump Republicans: no small task.   

If she succeeds, and unlike the other two candidates, she is more likely to seek consensus because she won’t have a solid base of believers.  She would need a good communicator to help get her message through that, as Talleyrand once said, governing is the art of the possible. Would this be her Vice President, her Secretary of the Treasury or her Secretary of Labor?  I don’t know.  Would she succeed?  Way too soon to tell.  Besides, if she didn’t heed Sanders’ entreaties, over time his supporters could set up the Democratic equivalent of the Tea Party.

In summary, and as of today, this presidential election looks like the most frustrating in years.  The two most likely candidates are viewed more negatively than positively.  The two with the greatest fan bases are party outsiders who promise the moon and howl that the political parties whose banner their carry are rigging the primaries against them and their voters.  The cooler headed one enjoys stronger support from party officials than from party members.

Fasten your seat belt but don’t get off the plane!  

Because if you think this political season can't hold any more surprises, THINK AGAIN.

---

[1]   But it has been for North Korea.