The Internet Leads to Disintermediation

2011 could be the year of disintermediation. In the 90's, the internet became a place where many entrepreneurs created new etail businesses with high expectations to grow forever at astronomical rates. Many of those expectations were not met and we had the .com crash. Of course, some of those enterprises are still around and thriving today while others have survived but remain a shadow of their original businesses. The first decade of 2000 resulted in the creation of many internet enterprises that enabled ecommerce companies to thrive. The use of analytics, data, search, consumer generated content, social networks, and other technology became a focus to drive the growth of retailer's sites and consumer brands, while dramatically expanding the usage of the internet globally. 2010 brought us the social network explosion and the growth in location based services and couponing.

Where do we go from here? I suspect the old trends will continue but mobile and video will become a bigger focus. In 2008, the United States and much of the rest of the world suffered through a financial crisis not seen since the Great Depression. The psychology of the consumer has been damaged for many years to come. No longer are people frivolously spending money and most consumers are looking for a bargain. This should propel the internet to become the driving force behind the "disintermediation of business". Traditional business has a supply chain that moves from manufacturing floor, to shipper, to wholesaler, to retailer, to consumer. 2011 will lead to the squashing of the supply chain and new fears will develop among the brick and mortar crowd. Entrepreneurs will develop ventures that either eliminate some of the supply chain or they will look to fill a need for lower prices for the consumer. In some cases, lower prices could result in expanding the customer base of a retailer so that overall their revenues rise as excess inventory gets depleted.

We recently have seen a trend of disintermiediation where some interesting businesses are starting to pop up. The combination of couponing and location based services may become a normal offering for every retailer if it wants to remain competitive. On the other hand, we find a company like http://www.jhilburn.com/ recognizing a niche to eliminate the supply chain for expensive men's shirts and using multi-level marketing to drive growth. The result is custom-made clothes at 1/3 the price of the retail store's off the rack designer shirts. It sounds crazy but how can a retailer compete? How about http://www.hbloom.com/? Many individuals order flowers weekly for their homes while businesses like to display flowers in their lobbies or reception areas. For those who buy flowers on a regular basis, this is not a cheap proposition. H Bloom has figured that out and they offer a weekly subscription for flowers. As a large buyer of flowers, they can offer customers this service cheaper than the local florist while guaranteeing fresh peddles conveniently delivered to your door. What is going to happen to the local florist? How about http://www.amazon.com/ and its new bar code App? Go to a store, scan the bar code, and Amazon will show you their price for that item which you can order immediately on-line, IF the price is cheaper. My guess is there is no IF. Amazon is likely using location based services in combination with their price optimization algorithm to guarantee they always have a compelling offer. Lookout retail?

The above three companies represent a new trend to displace or at least steal plenty of business from the good old brick and mortar retailer. We expect to see many more emerging companies that will cater to the thrifty consumer. Nobody wants lower quality goods but if one can use technology or remove the supply chain to lower prices, the move towards the disinetmediation of old line businesses will continue well into this new decade.

The Cayneing of Jimmy

Yesterday, Congress resumed their investigations of Wall Street and the financial crisis. It was Bear Stearn's turn on the hot seat as five former employees including Jimmy Cayne, the Chairman and CEO and Alan Schwartz the CEO for the last two months of the firm's life. Jimmy Cayne was not a man of many words when responding to the questions thrown at him. It may have appeared to be short and direct responses, which they were, but the man is not capable of being eloquent in public. Speaking was not his strength. In fact, his true strengths were probably selling municipal bonds and playing bridge. As a former member of the Bear family, we could never understand how Mr Cayne was elevated to the top of a major Wall Street firm during a time where financial instruments became much more sophisticated and complex. Of course to be a world class bridge player, he must be smart but that doesn't mean he was capable of managing a global financial empire.

Bear Stearns came crumbling down as it was clearly caught up in the housing collapse. Its history of strong risk management remained a focus within the firm but under Jimmy's leadership, attention to detail waned from the days of Ace Greenberg. Ace lived and died the firm and was always present. On the day before a holiday, one could always find Ace roaming the trading floors at 4pm to keep all the traders and salespeople on their toes. In 14 years at the firm, we never saw Jimmy Cayne once mingle with employees except at a cocktail party after the monthly Senior Managing Director meeting. Jimmy Cayne was arrogant and ran the business his way. The best managers are those who hire smarter people than themselves and expect them to bring fresh ideas and challenge the current operating procedures when necessary.

Jimmy Cayne had his small Executive Committee that raped the firm and its shareholders. Warren Spector and Alan Schwartz were certainly deserving of some big pay days. However, there wasn't an employee in the firm who could ever justify why Jimmy got paid the enormous sums year after year. The only bigger sin was paying the weakest CFO on Wall Street the highest compensation of any public firm's Chief Financial Officer. Sam was Jimmy's boy but it is hard to go from an average public accountant (maybe a good one) to CFO unless you have some great risk management skills and an ability to influence the firm's decisions. Sam did what Jimmy wanted and unfortunately, most Senior Managing Directors didn't believe Sam or Jimmy had a strong understanding of the complex nature of this global franchise.

For years, Jimmy Cayne either pushed out highly qualified employees as they gained power or refused to adequately compensate very skilled managers who in turn left the firm. The executive committee and their rich pay packages needed to be spread around to many talented people who eventually left Bear Stearns. It is ironic that two very senior people, who Jimmy Cayne refused to give more authority and power, left to become very very senior Partners at Goldman Sachs. This was Jimmy's way.

Congress asked Jimmy Cayne what he would have changed in his business model if he could do it all over again? Would it be the equity base, the leverage, and/or the short-term funding. The answer should have been all three. Jimmy said in retrospect maybe the leverage was too high. He couldn't answer the short-term funding as he probably didn't truly understand that much of the 1-day Repo loans were secured by longer-term assets. If one loses the short-term funding and the assets can't be sold in a day, a liquidity squeeze occurs, especially if the leverage is too high. My Cayne said he never would have issued equity as it was too cheap and he would have had to sell a big piece of the firm to do so.

Let's go back to September 2007. There were rumors that Bear was working on a partnership with a Chinese bank. We had a pretty good understanding of Bear Stearns at the time and began to feel uncomfortable with its financial position. The collapse of the two Bear Mortgage Hedge Funds put added pressure on the firm's balance sheet. It was very clear that the firm needed a big equity infusion or sell itself. A Chinese partnership could fill that need. My Cayne scurried to Asia over Labor Day weekend to ink a deal with CITIC and shortly afterward it was announced with many cheers. There were two problems with this deal. The first was that the details were never worked out and it was never signed. The second problem was that as proposed, the structure didn't result in Bear receiving additional cash to lower its leverage. The Chinese Bank/Securities Firm was going to invest $1 billion in Bear (hardly enough) and Bear was going to invest a like amount in the Chinese firm. Hence, no new cash and one of the dumbest deals of all time. Jimmy Cayne must have thought the investment community would perceive this new partnership as Bear's savior when in fact it was all smoke and mirrors. At the time, we assumed some other deal must be in the works.

The firm needed equity desperately but Jimmy Cayne, who owned about $1 billion of Bear stock, always thought the stock was worth more than it was. Apparently, some private equity firms saw value in Bear but no deal was good enough for Bear under Jimmy Cayne's watch. He is a master bridge player and the sale of Bear and some inflated price was always going to be his last trick. He was smarter than the rest of the world until he wasn't.

The questioning yesterday also addressed the difference in mortgage assets at other investment banks. Jimmy Cayne said the firm couldn't know others risk and there was no way for Bear to have seen the crisis coming. He said 99% of the financial community missed it. That may be so but 99% of the investment world didn't have a leading and dominant position in the mortgage market. As the leader of the firm, Jimmy Cayne should have asked more questions and Sam Molinaro should have been on top of the intricacies of the increasing defaults of the underlying mortgages as was Daved Viniar at Goldman Sachs. Since 2006, the unknown Hedge Fund manager named John Paulson, was scurrying to raise money specifically to short the mortgage market. John Paulson was not unknown to Bear Stearns as he was a former employee, a prime brokerage client, and a trading customer. The arrogance of Bear and of Jimmy Cayne cost employees and former employees billions of net worth. Good due diligence and strong risk management may have pushed Bear to understand why John Paulson had a different opinion than they did. The firm didn't have a leader in the mold of Ace Greenberg but instead this self-centered CEO ran the firm his way.

Leverage was high and the equity was always too cheap to sell. So when the perfect storm hit, this beloved firm evaporated over night. Better management could have changed history.

What Congress Doesn't Know About Wall Street

Congress is appropriately grilling Goldman Sachs executives on the mortgage debacle which helped to create the financial crisis. The practice of Wall Street has been and is to create products in the mortgage market, the equity market, the bond market, the loan market and many other markets. We have had many years of experience with the workings of Wall Street. The interesting facts that are not being discussed in these hearings is how the business actually works. Institutional investors expected investment banks to perform due diligence on New Issue Product. In this capacity, the underwriter is expected to analyze the deals to make sure no fraud is involved.

In aggregate, institutional investors looking at a deal will come to a consensus as to whether they like a deal or not. On the other hand, there is a wide range of buyers along the risk spectrum. Some investors are very conservative in the way they manage money and will only buy high quality securities in an extremely diverse portfolio. Others take a high risk, high reward approach. Such investors might only buy the riskiest securities that might produce out sized returns.

The approach Wall Street takes is to find the group of investors that is most appropriate for the risk of each specific transaction. In this light, the role of the institutional salesperson has been to provide his/her client with product that fits its strategy. As Congress pointedly asks the Goldman employees if their job is to look out for the interests of their clients, the Goldman response has been blank stares while not answering the question. The true answer is their responsibility is to provide product that meets the risk posture of each client as long as they knowingly are not selling them financial instruments that were created with fraudulent intent.

Congress wants Goldman and all other Wall Street firms to have their institutional traders and salesmen to act in a similar manner as they do with retail mom and pop clients. Many times institutional investors have differing opinions from Wall Street firms. As such, they are happy to buy securities being shorted by Wall Street. In the heyday of the mortgage market as well as in the heyday of the LBO frenzy, many institutional investors were aggressively trying to invest hordes of cash in their portfolios. In these situations, investors may have increased their risk tolerance and bought many securities that ultimately decreased in value or became worthless. Does such behavior and desires of sophisticated investors mean that Wall Street misled their clients?

The Misguided Financial Reform Bill

We have written before about our concerns and dislikes for the Financial Reform Bill proposed by Senator Chris Dodd. We continue to believe that the focus should be on reducing leverage of Wall Street firms to limit Too Big To Fail dramas of the future. Derivatives are clearly a focus of the bill and the current Goldman Sachs Mortgage investigation has elevated this issue to not only Congress but Main Street's average Joe. We would argue that there may be some moral and ethical issues to address but a synthetic security by definition needs a buyer and a seller. The seller needs to be someone shorting the securities. As such, the government argument about ACA and the German Bank not being aware of Paulson's involvement is irrelevant. For 25 years on Wall Street, we strictly adhered to the unwritten rule that nobody disclose the name of the buyer or seller of a financial transaction. This was sacrosanct to keeping the trust of customers. As for Mr. Paulson, he was an unknown hedge fund manager in 2006 when he was loudly saying the mortgage market was going to crumble. Nobody cared what he was preaching and in fact, it wouldn't be surprising if many buyers of mortgages were happy to be on the other side of one of his trades. Congress needs to rewind the clock and realize Mr. Paulson is famous today as he was absolutely correct with his analysis of the mortgage market and made billions in the process. However, in 2006 and 2007, he was just a name and he preached the future that most investors, Wall Street experts, and congressman didn't want to believe.

We are quite troubled with the provisions in the Bill which relate to Angel investing. For 20 years we have been active Angel investors in start-up companies. Some of those enterprises failed but many have grown and flourished. Our small universe of investments have resulted in thousands of new jobs as well as some new technologies that have driven commerce in the United States. Each of the thirty or so companies we have financed started as business plans and ideas for a business of the future. These fledgling businesses have no sales and certainly no earnings. As such, banks do not give loans to such enterprises. The entrepreneurs only hope is to find wealthy individuals (using the Obama definition) to supply venture money to fund the initial stages of their businesses. Typically an entrepreneur writes a business plan and sets out to find some individuals to give him/her some money to get this business off the ground. It could take a year or two in some cases until capital is raised to buy computers, rent space, and hire a few emplyees to test the new business idea. The good news is that small businesses under five years of age generated all new job growth between 1980 and 2005.

Given these facts, how could the Dodd Bill create new restrictions on Angel Investing? The Wall Street Journal recently had an Opinion similar to ours on this topic. Amazon, Facebook, Twitter, and Google were products of Angel investors. Does anyone believe these companies have created problems during the Financial Crisis? Start-up businesses beg to find any capital and take the money when an investor offers it to them. The new restrictions in the Bill would require an SEC review of these angel investments and delay the start of the funding for 120 days. This is ludicrous and will likely cause many of those companies to fail before they get off the ground. The ignorant policy makers need to understand that the U.S. economy is driven by small business and employment depends on the success of entrepreneurs' dreams. The Bill also wants start-ups to be regulated by all 50 states and for the angel investors' financial means to be increased. Congress should stick to the real problems facing the stability of the financial system. Whoever gave Senator Dodd the idea to restrict Angel investing needs to understand the facts of entrepreneurialism. Hopefully, Mr Dodd and Congress will come to their senses and allow fresh ideas to become the technologies and business ideas of the future.

The Volcker Rule Will Be Squashed

There is finally talk of diluting the Volcker Rule. Ever since the Obama Administration has backed Paul Volcker's thoughts on eliminating proprietary trading from Wall Street, we have been trying to understand why. First, it is impossible to separate proprietary trading from customer accommodation. The political gurus may think they have the answers but how many of them actually have ever traded a stock or bond? Believe us, they don't know. Second, proprietary trading didn't create the financial crisis. It was too much leverage and Congress's policies to force increased home ownership to levels where those unable to afford homes were offered extremely cheap financing.

Many months ago we wrote about "too big to fail". The Volcker Rule is trying to address that issue by eliminating all risky businesses from the operations of banks. There is a better way to do it and a few weeks ago we wrote to Senator Dodd our thoughts. Those thoughts were just a rehash of the thoughts we wrote in this blog about "too big to fail".

Our main thesis relies on letting the banks and investment banks to regulate themselves. The financial system came close to the abyss because the leverage at many of our largest financial institutions was way too high. The solution is for the Fed to determine how much leverage a bank can have at varying asset sizes. Thus, a small bank may need X% equity to run efficiently and be well capitalized. However, as the company grows in size the percentage of equity will also grow. The Federal Reserve's historical perspective and the FDIC's guidance should be used to determine appropriate equity levels for varying bank sizes. The larger the bank, the larger the equity base. The percentage of equity should grow with an upward slope as bank assets increase.

Such a formula will put the onus on bank management to determine how big their institutions will become. As the bank grows, there will be a trade-off between size of assets and return on capital. The addition of new assets will likely have lower returns on capital as the regulations will require increased levels of capital. If the bank has diminishing returns as it increases its size, then the bank will slow its growth. The result will be a self regulating system. Managers of financial institutions focus on risk and return on capital. Regulators need to focus on capital requirements. Require enough equity capital for large banks and we won't be discussing "too big to fail" as those capital requirements will limit the growth.

This seems like a simple solution to many problems but Congress and the Administration need to think out of the box. The Volcker rule is the easy way out but it is impractical and is not the right solution. Let the banks self regulate.

How Will Increased Taxes Bailout the Deficit?

The Obama administration and Congress seem to being focused on catering to the populist view and move this country one step closer to Socialism. We can argue about who was at fault for the financial crisis but there is no question that poor policy from Congress clearly played a significant role in creating the housing bubble. By imploring banks and mortgage companies to make mortgages available to all potential homeowners, a set of cascading events ensued whereas many new homeowners were never financially capable of affording those houses. Cheap money and Wall Street creativity pushed the envelop to keep the financing train going to a point where the housing "house of cards" ultimately reached a peak and then came tumbling down. Hence, blame is with Congress, the Federal Reserve, Banks, Mortgage Companies, Wall Street, and many others.



A year ago, this country faced a possible financial depression and the government and the Fed bailed out many financial institutions with Tarp money and forced some healthier institutions to also take Tarp dollars. Many of those institutions have paid back the government with interest and hefty profits. Others are still floundering. Of course, the auto companies are still a wild card in the potential government losses.



The deficits in this country are out of control and the debt the United States has makes us look like a Third World Country. We need this economy to grow; we need businesses to increase profits; we need companies to begin hiring again; and we need employment to drop. We do not need to TAX, TAX, TAX.



Taxes are a drain from the economy. If businesses pay higher taxes, they invest less in their operations and reduce their available capital to invest. The government wants banks to lend more. Taxing profits of financial institutions may punish them and make the Obama supporters feel better but the unintended consequences are likely to be a drag on the economy. The same can be said for individuals. What makes America great is the ability to work hard, be entrepreneurial, and earn as much as one can. The government shouldn't penalize those who make lots of money. The more one earns, the more taxes he/she pays. If one decides to have good health care coverage, don't tax them for paying high health care premiums. In fact, high cost states like New York, may bring high insurance costs. A new tax would be a double penalty.



Why don't we just raise income taxes to 90%, capital gains to 70%, and sales tax to 30%. The incremental boost could go to the Obama Deficit bank. By using the logic of this Administration and Congress, increased taxes will pay for the wars and the deficit. Our analysis would show an economy falling off a cliff, unemployment skyrocketing, and finally the start of The Great Depression II.

How Did We Do In 2009

Happy New Year. 2009 was a very volatile year and the upswing in the markets was quite surprising from the fear we all had at the end of 2008. As 2008 was coming to an end, we searched hard for the stocks that we thought weren't overleveraged and/or had great opportunities to perform well when the United States moved back to a period of growth. In that light we created a portfolio of stocks that we liked for long-term investors and would produce outsize returns in a three to five year period. Although we tried to pick stocks that might garner reasonable relative returns in a shorter time frame, our true goal was to focus on the long term. However now that 2009 has ended, we have calculated the returns of our portfolio for the first year. We have assumed that an investor bought an equal dollar amount of each stock to determine the yearly returns. In doing so, our 2009 return was 61.33%.


2009 Returns for Mack Attack Stock Picks:

Company/ 1-Yr Return

Alliant Technologies (ATK)/ 2.93%
BankAmerica Pfd e (BACPe)/ 48.33%
EMC (EMC)/ 66.86%
Forest City (FCE/A)/ 77.68%
Google (GOOG)/ 101.61%
Icahn Enterprises (IEP)/ 53.01%
ING Prime Rate Trust (PPR)/ 66.62%
Ishares Hi Yld Corporate (HYG) /26.52%
Leucadia (LUK) /20.15%
Loews (L)/ 29.47%
Masco (MAS) /28.21%
Microsoft (MSFT) /60.03%
Oracle (ORCL)/ 38.52%
Ownes Illinois (OI)/ 21.44%
Pimco Corp Oppty Fund (PTY) /56.41%
Pimco Income Fund (PCN)/ 36.63%
Sandridge (SD)/ 53.50%
SPDR Gold Trust (GLD) /24.19%
Temple Inland (TIN)/ 348.13%
USG (USG)/ 74.50%
Williams (WMB)/ 53.28%

Average Portfoio Return: 61.33%