Dear Puritans:

As I listened to President Obama’s latest proposals for dealing with the Credit Crunch, I was overwhelmed with the thought that he is treating the world as a vast Laboratory, in which he is attempting an extraordinary global Experiment.  His object is more than legitimate: it is to avert a financial and social catastrophe, which could have serious political consequences. Never forget that the Great Depression of the 1930s led to the rise of Adolf Hitler and World War-II. The name of  the Obama game is fiscal stimulus.

However, today’s great Experiment is not backed by an adequate theory. The name of Maynard Keynes is frequently invoked but he never advocated fiscal stimulus as such. Rather he favoured the rebuilding of the social infrastructure. This would certainly have resulted in a kind of fiscal stimulus but only in very slow motion – and Keynes envisaged it as happening only when the nation was in surplus. The savings from the Fat Years (the 1920s) were to be spent in the Lean Years (the 1930s). Regrettably,  America is in possession of no savings today from its recent Fat Years, quite the opposite. Three years ago the nation’s Comptroller-General,  David Walker, even declared that the federal government was bankrupt — and that was before fiscal stimulus had begun!

Critics of the Obama approach draw attention to the collapse of the Creditanstalt in 1931 as a fearful precedent. Faced with this event, the Austrian government of the day resorted to nationalisation. However,  the Austrian state was too small to bear the burden of the bank’s liabilities and  itself went bankrupt. Will something similar happen to the United States, faced with the extraordinary sums of money that Obama proposes to borrow on top of its pre-existing debts?  We frequently hear of some banks being ‘too big to fail’; is it possible that some American banks are ‘too big to save’. In the circumstances, it is not difficult to envisage the collapse of the US dollar vis-a-vis the euro and other international currencies, with serious inflationary consequences.

In tomorrow’s blog, I will explain why I think the pessimists may be wrong.

Best wishes –

Will Hopper

Dear Fellow Puritans,

Why good times breed bad guys

“It’s easy to look good in a boom. But also, every boom—and I have lived and worked through four or five—puts crooks in at the top.”

— Peter F. Drucker, The Daily Drucker

There is everything to be said for a daily dose of Drucker

Will Hopper.

Dear Fellow Puritans

Last week the FT interviewed Harvey McGrath, the new chairman of the UK’s Prudential Insurance Company. This is a strange appointment.  What a company like the Pru needs today in a chairman is ‘domain knowledge’ of insurance (to borrow a phrase from Jeff Immelt, CEO of GE).  What does McGrath offer to the party? As the former chairman of the Man Group, he brings  his experience of hedge funds. On his watch, Man lost billions in these overleveraged beasts; it also  invested $350 million with Bernie Madoff.

In his interview, McGrath argued that selling short was as natural an activity as buying. This is a false analogy. Selling in the usual way is as natural as buying; indeed, they are one and the same thing seen from opposite angles, every sale being a buy and vice versa. Short selling, on the other hand, involves borrowing the securities in question, often without making a deposit against them; the ‘leverage’ (or ratio of debt to assets pledged) can therefore be infinite.  In an ordinary buy/sell transaction, one can lose only what one has invested; in a short sale, the potential loss is infinite. Selling shares in the ordinary way can reasonably be characterised as  investment; short selling is undoubtedly speculation. McGrath argues that, on a small scale, it is harmless; that can also be said of swallowing arsenic.

A second objection is that the fees paid by short sellers to borrow shares have usually been grabbed en passant by fund managers  and not been passed on to the  lenders of the shares  — the very people  who  go at risk. This is an abuse of power arising from an acute conflict of interest. One would like to know what the practice was at Man.

The most powerful argument against short selling, however, is on another level altogether.  Companies will flourish only if  shareholders, managers and employees all work togther in a collegial fashion to achieve a common object. A short seller is someone who has declared war on both management and the staff. In most civilised communities, short selling is a criminal activity, an exception being made in very limited circumstances for listed securities . In other words, it is the very opposite of a natural activity. When I was a young man on Wall Stree some decades ago, short selling was tolerated  only: (a) against a substantial deposit; and (b) on an ‘uptick’ (i.e. on a rising market). Why have these limitations been abolished?  

Will Hopper

Dear Fellow Puritans

All financial bubbles from the Great Dutch Tulip Scandal of the 1630s to the Panic of 2008 have much in common with each other — for example, an excess of speculation accompanied by the abuse of credit — but each also has its own particular characteristics. The defining feature of the current crisis is the deterioration in the quality of corporate culture which occurred after 1970; this was most obvious in the United States but affected other countries to a greater or lesser extent. What did Chuck Prince at Citigroup and Fred Goodwin at RBS have in common? Both were non-bankers who ran one of the world’s leading banks into the ground. Both lacked what Jeff Immelt of General Electric has called ‘domain knowledge’. Welch is a superb manager who inherited almost insoluble problems from his predecessor, Jack Welch.

 

It follows that the basic problem reaches far beyond banking and indeed beyond the finance sector. The essential crisis at General Motors (which is effectively bankrupt) and General Electric (which has just cut its dividend and lost its AAA rating) is no different from that at Citigroup or RBS. The public is acutely aware of the crisis affecting the banks and near banks because of its impact on other sectors. However,  the decline in the managerial culture affects the whole of business and society. Among  other things, our book The Puritan Gift addresses this general problem.

Good morning, fellow Puritans!

There was a very interesting article by Peter Levene in yesterday’s Financial Times called Bad Bank insights from the rescue of Lloyd’s.  Pay attention to the apostrophe (‘) here; we are not speaking of Lloyds Bank, always written without an apostrophe (and also in the news yesterday because of bad earnings) but to the 320-year-old London insurance market called officially the Corporation of Lloyd’s and, less  formally, LLoyd’s of London. This body originated in the 1680s in a coffee shop owned by a Mr Edward Lloyd  in London.  It nearly went belly-up in in the 1990s owing to poor managment, but was saved when all its assets and liabilities were transferred to a new entity called Equitas.

Why is this important to us today? The big banks in the US, the UK and in some other countries are stuffed full of toxic assets arising from the subprime credit crisis and its consequences. One of the proposed solutions is to create so-called ‘bad banks’ which will acquire these assets. In theory this looks attractive but in practice will it work? As Ken and I say repeatedly in The Puritan Gift, studying the successes and failures of your predecessors is the cheapest and best form of research.  Equitas provides at least a partial model. It solved the problem! Stripped of  its toxic assets, Lloyd’s of London flourishes again. Meantime, Equitas has also been a success; it has been acquired by America’s  richest man, the Sage of Omaha, aka Warren Buffett.

Admittedly, Equitas does not provide a perfect model for a future ‘bad banks’ since  it acquired both assets and liabilities — and the ‘bad banks’ are expected to acqure only assets. However, the same problems of valuation will occur. The model also raises an interesting question: should the proposed ‘bad banks’ acquire some liabilities as well as assets?

Please comment! Ken and I are humble pilgrims, looking for the truth.

Will Hopper

STAFFORD BEER PROMOTES BETTER LEADERSHIP by David Howard

 

The Puritan principles defined by the authors can be abbreviated to Idealism, Craftsmanship, Teamwork and Leadership. They provide what I call the ‘First Metre’ advantage for new style management, minimising failure over the final furlong of any venture. They define the case for ‘management-by-means’ (MBM) rather than ‘management-by-objectives’ (MBO). Frederick Taylor receives severe treatment in this book but a greater injustice was the omission of any reference to British polymath, Stafford Beer (1926–2002). Despite this Stafford would surely have welcomed the central theme of the book.

When Stafford returned from India in 1949 he applied his wartime experience of operational research at Samuel Fox’s steel mills, outside Sheffield, increasing production by 30%. Seeing the essence of his work in print in Norbert Weiner’s “Control and Communication in Animals and the Machine” he visited Weiner who was impressed to see his theory in use. By 1959, Stafford encouraged by Weiner, had written “Cybernetics and Management”.

 

Throughout his professional life, Stafford’s main interest was the organisation of connections between entities. His concern was to find ways to improve an organisation’s performance by optimising its intrinsic connectivities. This resulted in his viable systems model (VSM). With it coherent action would replace piecemeal tampering.

 

The fourth Puritan attribute, Leadership, aims to “gather, galvanize and marshal financial, material and human resources to a single purpose” a task laden with  complexity that present evidence amply shows to be beyond the scope of old-style management and results-driven target-hunting. Stafford’s work provides a coherent approach to a new-style of management and leadership. I hope that his work can now be given its rightful emphasis in the next edition of this wonderful book.  (david.howard@flowmap.net)

 

Link:http://www.firstmetre.co.uk/UserFiles/File/Beer%20Promotes%20Better%20Management.pdf

 

FREDDIE AND FANNIE THROUGH PURITAN EYES by Will Hopper

On page 157 of The Puritan Gift (published in March 2007), Kenneth and I drew attention to the danger that Fannie Mae posed to the economy when we quoted Randy Quarles, undersecretary for finance at the US Treasury, as declaring that ”it posed a ‘systemic risk’ to financial markets”. We also drew attention to the statement by the company’s official regulator, Armando Falcom Jr., to the effect that it had engaged in a “pervasive and willful misapplication of generally accepted accounting principles”. What was true of Fannie was and is also in every sense true of its sibling, Freddie Mac. Fannie and Freddie were ’accidents waiting to happen’. They were also “open secrets”; everyone in Washington knew what was wrong but no politician was willing to say or do anything about it.

The Terrible Twins were abortions; the left-hand or liabilities sides of their balance sheets belonged to the public sector (since the risks were de facto borne by the taxpayer), while the right-hand or asset sides were situated in the private sector (since the outrageous profits arising from this weird arrangement went to the shareholders and managers). The simplest solution is to take them fully but temporarily into the public sector, through custodianship; and then, when they have been cleansed and healed (a procedure which might take a year), to launch them fully into the private sector, where they truly belong, possibly by selling off their portfolios. The first step is to get rid of their current disatrous management teams, while recovering for the benefit of the unfortunate taxpayer as much as possible of the ill-gotten gains which have accrued to them. Some attempt might also be made to recover some of the money spent by those managers on so-called public relations.

THE PURITAN GIFT argues that in recent decades there has been a serious failure of management in the United States affecting many aspects of government and society . The Terrible Twins constitute egregious examples of this weakness.

PROFESSIONAL MANAGERS DESTROYING A SOUND BUSINESS

We invited Will Treasure, director at Javelin Group to send us an initial thought to kick-off our weblog. This is what we received from him:

Is Barratt Developments an example of ‘professional managers’ destroying a sound business? Chief Executive Mark Clare joined in 2006 from Centrica, where he had spent the last 12 years. Finance Director Mark Pain arrived earlier that year from Abbey National, where he was finance chief. By contrast, Clare’s predecessor David Pretty has spent his entire life in the building industry.

In 2007, Clare and Pain bought Wilson Bowden for £2.2bn, leaving Barratt with £1.7bn debt. Now, as the housing market faces a massive downturn, Barratt looks very vulnerable. Attempts to sell parts of Wilson Bowden have not been successful. The share price has collapsed by 91%. It is touch and go whether the loan covenants will be broken. Investors are furious that Clare has gambled away Barratt’s legacy. Barratt may not survive as an independent business.

You can take one of two views:

• Clare and Pain were unlucky – and indeed, who would have predicted such a sharp downturn in building?  Investors and the analyst community applauded the deal at the time.
• Clare and Pain focused on financial engineering to grow the business, rather than organic growth. They did not realise the risks they were taking, because they had no background in the industry.  They did not take the time to understand their business and industry dynamics. In short, they are an excellent example of the ‘professional manager’ 

Will Treasure, Will.treasure@javelingroup.com

WELCOME

The Puritan Gift by Kenneth and William Hopper was published in 2007. For details see www.puritangift.com. This weblog was created to discuss its content.

Your comments are welcome,

K. & W. Hopper

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” – John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt, Brace and World, 1936), p. 159.