Future Of The U.S. Auto Industry

With the current debate focused on whether to bail out the U.S. auto industry or not, the U.S. is in danger of missing the “Big Picture.” The Big Picture here is transportation. Our love with cars began with the idea of having the freedom of movement. The ability to just hop in a car and go anywhere helped to spark the growth of the interstate system and solidified our car-centric culture (click here for a list of popular songs about cars).

A Bit Of History
As our love with cars grew, so did our desire for it to go faster and further while providing ever-increasing level of comfort and safety. How many of us actually remember when cars did not have passenger-side rear view mirror or without remote lock system? While our love of cars grew, we did not pay a lot of attention to the cost of ownership, especially the cost of fuel. With the aftermath of the 1973 oil crisis, did we pay attention to the fuel cost? This paved the way for the Japanese cars to enter the U.S. market with their inexpensive and fuel efficient cars. (It also helped BMW to solidify its foothold in the U.S. market with its fun, fuel-efficient, and sporty 2002.)

The U.S. auto industry, facing its first crisis with the 1973 oil crisis and the influx of inexpensive Japanese cars, shifted gears rapidly to produce more fuel-efficient cars. While their initial efforts were pitiful, such as the Ford Pinto, AMC Gremlin, AMC Pacer, and GM Vega, the U.S. auto industry moved quickly to counter the “Japanese auto invasion” and try to meet consumer’s demand for fuel-efficient cars.

The aftermath of the oil crisis led to the U.S. government establishing the Corporate Average Fuel Economy (CAFE) regulation in 1975. This was an attempt at forcing the U.S. automakers into making more fuel-efficient vehicles and thereby reducing our dependence on OPEC. After another crisis in 1979 with the Chrysler bailout, it would appear that the U.S. auto Industry had learned its lesson: quickly adapt and survive or die.

That brings us to the present
The crux of the two crises that the U.S. auto Industry faced in the 1970’s should have made them stronger, in the vein of Nietzsche’s famous quote: “What doesn't kill us makes us stronger.” However, it appears that another adage is more appropriate for the U.S. auto industry: “You Can Lead A Horse To Water, But You Can't Make It Drink.”

Facing a global recession and high cash burn rate, the U.S. auto industry is now begging the U.S. Congress for a $25 billion bailout. But, should they be bailed out? I will leave that debate to the academia and the pundits, as this risk manager thinks that the issue is beyond moot. Once again, the focus should be on the big picture. But first, some facts to set the stage.

First Some Facts
The facts are simple.
Fact 1: Oil is a non-renewable resource that is fast depleting.
Fact 2: Two countries that account for about 50% of the world’s population, India and China, will continue to increase their consumption oil products.
Fact 3: OPEC nations controls two-thirds of the world's oil reserves
Fact 4: U.S. imports nearly 50% of its daily oil consumption (imports 10 million barrels/day and consumes 20.68 million barrels/day).
Fact 5: Transportation accounts for 70% of all oil use
Fact 6: U.S. Consumers use about 9.3 million barrels of gasoline/day
Fact 7: Corporate Average Fuel Economy standards for passenger cars have remained stuck at 27.5 MPG since 1990.
Fact 8: Japanese cars’ average CAFE is approximately 32.2 MPG, or 17% more efficient (calculated using the Japanese cars’ domestic MPG figures for each manufacture and weighting Toyota at 50%, Honda at 30% and Nissan at 20%).
Fact 9: Tesla Motors is producing electric cars that have been EPA-certified at 227 MPG equivalent.
Fact 10: Tesla Motors only needed $105.5 million in private financing to get started.

The Big Picture
If Tesla Motors can produce a street legal sport car that gets 227 miles per electric charge with only $105.5 million in private investment, then why can’t the Big 3 U.S. automakers produce something equivalent? After all, they have billions to burn. Moreover, if the Japanese automakers are producing cars in the U.S. that averages 32.2 MPG, then why can’t the Big 3? After all, the Japanese automakers are employing U.S. workers and making the cars in the U.S.

The U.S. automakers are dinosaurs that will not change the way they conduct business. It is as if the spirit of Henry Ford’s infamous quote lives on: “Any customer can have a car painted any colour that he wants so long as it is black.” This inflexible mind set is the death of the U.S. auto industry.

We, the American consumer, still desire powerful cars with all the “bells and whistles.” However, in the era of high fuel prices, we also desire high fuel economy. Tesla Motors have pioneered the way to satisfy this need. While their initial 248 horsepower electric sports car is expensive at $109,000, with proper funding, it is easy to modify their design, step down the cost, and make it affordable through mass production.

After all, the first automobiles were too expensive for common folks. Only through the mass production genius of Henry Ford could the regular American afford a car. Much in the same way, Tesla Motors have clearly demonstrated that electric cars are viable, efficient, and fun to drive. The next step is to make the same technology affordable so that the middle class could afford one.

Conclusion – the Dawning of the New Automobile Society
The newly elected President could be the catalyst to push the U.S. auto industry into the new era. The days of internal combustion engine are limited. Along with that, the days of the parts manufactures. The electric cars have simple motor design, making them more reliable. Plug, charge, and go.

Gone also will be corner gas stations and many auto repair shops. Yes, there will be job losses but that is inevitable. The positives far exceed the negatives: Cleaner air, lower green gas emissions, no more ground water contamination from gas stations and auto repair shops. One can simply “fuel up” at any electric plug.

Let the trucks and buses idle their engines. There is no more harmful fumes or soot. Yes, we will still be burning fossil fuels to generate electricity but with 85% efficiency of an electric motor, as opposed to 25 to 30% efficiency of a gas-burning engine, we will reduce our consumption of fossil fuels, overall, while being able to drive 300 miles on a single charge.

I can see a day when we would be looking back and asking ourselves: “How many of us actually remember when cars did not have built-in GPS or used ‘gasoline’ to get around?” I see the day when all cars will be electric and have solar panels (for recharging the batteries) and an emergency hand crank (for those times when you run out of ‘juice’ in the middle of nowhere at night).

Until then, I will watch the unfolding of the U.S. automobile industry bailout drama while being reminded of another Henry Ford’s famous quotes: “I will build a car for the great multitude. It will be large enough for the family, but small enough for the individual to run and care for. It will be constructed of the best materials, by the best men to be hired, after the simplest designs that modern engineering can devise. But it will be low in price that no man making a good salary will be unable to own one — and enjoy with his family the blessing of hours of pleasure in God's great open spaces.” – My Life and Work (1922), Chapter IV.

Regards,
Ed Kim
Practical Risk Manager

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The Worst Is Not Yet Over…But Happy Days Can Come Again

With the recent massive injection of capital by the Feds and other governments around the globe, one would think that the worst is nearly over. After all, with nearly $1.2 trillion spent and earmarked alone in the U.S., it would seem that the worst is over and all that remains are localized events and global cleanup. Well folks, the worst is not over. In my opinion, the worst is yet to come and it would seem that we are nearly out of bullets.

The rationales for my assessment are as follows:
1. We have yet to register the losses to come from the credit card write-offs.

2. We have yet to account for the increased burden to the state and municipal governments from increased spending toward unemployment, welfare, and other social services benefits

3. We have yet to prepare ourselves for the substantial reduction in consumption, which will lead to further losses and contraction

4. We have yet to understand the long-term effects of the massive bail out of financial institutions

Was it the right move to spend / earmark for spending nearly $1.2 trillion to bail out the U.S. financial institutions? To me, the answer is clear “No.”

The purpose of the massive cash infusion into the banking industry was to “prime” the lending activity. In my view, this money was wasted by putting it into the financial market that allocates nearly 50% of revenue toward compensation and general administrative purposes. An apt analogy would be a donation to an organizations setup to help the less fortunate.

Which would be a wiser investment of funds?
1. To donate vast sums of money to an organization that uses only 2 to 5% of the donations toward administrative and salary and funnels 95 to 98% to where the money was really needed or,

2. To an organization that uses 45 to 55% of the donations toward administrative and salary and funnels the rest to “future” spending?

The answer to this is obvious, except for the Wall Street Firms who think nothing of taking billions of American Taxpayers dollars and still pay their senior managers millions of dollars in compensation.

Economists and risk managers, I include, scoffed when, earlier this year, Congress approved Mr. Bush’s $168 billion economic stimulus plan as being a misguided policy. They just do not get it; and for us to expect them to do so would be our fault.

So, where should the government inject its cash stimulus?
We could take a page from the Roosevelt era’s “New Deal” and put the money into rebuilding our infrastructure. President elect Obama is the right person who can, in the mold of FDR, put the government stimulus packages toward those projects that would help to put money into ordinary American citizen’s pockets, help to revive and modernize the manufacturing bases of the rust belt states, while helping to stabilize the financial markets.

One of the places for the right stimulus would be our crumbling highway system. Put the Federal funds toward re-building the Interstate system, this time with the addition of light-rails, high-speed rails, and cargo-rails as a part of the Interstate highway system. By doing so, people would be hired to build the system all across the U.S., manufacturing companies will have to rehire, ramp up, and seek capital to remodel or expand their facilities. Wall Street firms will lend to those companies involved in the rebuilding efforts, as the Federal Government would implicitly guaranty the income stream of these companies. Other places for a right stimulus would be our crumbling Electric grid system and our overburdened and antiquated Air Traffic Control Systems.

Even if President-elect Obama and his administration just focused on these three areas, our economy would:

1. Quickly revive through increased productivity and added jobs, which would increase the tax revenue to local, state, and Federal governments,

2. Benefit from lower overall fuel consumption as more people would travel on high-speed rails on shorter distance travel and air travel becomes more efficient,

3. Spend less on energy and fuel resulting from more efficient electric grids that lose less power along the way from generation to use

4. Experience faster recovery as innovations in services and manufacturing, resulting from the rebuilding of our infrastructure, would lead to creation of new industries and jobs,

5. Grow Growth from new capital investments made by investors into projects and companies involved in the rebuilding of America.

Happy Days will be here again. This risk manager is hopeful that President-elect Obama will take the right actions toward this better future.

Regards,
Ed Kim
Practical Risk Manager

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Increased Risk Of Regulatory Scrutiny Of Private Bankers

Senators Baucus (D-Montana) and Grassley (R-Iowa) of the Senate Finance Committee (SFC) are seeking to place their names next to Senator Sarbanes (D-Maryland) and Representative Oxley (R-Ohio). These SFC leaders are planning new laws against offshore tax evasion.

Now offshore tax evasion is not “News” as IRS had complained about this back in 2002. According to Global Policy Forum, IRS estimated in 2002 that anywhere from 1 to 2 million Americans were evading taxes. This is a problem as old as the beginning of time as it is in human nature to abhor having to pay a levy/tax to a central body. (For you theologians, check out Able and Cain story, referencing the grain offering by Cain.)

The reason why the latest government action on tax evasion is a Private Bank risk issue is that most people identified with tax evasion are the wealthy. It is not surprising then any new regulations and law would focus on the bankers working with wealthy clients.

Even without the new regulation / law the regulators have plenty to go after bankers. With the introduction of the PATRIOT Act in 2001, Bank Secrecy Act of 1970 (BSA) and the Money Laundering Control Act of 1986 (MLCA) were strengthened. The Title III of the PATRIOT Act provides the Government with additional reach into the international arena to find and persecute money laundering. While the original intent of the PATRIOT Act was to prevent terrorism, the act can be used for any acts of money laundering, be it to fund terrorism, narcotics, or to simply avoid paying taxes.

While money laundering has been a major concern for broker-dealers, hedge funds, and investment banks, the same cannot be said for Private Banks. For centuries, the Swiss Bankers – the ones who pioneered the modern day Private Banking concept – have had the reputation of complete secrecy. This allowed the wealthy to use the Swiss Banks to hide their assets from prying eyes. Naturally, this included any enquiry from the taxman.

While most people using the Private Banking services are honest folks, there are some who try to “push the envelope” with the aid of the Private Bankers. One such Private Bank that has been flagged twice in the recent past for aiding clients in this field is UBS. In 2007, a UBS Private Banker was one of 19 arrested in Brazil for money laundering.
Then, again in 2008, two top UBS Private Bankers were indicted for aiding in tax evasion.

Given that many Private Banks have been structuring deals for their wealthy clients that could be deemed to be money laundering or tax evading, the scrutiny and pressure are mounting against the Private Bankers. Even the Private Bankers themselves know this. According to the Times article, one Private Banker in London is quoted saying "My God, we're doomed."

Perhaps. It will be interesting in the next few months as the international effort into curtailing tax evasion and money laundering intensifies. This will be especially true for Chinese nationals as China is very tough on any crime that it focuses on to prosecute. . I agree with Professor Reuven Avi-Yonah’s comment that "The whole world of private banking is full of this stuff.” Maybe Senators Baucus (D-Montana) and Grassley (R-Iowa) may be relevant in the current dragnet, or maybe not. At least, if the Senators are successful, they can put a colorful moniker for their law.

SOX is just a bad moniker. I recommend that Senators Baucus and Grassley label their effort BAG-A-CHEATE, which stands for BAucus-Grassley Amendment to Congress Headed Efforts At Tax Evaders. This would be just as colorful a moniker as CAN-SPAM and just as difficult to remember what it actually stands for. Senators, you are free to use my suggested moniker, if you wish.

Oh, for those who are curious, here is the link to CAN-SPAM. Yes, it is an actual law.

Regards,
Ed Kim
Practical Risk Manager

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A Quick “Q&A” styled Risk Assessment Of Select Current Events

Q: What will happen to the gasoline prices once a hurricane hits anywhere near the oil refineries?
A: It will go up. Even if the hurricane misses the oil refineries, any close call will result in a decrease production of oil distillates. This is a normal precautionary measure taken by the refiners as they move employees out of danger and reduce the pressure within the pipes. If the hurricane hits the refineries directly, do expect to see a repeat of another immediate $0.30 to $0.40 per gallon spike. In case of a near miss, a rise of $0.05 to $0.10 could occur.

Q: Will the new President put his emphasis first on the economy or the war?
A: As it was in 1992, when a the incoming President had to focus attention on the economy (remember the slogan: “It’s the Economy, Stupid”?), the newly elected President will, once again, have to clean up after a Bush and focus most of his attention on reviving the economy.

Side note: Isn’t it interesting to note that after the Presidency of both George Bushs, we are left with a stagnant economy, large deficit ($290 billion in 1992 and $268 billion as at July 11), and having to pay to rebuild the armed forces after a Gulf War (1992 estimate, here). Like father like son.

Q: Will Ford or GM survive to see 2010?
A: Their respective cash burn rate is alarming. According to BusinessWeek, “GM burned through $6 billion in cash from the end of October [2007] to the end of March [2008].” This is a burn rate of approximately $1 billion per month. With about $24 billion as of March 2008, GM may be able to just squeak into 2010 with just enough pocket change. However, along the way, look for GM to jettison various units and cut payroll continually. This is analogous to the occupants of a falling hot air balloon trying to lighten the ballasts to stay afloat.

As for Ford, analysts think that they are in a better shape. According to JPMorgan analyst, “…Ford's 2008 cash, marketable securities and loaned securities will decline by $10.9 billion year over year to $23.7 billion." By the end of 2010, this is expected "to decline to $9.5 billion by the end of 2010." However, given their overweight and dependence on trucks and SUVs, Ford may be a bigger disappointment.

Q: Will Citigroup stay as a financial supermarket or be broken apart and realize its value?
A: The 10-year Sandy Weill’s experiment of trying to run a vertically integrated financial supermarket has been proven to be a failure. The market realizes this. I hope Pandit realizes this as well. Its parts are indeed more valuable than the whole. Having been a part of the Citi culture, I can attest to the difficulty management faces in trying to make all of its pieces fit together. The future of Citi lies with separating itself into four separate businesses: SmithBarney Asset Management, which can easily fit with Merrill Lynch or Charles Schwab; Consumer Banking and Cards (the true retail bank unit); Citi should revive the Salomon name and make it a stand-along Investment Bank unit; and the Global Wealth Management unit, which holds the core of the private bank businesses. However, I am only thinking out loud, just like the Union (American Federation of State, County and Municipal Employees Union, that is).

Q: Will the Federal Reserve fight to tame inflation or will it fight for growth?
A: They should try to fight to tame inflation. The operative word here is “try” as they have a long way to go if they really want to lower the price shock to the American consumer. Unfortunately, the “sticker shock” is only beginning. Companies have been holding back raising their prices for a while and they can’t hold it back any further. As more and more companies begin passing the higher costs of raw materials, expect to see the core CPI numbers to shoot up.

What will the Fed do? They will try to something that would be a good imitation of the Keystone Cops.

Q: Will the real estate market recover?
A: Yes.

Q: Will the new bankruptcy law help to keep people from filing for BK chapter 7?
A: No. The new bankruptcy law is not so new and, while it is not friendly to consumers, it has not prevented people from filing for bankruptcy. In fact, according to the U.S. Courts’ bankruptcy filing statistics, BK filing increased 29.7% for the 12-month period ended March 2008 from 12-month period ended March 2007. While the total number of filings of 901,927 as of March 2008 is below the high water mark of 1.6 million filing set in 2004, the trend is very disturbing. (Click here for a historic trend of BK filings from 1986 to 2003.)

Regards,
Ed Kim
Practical Risk Manager

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Risk Of Emergency SEC Emergency Rule Backfiring

There will be a temporary moratorium on naked short sale of select financial stocks, starting Monday, July 22. SEC enacted this moratorium to prevent flagrant speculations that, in the view of the SEC, were causing the financial stocks to be abnormally low.

Perhaps the SEC’s assumption is correct. However, the very action of forbearing natural capitalistic actions by employing such artificial stopgap measures will only cause a larger ripple in the market. The removal of the uptick rule for short selling perhaps was the undoing for the stock market. However, by implementing a desperate block on free and open trading, the SEC and the financial industry are inviting future litigations and reputational harm.

The basis of the stock market is the free and open trading of shares and options, based on a set of rules agreed upon by the stock exchange and the governing laws of the states. To change a major trading rule by carving out a list of no naked shorting when there is nothing in the market to indicate that there is a “run” or a panic, is openly admitting that there is something fundamentally wrong with the current pricing of the financial industry stocks to which the general public is not privy.

The Market will speculate on what the banks are hiding from public disclosure. These speculations will build and, when the naked short sale ban is lifted, look for new record lows for the financial stocks. The recent rise in financial stock prices is, in my view, a “fat” cat bounce, which is analogous to the dead cat variety. However, in this case, the bounce will allow those investors to cash out of their underwater position, before the total value of their portfolio is wiped out with subsequent valuation erosion.

The banks are not out of the credit mess. The picture is pretty bleak when one factors in the credit card landscape. More Americans are carrying higher balances on their credit cards as other sources of borrowing dries up for them. Having the credit cards still plying borrowers with zero interest until 2009 isn’t helping the matter.

Banks are still busily giving out credit cards. It will be only a matter of time, and soon at that, when they will start showing major losses and write-offs on ABS secured with credit card receivables. This will be on top of the write-offs of losses on vehicle leases. I am guessing that the 3Q 2008 will be just as bleak as the first half for the financial stocks.

So much for the temporary stop on naked short sales and SEC's vain attempt of manipulating the market. This action will only lead to more aggressive actions my those investors whose trading strategy have been hampered momentarily by the SEC.

Regards,
Ed Kim
Practical Risk Manager

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Mr. Bush, A Novice Checker Player, In A Global Petroleum Chess Tournament

Why do I constantly poke fun of Mr. Bush? Because it IS so easy, since he provides so much fodder. Fodders sufficient enough for everyone from late night comedians to staid risk managers. Once again, he does not disappoint. With mere months to go before his ignominious exit from the White House as, in Nancy Pelosi’s words, a “total failure,” Mr. Bush is again grasping at offshore oil drilling to secure some sort of a legacy.

In this vain attempt, he is now accusing the Congressional Democrats of impeding in tapping the vast offshore oil reserve. Now this is amusing to people who know since the ones who have been resisting offshore drilling for a while are Florida Republicans, led by his own brother, Jeb Bush.

Now, Jeb has been saying the right things about offshore drilling for sometime now, which is to balance the need for drilling with the need to protect the coastline. Jeb’s idea, co-sponsored and floated in 2006, is a sound idea of imposing a 100-mile buffer around the coastal states while allowing for drilling offshore. Apparently, George W. Bush doesn’t seem too concerned about the environment at all.

George W. Bush also doesn’t seem too concerned about the actual logistical implementation of offshore drilling. “The sooner Congress lifts the ban, the sooner we can get these resources from the ocean floor to the gas pump,'' Bush said today in his weekly radio address. His statement seems to imply that we can obtain oil from offshore drilling as soon as a year, once the Democrats in Congress stop dragging their feet.

Perhaps someone should remind him that just because the ban is lifted today, it does not mean that drilling can commence right away. Typically, it would take at least three to five years to ensure proper safeguards are taken for environmental and economic feasibility studies, including impact of drilling on ocean pollution, shipping lanes, and fishing. Moreover, it would take a survey ship and a drilling rig several years to identify the location of a rich enough pocket of oil. Further complicating the process is that fact that the oil appears to be located in the deeper portion of the De Soto Canyon. According to Minerals Management Service, “For the oil resources, the vast majority of this increase occurred in the deepwater areas of the Gulf of Mexico,” that, it their estimation, could be “located in waters that are water in excess of 3000 meters (10,000 feet) deep and to subsea depths in excess of 9600 meters (31,700 feet).”

(Source: U.S. Geological Survey)

What this means is that deep-sea drilling rigs are required to access the potential 17.8 billion barrels of oil. This is where Bush is a novice checkers player in a global championship chess tournament. If Bush were a chess player, he would have lined up all remaining deep-sea rigs before Brazil did. Now, with the backlog of rigs worldwide, whatever Congress decides to do will be moot.

(Source: New York Times)

Now, if Bush were a chess player, he would simply declare the Gulf of Mexico, from 200 to 500 miles off the coastal U.S. as off limits to any drilling of oil and gas and declare U.S. sovereign rights to all resources in the area, including oil, gas, and fishing. The 17.8 billion barrels of oil in the area seems mighty valuable now but it will be even more valuable 10, 20, or 30 years from now.

Now, that’s playing chess. Perhaps, Obama will play this out correctly, come the New Year.

Regards,
Ed Kim
Practical Risk Manager

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Rating Agencies' Value To The Market? Nada, According To Their Disclosures

With the unraveling of the credit market, one has to wonder what value had the rating agencies actually provided to the investors. It appears quite obvious, in hindsight, that the rating agencies’ values were all perception and not reality. After all, why are financial institutions so busy marking down even “AAA” rated bonds and taking ever-increasing loss reserves against them?

If one read the typical disclosure that is on a rating agency rating letter, one would quickly realize that there is no real value. In fact, the rating agencies’ disclosures would read something like this:

Ratings are based upon information that we consider to be reliable, but neither [Rating Agency] nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. Rating agencies do not perform due diligence and assume the accuracy of the information that is provided to them by issuers and their advisors. Neither [Rating Agency] nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. This material is not intended as an offer or solicitation from the purchase or sale of any security or other financial instrument. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue.

(Note: the above is not an actual disclosure from any one rating agency; however, if one looks at S&P and Fitch Ratings, one would see where I had obtained the above language.)

The rating agencies are on the hot seat, again, for their contribution in the current financial downturn. They were here before in 2002, with their corporate credit ratings of Enron: (S&P response to SEC; Fitch Ratings response to SEC; and Moody’s response to SEC). The rating agencies’ argument now is the same as it was then: they are not in any conflict of interest and the ratings they provide is beneficial to the market and is simply an opinion protected by the first amendment and not bound by Regulation FD.

Government Is Forced To Act, Again
Again, the market has forced the government to react. Most recently, the SEC released their examination report of the rating agency and found the following issues, among others:
1. Significant Aspects of the Ratings Process Were Not Always Disclosed
2. Policies and Procedures for Rating RMBS and CDOs Can be Better Documented
3. Rating Agencies are Implementing New Practices with Respect to the Information Provided to Them
4. Rating Agencies Did Not Always Document Significant Steps in the Ratings Process
5. Rating Agencies Did Not Always Document the Rationale for Deviations From Their Models
6. Rating Agencies Did Not Always Document Significant Participants in the Ratings Process Rating
7. Rating Agencies Did Not Always Document Committee Actions and Decisions
8. Issues Identified in the Management of Conflicts of Interest

Truly no surprises here, especially to those who have been following this circus act of “slap the rating agencies on the wrist.” The Investment Company Institute (ICI), the national association of U.S. investment companies, has been lobbying the government to improve its oversight of the rating agencies for over 20 years. Here are the ICI’s comment letters to the SEC on regulation of the rating agencies: 1998 comment letter, 2002 testimony, and 2003 comment letter.

If the SEC had listen to ICI then or even listen to Senator Joe Lieberman in 2002, perhaps things may have turned out a bit better. Perhaps the combined efforts of the EU (European Union) and SEC might finally provide enough momentum in tightening up the supervision and accountability of the rating agencies. Or, perhaps not.

It may be a while before any truly innovative accountability and supervision are placed on the rating agencies. Until then, let’s not forget what we all learned in business 101: “Caveat Emptor.” After all, the rating agencies are simply stating that their ratings are simply their opinions based on information given to them that they assume is correct.

Let the rating agencies hide behind the first amendment; they have the right, just as supermarket tabloids like the National Enquirer.

Regards,
Ed Kim
Practical Risk Manager
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Disclosure: Ed Kim was formerly a rating analyst with Fitch Ratings in the late 1990’s, responsible for performing credit rating and due diligence on several CMBS and FASIT transactions.

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Risk Of Another Major Electric Blackout In The U.S.

With the news constantly streaming about various crises – the credit crisis, confidence crisis, mortgage crisis, and housing crisis, to name a few – it seems that people are forgetting about a looming risk that is just budding its head right now. That risk is the failing electric grid system in the U.S.

The potential is the need to replace the aging electric grid system in the U.S., which is so antiquated that another “cascade” failure leading to a blackout, a la 2003, is a high probability. This issue is not something new. In fact, New York Times wrote an article in August 2003 about the dangers of serious failure if the electric grid system did not receive substantial upgrade to keep up with demands.

Since 2003, our electric uses have gone up while the electric grid system has been just barely maintained. According to Energy Information Administration (EIA), our electric consumption has gone up from 3,662,029,012 KwH in 2003 to 3,891,705,491 KwH in 2007, a 6.3% increase (EIA table 8-1).

We are not slowing down in our demand for electricity. In fact, with the renewed interest in alternative fuel source, many people are turning to electric vehicles. This includes major auto manufacturers. As more electric-gas hybrid cars are sold and used, the electric consumption will trend higher than the EIA projection of 4.97 billion KwH of electricity used by 2030.
Here is an assessment from the U.S. Department of Energy’s Office of Electricity Delivery and Energy Reliability (I too am surprised that this office actually exists) on the current state of the electric grid system (as of 2005-2006 period):

“America operates about 157,000 miles of high voltage (>230kV) electric transmission lines. While electricity demand increased by about 25% since 1990, construction of transmission facilities decreased about 30%. In fact, annual investment in new transmission facilities has declined over the last 25 years. The result is grid congestion, which can mean higher electricity costs because customers cannot get access to lower-cost electricity supplies, and because of higher line losses. Transmission and distribution losses are related to how heavily the system is loaded. U.S.-wide transmission and distribution losses were about 5% in 1970, and grew to 9.5% in 2001, due to heavier utilization and more frequent congestion. Congested transmission paths, or "bottlenecks," now affect many parts of the grid across the country. In addition, it is estimated that power outages and power quality disturbances cost the economy from $25 to $180 billion annually. These costs could soar if outages or disturbances become more frequent or longer in duration. There are also operational problems in maintaining voltage levels.

America's electric transmission problems are also affected by the new structure of the increasingly competitive bulk power market. Based on a sample of the nation's transmission grid, the number of transactions have been increasing substantially recently. For example, annual transactions on the Tennessee Valley Authority's transmission system numbered less than 20,000 in 1996. They exceed 250,000 today, a volume the system was not originally designed to handle.” (Click here to view a PDF fact sheet, as of February 2006, of the electricity delivery system in North America.)

What is really shocking (excuse the pun) is that the U.S. government has not put a lot of effort into rectifying this problem. Just the fact that the Department of Energy’s most recent study of the electric transmission and delivery system is dated from February 2006 should be cause for concern. (By the way, the URL http://www.electricity.doe.gov/ at the bottom of the fact sheet is a dead link, another sign that there isn’t a lot of effort or emphasis placed on this risk issue.)

What this means is that the risk of another catastrophic blackout can be expected in the very near future. With most people’s attention diverted by the dying “swan dance” of the financial market and the SNAFU situation in the Middle East, the real risk close to home is ignored.

Unfortunately, this is one case where ignorance is not bliss.

Regards,
Ed Kim
Practical Risk Manager

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Fed’s Failures To Stabilize The Market Continues

With the Sunday announcement that the Federal Government will honor the implied guaranty of Fannie (FNMA) and Freddie (FHLMC), it would appear that many MBS bond investors may feel a bit more positive in an otherwise a negative market. So, does this mean that the MBS bonds backed by Fannie (FNMA) and Freddie (FHLMC) mortgages will stabilize?

I think not. The smart investors will be trying to unload as much MBS bonds as possible while the good news is still creating a tiny bit of uptick. This is because they know that the euphoria will be short lived. Very soon, the investment community will come to realize that the Federal Government of making Fannie and Freddie “too big to fail” will hurt the U.S. economy and the financial market.

Firstly, both Fannie and Freddie are public stock companies, not a part of the Federal Government. By explicitly posturing that the U.S. Government will support and even bail out these two firms, the government is adding more uncertainty into the market.

Uncertainty such as:

• How will the U.S. Government ensure that Fannie and Freddie do not fail?
  
  
• To what extent is the U.S. Government willing to support these companies that, in the recent past, have clearly demonstrated illegal accounting activities (also here)?
  
  
• How much will it cost the taxpayers to support Fannie and Freddie?
  
  
• What will do to our money supply and interest rate?
  
  
• How will the U.S. Government react if China, Japan, or other large holders of the Fannie and Freddie MBS bonds decide to sell?
  
  
• What will happen to the U.S. economy if China, Japan, or other large holders of the Fannie and Freddie MBS bonds decide to sell?
  
  
• How will the U.S. Government convince investors to continue buying Fannie and Freddie MBS bonds when Fannie and Freddie won approval recently to raise the conforming loan limits to 125% of area’s median home prices in select areas, not to exceed $729,750? This especially, in a market that is expected to lose 10% to 20% or more in value?
  
  
• With foreclosure rates up over 73% from April to May 2008, what how much of the MBS b-pieces and subornation be wiped out?
  
  
• With so much financial institutions – Lehman, Citigroup, Merrill, to name a few – holding on to so much b-pieces and unsold subornated MBS paper, how much more can they lose?

With so much uncertainty, the risks are very high. Traders would think: “higher the risk, higher the reward.” However, in this case, the rewards are not sufficiently high enough to justify the risks, especially when the Federal Government is manipulating them.

I see more trouble ahead for the financial institutions well into 2009 because Fannie and Freddie MUST continue to lend to marginal borrowers (also, here) even as the market tanks. It is in their mandate, which was modified with the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. So, as the housing market continues to sour, Fannie and Freddie must continue to lend and churn out MBS bonds. This is a recipe of a major disaster.

I wonder how the federal government will play this one out. Stay tuned.

Regards,
Ed Kim
Practical Risk Manager

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Risks And Follies of More Financial Regulations

It seems that our financial gurus in Washington, D.C. have finally put their brain on autopilot and left their mouths on auto “rant.” I know Hank Paulson has been doing this for a while, with his well-worn rant of "We want a strong dollar. A strong dollar is in our nation's interest.” (For those interested, there is a drinking game devised by Paul Kedrosky, based on Paulson’s strong dollar rant. Click here for the rules.)

And now, with Ben Bernanke, one of the few voices of reason in the government, calling for a consolidated oversight of investment banks, there doesn’t seem to be anyone in Washington, D.C. who is willing to face the facts that trying to heal a ailing economy with more regulatory duct tapes and rhetorical rants.

According to Bloomberg, Ben said: “Congress should give a single federal regulator enhanced power to set standards for the capital, liquidity and risk management of investment banks,” in his testimony to the House Financial Services Committee today. “He also asked for a procedure to liquidate failing investment banks and for Fed powers over payments systems.”

Mr. Bernanke, such a single federal regulatory body exists: The SEC. Perhaps, we should let the SEC do what it was founded to do: “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

A Quick Romp Through Recent History Of Knee-jerk Regulatory Actions

1 – The Great Depression
Congress created the SEC in response to the Great Depression. SEC, with the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934, had the responsibility to restore investor confidence in the capital markets by providing more reliable market information and clear rules of honest dealing.

I doubt that SEC is fulfilling its mandated mission if financial crises continue to occur with such regularity.

2 – S&L Crisis of 1980’s
The Savings & Loans crisis in the 1980’s led to the government adding another layer of regulation through the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). All this regulation did was to shutter existing agencies, create new ones, and shuffle existing government staffers from the old agencies to the new agencies. Change the nameplates, slap on a new cost of regulatory whitewash and everything is now supposed to be better and improved.

One of the interesting regulations that came out of this was the new capital reserve requirement that banks had to meet to ensure that they can weather the financial downturns. (FYI, this requirement was rescinded in 1990; so much for regulations.)

3 – Dot Com crash
With the blow up of Enron and other similar high-flying companies, the Congress rushed and passed the now infamous Sarbanes-Oxley Act of 2002 (SOX). Infamous in that it added such a deep layer of needless complexity, large public companies are still, to this day, trying to comply with its requirements. In a nutshell, SOX made it a criminal offense to falsify or sign falsified financial reports and held the CEO accountable. Also, it created a quasi-governmental agency, Public Company Accounting Oversight Board (PCAOB), and charged it to define the audit process and procedures.

My question on this is what really is the difference between PACOB and Financial Accounting Standards Board (FASB)? Private versus public?

What’s Changed?
Astute readers would note that another financial meltdown happened, even after all the regulatory laws and governing bodies that have been created to prevent such an event. So what has changed? Much like the rest of human development, when one side comes up with a rule, someone else will come up with a way to circumvent it. This escalation is almost instinctive. On the positive, it drives innovation, leads to new discoveries, and growth of human civilization. On the negative, it drives those bound by greed or other selfish desires to find ways to gain at the cost of others’ suffering; a zero sum game.

Ergo, the same is playing itself out in the financial market. A similar meltdown will happen. It won’t happen in the same way. However, when it does happen – a matter of when and not if – it will look similar to the past meltdowns.

Mathematics calls this The Chaos Theory. For those investors who seek to understand why and what a near catastrophic financial meltdown is happening, look at the work done in weather prediction. It is similar to that of the financial market.

Getting Back On Point And Conclusion
So what does all these historical and mathematical diversions have to do with the main point? Simple.

A direct message to Mr. Bernanke: We haven’t learned from our past mistakes and, judging from the messages being sent out from Washington, D.C., it appears that we will very likely see a similar situation in the near future, regardless of how many more additional regulations and oversights you propose to add to the already motley mix.

Regards,
Ed Kim
Practical Risk Manager

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Downgrade U.S. Government’s Credit Rating To "A2"?

With the news out that derivatives traders are treating Fannie Mae (Fannie) and Freddie Mac (Freddie) as if they should be rated “A2”, five levels lower than the implied government backed rating of Aaa. According to Bloomberg, “Credit-default swaps tied to $1.45 trillion of debt sold by the two biggest U.S. mortgage-finance companies are trading at levels that imply the bonds should be rated A2 by Moody's Investors Service,”

What the derivative market is saying, in essence, is that the likelihood of Fannie and Freddie being able to repay their obligations in full is in doubt. Taking this logic couple of steps further, since Fannie and Freddie have implicit backing of the U.S. Government, this implies that either (1) the implicit guaranty means nothing to the derivative market, and therefore they do not expect the government to bail out Fannie and Freddie; or (2) even with the implicit guaranty of the U.S. Government, the likelihood of being made whole is in doubt since the Government is already operating in a deep deficit.

Both scenarios bode very badly for the U.S. economy. I have stated this sort of problem in my March 19th article:

“Should losses in the 4% to 5% range occur, Fannie and Freddie will require immediate capital injection. Moreover, this would cause substantial losses in the market. After all, if Fannie and Freddie, the two truly “can’t fail” companies begin teetering, then the entire market will begin free falling.

The probability of this risk event unfolding is high given the continuing deterioration in the real estate market and with nearly $700 billion in ARM mortgage interest rate resets to occur in 2008. If the projected defaults increase substantially over the historic average, then the Federal Government will be forced to step in with tens of billions dollars in capitalization. And guess where that money is coming from.”

Let’s take some hypothetical looks at how this scenario might play itself out:

(1) Fannie and Freddie obtain capital injections from SWFs or private funds. The market will see the capital raise, as a red flag and drive the credit default spread even higher, a scenario that I think will definitely happen.

Since the cost of capital has increased substantially, the cost of the capital raise, in the capital market, will negatively affect Fannie and Freddie’s net income for years to come, if they can even obtain the capital. This too will have a long-term negative affect as more income is diverted to servicing the cost of capital. Again, the credit default spread will go even higher. This is another likely scenario, in my view. The stock prices of these two may see a little bounce; dead cat version, in my view.

(2) Fannie and Freddie fail to obtain capital injection or the funds raised are deemed to be inadequate. The market will see this as a very bad sign – double red flags – and begin abandoning their positions in Freddie and Fannie, and causing a substantial dislocation in the global market; a scenario that I hope does not happen but has an outside chance of occurring.

(3) The Federal Reserve, at the urging of the U.S. Government, steps in and provides the same short-term liquidity injection that Wall Street received (Term Securities Lending Facility). The Fed will take Fannie and Freddie’s junky bonds in exchange for UST (U.S. Treasuries), at very favorable terms. This, too, is a likely scenario, in my view.

This will increase the risks I have outlined in my March 11th article: (a) increasing the credit malaise, (b) driving away foreign investors in UST and causing the rates to rise, (c) lowering the value of the U.S. dollar, (d) driving the U.S. economy further into hyperinflation. While this move will lower the credit default swap spread, it will cause more upheaval in the bond market and drive the stocks of these two down substantially.

None of the three above scenarios are pretty. It is basically choosing the lesser of the evils at this point. It is clear at this point that the market does not believe the U.S. government’s desire to step into save Freddie and Fannie and any move by them to raise capital will trigger further widening of the default swap rate.

With the potential for housing prices to decline 10% to 20% further, the mortgages on Fannie and Freddie’s books are looking very suspect. A typical loss (haircut) given on the balance of a mortgage is 10%. Based on the $1.4 trillion in debt outstanding, a haircut of 10% results in a potential loss of $112 billion.

$1.4 trillion x 10% mortgage write-off x 80 cent loss per $1 = $112 billion in potential losses, nearly 146% of the estimated 76.8 billion in reserve capital, estimated as of December 2007.

Fannie and Freddie may not survive in their current form, after all the losses have been tallied. Batten down the hatches because here comes the other side of the hurricane!

Regards,
Ed Kim
Practical Risk Manager

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Is There A Bright Side To The Current Economic Doom And Gloom?

Surprisingly, yes. In fact, there are lots of upside to all this doom and gloom.

The major beneficiaries of the economic downturn will be the American consumers. They just don’t realize it yet. Like a person trying to recover from a hangover, consumers are slowly realizing the high cost of their excessive lifestyle of living in a McMansion set in a former crop field miles from a major urban center.

Large ostentatious homes will be a relict of past frenzy, much like the Pet Rock craze. Consumers are also realizing that living in such a remote location is not as glamorous as it seemed at first: the long commute to work, the need to drive everywhere, trying to deal with wild creatures grazing in their yard or garbage can, etc.

The ever-increasing gas price has consumers seeking ‘green’ alternatives (or lat least more economical alternatives) to driving SUVs. Sales of bicycles and scooters are up. Electric vehicles, once derided as transportation of the ‘tree-huggers’ are now mainstream. Public transportation and car-pooling are even making a come back. Frugal is now vogue. People are driving less, downsizing their vehicles, conserving more, and seeking ways to reduce their total consumption costs.

Industries that will benefit
With consumers strongly signaling desire to reduce costs, those manufacturers that can meet the new consumer demand will benefit. And those companies are:

• Makers of the next generation of lithium-ion batteries
  
• Makers of solar energy: Electric Panels, Water Heaters, and Heat Pumps
  
• Makers of Genetically Modified crops and seeds
  
• Makers of Vertical hydro-farming
  
• Green gas capture and trading
  
• Makers of Green Construction Materials
  
• The car manufacturer that comes to the market first with the economically viable 100-mpg car

I am most excited about the innovations in automotive design that should be hitting the showrooms around 2010-2011. With the advances in the next generation lithium ion batteries – no more of Li-ion batteries spontaneously combusting – we should see exciting versions of the electric cars. I can hardly wait to buy an electric hybrid car for about $20,000 that comfortably seats four, gets at least 100 miles per gallon, and still go from 0 to 60 mph in less than 5 seconds

Regards,
Ed Kim
Practical Risk Manager

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Industries Primed For A Fall

We all know about the auto industry and the mess that they are in right now. I expect that in the near future, GM and Ford may have to merge to stay alive. Given how ‘cheap’ their stocks are right now, the temptation is to jump in and buy. However, in the Practical Risk Manager’s view, the risks still outweigh the reward. Firstly, there is no other automaker desiring to take over the bloated pension deficit, existing high-cost structure, and antiquated assembly plants that GM and Ford have.

The other automakers have their own problems. With increasing cost of raw materials such as steel and plastics, car manufacturers are running on fumes. If there were an investor willing to take over GM or Ford, it would be to extract the value within each firm and sell the auto operations at a steep discount. File this under “there is a valid reason why their stock prices are so low.”

GM has hidden value in its Onstar satellite communication division and its non-North American auto operations. A bold move for GM would be to (1) follow Halliburton’s move and relocate its HQ offshore, (2) sell off or shutter its North American operations (this would put a cap on its retirement fund obligations), (3) Expand the Onstar satellite communication division’s capabilities to compete with Sirius and XM Satellite, and (4) be an importer of ultra-small cars from its international operations into North America.

I wonder if any senior executives from from GM / Ford are reading this…

Another industry that will see more failures is the Airline Industry. While they have taken dramatic steps to cut costs and increase revenue – a position proposed by the Practical Risk Manager several months ago – there are still the issues of ever-increasing fuel costs and continuing trend of reduced demand for air travel. Given that consumers are traveling less and increasing the use of alternative transport means, airlines will have to have to begin offering something that they did away with a long time ago: good customer service.

Airlines need to offer something tangible without tremendous added cost. The bold move would be to raise the profile of the cabin attendants to that of air hosts / hostesses. The international carriers do this very well. In fact, most Asian airlines have one of the most rigorous training for their flight hosts / hostesses. This is clearly evident by the Skytrax’s list of six airlines worldwide that are rated 5-stars, its top rating. All six airlines are Asian: Asiana Airlines, Cathay Pacific Airways, Kingfisher Airlines (India), Malaysia Airlines, Qatar Airways, Singapore Airlines.

Where are the major American carriers? They are clustered together in the mediocre 3-star category. The U.S. airline industry seems to think that good customer service means offering free beverages, food, and onboard entertainment. Good customer service does not mean just what happens on the plane; it starts with the reservation and goes all the way to deplaning.

Currently, the airline industry has so many built-in inefficiencies that actually prevent them from providing good customer service. This is a clear risk factor in the Practical Risk Manger’s view; a clear financial and reputational risk factors.

What more can the airline industry do? Here is a sample of bold moves (I have more) that the industry can take to reverse the traveler’s view of the airline’s poor customer service:

Provide free curbside baggage loaders. The redesigned baggage loaders is capable of holding up to 5 large check-in bags and 3 carry-on bags, is electric driven, lies flat on the ground for easy loading / unloading and rises to move. Customer could use this to load their bags at curbside and guide the electrically driven loader to check-in.

I think that even with bold moves, there are certain airlines that cannot make it if the fuel prices stay high into 2009, which is highly probable. To wit, I stand by my previous assertion that American Airlines will not make it. This is even more probable since they have not taken strategic actions to reduce their reliance on their fleet of MD80s. I would file American Airlines as an investment that I wouldn’t touch with a ten-foot pole.

Regards,
Ed Kim
Practical Risk Manager

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Are We Near The Bottom Yet?

The short answer is still “Not yet.” The news continues to be grim without any signs of letting up. In fact, the major media appeared to have all climbed on to the Bear market bandwagon. As any prudent investor knows, one can make money in a Bull market as well as a Bear market. The converse of this is equally true.

My readers have been aware, several months ago, the risk factors that are manifesting themselves in current events. Hopefully, the readers have made some good and wise investments based on the risk factors, as I have presented previously. Continuing on this theme of taking prudent risks, here are additional ‘futurescape’ of the global economic condition, in my opinion, based on the publicly available data.

Will Large Banks Fail?
While it is highly improbable that many large money center banks will fail, there are certain candidates that are closer to the precipice than others. The risk manager, using a standard six-sigma approach, would note that we are currently in a ‘tail’ event economy - an economic event that typically has 0.3% or less of occurring. This means that an unthinkable can and may occur, including at least one “too-big-to-fail” bank failing. It is not a matter of “IF,” it is a matter of “When” and Which.”

In my view, the front-runners, vying neck to neck, for this dubious distinction are: Citigroup, Lehman, UBS, Merrill Lynch, and Morgan Stanley. I wonder if Ladbrokes would open betting lines on this action. If so, I would take UBS as being the candidate to fail. This is based on three factors, in addition to the general malaise affecting all banks: (a) it is still losing its high net worth clients, (b) is downsizing its investment banking division, in attempt to cut costs, and (c) the unwillingness of its senior management to admit its mistakes. With its sterling reputation tarnished, clients leaving, revenue sources drying up, it would be very difficult for it to remain independent for too long.

Banks will need to continue raising capital as more assets are reclassified to tier-2 and tier-3. The only problem is that most potential investors have already been burned and are sitting on substantial paper losses. That means that banks will have to juice up the preferred rate of return and provide a recast trigger should the stock prices drop below a threshold. Furthermore, the banks will have to go to lesser known investors and SWFs (think Brazil, South Korea, India, Taiwan, and Russia).

Regards,
Ed Kim
Practical Risk Manager

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Risks Of Sound Risk Management – Part 1

It has been slight over a month since I last wrote my 99th article. As I pondered the subject of my 100th article, I agonized over the topic that would grace the 100th writing, as I thought that the number symbolized something special. During my pondering, I realized that there is nothing significant in the number itself. Although we tend to hear the centennial being a major milestone – such as the 100th episode of a long running TV show, the first 100 days of the Presidency, etc. – its significance has largely lost its meaning in the today’s “do it now” society where a story that occurred more than a week ago is no longer news but trivia.

This is also true in the realm of business where “what have you done for me lately?” attitude is prevalent. In this environment of corporate upheaval, continual job cuts, economic uncertainty, and senior management lost in a myopic miasma of “try everything to stem losses” school of management, the risk managers are especially in dangerous waters as they have to try to bring reason and sanity to the this corporate environment.

As a risk manager, I have always practiced the following rules:

1. Never compromise my integrity. This means that that while the allure of the brass ring is tempting, a risk manager’s responsibility is directed to ensuring that the organization is abiding by all requirements as set forth by law, regulations, and its own policies and procedures. Staying your course in not compromising one’s integrity does not win you any favors with those who cut corners and operate openly in the interpretive gray areas. However, the risk manager is charged with the sacrosanct responsibility of being the beacon of rationality in face of blind greed.

2. Don’t sugar coat the truth. In the corporate world, the managers are in their position for a reason. They should be mature enough to accept the facts and consequences of the facts without the need for circumlocution. However, good business practice is to recommend choice of action plans to the manager. This way, the risk factors are properly “actioned” and potential losses minimized or even mitigated.

3. Watch out for unscrupulous managers. This is difficult to do, as most of these managers will not be transparent in their mendacity. However, if they arrived at their station by trickery or deception, then these unscrupulous individuals, who fear being caught by a diligent risk manager, will make the risk manager’s job difficult. Knowing this, tread cautiously as these people may have supporters in upper management.

4. Incompetence is throughout, so don’t be too efficient. Now, this seems counterintuitive and possibly a contortion of logic. However, this is a vital point that most risk managers fail to keep in mind, including yours truly. By incompetence, I mean those individuals whose job functions are antitheses to organizational profitability but perform them very well, to the detriment of the organization. The saddest aspects of incompetence come when an entire unit is happily doing work that other unit/units will have to undo.

When joining an organization, one is given a grand overview of the organization’s principals. This is especially true when joining a Fortune 50 company or an elite financial institution. However, a risk manager needs to realize that there are people of incompetence in all organization, even in the best organization. And the incompetence exists at the top. Take the case of Charles Prince of Citigroup when he uttered the now infamous statement: “As long as the music is playing, you’ve got to get up and dance,” In the immortal words of Dr. Seuss, Mr. Prince “said what he meant and meant what he said.” He honestly believed in his statement and stuck with it, even in the face of blatant fact to the contrary.

So, what is a risk manager to do? Firstly, don’t be a hero. A risk manager or a team of risk managers cannot fix such a process. Those who try are labeled Don Quixote or even worse. At best, the risk manager’s effectiveness is questioned. Now, this was very difficult for me to turn a blind eye to a group that cost millions in operational cost to the firm and it cost me my job. While I do not regret my actions, as I followed my first rule of never compromising my integrity, I caution other risk managers to seriously weigh their personal financial risks and rewards before acting against established incompetence.

5. Add value using dollars and sense (practical sense). Corporations toss around “value-added” a lot in their stated principals. This is also true in their risk management units. However, most people do not truly understand what “value-added” means or even how to enact it. Presenting a month-old risk report to senior management is not “value-added.” Rather, it is value lost, as numerous highly paid managers are forced to attend an hour-long meeting to comply with Basel II accord. Any action taken post event is not valued-added.

The value addition comes from two main practices: (a) concrete and practical preventative action plans that the business can implement and (b) identifying process improvements that reallocates existing workforce to a more effective (and profitable) use within the organization.

I will follow up later on these points; after all, I do want a rapt audience. So, enjoy the weekend and look forward to more insights and risk analyses.

Regards,
Ed Kim
Practical Risk Manager

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Risks Of Oil Price Optimism

The oil price fell by more than $3 from outrageous $130 per barrel to I-still-can’t-believe-it level of just below $129 per barrel. However, based on the media, it would seem that the camel’s back had been broken and we would be seeing more ‘reasonable’ prices shortly.

CNNMoney had this to say today in its report: “"You usually see prices bid-up before the holiday," Stephen Schork, an oil industry analyst and publisher of the Schork Report. "Today we're seeing some of the air let out of the balloon." If the market follows its typical seasonal pattern, Schork thinks crude's "highs have been put in." Though he added that the market has seen "a tremendous amount of support" and the seasonal pattern may not hold this year.

USAToday was also very optimistic in its article, which it titled “Pump prices may have peaked.”

While it is nice to see oil prices coming down a bit from profit taking due to concerns about slowing U.S. economy, it is not indicative of the change in the direction of the price of oil or gasoline. This is prudent to note, as we are now about to enter the hurricane season. If a major hurricane hits of even skirts the gulf coast, the production of gasoline and oil drilling in the gulf will be disrupted, causing a spike in oil and fuel prices once again.

National Oceanic and Atmospheric Administration (NOAA) is forecasting an active hurricane season in 2008 with up to nine hurricanes in the Atlantic Ocean with five of them being major. While NOAA had been predicting more hurricanes in the past two years than actual, there were still six hurricanes in 2007 (out of 10 that NOAA forecasted) and five hurricanes in 2006 (out of nine that NOAA forecasted).

More signs that the 2008 hurricane season may have a substantial impact on the oil and fuel prices comes from AccuWeather.com, Colorado State University, and CSU, according to Bloomberg: “AccuWeather.com and Colorado State University both said the 2008 hurricane season, which runs through Nov. 30, would be more active than usual.”
Additionally, CSU “said both the East Coast and the Gulf of Mexico coast, home to dozens of oil and gas rigs, have a 45 percent chance of being hit by a major hurricane. That compares with a 30 percent chance historically.”

Therefore, based on four separate professional meteorological opinions, the consensus is that 2008 season will be more active than typical. If NOAA’s trend of its forecast being about 55% to 60% of the actual, then the U.S. may see about five hurricanes with about two of them being a major one. Applying a 45% chance of the gulf region being hit by a major hurricane, that gives us a good chance that roughly about one or two major hurricanes may affect the gulf region substantially enough to disrupt or slow down the oil production and processing.

Given that any slight negative news is able to send the oil prices skyrocketing, I do expect to see the oil and fuel prices not easing anytime soon. If we have a hurricane similar to Katrina, then expect to see gas lines in the U.S. once again (picture: 1979 gas line; source: wikipedia.org).


Regards,
Ed Kim
Practical Risk Manager

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China’s Temporary Housing: A Thousand Times Better Than FEMA Trailers

Mere ten days after the terrible earthquake in Sichuan Province, China is well on its way of building 1 million temporary housing. One million temporary homes in three months!

According to China Daily, China plans on building 1-million temporary housing built from modular material by August 10. In their May 22 photo, below, one can see the quality of the housing that China is building, which puts FEMA and the U.S. efforts after Hurricane Katrina to shame.

“China's Ministry of Housing and Urban-Rural Development said Thursday that it had requested local authorities in earthquake-hit areas to build 1 million temporary homes by August 10 to accommodate quake victims of the May 12 earthquake. A circular issued by the ministry said the transitional homes should be either assembled with steel sandwich panels or made of light-weight steel and plywood kit sets. The size of the houses should be about 20 square meters and provide minimum living space for quake victims, it said. They should be capable of withstanding earthquakes and be recyclable after three to five years of use, said the circular.

It also stipulated that local authorities should construct one primary school, one clinic and one retail store for every 1,000 temporary homes. For every 2,000 houses, a middle school should be built, it added.” – China Daily

The picture, below, shows approximately 240 attached modular homes, each containing 20 square meters (approximately 212 SF). When compared to the FEMA trailers, these temporary modular homes look much more like a home.
China has a robust prefab housing industry[i] so the goal of 1-million homes by August 10 is achievable. Moreover, the central government will ensure that there will be none of the blatant corruption and incompetence shown by FEMA with the aftermath of Hurricane Katrina.

According to a NBC Investigative Unit report, FEMA paid approximately $229,000 per trailer and support infrastructure. The Government Accountability Office (GAO) investigators found “the trailers themselves cost only $14,000, but FEMA wasted big money by placing them at a small temporary site built from scratch with huge maintenance costs.” Additionally, “the GAO found that over a seven month period, FEMA made a total of $30 million in improper or fraudulent payments for trailer maintenance alone. The investigators also found examples of phony inspections, rigged bids, and excessive payments.”

We pride ourselves as being the world’s super-power. However, when it comes to providing even the most basic infrastructure support and aid to our own citizens, the U.S. has clearly demonstrated that it is no better than some third-world banana republic.

This will be clearly evident at the Beijing Olympics as the Chinese Government showcases the relief efforts’ successes, including building 1-million temporary homes, schools, hospitals, and other support structures made from recyclable materials. Once that happens, there will be a lot of compare and contrast made in the media between the Chinese’s success and U.S.’ dismal failure, which is still continuing in the Gulf region.

Regards,
Ed Kim
Practical Risk Manager
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[i] Some of the companies that manufacture prefab housing in China are:
Beijing Baofengyuan Steel Structure Engineering Co., Ltd.
Shangyu Silverwood Lightsteel Technology Co., Ltd.
Nantong Huasha Movable House Co., Ltd.
Beijing Chengdong Prefabricated House Co., Ltd.
Conceiving Board-Manufacturing Co., Ltd.

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SocGen Is Still Lying

Societe General (SocGen) is back in the headlines again, this time with a little more (just a nanometer more) truthful then what was reported back in January. Back in January, the blame was firmly and solely on Jerome Kerviel, the rogue trader who was somehow able to hack the banks middle-office and back-office trade reconciliation and audit systems single-handily.

Now, SocGen, in its internal report released Friday, May 23, is stating that there were some management oversight failures. According to MarketWatch, SocGen is stating “Multiple mistakes along most of the chain of command allowed a rogue trader to amass billions of euros of fraudulent positions that eventually led to a loss of $7.7 billion.”

Yes, managers up the chain of command made multiple mistakes. However, having worked in an Investment Bank front- and middle-offices and in risk management, I find it laughable that SocGen is still in denial and is willing to publish this type of rubbish. I think other people who have worked at an investment bank middle-office will also find SocGen’s latest report to be incredulous.

The truth will come out, no matter how slowly; it will come out. And the truth is that someone at the senior management level knew of Jerome Kerviel’s activities and signed off on it. Other layers of management, knowing that a senior manager signed off on Kerviel’s activities, allowed the trading marks to continue.

The real mystery that I cannot fathom is what SocGen’s internal audit and compliance departments were doing all those years that Kerviel was trading and why they didn’t raise any red flags to the board of directors. Perhaps, the board of directors was the one who signed off on Kerviel’s activities.

I look forward to another official report from SocGen toward the end of 2008 stating that there were additional mistakes made along the way, including managers in charge of checking trading marks and positions. Even if that report comes out, it will still be mostly fiction.

Have A Great Weekend!

Regards,
Ed Kim
Practical Risk Manager

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Can The Big Three Auto Makers Make It To 2010?

In March, I seriously questioned the viability of GM and Ford given their overly optimistic projections and declining economic conditions. Now, after months of denial, Ford has finally come clean and admitted that they would not be able to meet their profitability projection for 2009. GM had already stated in their FY 2007 financial results that they are looking to 2010, having written off 2008 and 2009.

“Ford said Thursday that it would drastically scale back production and step up cost-cutting efforts in response to a sharp drop in sales of pickups and sport utility vehicles. Ford executives also retreated from their pledge of delivering a full-year profit for 2009.” - NY Times

A surprising turn of events after Ford announced a first quarter profit? Not at all. Rather, the first quarter profit is the surprise. With the Big Three U.S. automakers (GM-Ford-Chrysler, a.k.a. the “Big-3”) still producing larger SUVs and trucks instead of fuel-efficient cars that consumers are demanding, it will be a very difficult future for the Big-3.

Simply put, the high fuel prices changed the rules of the game and the Japanese automakers making further changes with their hybrid cars. Honda has its hybrid Civic and Toyota has its Prius – the tope selling hybrid cars in the U.S. For the Big-3, only GM and Ford have hybrids in their current lineup. GM has hybrid SUVs, GMC Yukon and Tahoe, that get 20 city / 22 hwy MPG. GM has hybrid Chevy Malibu and Saturn, a part of GM, has two hybrid cars, Aura and Vue. However, their MPG is no better than a small block 4-cylinder engine’s at 25 city / 32 hwy MPG. Ford has only the hybrid Escape that is rated at 30/34 MPG. (Source: Yahoo Auto)

How Much Worst Can It Get?
“Ford is now forecasting that industry demand for cars and light trucks will be 14.7 million to 15.1 million vehicles — the lowest point in more than a decade.” - NY Times

According to BTS, the total figure for new vehicles sales and leases for 2007 was 17,129,000. So Ford is forecasting 2008 sales to decrease by approximately 11.8% to 14.2% from 2007. According to Motor Intelligence’s New Car Sales report as of May 5, 2008, the total light truck sales dropped by 17.6%, year over year, from 715,730 in April 2007 to 589,989 in April 2008. On a year-to-date basis, the total light truck sales dropped by 13.5%, year over year, from 2,817,280 for January-April 2007 period to 2,436,375 for January-April 2008 period. For cars the total year-to-date sales dropped by – 0.8%, year over year, from 2,409,394 for January-April 2007 period to 2,389,234 for January-April 2008 period.

With the fuel prices well over $4 in many cities, the potential for regular mid-size to large cars, SUVs, wagons, and light truck sales to drop even further than 11.8% to 14.2% in 2008 is quite high. With GM, Ford, and Chrysler not having much to offer to panicked buyers seeking high MPG cars, it will be the Japanese auto makers, once again, taking more market shares away from the Big Three. The shift of market shares to the Japanese auto makers have been very sharp in the first few months of 2008 with buyers scooping up hybrid electric-gas cars made by Toyota and Honda.

Further adding sting to the pain, is the news that Honda is on a mission to bring a hybrid Honda Fit to the U.S. market in 2009 and plan on adding new models to the hybrid lineup in the next three years. The Honda Fit is already a very fuel-efficient car at 28 city / 34 hwy MPG. Imagine what the hybrid engine will do. I am guessing at least 50 MPG. Oh, the new hybrid Fit will be only about $1,900 more than the standard gas model. The Big-3 is in big trouble.

Toyota is not standing pat. They announced plans to expand their battery producing capacity and plan on selling 1 million hybrids by 2010. With Toyota and Honda eating Big-3’s lunch, what are the Big-3 doing? It is not like they didn’t know that this was happening or lack the technology. GM and Ford have their international divisions that are experienced in building small cars such as the popular Ford Ka and GM Matiz / Spark. Why didn’t they look to building them in the U.S.? Even the Japanese, Korean, and German automakers are building cars in the U.S. and exporting them out.

Are the Big-3 officers so dense as to not realize that the oil prices will go up and quite soon? Have they not learned their lessons in 1970’s with the OPEC oil embargo and Japanese car invasion? How is it that the international automakers are able to build vehicles that consumers want on a timely basis while the Big-3 cannot seem to make substantial changes even when given a head start with the Freedom Car Project that launched in 2002?

For those naysayers that think that we cannot bring the extreme subcompact cars such as the Ford Ka and the GM Matiz / Spark to the U.S., please look at other extremely small cars that have passed the necessary federal standards and are selling in the U.S.: Smart Car and the Cooper Mini.

Finally, if any of the readers think that I am bashing U.S. automakers, dissuade yourself of that thought. All automakers are international, including the Big-3. While their headquarters are in Detroit, the Big-3 have less footprint in the U.S. than the Japanese automakers. In my book, the U.S. automakers are the ones that create jobs in the U.S. by building plants in the U.S. Using this measuring stick, the Big-3 are ‘foreign’ automakers.

So, God bless the automakers, with U.S. assembly plants[i], who are turning out quality cars that rank high in safety, quality, reliability, and customer satisfaction. Maybe you have heard of them. They are Honda, Toyota, Nissan, BMW, and Hyundai.

Risk Assessment
The potential for the Big-3 to lose more market shares to other international automakers are increasing every year. As more fuel-efficient cars enter the market, such as the VW Up! and the Fiat 500, the Big-3 will be forced to close more of their existing assembly plants to retool to build smaller, fuel-efficient cars. Additionally, they will be financially strapped as they sit on growing inventory of SUVs and light trucks that just won’t sell. Making matters worst are the SUVs and light trucks coming off leases. They will add to the bulging inventory of large vehicles that consumers will shun. So, between market loss, closure of plants, retooling, and ever-growing inventory of un-sellable vehicles, expect to see more news of Big-3 taking billion dollars more in losses.

Regards,
Ed Kim
Practical Risk Manager
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[i] http://www.globalautoindustry.com/images/USA_SE_Auto_Assembly_Plants.pdf
http://www.usatoday.com/money/autos/2007-03-22-american-usat_N.htm
http://en.wikipedia.org/wiki/List_of_Honda_assembly_plants
http://en.wikipedia.org/wiki/Toyota_Motor_Engineering_%26_Manufacturing_North_America
http://www.autofieldguide.com/articles/089705.html

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