FINANCIAL REVIEW

Financial Engineers at the Gate

Sinclair Noe — October 21, 2014

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DOW + 215 = 16,614

SPX + 37 = 1941
NAS + 103 = 4419
10 YR YLD + .03 = 2.21%
OIL + .64 = 82.55
GOLD + 2.50 = 1250.40
SILV + .09 = 17.62

In economic news, the National Association of Realtors reports sales of existing homes rose 2.4% in September to a seasonally adjusted annual rate of 5.17 million, hitting the fastest pace in one year and rebounding from an unexpected drop in August. However, September’s pace of sales was down 1.7% from a year earlier. So, the housing market isn’t roaring, but lower interest rates managed to pull some buyers off the sidelines last month.

Low interest rates are just part of the equation in the housing market; buyers also need to be employed. The Labor Department today released state unemployment numbers, and in 15 states, the unemployment rate is now under 5%; that list includes: North Dakota at 2.8%, South Dakota at 3.4%, Utah 3.5%, and Nebraska, Minnesota, Hawaii, New Hampshire, Vermont, Idaho, Iowa, Montana, Dolorado, Oklahoma, Wyoming, and Kansas. Georgia has the highest unemployment rate at 7.9%. Arizona made the bottom 10 with a 6.9% unemployment rate, a full percentage point higher than the national average.

Reuters reported the European Central Bank was looking at buying corporate bonds as soon as December in its efforts to revive the Eurozone economy. The move to buy corporate debt reinforced the idea that ECB President Mario Draghi really will increase the ECB’s balance sheet by a significant amount. The euro fell against the dollar.

China reported third quarter Gross Domestic Product rose 7.3%, which is down from 7.5% growth in the second quarter, but still better than most estimates. The positive news out of China and Europe lifted overseas equity markets and the US markets moved higher from the open. Also, lifting US markets, was a good earnings report late yesterday from Apple. And yes, Apple is big enough to move markets, especially combined with decent economic news.

The earnings news today has been a mixed bag. McDonald’s reported third quarter profit fell 30% and sales were down for a fourth straight quarter. Net income dropped to $1.07 billion, or $1.09 a share, from $1.52 billion, or $1.52, a year earlier. Sales at US and global stores fell 3.3% for the quarter. And this is now turning into a trend for McDonald’s.

Coca Cola reported 3Q sales fell slightly from $12 billion a year ago to $11.98 billion. Third-quarter net income fell 14% to $2.1 billion, or 48 cents a share, from $2.4 billion, or 54 cents, a year earlier. And so, Coke announced a $3 billion cost cutting plan that includes selling company owned distribution territories back to independent bottlers over the next 3 years.

After the close, Yahoo reported third quarter profit, excluding items such as stock-based compensation, was 52 cents a share. Analysts had projected 30 cents a share. Net income attributable to Yahoo was $6.7 billion, up from $296 million a year earlier. The company got a one-time boost of more than $9 billion before taxes last month from a sale in the initial public offering of Alibaba, which still makes up more than half of Yahoo’s valuation. So, you have to look past profits to revenue, which was up 1.5% to $1.09 billion. That’s pretty weak sales growth. So, it’s not surprising the hedge fund activists (in this case it’s a fund called Starboard) are calling for Yahoo to acquire AOL, or if not that, then to break up and be sold off.

In case you are not familiar with the term “hedge fund activists”, it’s what we used to call corporate raiders, or the barbarians at the gate. Nowadays they have tried to polish up their image as defenders of shareholder value. What they do is called financial engineering. We’ve seen it at Apple, where Carl Icahn has been pushing hard for more and more stock buybacks. We saw it at IBM, where they developed something called Roadmap 2015, which was basically a plan to prop up the stock by buying back shares by the cartload. Unfortunately for IBM, the focus on shareholder value meant they lost focus on doing their job. Revenue hasn’t grown since 2008. While the company spent $138 billion on its shares and dividend payments, it spent just $59 billion on its own business through capital expenditures and $32 billion on acquisitions.

And if you are wondering about a potential pattern here; sure, we can help you there. Most companies are precluded from engaging in open-market stock repurchases during the five weeks before releasing earnings. For many companies the beginning of the blackout period coincided with the S&P 500 peak on September 18. So the sell-off occurred during a time when the single largest source of equity demand was absent. Buybacks dip during earnings reporting months. And for the past 7 years, the bulk of buybacks happens in the fourth quarter, with 25% of all buybacks happening in November and December; which tends to juice prices just in time for end of year bonuses.

And how do companies pay for stock buybacks? Well, we’ve heard that corporations are sitting on piles of cash; they’ve been stockpiling the dead presidents because they have been nervous about incurring expenses related to long-term investments, which could torpedo a quarterly earnings report, and that would really hurt executive compensation. And so, rather than spend the cash, they focus on cost cutting and they borrow the money for the stock repurchase. Makes sense because interest rates are so low. And the Federal Reserve has perpetuated this scheme by offering up QE parts one through three, along with a big dose of Zero Interest Rate Policy; the barbarians at the gate are reaping the spoils, but the rest of the economy…, not so much.

The Fed seems to think a thriving stock market will lift the rest of the economy, and as QE3 comes to an end this month, they’ve already started jawboning about whatever stimulus they can provide to keep Wall Street fat and happy. Let’s hope they forget that nonsense and make QE4 do something for Main Street.

It’s time once again for another edition of “Banks Behaving Badly”. Today, the European Commission fined 4 banks for rigging interest rates. JPMorgan Chase was fined $78 million for manipulating the Swiss franc Libor interest rate as part of an illegal bilateral cartel with the Royal Bank of Scotland. RBS was granted immunity because they revealed the existence of the cartel to the commission. JPMorgan got 40% knocked off the fine because they cooperated with the Commission. Neither bank was forced to admit wrongdoing.

Separately, the Commission fined RBS, UBS, JPMorgan, and Credit Suisse for operating a cartel on bid-ask spreads of Swiss franc interest rate derivatives. Essentially the banks quoted wide bid-ask spreads to customers, but then used narrower spreads for trades among themselves.
The total fine for the 4 banks was $119 million, which is basically like you or me paying a parking ticket.

There will be much bigger fines for a variety of other indiscretions. Citigroup analysts estimate that probes into allegations that traders rigged foreign-exchange benchmarks could cost banks as much as $41 billion to settle. Authorities around the world are scrutinizing allegations that dealers traded ahead of their clients and colluded to rig currency benchmarks. Regulators in the UK and US could reach settlements with some banks as soon as next month, and there is speculation that prosecutors at the Justice Department plan to charge one by the end of the year. Citigroup analysts made their calculations based on fines in the Libor rate manipulation cases. Citi analysts estimate some big fines for Deutsche Bank, Barclays, and UBS. Citigroup is the biggest player in the $5.3 trillion-a-day foreign-exchange market, believed to control about 16% of the market. Citigroup’s potential fine in the currency manipulation investigations wasn’t mentioned in the analysts’ report.

Yesterday, William Dudley, the president of the Federal Reserve Bank of New York gave a speech where he actually sounded like he was getting tough on banks. Dudley said: “If those of you here today as stewards of these large financial institutions do not do your part in pushing forcefully for change across the industry, then bad behavior will undoubtedly persist. If that were to occur, the inevitable conclusion will be reached that your firms are too big and complex to manage effectively.” Dudley added that it was up to the banks to address this cultural and ethical challenge.

And that speech was followed today with reports that the New York Fed has fallen down on the job of regulating banks. This goes back to the 2012 London Whale scandal involving JPMorgan’s investment unit; turns out that Fed supervisors saw signs of problems with some derivatives deals and recommended that the New York Fed conduct a full-scope investigation, but they never got around to investigating further. The London Whale trading unit eventually lost over $6 billion in high risk trading, and when it got in trouble, it resorted to fudging its numbers in order to disguise the fact that it was losing money hand over fist. You may recall that there was a congressional puppet show last year that was designed to give the appearance that something was being done about a serious problem. JPMorgan was fined, with no admission of wrongdoing. It’s just part of a very long list of illegal activity, and if you want a better list, you can check out a link at my website (see link below) that details more than 23 specific violations over the past few years.

And now Dudley is talking tough about the banks, but what he is really saying is that the banks need to address the cultural and ethical challenges; which is true enough, but it also fails to address the failures of the New York Fed and basically all the other regulators. Remember that this is the same New York Fed that just a couple of weeks ago was called out by a former investigator who was fired and turned whistleblower, Carmen Segarra, that accused the NY Fed of being too cozy to ask tough questions of Goldman Sachs. Now, Mr. Dudley talks tough about the banks, but the Fed still hasn’t taken action, and until the Fed takes action, Dudley is just full of hot air.

  GF&Co: JPM - Out of Control