Page 1of 13

Finance Industry Futures I:Credit, Leverage, Malfeasance and Broken Business Models

Table of Contents

Re-thinking, Re-Thinking, Re-Thinking? 2It's Over, It's Over...Yeah Right! 3Boiled Frogs Getting Flayed 4Fundamental Breakage in the BM 5Private Equity Futures - from Golden(Gilt) to Iron Age 64 Year Crunch, Broken BizzMods 7Bad Times, Bad Companies: More Finance Industry 8Vicious Credit, Economy, Market Cycle Spotted 10Frannie From Pan to Fire: Rescue Me...Us...the System ? 11

Introduction and Summary

We have all had to learn more than we ever wanted to know about the internal workings of the Finance Industry and itsimpacts on the rest of the economy. After, literally, decades of viewing the industry as a magic black box where super-intelligent wizards created wealth out of thin air we’ve all learned, painfully, that the wizards had more in common withcarnival side-show hustlers out to make a fast buck by fleecing the next fool in line. We’ve also learned, even morepainfully and unfortunately, that Finance wasn’t just another industry and part of the economy. Instead it was the lifebloodwho’s credit creation mechanisms kept the real economy flowing. Now we all know that systemic risk means that thesurvival of the economy could be at stake.We’ve been tracking the Finance Industry for over two years now and following a learning curve of our own andtranslating those learnings into various postings and discussions. Starting with early in 2008, in this case, with thesuggestion that the Industry was going to have to be re-thought. And debunking other early 2008 fantasies that the creditcrunch and the problems with the Industry would go away soon. In fact they were just beginning and as the crunch went tocrisis we found out that the business models were badly flawed.This set of postings traced the evolution of the breakdown and near-collapse of the Industry from early 2008 until the endof the year. Sadly all of this analysis is far from out of date. The problems with malfeasant behavior, willful ignorance,violations of fiduciary trust, lack of understanding and badly flawed, even broken, business models are still with us and willbe for years. As we look back at the crisis perhaps the scariest thing is that the leadership of the industry was in denialuntil the cusp of the collapse. And would have taken us all over the edge of the cliff without government intervention.It will take years to contain, stabilize and repair the damage within the industry and, more broadly, for the economy as awhole. Perhaps the worst of all though is that it appears that the Industry is not only still in denial but attempting to returnto business as usual. Where this is important to you is in several ways. First off, as a potential direct stakeholder: investor,employee or supplier. Secondly as a customer and thirdly as a member of society. Unless these problems are correctedand new strategies, business models and services that are value-creating, instead of leverage manipulating, result theIndustry will perform poorly, credit will continue to be restricted and society will remain threatened.Put that another way…by paying attention to the warnings and analysis at the time you could have avoided loosing a lot ofmoney, suffering a lot of pain and could even made a lot of money with the right investment tactics. We think the samething will hold true in the future because all the problems discussed are still in place, only in slightly different form.

Page 2of 13

WRFest 20Jan08(FinInd): Re-thinking, Re-Thinking, Re-Thinking ?

http://llinlithgow.com/bizzX/2008/01/wrfest_20jan08finind_rethinkin.html#more

Last week, actually the last several, were terrible for the markets. And judging by the carnage in Asia and Europe so fartoday we can anticipate more trouble as the markets re-open. While it's not clear how much farther we've got to go it lookslike a major shift in outlook and sentiment is underway. One which, partly in a spirit of schadenfreude, we've been pointingto for quite a while now. There was so much last week in fact on the spreading credit contagion that we pulled thoseexcerpts out into a seperate post (

Ebolatization Contagion: Credit Mess II

) to highlight them. A comment on that post askedan interesting and key question:It's as if you are discriminating between financial sector growth, which I assume you measure in financialterms, and economic value, which I also assume you measure in in financial terms. That is, there is non-value adding financial growth. Am I close to correct here?If so, how do we distinguish between the value-adding financial growth and that which does not add value?One could argue that any shift of resources into newer sectors helpe the overall economy become more efficient - in thecase of the Finance Industry by helping to raise and create capital and more efficiently allocate it. The question we wereasking that led to the comment was whether or not the shift of resources into the Finance Industry had gone too far andour implied answer was "hell yes". But it was an answer based on a fair amount of prior investigation on the rapidly risingshare of the Financial sector in profits (

The Heart of the Matter: Profits vs Earnings

?), on the buyback and buyout manias(

Market Drivers 3 (Buybacks):Investment, Hiring, Nah...Bonus, Bonus, Bonus !

plus two prior posts) and on what's turningout to be alleged profits built on leverage and unaceptable risks (

Rocks, Ponds, Perverse Incentives: More on CreditContagion

)In other words, as write-downs continue, we're arguing that most of the Finance Industry profits that were booked in thelast several years will disappear. And that disappearnce is reflected in the poor outlooks for many of the major companiesAND their need to re-capitalize. Taking these arguments and investigations all together it seems reasonable to argue thatindeed to much money went into bad investment ideas, that capital was very inefficiently allocated and, as a result, theoverall health of the economy will be badly damaged.And, further, that the industry itself is going to have to re-think its' business models which increasingly appear to bebadly....badly broken. The readings, links and excerpts on the continuation sustain this argument and extend it. But toanticipate what we think is happening is at least two things.First, the industry needs to re-think and a new set of business models has yet to make an appearance. And second, as aconsequence, despite all the folks who're starting to argue that all the catastrophes have been priced into the stocks ofthe Financials we're a long way from seeing a bottom grounded in fundamental realities. If and when we recovereconomically we're likely to see a major bounce in Financials based on that argument. In fact we're likely to see somebounced that will be trading opportunities before then. But not investing opportunities. Until the industry re-thinks itself itwon't be well-grounded IMHO. The trick as an investor will be to watch the evolution of the reconstruction of the industryand then invest.We covered some of these points in an earlier readings collection on the Industry (

"Interesting Times" for the FinanceIndustry: Readings & Resources

) which is worth reviewing as well). One of the stories there that encapsulates the situationand provides a nice historical overview is this:

Wall Street doesn't want you

After an era of innovation in financial services that benefited the middle class,The Street has abandoned individual investors in favor of big institutions and wealthy private traders. It'stime for big changes. Wall Street doesn't care about the individual investor anymore. We're not profitableenough. Look at the billions the financial industry has made in recent years from trading, buying andpackaging mortgages and credit cards, financing buyouts and selling ways to reduce risk. That kind ofbusiness drove operating income at Goldman Sachs) to $14.6 billion in 2006 from just $3.3 billion in2002, a 340% increase, and at Merrill Lynch to $10.4 billion in 2006 from $2.3 billion in 2002, a 350%increase. Until they blew up, that is. It's not just that Wall Street's newest inventions -- collateralized debtobligations and asset-backed commercial paper and the like -- are irrelevant to the stuff we care about,like having enough for retirement. Wall Street's actions seem positively dangerous to our goals. It wasn'talways this way. For 20 years, beginning in 1975, Wall Street produced a wave of innovation for middle-class investors that brought more and more people into the financial markets. The revolution began in1975 with the invention of cash-management accounts at Merrill Lynch. From our position in time, it'shard to remember that there once was a day when all we had were savings and checking accounts, andthat the two were so rigidly separated that you couldn't write a check from an account that paid interestIf any of this makes sense to you it's a good opportunity to apply the thinking and tools for analyzing industry/companyperformance we sketched in another post as well:

Winners & Loosers: Rubble Sorting

Page 3of 13

The bottomline - we're not anywhere near a bottom, the industry has broken itself, there are good operators who will getout of this mess and innovators who will come up with the next wave of ideas and business models. In other words therewill be significant opportunities in the Finance Industry over the next several years but they ain't here yet. But it's never tolate to start investigating and building a little shopping list for when things start to turnaround !Good luck and good hunting ! Keep your powder dry for now.

ril 24, 2008

Readings (Finance): It's Over, It's Over...YeahRight

http://llinlithgow.com/bizzX/2008/04/readings_finance_its_over_its.html

Here's our rather massive collection of readings excepts related to theFinance Industry. Judging from the fact that the ETF, XLF, is up almost4% to day clearly the worst is over. Of course that not only is there nogood news on the economic front but that this has been a month ofwritedowns and downsizings gone wild we'll admit to feeling a taddisconnected to the new realities. With this large a collection it'll behard to summarize and just skimming the headlines, let alone the excerpts, will just about put you in the picture. But we'lltake a pass.1. The general theory, other than the talking heads talking themselves into thinking the "worst is over", seems to be thatthis was the kitchen-sink finale and from now on it'll be tough, very tough, but clear sailing. Until we see fundamentalreform and re-structuring we're going to be locked into this boom-bust financial cycle with increasing frequency andseverity of breakdowns.2. The structural flaws of the industry's business models have yet to be addressed because it's the work of a decade ormore - fair, considering it took nearly three to evolve this mess. Speaking of boiled frogs. UBS recently came out with themost candid internal appraisal which could be paraphrased as, "boy, did we ever screw the pooch on this" and "there wasa total lack of either adult supervision or responsible business management". Seems fair to us.3. The writeoffs aren't over and the various institutions are going to be exposed to more as Housing continues its' dive offthe cliff, bad mortgages and securities reset and other asset classes, e.g. consumer debt, business loans, etc. comeunder increasing pressure. Future writeoffs will continue the debacle most likely. Which will in turn continue to putpressure on capital and will likely lead to a need for more infusions - the capital base of many of the banks is inadequateas it is without more writedowns.3. In reaction to the destruction of capital the banks are tightening up on credit enormously. The business cycle was goingto put serious pressure on loans anyway and lead to defaults, losses and bankruptcies. Combine the two and we have yetanother Perfect Storm. And the writedowns, infusions, capital pressures, losses, etc. will feedback on one another. Inother words in addition to the writedown problems we are just heading into a classical increase in loan losses.4. These troubles in slightly different form are percolating to other sectors. While not exposed to the securitization debaclethe Regional Banks are just beginning to feel the pain and are headed down their own slippery slop, I mean slope.5. Accounting for this mess has been disingenous to deceptive with Level III "funny-money" assets protected andinappropriately valued and with various manuvers being used to keep other writeoffs and impairments away from thebalance sheet and the bottomline. Even if nothing changes there'd therefore still be serious risks hiding in the wings.6. Each major sector is having problems from LBO loans to the PE firms. For example no LBO's no fees. And the LBOdebt is getting written off at ginormous discounts. The PE guys are going to have to re-discover their roots of actuallyfocusing on and improving the operations of their portfolio companies. Hedge funds are being called on the carpet as well.7. And this all doesn't mention the burgeoning job losses that have actually been fairly low so far.