Merrill Lynch

The Wall Street bailout legislation, formally known as the Emergency Economic Stabilization Act of 2008, includes limits on compensation for executives of companies receiving taxpayer support.  So what does this mean for taxpayers who are footing the bill?

Not much.

Unfortunately, as drafted the provisions are practically meaningless and will do little to limit the gross payouts already available for these executives. Section 111 of the Act only restricts compensation paid to the top five executives at these companies. In addition, it provides for the recovery, or “claw back,” of ill gotten compensation, that is, performance pay received based upon materially inaccurate financial information.

The “big” provision that has both Republicans and Democrats squealing to their constituents is the provision in the Act that bans payments of “golden parachutes.” These are executive severance agreements that usually pay executives when there is some sort of change in control in the company or, as is often the case, when the executive is fired.  This later provision only applies as long as the federal government holds an equity or debt position in the company.

As noted in last week’s Wall Street Journal, the stakes are significant. The paper reported that executives of financial institutions receiving federal assistance are owed more than $40 billion for past years’ pay and pensions.  Deferred compensation coming due includes $11.8 billion at Goldman Sachs Group Inc., $8.5 billion at J.P. Morgan Chase & Co., and $10 billion at Morgan Stanley.

Since most of these firms haven’t set aside the cash required, they are a drag on current earnings and will be paid out of the corporate coffers.

The liabilities are an essentially a hidden obligation. Even when the debts to their executives total in the billions, most companies lump them into “other liabilities” and only a few of the companies identify amounts attributable to deferred pay.

In today’s Financial Times, it was noted that these Wall Street firms have promised not to use public support to pay these executives’ bonuses.  Bank of America, Bank of New York, Citigroup, Goldman Sachs, JPMorgan Chase, Merrill Lynch, Morgan Stanley, State Street and Wells Fargo all promised to pay salaries and bonuses from existing cash resources.

So lets walk through this scenario and look at the situation at Morgan Stanley.

The company received a capital infusion of $10 billion from the federal government. They stick their newfound money in their corporate pocket (this is a really big pocket by the way) along with their other cash reserves. Let’s say that tomorrow is “bonus day” at the company.  Colm Kelleher, Morgan Stanley’s Chief Financial Officer reaches deep into the company “pocket” and pulls out $21,015,689, which he intends to use to pay himself (this is the total compensation that Mr. Kelleher received in 2007 according to company filings).

“Ooops! That looks like “government” money. Back in it goes,” he muses. Digging around for “loose change,” he eventually finds some “corporate” money and marches off to his bank in the Hamptons where he can console himself over the terrible financial crisis facing America.  This shell game would be laughable if it weren’t our money!

Meanwhile, our leaders in Congress are calling on the government to tighten restrictions on executive pay for these institutions receiving our money. House Speaker Nancy Pelosi and Senate Leader Harry Reid are wringing their hands with concern.  If their last attempt at reining in executive compensation is any measure, we shouldn’t expect real reform anytime soon.

The task of holding corporations responsible for grossly excessive executive pay falls squarely on shareholders. The only problem is that, in years past, the Securities and Exchange Commission has prevented shareholders from raising compensation issues in the form of shareholder resolutions, arguing that such matters constitute “ordinary business” that is exempt from proper shareholder consideration. Let’s hope that, given the massive public policy issues raised by using public funds for executive compensation, the SEC will reconsider its policy in regard to this important matter.

Stay tuned.

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Editor’s note: This article is the third installment in a four-part series on the rise of sovereign wealth funds and what they mean for U.S. investors. Part IV will appear next Friday on GIW.

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Riches in the Sands of Syriana

If only T. E. Lawrence were alive today, he no doubt would be smiling. The British intelligence officer memorialized as “Lawrence of Arabia” for leading the successful Arab revolt against the Ottoman Turks during World War I would surely need a tour guide if he were to return to his old stomping grounds of Cairo, Amman or Damascus. What was once a backwater of political in-fighting among warring Arab clans has emerged a century later as one of the geopolitical “hot spots” of the modern world. Today’s Middle East is a far cry from the world Lawrence of Arabia knew and loved.

The reason, we all know, is simple – oil. And lots of it. The Persian Gulf states are in fact so flushed with it that their export earnings from the commodity has been the single largest source of wealth creation in modern history. Virtually every major oil-bearing country in the region sponsors its own sovereign wealth fund to help manage these growing reserves. Current estimates suggest that those funds derived from oil and gas export revenues account for one-half of the total assets held by all SWFs around the world.

While sovereign funds have existed since the 1950s (the Kuwaiti Investment Authority was the first to be established in 1953) their size and influence worldwide has increased dramatically over the past two decades. In 1990, sovereign funds held about $500 billion. Today, the current total is estimated to be $3 trillion and based on the likely trajectory of current accounts this sum could surpass $10 trillion as early as 2010.

It may surprise some to learn that the Middle East, not China, is at the epicenter of this growth trend. The Carlyle Group declares that the Middle East is now the primary destination for private equity deals and the British bank HSBC estimates that as much as one-third of all project finance involves Middle Eastern projects. According to the U.S. Government Accountability Office (GAO), 28 of the 48 SWFs have been created since 2000, primarily in countries whose foreign exchange reserves are growing through oil revenues or trade export surpluses. The preponderance of those are in the Middle East.

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A number of Japanese corporations that we monitor at JMR Portfolio Intelligence have been in the news lately. As reported in a September 23, 2008 article by Marcus Gee, the Asia-Pacific Reporter for Canada’s The Globe and Mail, “When the Japanese asset bubble burst in the early 1990s, Japanese banks retreated to their own shores to lick their wounds. But the caution fed by that trauma meant they were hurt less by the U.S. subprime credit crisis than many U.S. and global lenders because they were less exposed. As a result, they are flush with cash at the very time that U.S. financial institutions are desperate for investment.” More recently it has become clear, however, that Japan is less unscathed than previously thought as evidenced by turmoil on the the nation’s benchmark Nikkei. Yesterday BBC News reported that Japan’s Nikkei 225 index fell 6.36% to its lowest close since October 1982 amid concerns at the yen’s high value.

Nevertheless, here are some highlights of the major activity that is taking place currently:

• Mitsubishi UFJ Financial Group (MUFG), Japan’s largest bank, is set to acquire 10-20% of Morgan Stanley
• Nomura Holdings Inc., Japan’s largest stock-broking firm, will acquire the Asian remnants of Lehman Brother’s
• Tokio Marine Holdings, Japan’s biggest property insurer, has acquired the U.S. insurer, Philadelphia Consolidated
• Mizuho Financial Group Inc. Japan’s second-largest bank by assets, announced plans to invest $1.2-billion in Merrill Lynch and $120-million in Evercore Partners, a U.S. mergers adviser.

And the list goes on. In his report Mr. Gee states that “With savings-obsessed Japanese holding more than $15-trillion in household assets, Japan has a huge pool of capital that could, in theory, help bail out a credit-starved Western world.” Yet, he goes on to explain that there are two schools of thought. Japan may be making moves that could re-establish the country as a financial powerhouse. On the other hand, it is possible that “Japanese banks are seeking to expand abroad because conditions at home are so poor. After suffering through the “lost decade” of the 1990s, then recovering in the earlier part of this decade, Japan is in economic straits again.”

Time will tell how things will shake out in this ever-shifting global financial landscape. In the meantime, perhaps we should all brush up on our Japanese…just in case.

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Editor’s note: This article is the first in a four-part series on the rise of sovereign wealth funds and what they mean for U.S. investors. Part II will appear next Friday on GIW.

Rolling Snake Eyes

For those of you who have played craps, you know that it can be a pretty easy game to win at, even when you really don’t know what you’re doing. When someone is on a hot streak, everyone at the table can partake in the winnings. A main nemesis in the game is rolling the dreaded “snake eyes” (what’s known as a pair of pips among gamblers). Interestingly, and perhaps not coincidentally for our purposes here, the etymology of the reference traces back to 1929 – the onset of the Great Depression.

Several months ago, sovereign wealth funds (SWFs) from Singapore, Kuwait, Saudi Arabia, Abu Dhabi and Korea stepped up to the table to test their luck. These five government-sponsored funds went high stakes with their chips by collectively pouring nearly $60 billion into Citigroup, UBS and Merrill Lynch. These “experts” (bolstered by their outside advisors) were confidant that the sell-off which had rampaged Wall Street beginning in mid-2007 and continuing into early 2008 had reached its end. They thought they were correctly timing their purchase at the bottom of the downturn. No such luck. There was more carnage to come. Snake eyes all around.

Still smarting from their dramatic losses, many of these funds were invited in June to return to Casino High Finance, this time by Lehman Brothers. But unfortunately for Richard Fuld and his band of con artists, the managers at these funds had learned their lesson and declined the invitation to return to Las Vegas for one more roll of the dice. We will never know if that second roll would have brought more misery or good fortune, but something tells me the odds favored the house.

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