What Went Wrong - Corporate and Educational

As I peruse through the earnings reports of a number of firms this quarter, I am struck by the carnage that has been wrought on companies like GE (NYSE: GE) and Textron (NYSE: TXT)

Recessions are obviously bad news for all firms, and large industrials are no exceptions.  But the destruction to these firm's value is not really found in their net production of "things", like Jet Engines and Avionics.

No, that is found in these firms attempts to get too cute by half by becoming a "financial superstore" along with a builder of "things."

Some of the blame for this insanity lies with the CEO, who is the "helmsman" in any firm.  But not all.

The rest lies with the financial geniuses that have been cranked out at an ever-increasing pace by our "higher" education system.

And when I say "higher", I mean this sort of "higher":

(Heh, if its good enough for a swimmer.....)

In all seriousness, this nation's firms need to take a serious look inside their board rooms, executive suites and their corporate mission statement.

If there is a place where I "missed it" during the last eight years, this has been it.  General Electric and Textron, as just two examples, became finance companies that happened to build jet engines and avionics, instead of a jet engine company that happened to finance some of its customer's purchases.

Finance, in the end, must return to whence it came.  And "whence it came" predates the 1990s - because the last set of really impressive blow-ups in the industrial and equipment spaces happened for the same reason this set did.

Anyone remember Lucent?  I do - very well.  Spun off from AT&T Bell Labs, Lucent was a telecommunications hardware powerhouse.  The 5E telephone switch, internet call termination equipment and more.  They bought up Livingston, a maker of common terminal equipment for ISPs (much to my chagrin) along with many others.

Enter a whole host of sprinting telecommunications firms, among them Winstar Communications.  Winstar had a vision - they were going to take over the (telecommunications) world.  A common dream, among entrepreneurial firms, but one that is frequently not realized; after all, only one firm in ten among small businesses even survive five years, and among midsize and large firms there are plenty of "lots of pieces" stories scattered on a field of what was pristine grassland before the firm did a lawn dart imitation.

Unfortunately Winstar relied on market-based leverage - that is, the ability to go into the marketplace and borrow money like mad, using the word "Internet" as the key that unlocked the door.  Greedy investors of all stripes smelled blood (money) and quickly beat a path to their door, allowing them to access funds from both the equity and debt markets. 

But that wasn't enough.  See, Winstar had tremendous ambition, but pulling fiber, lighting it up and then providing the switching, infrastructure and terminal equipment to actually make that fiber useful is an expensive thing.  You can't factor your employees but you sure can your receivables and you can finance your equipment.

Enter Lucent.  Lucent was also on a quest to take over the world, but in this case their world was Internet-related hardware.  They (correctly) surmised that plain old-fashioned voice telephone switching was going to become a business that was destined to end in the tears of collapsing margins.

Lucent was a perfect fit.  But Winstar wanted to conserve capital, as great profits were just around the corner - but current cash is a finite resource.  Lucent was only too happy to oblige, and financed billions of their own hardware internally.

Thus the die was cast.

On 4/18/2001 Winstar Communications filed Chapter 11 and sued Lucent, alleging a breach of obligation by Lucent in their strategic partnership.  The triggering event for that filing was a debt payment that Winstar defaulted on in the amount of $75 million about a week previous.

What went wrong?

Plenty.  At its root, Winstar was a company that, like many, was engaged in a build-out race that was extremely difficult to manage successfully.  They, along with many others including MCI/Worldcom, failed to successfully navigate the shark-infested waters.  Among the sharks were unrealistic and even fraudulent claims by market participants - the most often-cited being the claim that "The Internet is doubling every three months!"  That was true in 1995, when Win/95 first hit the scene - I can attest to it, as I was running a company in that space (a firm that ultimately was sold to Winstar!)  But by 1998 that explosive "new adopter" growth was over - yes, there was growth to be had, especially in building out business-class services and enhancing capability, but the industry had also matured greatly and was in its "let's see how much margin we can squeeze out" phase.

At the root of Lucent's problems, however, was its willingness to get away from its core competence and try to make money off esoteric financial products.  Sound familiar?  It should - it's what has brought down the share prices of mighty industrial firms like General Electric and Textron this time around.

Do we ever learn?

It would appear not.

Why do I wax poetic (or polemic, depending on your point of view) about this aspect of the markets? 

Because if we are to recover and find our way in this economy, and to become what America has been known for through most of its 200 years, we must recognize that finance is a utility, not a means of making money in and of itself.

CNBC and the rest of the "punditry" is entirely missing the point.  Everyone is looking for how we "unfreeze" the credit markets, but this is wrong-headed and stuck - literally - in the 1990s.  We learned exactly nothing from Lucent's blowup, and now we get a second try at learning these lessons, this time spread among not only our banks but our major industrial firms as well.

There is no shortage of finance as a utility function.  There never has been and there never will be.  Short-term self-liquidating trade credit for sound firms who didn't get "too cute by half" is and will remain available.  Finance for a home purchase where you put down 20%, have a reasonable coverage ratio (36%) on debt-to-income and are financing for a fixed term of years is and will remain available.  Finance for car purchases where you put 20% on the table and finance for three or four years is and will remain available.

What's not available and should never return are the "too cute by half" games that far too many financiers and financing arms of major corporations have engaged in. 

And let me be clear - essentially all of these deals have and do rely on some sort of misrepresentation - whether it be starry-eyed "blue sky" projections (e.g. "home prices never go down") or out-and-out fraud ("stated income" loans and inventing values to plug into models when you're not provided them.)

Just last night S&P downgraded a monstrous set of "ALT-A" mortgage deals (warning - Excel link from S&P) that reads like a "who's who" of various banking institutions, both extinguished and standing.  Washington Mutual, Bank of America, IndyMac and more - all the "big names" in the ALT-A space are represented.  Many of these deals were downgraded to "D", or DEFAULT.  So much for those who claimed that the "market prices" on these securities were "too pessimistic"; will we see those people paraded on CNBC and humiliated in public?  Of course not.

We the people - as shareholders either directly or indirectly through mutual funds and 401ks - must demand that the "kings of finance" that come out of these so-called "business schools" be shown the door and go clean the toilets at WalMart.  I lay a major part of the blame for this mess square at the door of these so-called "higher education" institutions where they crank out MBAs by the boatload, most of whom have spent six years figuring out how to ignore the mathematics of exponents and the inevitable liquidation that must follow credit expansions.

I've met more than my share of these geniuses and they all point to their "superior education" while the firms they work for go straight down the drain as a direct consequence of their attempt to get too cute by half with financial engineering.  An $80 HP-12C tells you more about the truth of exponential functions that lie at the root of all interest-bearing financial systems than a $200,000 "education" from these bastions of old-growth cruft.

We can only produce if we produce.  I know, its a tautology, but the only free lunch in the world comes from the Sun.  You can grow it, mine it or manufacture it - no matter what "it" is.  That's all the value there is; when the wrench-turning and welding stops the value-adding ends.

Everything else you do is a value SINK, not SOURCE.

If I build a jet engine I have a jet engine.  It can propel an airplane, and that has value.  But when I take that jet engine and turn it into a discounted cash flow and then slice and dice it into tranches and sell it off into the marketplace via my "financial wizards" I am consigned to get less in total than if I just sold the engine outright.

Why?  Because nobody works for free, that's why, and the only way I can pretend to get more value this way than via direct sale is when I cheat.  That is, when I invent a model that has too-rosy assumptions, either because I have stars in my eyes - or fraud in my heart.

We as Americans must look at the future differently and discard the ways of the past.  We must eschew the institutions who refuse to take responsibility for turning out MBAs by the boatload and consign both their graduates and the institutions themselves to the dustbin of history.  These people and these institutions have not advanced our common wealth and weal - they have destroyed it. 

Finance is a utility function and we as Americans had better recognize that as the fact that it is.  We need financing of some sort; throughout history there has been a means of financing production over short periods of time.

But financial engineering is not and never can be a profit center.  It is a profit drain in that for each hand a deal passes through more value is extracted - not added.

All claims to the contrary are fraudulent on their face and must result in criminal penalties and civil disgorgement of every nickel allegedly "earned". 

We would not be here were it not for the "financial engineering" that has been fraudulently sold off to the world as a means of "creating value."  If we are to return to financial and economic stability instead of a world where "bubble-blowing" is the meme of the day we must eject both the progeny of these "higher education" institutions as well as the institutions themselves who refuse to accept their share of responsibility for the mess they have both fomented and profited from.