Valuation of Bear Stearns

They say Bear was sold for a song- around $230 mn. Not true. JP Morgan has taken a charge of $6 bn, so the cost comes to $6.3 bn. The building costs $ 1bn. So, we could say the financial assets were valued at $5.3 bn. Last week, the market was a little over $7 bn. So, we are talking a discount of 25% to market price before this week's run on Bear. I read that Sanford Bernstein had valued the bank at $7.7 bn before this week's crisis.

Nothing wrong with the valuation- except that Bear shareholders have almost wiped out.

Alan Greenspan on risk management

The erstwhile Oracle of the Fed holds forth on risk management in FT:

I do not say that the current systems of risk management or econometric forecasting are not in large measure soundly rooted in the real world. The exploration of the benefits of diversification in risk-management models is unquestionably sound and the use of an elaborate macroeconometric model does enforce forecasting discipline. It requires, for example, that saving equal investment, that the marginal propensity to consume be positive, and that inventories be non-negative. These restraints, among others, eliminated most of the distressing inconsistencies of the unsophisticated forecasting world of a half century ago.

But these models do not fully capture what I believe has been, to date, only a peripheral addendum to business-cycle and financial modelling – the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve. Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved. To be sure, we tend to label such behavioural responses as non-rational. But forecasters’ concerns should be not whether

Bear Stearns' collapse- LTCM all over again !

Bear Stearns, one of the top five investment banks in the US, ends its 85-year old existence as an independent bank. JP Morgan announced on Sunday that it is acquiring the firm for $2 per share or a total value of $235 mn. This does not reflect the full cost to JP Morgan. Bear Stearns faces several lawsuits relating to the collapse of its hedge funds, so Morgan has to set aside $ 6bn towards litigation costs. Morgan acquires the $1 bn headquarters of Bear.

What a fall, my countrymen! Bear's share was valued at $169 last year and $30 last Friday. Bear's top management and hundreds of employees who have been rewarded heavily through stock options- think of what happens to their investment!

Jimmy Cayne, the chairman, himself was said to be poorer by more than half a billion dollars in a week's time. His holdings were worth $ 1 bn at one time. Now, it's said he gets all of $12 mn. People will say he asked for it- he must bear responsibility for pushing Bear into high-risk mortgage securities. That's not all. FT reports that JP Morgan is likely to sell off many of the pieces of Bear, including the investment bank, and lay of many of Bear's 14,000 employees.

Bear Stearns was different on Wall Street. It did not rise to the top meteorically. It clawed its way gradually without fanfare, without headline-grabbbing acquisitions, for instance. Its management culture was distinctive. It was an aggressive risk-taker and prided itself on its ability to manage those risks. Insiders used to talk of 'sweat sessions' between top management and leading traders where management would grill traders on their positions- the grilling was so intensive that those who concealed anything would start sweating.

Until about a decade ago, Bear shunned MBAs and management consultants. It hired ordinary guys with spunk and trained them to deliver. Base salary for top management was among the lowest on Wall Street; the firm believed in heavily compensating those who delivered. A big chunk of the firm's shares were held by employees awarded stock options over the years- that's why Bear's collapse will hurt its employees even more. Bear was also less diversified than other Wall Street firms and less international in its operations. But it kept shareholders happy year after year until it was undone by the disaster that hit its hedge funds recently.

Did Bear deserve such a fate? Of course, it was highly leveraged. Its capital of %11 bn was used to support a balance sheet of nearly $495 bn. But that's not new. Lenders have been happy to make funds available to Bear. It's just that, in today's conditions, confidence is scarce. That makes all the difference to a highly leverage institution.

Rumours have been rife about Bear's troubles, so every lender wants to pull out. The only way Bear can meet their demands is to sell assets. Asset prices tumble, the liquid assets disappear and then only illiquid assets are left. A liquidity problem quickly becomes a problem of solvency. Those who watched the collapse of LTCM will have a sense of deja vu.

Farm loan waiver: net impact on banks

Okay, the FM has given the details of the farm loan waiver package. I notice that the commercial banks' exposure in the overdues of Rs 60,000 crore is 35% or nearly Rs 21,000 crore- a lot higher than the figure of Rs 10,000 crore that papers had mentioned earlier. Cooperatives and regional rural banks account for the rest.

As for the package itself, the government will provide cash to lenders as follows:

• Rs 25,000 crore in 2008-09
• Rs 15,000 crore in 2009-10
• Rs 12,000 crore in 2010-11
• Rs 8000 crore in 2011-12

I am still not clear as to whether the Rs 60,000 crore constitutes gross NPAs or net NPAs. The figure is said to constitute "all farm overdues" in the eligible categories. That sounds like gross NPAs.

This means that banks that have made provisions can write back these provisions and make gains as a result. But, in 2008-09, they will have to write off the entire amount, including the unprovided portion. So, in 2008-09, their bottomline will take a hit in net terms. In the subsequent years, there will be gains to the bottomline as cash flows in against amounts written off.

However, if the banks are writing off Rs 60,000 crore, the compensation in present value terms is smaller than this amount. Banks will gain to the extent of provisions already written off; they will lose to the extent that the compensation is less than Rs 60,000 crore in present value terms.
It's hard to say what the net effect is. Probably a small gain, although this could vary from bank to bank. On the whole, listed bank stocks should gain.

Some rosy forecasts for the Indian economy

Interesting.....Investment banks' and commentators’ pessimism about the outlook for the Indian economy in 2008-09 is not shared by others. J P Morgan has revised its GDP forecast for India downwards to 7% for 2008-09.

In contrast, Finance minister P Chidambaram thinks the Indian economy will grow at 8.5% this year. So does the PM’s economic advisory council headed by C Rangarajan. India’s chief economic statistician, Pronob Sen, forecasts growth of 8%. The CMIE expects growth of 9.1%, higher than the 8.9% it projects for 2007-08!

Fair value accounting in the financial sector

I have flagged this issue before. Fair value accounting has come to the fore as a vexed issue in the present financial market crisis. Loans are not marked to market, so banks should not have had to worry. But they hold marketable securities and have huge positions in derivatives, both of which are marked to market. That is why banks- and not just investment banks or hedge funds- are feeling the heat this time around. FT carries a detailed report:

As the losses rise, anxiety is growing over the way these hits are being
measured. At present, accounting is dominated by a concept of “fair value”: companies are expected to report the value of their holdings in as “current” a manner as possible, which in practice means marking to market prices.

However, there is mounting concern that this approach creates distortions when markets are as dysfunctional as they are now. Indeed, some bankers fear that the system is actually making the crisis worse. Far from offering a reassuring yardstick, it is forcing banks and hedge funds to sell assets in a manner that is stoking investor panic...

...Many investors are sceptical about the accuracy of models used to
estimate the price of untraded assets. “When markets dry up there are problems with mark-to-market disclosure because there are no markets. Then people have to use mark to model but there are big problems with that too,” observes Charles Goodhart, professor of finance at the London School of Economics.

US will avoid recession?

I don't get this. When US economic prospects looked grim a couple of months, the stock markets seemed not to notice. Now even the occasional good news, including the Fed's determined effort to stave off recession, gets shrugged off by the markets.
I am among those who believed- and still believe- that the US economy could ride out the financial crisis without a serious slump. The University of California's quarterly Anderson forecast, released this week, is upbeat compared to some of the other stuff we have seen recently. The forecast expects US GDP growth of 1.5% this year, rising to 3% next year. Growth in 2007 was 2.2%.

The other good news comes from the Fed. The Fed still believes that the US will avoid a deep and prolonged recession such as that experienced by Japan in the nineties. Why? Because US policy makers will do what it takes to avoid recession.

Joy on Wall Street!

Wall Street continues to be rocked by the sub-prime crisis but there is some joy from an unexpected source. Mark Spitzer, Governor of New York and former attorney general of the state, is in trouble over his alleged involvement in a high class prostitution ring. Spitzer has tendered an apology of sorts and is under pressure to quite after federal wire-taps are said to have implicated him as a client of the prostitution ring.

Spitzer went after Wall Street firms in a big way and was responsible for the multi-billion dollar settlement with top firms after the Internet bubble collapse in 2002. Spitzer also prosecuted those involved in two prostitiution rings at the time. Seeing this crusader of yesteryear the receiving end has given some delight to investment bankers who took some pounding from him.

Legions of Wall Street’s bankers, traders and investors relished the dark clouds enveloping New York governor Eliot Spitzer, who on Monday informed his most senior administration officials that he had been tied to a prostitution ring, the New York Times reported.

.....“The guy is a quintessential hypocrite,” said Jeffrey Gundlach, chief investment officer of TCW Group in Los Angeles, which invests $160 billion. News of Spitzer’s political fall from grace, however, did little to lift the mood on Wall Street. “I would think the markets would rally off this news as it brings some relief to Spitzer’s dealing with Wall Street and traders,” said Gundlach of TCW

Incidentally, bashing Wall Street has been one sure route to high office in the US. Spitzer is not the only one to have made it big. He was only following in the footsteps of former New York Rudolph Guiliani who made a name for himself in an insider trading scandal when he was New York attorney general.

Objections to loan waiver scheme

I read that the financing of the loan waiver scheme announced in the budget has been firmed up. The FM will disclose this to parliament on March 14.

I have been a guarded supporter of the scheme as readers of this blog would know. I think it's a good scheme as long as the burden is borne by the government and not by the banks.

In the meantime, I have seen a barrage of criticism, mostly misplaced. In TOI on Sunday, Gurcharan Das called the scheme 'immoral' saying that the government should not break the bond of commitment that the borrower has towards the lender. As immoral, I suppose, as the US Treasury which has asked banks to restructure many of the sub-prime debts.

The contractual relationship between borrower and lender is redone all the time- it may not be at the best of the government. But when this happens to businesses, there's not a squeak from anybody. Think of some of the big names in Indian industry that have benefited from such restructuring, which often includes sacrifices from banks.

Das says that hereafter farmers will not have incentives to repay. Not true. As we know in the case of businessmen, you can get away with default only once. Once you default, you lose access to credit. So there are huge penalties to wilful default. This holds for farmers as well. I would only say that we should extend the newly created credit bureau to the rural areas and keep tabs on individual payment histories to strengthen incentives to repay.

Swaminathan Aiyar, writing again in the Sunday TOI, says that banks will hereafter be wary of making loans to farmers and such loans will be hard to come by. Not necessarily. Most of the bigger banks are government-owned. Both government and the RBI will be leaning on banks to meet loan targets (which is why rural credit has doubled in the past three or four years). Banks may try to get around this by avoiding small farmers but keeping separate targets for each category of farmer could address this issue as well.

Aiyar also says that farmers who have been repaid loans will be angry that others are being cosseted and this will cost the UPA dearly at election time. Do businessmen, who have repaid loans, get upset when businesses in distress get special treatment from banks? I don't know why farmers should behave any differently.

Subir Gokarn, writing in Business Standard, says that we need to ensure proper incentives hereafter giving a concessional rate on fresh loans to those who have made repayments this time. This makes sense- and indeed ties in with the idea of a credit bureau I mentioned above that will monitor payment histories.

The scheme brings a smile to farmers' faces. Banks will have their balance sheets cleaned up. Government can minimise the burden to itself by raising funds through disinvestment- and seeking the Left support for this, saying it's for a good cause. It's win-win for the most part. Who loses? Economists and columnists!

No housing bubble in India

Housing prices elsewhere have collapsed. There has been talk that India might witness such a correction. Rubbish. There's no real estate bubble here, as Keki Mistry, MD of HDFC pointed out recently.

True, housing prices have shot up. True also that EMIs have gone up thanks to the increase in interest rates. But, compare affordability- income in the relevant segment to EMIs- with those of 15 years ago and you realise how far we have travelled. This ratio is 4.9 today, according to Mistry, compared to nearly 15 about ten years- an improvement by a factor of three!

Affordability is better for a number of reasons:

• Sharp increases in income
• Lower interest rates
• Tax incentives for housing

Remember this the next time somebody comes up with a doom scenario for India arising from a collapse in housing prices similar to what we have seen elsewhere.

Exaggerated bank 'losses' in sub-prime crisis

ICICI Bank makes a provision of $265 mn against mark-to-market positions. The stock tanks- and so does the Sensex. Does this make sense?

I think not. There is huge overshooting of asset prices in panic conditions- that is, prices go well below "fair" value. Naturally, mark-to-market losses will be commensurately high. Once the market bounces back, these provisions will be written back.

We have it on the authority of Fed Chairman, Ben Bernanke, no less, that bank writedowns have been overdone in the present crisis. He said as much in his congressional testimony on February 28. How does this happen? Many of the assets are not traded. So marking to market is done using certain indices. These indices' movements don't correctly reflect actual losses. One analyst points out that one index shows an 8% potential loss in commercial real estate when the real loss has been one quarter of 1%. As the Yanks would say, the thing sucks.

There is a larger issue here: how do we enforce mark-to-market requirements in such crisis situations? As Gillian Tett points in the FT, "The western financial system is caught in a trap. On the one hand, there is an urgent need for clearing prices to be established for impaired assets to restore confidence; on the other hand, if this is done in a mark-to-market world, there is a risk that some banks will run out of capital."

One solution proposed is a six month grace period for marking to market. But this could undermine investor confidence- people won't know what sort of losses a bank is hiding. I can't see an easy way out. But I am glad we don't have mark-to-market requirements for bank loans although investment bankers have long demanded this in the interest of having a level playing field between investment banks and commercial banks. Can you imagine the havoc that could wreak in such conditions?

Coming back to ICICI Bank, the stock price is close to its last FPO price. If I were an analyst taking a long view, I would put a 'buy' recommendation.

PIL challenge to loan waiver scheme

The Supreme Court has refused to hear a challenge to the Rs 60,000 crore farm loan scheme proposed in the recent budget, TOI reports. Chief Justice Balakrishnan said that the SC could not entertain the PIL at the present stage when the proposal was being discussed in Parliament. Any hearing could happen only after the proposal had been approved by Parliament.

However, the TOI reporter says that the legal challenge could still continue. He points out that in the case of Mandal II, a bench of the SC decided to entertain a challenge even before the relevant Bill had been passed by Parliament:

Going by Justice Balakrishnan's reasoning, the PIL should not be entertained till at least the proposal is pending in Parliament. In other words, it should be dismissed outright. But since it could come up before any of the benches, there is no predicting the outcome of the PIL.

Barely two years ago, a bench headed by Justice Arijit Pasayat entertained a PIL on another contentious issue, Mandal II, even before the Bill concerned was introduced in Parliament. And when the Bill was subsequently introduced, Justice Pasayat stretched the system to the extent of telling Parliament not to proceed with it till the court decided its validity. It was only after the government's counsel protested that the judiciary could not interfere with legislative functioning, Justice Pasayat toned his order down to saying that a copy of the parliamentary standing committee's report on the Bill should be "placed in a sealed cover before this court."

In the event, the sealed cover was rendered meaningless as the government gave the report to the court only after it was tabled in Parliament.

The general rule, however, is that since a Bill is merely a proposal and not legislation, it falls outside the domain of the courts. This is because a Bill has no legal force and is liable to be changed or even dropped by Parliament.

As for the farm loan package itself, I think the opposition to it is overdone. The cost of Rs 60,000 crore is eminently affordable. It is a one-time cost whereas the tax deductions given on income tax - which would amount to Rs 4000 per month for those earning more than Rs 10 lakh- are forever. My main concern, as I point out in my Et column, is that the banking system should not be loaded with the cost. The government should pick up the tabs.

There are , of course, many implementation issues. Farmers who have repaid their loans are being penalised. So are banks that have already made provisions. But the point about such packages is that you help those in distress. Those who can pay or who can cover the cost do not need government support.

There are other issues. Distress may not have to do only with the size of the farm- somebody with over 5 acres in a rainfed area may be worse off than somebody with a small farm in an irrigated area. I have also seen reports that the package may not help those who have borrowed heavily from money-lenders. Note, however, that the Radhakrishna committee on distressed farmers had favoured help to this category as well through a long-term loan.

Code on bankers' pay

As somebody who was amongst the earliest to raise the issue of incentives in banking as a source of instability, I am gratified to note that a code on bankers' pay is under consideration at the Institute of International Finance.

Ideas being floated include bonuses being deferred until the full impact of bankers’ strategy is clear to prevent them benefiting from short-term high-risk bets that subsequently turn sour.

Another variant would see those who lost money for their businesses having to earn it back before they secured new bonuses. However, the concept is likely to prove highly controversial, particularly among investment bankers in London and New York. “It does not sound workable,” said a senior Wall Street executive, who argued that it was highly unlikely Wall Street banks would agree to any kind of uniform compensation rules for fear of giving up a competitive advantage.

Centre's subsidy bill

How large is the central government's subsidy bill? The latest budget papers show a figure of Rs 66, 537 crore. Fertiliser and food subsidies acount for Rs 32,000 crore and Rs 31,000 crore respectively. Then, there are petroleum, interest and other subsidies.

In addition to these figures, the budget shows off-balance sheet bonds on account of over Rs 18,000 crore. This is just 0.3% of GDP. According to the Economic Survey, subsidies as a proportion of GDP have been declining over the years- they have come down from 1.7% of GDP in 2002-03 to 1.1% in 2007-08. Add the 0.3% of off-balance sheet subsidies to the figure of 2007-08 and it is 1.4% - still lower than the figure of 2002-03. So, it does appear that even if the absolute amounts of subsidy are going up, as a proportion of GDP, subsidies have, in fact, been contained.

The fly in the ointment is the estimate of off-balance sheet subsidies. The PM's Economic Advisory Council estimates off-balance sheet bonds on account of subsidies at 2% of GDP, way above the government's figure of 0.3% of GDP. The IMF had estimated at 1.2% of GDP.

The differences arise because the government has not met its subsidy commitments in full. But these commitments have to be met and we should expect more issuance of bonds. If we add the EAC's estimate of 2% of GDP to the figure shown in the budget, the total cost comes to nearly Rs 3.2% of GDP. That would be a significant increase over the level of subsidies in earlier years.

We need some clarity on the total amount of subsidies- in the budget and outside it.

What is the correct fiscal deficit figure?

The budget for 2008-09 shows a fiscal deficit to GDP ratio of 2.5%. Critics scoff at this figure. They say it does not include three things: the proposed loan waiver of Rs 60,000 crore, the Sixth Pay Commission report and off-budget subsidies.

The details of the loan waiver, we are told, will be revealed later. The key issue is what proportion of the burden will be borne by the exchequer and what proportion by banks. The costs of the exchequer, it is reasonable to suppose, will be borne through the issue of bonds. That too in instalments. Assume that Rs 40,000 crore is the burden on government and this is borne over three years. The annual impact of the fisc would be insignificant- 0.3% of GDP.

The Sixth Pay Commission is estimated to cost around 0.5%of GDP annually. Arrears may be staggered over a few years.

The FM claims that,for the first time, there is transparency in respect of off-balance sheet subsidies. These are shown in 'budget at a glance' at around 0.35% of GDP. The PM's Economic Advisory Council estimates these at 2% of GDP. Queried on this point by Business Standard, the FM retorted that the question should be put to the EAC!

Where lies the truth? Well, the FM js technically correct in that the figures shown in the budget show the value of bonds issued thus far. But the bonds issued so far do not cover the dues payable to fertiliser and oil companies in full- this figure is the correct figure for contingent liabilities of the government of India because the government is committed to paying these.

If the disclosure in the budget is what is meant by transparency, we can do without it.

Incidentally, going by the above assumptions, the adjusted fiscal deficit would be closer to 5.5% of GDP if you include the value of subsidies payable in full.

Some thoughts on the Economic Survey (2007-08)

The Economic Survey came out yesterday and I was on CNBC TV to give my comments.

There are a couple of issues I would like to flag. The Survey notes that we could achieve one of the FRBM targets by 2008-09, namely, the reduction in fiscal deficit to 3% of GDP. We are unlikely to meet the target of reducing revenue deficit to zero. I have a problem with the suggestion that we should consider even further reduction in the FRBM targets.

What's the rationale for a further reduction? The Survey argues that such a reduction would make monetary policy more effective- it would be easier to bring down interest rates. I do not find this line of argument persuasive.

We have had even higher levels of fiscal deficit in the post-reform years and yet interest rates declined. Why? Because in an open economy, interest rates are not determined only by domestic savings- we have access to savings from outside. Secondly, as the Survey itself notes, there has been a trend towards narrowing of the interest rate differential between India and the developed world in recent years.

The danger with pursuing the Survey's line of argument is that we lose out on a key item of expenditure, public investment. As I argued in my recent ET column, I actually favour a relaxation of the FRBM limit so as to permit larger public investment in infrastructure (and here I include investment in agriculture) which has been languishing in recent years.

This will upset fiscal purists. But the point is that we should not get carried away by slippages in respect of deficit targets at the center. The states have been doing better than expect and as a result the combined fiscal deficit of the centre and the states, which is what we should be focusing on, is likely to be within the 6% limit stimulated by the Eleventh Finance Commission by, say 2008-09- perhaps even if we include off-budget bonds and the Pay Commission impact !

All our deficit targets were set at a time when the optimistic expectation was of growth of 7-7.5%. Once you move into the 85.-9% range, you have that much more flexibility in respect the deficits you can run up. Timidity is likely to be our greatest enemy.

The other comment is about the laundry list of "reforms" that the Survey proposes. I notice that this is no longer the list we saw through the nineties and until a few years ago- cuts in subsidies, downsizing of government, labour market reforms, privatisation, all taken straight out of the infamous "Washington Consensus".

No, today's list includes a more liberal FDI regime for insurance, retail trade and banking, private sector entry into coal, deregulation of fertilisers, sugar and drugs, etc. Now, we can debate the merits of these proposals but how critical are these to growth? Are they saying that we can't get to 9% growth without these? If they are, then they are dead wrong.

None of the earlier "reforms" was seriously implemented and yet we move from 6.5% to 8.5%. I daresay that without the latest set of reforms we will get to 9%. Stay focused, I say, on creation of capacity in physical and social infrastructure and growth will take care of itself.

Are corporate leaders noble souls?

Look at material on corporate leadership and you will find loads of stuff on "values", empathy, caring, integrity, social responsibility, etc. Listen to corporate leaders on TV and you will find the same stuff- they will come across as decent folks with strong family values and lots of humility, concern for colleagues, society and nation. In other words, noble souls who are wonderfully balanced - and with loads of intelligence and drive to boot.

How far does this accord with reality? Well, apparently the film, There will be blood, for which actor Daniel-Day Lewis won the Oscar this year, has a different view. It shows an oil prospector who goes on to make fortune and destroys people along the way. The history of business enterprise is replete with such leaders, not the evolved souls portrayed in the business media. Luke Johnson, chairman of Channel 4, writes in FT:

As you claw your way to the top of the capitalist heap, the struggle can blunt your senses. All too often self-made men have come up the hard way and they see existence as survival of the fittest. Commercial success is about endless tough decisions – getting out of messy situations that haven’t worked, beating the competition, running a low-cost operation and so forth.

But sometimes the oxygen in the boardroom can get mighty thin and bosses lose perspective. Partners, family and friends can get sacrificed for another deal, another dollar. Occasionally paranoia sets in: it appears everyone is out to steal your money, seize your crown. Bright rising stars are seen as a threat, and are dispatched.

Loyal supporters are suddenly seen as spies. Too often, the super-rich end up surrounded by flunkeys and parasites, the most apocalyptic example being desperate old Howard Hughes with his Mormon handlers, going mad in a Las Vegas hotel.

Alas, there is great truth to all this. Those who have watched CEOs and business tycoons from close quarters are often struck by their utter lack of scruple and often at how emotionally unbalanced they are. That is because, in hacking their way to the top, many of these people manipulated, deceived, cheated and sucked up as required.

A certain lack of scruple- and particularly the ability not to strike a dissenting note- is virtually a requirement for making it to the top. Most people have no difficulty associating this trait with politicians. But there are politicians in every organisation- and they are no different from those who practise politics for a living.

Why business doesn't care for b-school academics

Managers don't take b-school academics and their output seriously- most journal papers are not even read by the academics themselves, leave alone by practising managers.

How come medical and law school academics' papers are read? How come those schools influence practice more? Michale Skapinker has an explanation in FT:

Law, medical and engineering schools are subject to the same academic pressures as business schools - to publish in prestigious peer-reviewed journals and to buttress their work with the expected academic vocabulary.

The reason that real-life lawyers, doctors and engineers have no problem with their research is not because they are smarter than business people, but because the research assists them in what they do.

Lawyers and doctors proceed from a corpus of knowledge and build on it. They look at what their colleagues do and try to do it better.

They are also dealing with more predictable material. People's hearts, lungs or nervous systems behave in similar ways. The way people behave in the office is far more mysterious. What works in one company may not work in another.

Managers tend to be practical rather than theoretical, proceeding by trial and error: this works, that doesn't. Rather than building on competitors' achievements, the best often seek to do something different.

Business schools can describe what innovative companies have done: Harvard's case study method does just that. But this is, by definition, backward-looking. Business school professors will struggle to tell us what innovators will do next. If they knew, they would surely do it themselves.

Northern Rock nationalisation shocker !

There is shock and dismay in some circles in UK over the decision to nationalise the failed bank, Northern Rock. Many in Thatcherite Britain see it as a huge ideological setback when, in fact, it is no more than an acknowledgement of the ground reality that a private acquisition was just not possible.

It is one of those situations when the government is compelled to step in. Will Hutton points out in the FT that this compulsion has manifested itself before. Governments took over major private enterprises in the UK and re-privatised them when their fortunes improved. Further, private enteprises do benefit from a variety of government actions that fall short of nationalisation:

As the postwar period wore on, nationalisation became more obviously justified only by pragmatism, whatever the rhetoric. The government of Edward Heath did not nationalise Rolls-Royce for any reason of socialism; it took it into temporary public stewardship because its technology was deemed too important to allow it to slide into bankruptcy – a decision amply justified by events. The government of Harold Wilson could justify the nationalisation of the bankrupt shipbuilding industry and British Leyland only because it was the last hope of saving them and, as it transpired, organising their orderly dispatch. The Bank of England did not “nationalise” the secondary banks in 1974; it operated a financial lifeboat for the same pragmatic reason that today’s government has ended up owning Northern Rock. It was likewise for this reason that the US government came to own Continental Illinois in the 1980s.

......There are few companies in the FTSE 100 that have not in some way had their franchise today shaped, supported and helped by government action. One obvious example is BP, which was nationalised by Winston Churchill in 1913 in part for the pragmatic rationale of securing oil supplies. But Vodafone, which was given the 900 MHz spectrum on which to launch mobile phone services by Margaret Thatcher, and GlaxoSmithKline, which was until recently accorded generous margins by National Health Service procurers to support pharmaceutical research, are other examples. Whether it is ITV, BAE Systems, Tesco, HSBC, Johnson Matthey or Standard Chartered Bank, every corporate history is intertwined with the state.

In other words, it is not always public versus private ownership. There is a continuum in ownership with nationalisation at one end and zero government support at the other. Most enterprises come in between. At which point in the continuum particular businesses should be located is a determination one makes on pragmatic, not ideological grounds. But die-hard advocates of the market just can't see that.

Measuring returns to investment banks

I noted a Bloomberg report that said that four out of the five top investment banks - Merrill Lynch, Morgan Stanley, Bear Stearns and Lehman Brothers- suffered a decline in market value of $83 bn last year. That cut the annual average rate of return for those firms in the past nine years fro 16.8% to 9.7%. Presumably, this refers to the returns that investors in stocks of these firms made.

What about the return on equity of the firms themselves? Investment banks have enjoyed a return on equity that is the envy of their peers in other businesses. Long term on equity for the top investment banks has been 16%- there have been periods when RoE has been as high as 48%. It would be interesting to see what the returns look like over a typical business cycle- say, after taking into account RoE in 2007 and 2008. The RoE would fall quite a bit.

This suggests that RoE figures for investment banks at any given point in time are deceptive because they don't quite factor in risk. We need really to measure risk-adjusted return on equity for investment banks. Or return on risk adjusted capital. Investment banks must put out these numbers so that market valuations can be based on these.

True, investment banks and banks are perceived to be riskier than the broader market which is why they trade at a discount to the market multiple. But these discounts may not be taking into account risks at a given point in time. More importantly, these discounts may not be taking into account institution-specific risk. The only this can happen is if these institutions are valued and compared on the basis of returns to risk adjusted capital.

Valuing investment banks on the basis of RoE can lead to huge distortions and inflated values at any given point because the underlying risks are not quite taken into account