Thriving in the New Economy: Lessons from Today's Top Business ...
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F O R E W O R D B Y H. WAYNE HUIZENGA“ . . . a compell<strong>in</strong>g, page-turn<strong>in</strong>g book.”DONALD TRUMP, Chairman and President, The Trump OrganizationLori Ann LaRoccoCNBCA F T E R W O R D B Y RUDY GIULIANI
THRIVINGIN THENEWECONOMY<strong>Lessons</strong><strong>from</strong>Today’s<strong>Top</strong>Bus<strong>in</strong>essM<strong>in</strong>dsLORI ANN LAROCCOJohn Wiley & Sons, Inc.
Copyright # 2010 by Lori Ann LaRocco. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, <strong>New</strong> Jersey.Published simultaneously <strong>in</strong> Canada.No part of this publication may be reproduced, stored <strong>in</strong> a retrieval system, or transmitted<strong>in</strong> any form or by any means, electronic, mechanical, photocopy<strong>in</strong>g, record<strong>in</strong>g, scann<strong>in</strong>g,or o<strong>the</strong>rwise, except as permitted under Section 107 or 108 of <strong>the</strong> 1976 United StatesCopyright Act, without ei<strong>the</strong>r <strong>the</strong> prior written permission of <strong>the</strong> Publisher, orauthorization through payment of <strong>the</strong> appropriate per-copy fee to <strong>the</strong> CopyrightClearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax(978) 646-8600, or on <strong>the</strong> web at www.copyright.com. Requests to <strong>the</strong> Publisher forpermission should be addressed to <strong>the</strong> Permissions Department, John Wiley & Sons, Inc.,111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or onl<strong>in</strong>e atwww.wiley.com/go/permissions.Limit of Liability/Disclaimer of Warranty: While <strong>the</strong> publisher and author have used <strong>the</strong>irbest efforts <strong>in</strong> prepar<strong>in</strong>g this book, <strong>the</strong>y make no representations or warranties with respectto <strong>the</strong> accuracy or completeness of <strong>the</strong> contents of this book and specifically disclaim anyimplied warranties of merchantability or fitness for a particular purpose. No warranty maybe created or extended by sales representatives or written sales materials. The advice andstrategies conta<strong>in</strong>ed here<strong>in</strong> may not be suitable for your situation. You should consult witha professional where appropriate. Nei<strong>the</strong>r <strong>the</strong> publisher nor author shall be liable for anyloss of profit or any o<strong>the</strong>r commercial damages, <strong>in</strong>clud<strong>in</strong>g but not limited to special,<strong>in</strong>cidental, consequential, or o<strong>the</strong>r damages.For general <strong>in</strong>formation on our o<strong>the</strong>r products and services or for technical support, pleasecontact our Customer Care Department with<strong>in</strong> <strong>the</strong> United States at (800) 762-2974,outside <strong>the</strong> United States at (317) 572-3993 or fax (317) 572-4002.Wiley also publishes its books <strong>in</strong> a variety of electronic formats. Some content that appears<strong>in</strong> pr<strong>in</strong>t may not be available <strong>in</strong> electronic books. For more <strong>in</strong>formation about Wileyproducts, visit our web site at www.wiley.com.ISBN: 978-0-470-55731-0Pr<strong>in</strong>ted <strong>in</strong> <strong>the</strong> United States of America10987654321
This book is dedicated to my true companion—my husband, Michael—and my three wonderful children:Nicholas, Declan, and Abigail.Thank you for understand<strong>in</strong>g mommy’s even crazier schedule.
ContentsFOREWORD H. WAYNE HUIZENGA ixPREFACExiiiPart One The <strong>Economy</strong> 1Chapter 1 Larry L<strong>in</strong>dsey 3Chapter 2 Steve Forbes 25Chapter 3 David Malpass 31Chapter 4 Jack Bogle 37Chapter 5 Bob Doll 47Chapter 6 Abby Joseph Cohen 59Chapter 7 Paul McCulley 71Chapter 8 Ron Baron 79Chapter 9 Ken Langone 91Chapter 10 Peter Cohen 99Chapter 11 115Chapter 12 Jerry York 117v
viCONTENTSPart Two Bank<strong>in</strong>g 123Chapter 13 Kelly K<strong>in</strong>g 125Chapter 14 Donald Powell 141Chapter 15 Cam F<strong>in</strong>e 149Chapter 16 Donald Marron 165Part Three Real Estate 177Chapter 17 Richard LeFrak 179Chapter 18 Don Peebles 189Chapter 19 Ron Peltier 199Part Four Autos 207Chapter 20 Mike Jackson 209Chapter 21 Jim Lentz 215Chapter 22 Gerald Greenwald 225Part Five Retail 239Chapter 23 Steve Sadove 241Part Six Opportunities 249Chapter 24 Wilbur Ross 251
CONTENTSviiEPILOGUE 265AFTERWORD MAYOR RUDY GIULIANI 267ACKNOWLEDGMENTS 271ABOUT THE AUTHOR 273INDEX 275
ForewordH. Wayne HuizengaToday we f<strong>in</strong>d ourselves <strong>in</strong> what may be <strong>the</strong> most troubledeconomy <strong>in</strong> three generations. For a good number ofAmericans, <strong>the</strong> biggest concern isn’t how to survive <strong>in</strong> today’snew economy—it’s how to thrive <strong>in</strong> it. There were signs. All ofus could see that we were due for a rough patch.What no one could have predicted with any confidence was justhow rough that patch would be. After all, you have governmentdo<strong>in</strong>g what it can to overstep its bounds. Every day, Wash<strong>in</strong>gton ismak<strong>in</strong>g decisions it simply has no bus<strong>in</strong>ess mak<strong>in</strong>g, decid<strong>in</strong>g whichcompanies cont<strong>in</strong>ue and which ones fold up.That’s not capitalism, and it’s certa<strong>in</strong>ly not a free market. Thereare plenty of companies out <strong>the</strong>re that are successful even <strong>in</strong> today’sdownturn, and <strong>the</strong>y deserve <strong>the</strong> exact same opportunity to succeedthat <strong>the</strong>ir predecessors did. In fact, when you consider that <strong>the</strong>secompanies are prosper<strong>in</strong>g <strong>in</strong> <strong>the</strong> face of such extraord<strong>in</strong>arily direcircumstances, you could credibly argue that <strong>the</strong>y deserve evengreater latitude to conduct <strong>the</strong>ir affairs <strong>in</strong> <strong>the</strong> manner of <strong>the</strong>irchoos<strong>in</strong>g. After all, <strong>the</strong>y’re <strong>the</strong> ultimate survivors, <strong>the</strong> companiesmost able to prove <strong>the</strong>ir value to <strong>the</strong> marketplace at a time when <strong>the</strong>marketplace is most resistant.These are bus<strong>in</strong>esses whose leaders have a genu<strong>in</strong>ely rare comb<strong>in</strong>ationof vision, <strong>in</strong>genuity, and energy. People whose fortunes riseix
xFOREWORDand fall based on <strong>the</strong> decisions <strong>the</strong>y make every day—and who excelat mak<strong>in</strong>g great decisions time and aga<strong>in</strong>.Compare <strong>the</strong>m with <strong>the</strong> government bureaucrats mak<strong>in</strong>g <strong>the</strong>irown decisions about <strong>the</strong> bus<strong>in</strong>esses <strong>the</strong>y run. These are people whofrequently have little or no corporate experience, who’ve seldom hadto worry about whe<strong>the</strong>r <strong>the</strong> choices <strong>the</strong>y make today will benefit<strong>the</strong>m directly or <strong>in</strong>fluence <strong>the</strong> prospects of <strong>the</strong> organization <strong>the</strong>ywork for. Yet <strong>the</strong>se are <strong>the</strong> people mak<strong>in</strong>g rules that impact <strong>the</strong> worldof bus<strong>in</strong>ess arbitrarily and capriciously.That isn’t to say that I believe bus<strong>in</strong>ess is without blame <strong>in</strong> ourcurrent environment. Too many companies have <strong>in</strong>deed steppedover <strong>the</strong> l<strong>in</strong>e. And yes, we do need some realignment to address <strong>the</strong>seexcesses. But we must temper that with <strong>the</strong> understand<strong>in</strong>g that <strong>the</strong>more regulated we become, <strong>the</strong> less free we become.In fact, I believe with everyth<strong>in</strong>g I am that ma<strong>in</strong>ta<strong>in</strong><strong>in</strong>g free marketsis <strong>the</strong> s<strong>in</strong>gle most effective th<strong>in</strong>g we can do to foster cont<strong>in</strong>ued growthand opportunity <strong>in</strong> <strong>the</strong> United States. There is no such th<strong>in</strong>g as a limiton <strong>the</strong> number of visionaries out <strong>the</strong>re. A new Bill Gates could be <strong>in</strong><strong>the</strong> mak<strong>in</strong>g right now. There’s a good chance <strong>the</strong> next Warren Buffettis enter<strong>in</strong>g bus<strong>in</strong>ess school <strong>in</strong> <strong>the</strong> fall semester. And <strong>the</strong>re are certa<strong>in</strong>lyo<strong>the</strong>rs with <strong>the</strong> talent and drive to eclipse my own accomplishments.Their fields may be varied—for some of <strong>the</strong>m, <strong>the</strong>ir fields may noteven exist yet—but <strong>the</strong> one th<strong>in</strong>g <strong>the</strong>y all need collectively to succeed isa fair and function<strong>in</strong>g free market system.I look at Mike Jackson of AutoNation, Mike Duke of Walmart,Evan Williams of Twitter, and Wilbur Ross of WL Ross & Co.; allof <strong>the</strong>m are people who are lead<strong>in</strong>g, chang<strong>in</strong>g <strong>the</strong> market, and yes,mak<strong>in</strong>g money <strong>in</strong> an environment like this. Although each has adifferent story to tell, <strong>the</strong>y all share <strong>the</strong> leadership and foresight thatallowed <strong>the</strong>m to take advantage of a chang<strong>in</strong>g economy and reachout to consumers with a proposition that proved compell<strong>in</strong>g, even <strong>in</strong>challeng<strong>in</strong>g times.This book looks at how real leaders tackle crisis and succeed—how <strong>the</strong>y take a risk, plan for <strong>the</strong> future, and create growth
FOREWORDxiopportunities. It’s about how real leaders managed to thrive <strong>in</strong> ournew economy. Spend time with its subjects, and you’ll see thatopportunity does <strong>in</strong>deed exist and that <strong>the</strong> best role for governmentto play is as a partner to enterprise, help<strong>in</strong>g promote an environmentthat rewards <strong>in</strong>novation, diligence, and creativity.Ultimately, I believe that organically successful companies—thatis, companies that generate <strong>the</strong>ir own success by <strong>in</strong>teract<strong>in</strong>g favorablywith <strong>the</strong> market—will prove <strong>the</strong>mselves to be today’s truestw<strong>in</strong>ners. When <strong>the</strong> economy <strong>in</strong>evitably recovers, <strong>the</strong>y will be <strong>the</strong>ones to emerge with <strong>the</strong> strongest brands <strong>in</strong> <strong>the</strong>ir fields and <strong>the</strong>greatest prospects for ongo<strong>in</strong>g growth. But for this to happen, andfor our economy as a whole to become healthy aga<strong>in</strong>, we must follow<strong>the</strong> free market model. Flawed as it may be, it still undeniablyprovides <strong>the</strong> world’s greatest opportunity for bus<strong>in</strong>ess to thrive.H. Wayne Huizenga is one of America’s greatest entrepreneurs.He founded Blockbuster and AutoNation and isowner of <strong>the</strong> Miami Dolph<strong>in</strong>s.
PrefaceHistory’s def<strong>in</strong><strong>in</strong>g moments have taught us that leaders aretested, made, or broken, and we are liv<strong>in</strong>g <strong>in</strong> one of thosemoments right now. When <strong>the</strong> markets collapsed <strong>in</strong> September2008—and as one spectacular failure rode on <strong>the</strong> heels of ano<strong>the</strong>r—people wondered when it would end. As we entered each weekend ofthat month, my CNBC show Squawk Box left <strong>the</strong> guest list loose.There was no sense <strong>in</strong> try<strong>in</strong>g to fill up <strong>the</strong> show with guests forMonday when we had two entire days left between shows, andanyth<strong>in</strong>g could happen. The weekends quickly turned <strong>in</strong>to a ‘‘waitand see’’ of which company would fail and which one Uncle Samwould rescue. We would book our Monday morn<strong>in</strong>g news makerson Sunday.This market crisis took me back to my years as <strong>the</strong> nightside assignment editor at WFTV-TV <strong>in</strong> Orlando. The wildfiresof <strong>the</strong> 1990s were consum<strong>in</strong>g hundreds of acres <strong>in</strong> central Florida;<strong>the</strong> w<strong>in</strong>ds were pick<strong>in</strong>g up, and <strong>the</strong>re was no ra<strong>in</strong> <strong>in</strong> sight toquench <strong>the</strong> parched soil. Despite <strong>the</strong> fact that <strong>the</strong> flameswere miles away, I can remember <strong>the</strong> dense, stifl<strong>in</strong>g smell of<strong>the</strong> forest fires hang<strong>in</strong>g <strong>in</strong> <strong>the</strong> newsroom. Watch<strong>in</strong>g <strong>the</strong> imagesof flames several stories high swallow<strong>in</strong>g up trees and homes <strong>in</strong>a bl<strong>in</strong>k, I thought to myself, When will this end? No oneknew; we were <strong>in</strong> unchartered territory. A crisis like this hadno timel<strong>in</strong>e. The unknown was <strong>the</strong> most frighten<strong>in</strong>g th<strong>in</strong>g wewere fac<strong>in</strong>g.xiii
xivPREFACEThe September 2008 economic crisis was <strong>in</strong> fact a firestormengulf<strong>in</strong>g <strong>the</strong> markets. Much like <strong>the</strong> massive Florida wildfires of<strong>the</strong> 1990s, we were report<strong>in</strong>g on events we had never seen before. Wewere report<strong>in</strong>g on history. No one knew when <strong>the</strong> market turmoilwould end or what k<strong>in</strong>d of reaction <strong>the</strong> rest of <strong>the</strong> world would haveto <strong>the</strong> U.S. markets. It was a global crisis. Both Ma<strong>in</strong> Street and WallStreet depended on our program for unbiased, actionable, and up-to<strong>the</strong>-m<strong>in</strong>ute<strong>in</strong>formation. It’s a responsibility we never took lightly.The mantra ‘‘too big to fail’’ became <strong>the</strong> ‘‘it’’ phrase as <strong>in</strong>vestorstried to wrap <strong>the</strong>ir arms around what was happen<strong>in</strong>g. The 401(k)plan quickly became ‘‘201k,’’ and <strong>the</strong> once-golden boys of WallStreet jo<strong>in</strong>ed thousands of o<strong>the</strong>rs who were out of jobs. But despite<strong>the</strong> credit crunch and economic headw<strong>in</strong>ds, <strong>the</strong>re are capta<strong>in</strong>s of<strong>in</strong>dustry out <strong>the</strong>re who are not only surviv<strong>in</strong>g but thriv<strong>in</strong>g <strong>in</strong> this<strong>the</strong> ‘‘<strong>New</strong> <strong>Economy</strong>,’’ and what makes <strong>the</strong>se leaders unique are <strong>the</strong>strategies <strong>the</strong>y employ. They are <strong>the</strong> ultimate chess players <strong>in</strong> <strong>the</strong>economy game. By offer<strong>in</strong>g advice, cutt<strong>in</strong>g budgets by millions ofdollars, and meticulously manag<strong>in</strong>g <strong>the</strong>ir <strong>in</strong>vestments, <strong>the</strong>se pacesettersare navigat<strong>in</strong>g through <strong>the</strong> turbulent markets—and not be<strong>in</strong>gswallowed up <strong>in</strong> <strong>the</strong> undertow. As Senior Talent Producer forCNBC, I am lucky to speak with some of <strong>the</strong> world’s richestand most successful bus<strong>in</strong>esspeople on a daily basis.To write this book, I opened my ‘‘trillion dollar’’ Rolodex—aso<strong>the</strong>rs <strong>in</strong> my <strong>in</strong>dustry call it—because it conta<strong>in</strong>s a trillion-dollarmoney manager, a baker’s dozen of billionaires, and countlessmillionaires—and sat down with some of my close contacts.Here, I have asked <strong>the</strong>m not only to expla<strong>in</strong> how <strong>the</strong>y are respond<strong>in</strong>gto <strong>the</strong>se historic times, but more importantly, how <strong>the</strong>y have beenable to defy failure and what opportunities <strong>the</strong>y currently see.Although <strong>the</strong>ir <strong>in</strong>dustries and backgrounds may be different, <strong>the</strong>yall share <strong>the</strong> same qualities that enable <strong>the</strong>m to be leaders. They arenimble, forward-look<strong>in</strong>g, and opportunistic, and all refuse to have achallenge take <strong>the</strong>m down. These <strong>in</strong>dividuals are thriv<strong>in</strong>g <strong>in</strong> <strong>the</strong>new economy.
Part OneThe <strong>Economy</strong>
1Larry L<strong>in</strong>dseyNo matter what state<strong>the</strong> markets are <strong>in</strong>, <strong>the</strong>reare a handful of economicand strategist ‘‘goto’’people I always relyon. Larry L<strong>in</strong>dsey, CEOof <strong>the</strong> economic advisoryfirm The L<strong>in</strong>dseyGroup, is one of <strong>the</strong>m.What makes Larry standout <strong>from</strong> <strong>the</strong> hundreds of o<strong>the</strong>r economists out <strong>the</strong>re isthat he not only cares about <strong>the</strong> topics he discusses but canbreak <strong>the</strong>m down <strong>in</strong> such a way that makes <strong>the</strong>m understandableand <strong>in</strong>terest<strong>in</strong>g to those watch<strong>in</strong>g and listen<strong>in</strong>g(which, believe it or not, is hard to do when it comes to atelevision <strong>in</strong>terview). We want <strong>the</strong> guests on my show tooffer our viewers actionable <strong>in</strong>formation. Lengthy discourse,although occasionally colorful, is not all that useful; and Larrygets that. I have known Larry for years. I’ve found him to bealways candid, and his global economic contacts are someof <strong>the</strong> best.(cont<strong>in</strong>ued)3
4 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)Before his latest private venture, Larry was a man of <strong>the</strong>beltway. He served as director of <strong>the</strong> National EconomicCouncil <strong>from</strong> 2001 to 2002, and was <strong>the</strong> assistant to <strong>the</strong>president on economic policy for U.S. President George W.Bush. In fact, Larry was one of <strong>the</strong> leaders craft<strong>in</strong>g PresidentBush’s $1.35 trillion tax cut plan, call<strong>in</strong>g it an ‘‘<strong>in</strong>surancepolicy’’ aga<strong>in</strong>st an economic downturn. Back <strong>in</strong> 1996—while act<strong>in</strong>g as a governor of <strong>the</strong> Federal Reserve Board—L<strong>in</strong>dsey made headl<strong>in</strong>es for spott<strong>in</strong>g <strong>the</strong> appearance of<strong>the</strong> late 1990s U.S. stock market bubble.Today, as CEO of The L<strong>in</strong>dsey Group, Larry exam<strong>in</strong>esglobal macroeconomic trends and events that can significantly<strong>in</strong>fluence his firm’s f<strong>in</strong>ancial markets and economicperformance. Larry breaks down today’s navigation of <strong>the</strong>economic crisis <strong>in</strong>to a formula of three different qualities ofleadership that one must have to thrive <strong>in</strong> <strong>the</strong> new economyand details how he uses <strong>the</strong>m to grow his company andcounsel clients.Three decades serv<strong>in</strong>g <strong>in</strong> a variety of positions <strong>in</strong> government,academia, and <strong>the</strong> private sector have conv<strong>in</strong>ced me that oneof our society’s greatest weaknesses, when deal<strong>in</strong>g with crises, is thatmanagerial and rhetorical leadership qualities have crowded outsimple analytics. The reason for this is <strong>the</strong> confusion that existsbetween leadership and followership. Most <strong>in</strong>stitutions prefer managerswho will serve <strong>the</strong> needs of an exist<strong>in</strong>g <strong>in</strong>stitution—that is, whowill follow <strong>the</strong> wishes of <strong>the</strong> various constituencies with<strong>in</strong> <strong>the</strong><strong>in</strong>stitution—ra<strong>the</strong>r than managers who will lead <strong>the</strong> <strong>in</strong>stitutionto a new place.Our political process is dom<strong>in</strong>ated by leaders who tell us what<strong>the</strong>y th<strong>in</strong>k we want to hear, <strong>the</strong>reby effectively follow<strong>in</strong>g <strong>the</strong> pollsand <strong>the</strong> media and not necessarily lead<strong>in</strong>g <strong>the</strong> country. Worse, our
LARRY LINDSEY 5government has created <strong>in</strong>stitutional barriers around our leaders thatactually prevent <strong>the</strong>m <strong>from</strong> hear<strong>in</strong>g a variety of analytic po<strong>in</strong>ts ofview <strong>in</strong> <strong>the</strong> name of m<strong>in</strong>imiz<strong>in</strong>g <strong>the</strong> <strong>in</strong>fluence of ‘‘special <strong>in</strong>terests.’’Similarly, <strong>the</strong>y discourage those who have actually been analyticallysuccessful outside of government <strong>from</strong> enter<strong>in</strong>g public service by<strong>the</strong> current vett<strong>in</strong>g process. For example, <strong>the</strong> usual connotation ofleadership is wrapped up <strong>in</strong> <strong>the</strong> presence of followers. After all, onecan hardly call oneself a ‘‘leader’’ if no one is follow<strong>in</strong>g beh<strong>in</strong>d. Thisis true of <strong>the</strong> lieutenant who <strong>in</strong>spires <strong>the</strong> troops <strong>in</strong>to battle and isalso <strong>the</strong> case for a political leader who, after all, doesn’t become aleader unless he or she has more followers than <strong>the</strong> opponent onElection Day. But that type of leadership by itself can actually be ahandicap for a society deal<strong>in</strong>g with a f<strong>in</strong>ancial or economic catastrophe.To be precise, f<strong>in</strong>ancial crises throughout history havedeveloped when excesses went unchecked. Like <strong>the</strong> over-leverag<strong>in</strong>gof risk <strong>in</strong> our capital system. All <strong>the</strong>se manias, panics, and bubbleshave <strong>the</strong> same characteristic: <strong>the</strong> absence of real leadership that takesa contrarian perspective. None of this is a criticism of <strong>the</strong> actions ofpolitical and f<strong>in</strong>ancial leaders <strong>in</strong> this or any o<strong>the</strong>r crisis; <strong>the</strong> problemseems to be structural. Societies create <strong>in</strong>stitutions that have built-<strong>in</strong>biases and constra<strong>in</strong>ts, and <strong>the</strong>se leaders have very little choice but tocarry out <strong>the</strong> <strong>in</strong>stitutional imperative. Indeed, that is <strong>the</strong>ir job asleaders of <strong>in</strong>stitutions.One of <strong>the</strong> most unfortunate examples of this flawed model ofleadership was a comment made by Citigroup CEO Chuck Pr<strong>in</strong>ce <strong>in</strong>July 2007, when he said of <strong>the</strong> bank he was supposedly lead<strong>in</strong>g: ‘‘Aslong as <strong>the</strong> music plays, you’ve got to get up and dance. We’re stilldanc<strong>in</strong>g.’’ This quote shows that despite his personal skepticismabout <strong>the</strong> ability of <strong>the</strong> market to cont<strong>in</strong>ue with its excesses, <strong>the</strong><strong>in</strong>stitutional demands of his firm required him, as a leader, to overridehis personal cautionary views—and forced his firm to cont<strong>in</strong>ue onwith <strong>the</strong> practices that ultimately led to disaster <strong>in</strong> <strong>the</strong> first place.In fact, as much as we and <strong>the</strong>y like to deny it now, bothpoliticians and market participants actually demanded that firms
6 THRIVING IN THE NEW ECONOMYcont<strong>in</strong>ued to ‘‘dance’’—and that <strong>the</strong> band keep play<strong>in</strong>g dur<strong>in</strong>g <strong>the</strong>run up to <strong>the</strong> current crisis. Leverage was encouraged—not discouraged—bymarket players, <strong>in</strong>clud<strong>in</strong>g most notably many selfdescribed‘‘shareholder activists,’’ who acted <strong>in</strong> <strong>the</strong> name of creat<strong>in</strong>g‘‘shareholder value.’’ The markets rewarded earn<strong>in</strong>gs growth andruthlessly punished firms that balanced <strong>the</strong> pursuit of profit with ahealthy respect for risk. Members of both political parties pushed forever-higher degrees of homeownership and demanded that lendersand mortgage securitizers give ever-<strong>in</strong>creas<strong>in</strong>g amounts of loans toless qualified borrowers. Leaders who did not dance to this tune facedcondemnation <strong>in</strong> <strong>the</strong> press, challenges to <strong>the</strong>ir positions by irateshareholders, and wi<strong>the</strong>r<strong>in</strong>g criticism <strong>from</strong> members of Congress.The First Economic AvalancheIt was clear that it was all go<strong>in</strong>g to come crash<strong>in</strong>g down; <strong>the</strong> questionwas how. Usually such crashes happen like avalanches; a smallchange somewhere <strong>in</strong> <strong>the</strong> structure f<strong>in</strong>ds a critical po<strong>in</strong>t of weakness.Relationships and transactions that had held toge<strong>the</strong>r no longerdo. F<strong>in</strong>ally—and what appears on <strong>the</strong> surface to be suddenly—<strong>the</strong>whole hill collapses.The <strong>in</strong>itial weakness here was hous<strong>in</strong>g. While serv<strong>in</strong>g on <strong>the</strong>Federal Reserve Board, I was <strong>the</strong> governor responsible for hous<strong>in</strong>gand community affairs issues back <strong>in</strong> <strong>the</strong> 1990s dur<strong>in</strong>g <strong>the</strong> lasthous<strong>in</strong>g recession—and it taught me a lot about mortgage markets.We had warned clients—and as <strong>the</strong> <strong>New</strong> York Times reported, <strong>the</strong>White House—<strong>in</strong> late 2005 that a hous<strong>in</strong>g bubble was form<strong>in</strong>g andthat action should be taken to prevent consequent problems. Hous<strong>in</strong>ghad not had a catastrophic nationwide collapse s<strong>in</strong>ce <strong>the</strong> 1930s; itwas generally viewed as an impossibility. By <strong>the</strong> middle of 2007, <strong>the</strong>rehad been a slight deterioration <strong>in</strong> hous<strong>in</strong>g prices, with <strong>the</strong> Case Shiller<strong>in</strong>dex down 5 percent. Hous<strong>in</strong>g <strong>in</strong>ventories appeared to have stabilized,and a wide variety of commentators and government officialshad concluded that <strong>the</strong> hous<strong>in</strong>g recession had bottomed.
LARRY LINDSEY 7At that po<strong>in</strong>t we concluded that far <strong>from</strong> end<strong>in</strong>g, <strong>the</strong> avalanchewas only about to beg<strong>in</strong> unless someth<strong>in</strong>g was done. The key was tostop or sharply slow <strong>the</strong> pace of subprime lend<strong>in</strong>g. These mortgagesconstituted 24 percent of <strong>the</strong> total dollar volume of mortgages <strong>in</strong>2006, an unsusta<strong>in</strong>able number. Some of <strong>the</strong> mortgage marketreforms we had <strong>in</strong>stituted <strong>in</strong> <strong>the</strong> 1990s to encourage homeownershiphad helped create <strong>the</strong> subprime market. But around <strong>the</strong> time I left<strong>the</strong> Fed, it was tightly controlled and constituted only about 3percent of all mortgages. As <strong>the</strong> late Herb Ste<strong>in</strong> used to say, ‘‘When atrend is unsusta<strong>in</strong>able, it will stop.’’ But this particular trend was <strong>the</strong>self-perpetuat<strong>in</strong>g k<strong>in</strong>d. If subprime mortgages stopped be<strong>in</strong>ggranted, demand for houses would collapse; this, <strong>in</strong> turn, wouldmean fewer buyers and lower prices throughout <strong>the</strong> market. In July2007, we estimated that <strong>the</strong> pace of home sales would drop by atleast ano<strong>the</strong>r 1.5 million—more than twice <strong>the</strong> drop that hadoccurred so far. While o<strong>the</strong>rs were predict<strong>in</strong>g that <strong>the</strong> bottomhad been reached, we saw that <strong>the</strong>re was still a substantial downsiderisk that <strong>the</strong> weight of <strong>in</strong>ventories would cause prices to crack andthat a self-re<strong>in</strong>forc<strong>in</strong>g cycle where foreclosures and prices start to<strong>in</strong>teract more directly would beg<strong>in</strong>.Later that month, while market <strong>in</strong>dices reached double what <strong>the</strong>yhad been for <strong>the</strong> previous four and a half years and were still on <strong>the</strong>irway to a new high, we identified for our clients <strong>the</strong> likely place where<strong>the</strong> avalanche would beg<strong>in</strong>. We wrote that ‘‘<strong>the</strong> biggest risk lies with<strong>the</strong> <strong>in</strong>termediaries <strong>in</strong> <strong>the</strong> leverage game—<strong>the</strong> big players <strong>in</strong> <strong>the</strong>f<strong>in</strong>ancial arena—whose top l<strong>in</strong>e is driven by fee <strong>in</strong>come <strong>from</strong> do<strong>in</strong>g<strong>the</strong> deals and whose balance sheets are crammed full of <strong>in</strong>ventorywait<strong>in</strong>g to be dumped on some buyer.’’ We identified <strong>the</strong> market’sfaulty logic as this: ‘‘If someth<strong>in</strong>g goes wrong with <strong>the</strong> f<strong>in</strong>ancialsystem, <strong>the</strong> world’s central banks will have no choice but to open <strong>the</strong>liquidity spigots and play lender of last resort. Heads you w<strong>in</strong>, tails<strong>the</strong> system gets bailed out tak<strong>in</strong>g you along with it.’’That was 14 months before Lehman Bro<strong>the</strong>rs’ collapse. Theproblem with <strong>the</strong> logic up to that po<strong>in</strong>t, as we identified it, was that
8 THRIVING IN THE NEW ECONOMY‘‘<strong>the</strong> relative prices of assets and goods can only vary so far.’’ Given<strong>the</strong>ir pace of divergence, we questioned, ‘‘Will <strong>the</strong>se momentumsplay on asset prices and cont<strong>in</strong>ue for ano<strong>the</strong>r year? Probably.Eighteen months? Possibly. Two years? Probably not. Enjoy <strong>the</strong>party, but also be ready to leave when <strong>the</strong> hosts start look<strong>in</strong>gworried.’’ The reason for <strong>the</strong> tim<strong>in</strong>g was <strong>the</strong> parabolic rate at whichasset prices were climb<strong>in</strong>g. The music probably had to stop play<strong>in</strong>gfor <strong>the</strong>se <strong>in</strong>termediaries before <strong>the</strong> end of 2008—and certa<strong>in</strong>lybefore <strong>the</strong> middle of 2009.The Best Offense Is a Good DefenseThere is only one way to deal with an impend<strong>in</strong>g avalanche: getout of <strong>the</strong> way! Although our clients’ base is quite diverse, whatever<strong>the</strong>ir responsibilities, <strong>the</strong> key for <strong>the</strong>m was to assume a defensiveposture. This became clearer as—follow<strong>in</strong>g <strong>the</strong> avalancheanalogy—o<strong>the</strong>r cracks were start<strong>in</strong>g to appear <strong>in</strong> <strong>the</strong> f<strong>in</strong>ancialstructure, particularly <strong>in</strong> <strong>the</strong> area of consumer f<strong>in</strong>ance. In March2008, I appeared on <strong>the</strong> show Squawk Box, which Lori AnnLaRocco produces for CNBC, with former Treasury SecretaryJohn Snow. I warned that auto f<strong>in</strong>ance was <strong>the</strong> next shoe to drop,and jok<strong>in</strong>gly added that by <strong>the</strong> end of <strong>the</strong> year, people would haveto go to <strong>the</strong>ir local Federal Reserve Bank to get an auto loan. As itturned out, <strong>the</strong> auto f<strong>in</strong>ance companies were <strong>the</strong> ones go<strong>in</strong>g to <strong>the</strong>Fed; it was still provid<strong>in</strong>g <strong>the</strong> money.At this po<strong>in</strong>t, <strong>the</strong> f<strong>in</strong>ancial system was do<strong>in</strong>g its best to paper over<strong>the</strong> cracks <strong>in</strong> <strong>the</strong> ice sheet. On July 14 we noted that althoughFreddie Mac had reported that it had $16 billion <strong>in</strong> stockholder’sequity <strong>in</strong> a supplement to <strong>the</strong>ir GAAP (Generally AcceptedAccount<strong>in</strong>g Pr<strong>in</strong>ciple) numbers, <strong>the</strong> firm had also reported that<strong>the</strong>y had a net asset value of negative $5 billion under Fair ValueAccount<strong>in</strong>g. We noted that a similar exposure existed at Fannie Maeand that <strong>the</strong> amount of leverage both companies had to home pricesmeant that th<strong>in</strong>gs could deteriorate very quickly. Both stocks rallied
LARRY LINDSEY 9that week on <strong>the</strong> seem<strong>in</strong>g ‘‘good news’’ <strong>in</strong> <strong>the</strong>ir quarterly report.However, it was to be short lived.Two months later, Lehman Bro<strong>the</strong>rs collapsed, and a panickedWash<strong>in</strong>gton rushed to fill <strong>the</strong> breech. We wrote to our clients, ‘‘Forall <strong>the</strong> observations by policy makers that <strong>the</strong> market had six monthsto prepare for Lehman, [<strong>the</strong>se] policy makers <strong>the</strong>mselves had notbeen fully prepared for this fur<strong>the</strong>r deterioration <strong>in</strong> markets. Dur<strong>in</strong>gthis time, many of <strong>the</strong> activities <strong>in</strong> Wash<strong>in</strong>gton were designed forpublicity but had little developed policy beh<strong>in</strong>d it.’’ The shockerabout Lehman Bro<strong>the</strong>rs—and particularly, <strong>the</strong> rescue of AIG—wasthat policy makers were essentially mak<strong>in</strong>g up <strong>the</strong> rules as <strong>the</strong>ywent along. That po<strong>in</strong>t was crucial. In <strong>the</strong> same note to clients, wepredicted that <strong>the</strong> Troubled Asset Relief Program (TARP) designedto purchase distressed assets <strong>in</strong> an attempt to fortify <strong>the</strong> f<strong>in</strong>ancialsector would not work; and <strong>in</strong>deed, after many false starts, it didn’t.Our focus shifted <strong>from</strong> <strong>the</strong> <strong>in</strong>evitable market meltdown to <strong>the</strong>government’s efforts to repair <strong>the</strong> damage. In a piece on March 11,we laid out <strong>the</strong> details of what was likely to work and what was notlikely to work. This rema<strong>in</strong>s very much a work <strong>in</strong> progress and is <strong>the</strong>center of our attention and <strong>the</strong> attention of my company.<strong>Thriv<strong>in</strong>g</strong> CriteriaTo put it mildly, we are an unusual firm. I doubt very much that myhigh school guidance counselor had anyth<strong>in</strong>g like my current job <strong>in</strong>his great catalog of ‘‘th<strong>in</strong>gs you can do when you grow up.’’ Webelieve that analytic leadership is <strong>in</strong> short supply and that it is our jobto provide it. But given <strong>the</strong> shortage of road maps <strong>in</strong> this regard, wehave had to make up our own guideposts and have settled on three:<strong>in</strong>dependence, objectivity, and candor. Although <strong>the</strong>se are greatwords, implement<strong>in</strong>g <strong>the</strong>m can be challeng<strong>in</strong>g—because none of<strong>the</strong>m represents a path to popularity.Independence requires we not be tied to any exist<strong>in</strong>g <strong>in</strong>stitution.Chuck Pr<strong>in</strong>ce’s private analysis—and given <strong>the</strong> e-mail trails that are
10 THRIVING IN THE NEW ECONOMYnow be<strong>in</strong>g revealed, probably those of many o<strong>the</strong>r corporateleaders—was that <strong>the</strong> f<strong>in</strong>ancial system was on an unsusta<strong>in</strong>ablepath. But <strong>the</strong> needs of <strong>the</strong> <strong>in</strong>stitutions <strong>the</strong>y led demanded that <strong>the</strong>ystay on it. Moreover, a variety of <strong>in</strong>-house analytic shops <strong>in</strong> <strong>the</strong>f<strong>in</strong>ancial sector had encountered some difficulty <strong>in</strong> recent years as<strong>the</strong>ir forecasts became suspect. Markets wondered whe<strong>the</strong>r <strong>the</strong>se <strong>in</strong>houseshops could keep <strong>the</strong>ir <strong>in</strong>dependence or whe<strong>the</strong>r <strong>the</strong> <strong>in</strong>terestof <strong>the</strong> <strong>in</strong>stitution that was pay<strong>in</strong>g <strong>the</strong>ir salaries would <strong>in</strong>fluence <strong>the</strong>irdecision. Even if <strong>the</strong> <strong>in</strong>dividuals <strong>in</strong>volved did <strong>the</strong>ir best to preserve<strong>the</strong>ir autonomy, <strong>the</strong>y would still face market skepticism. So weconcluded that <strong>the</strong> only way to preserve <strong>in</strong>dependence is to actuallybe <strong>in</strong>dependent. We are unaffiliated with any organization, and wemake sure that our cash flow is not dependent on any s<strong>in</strong>gle client.Ahead of <strong>the</strong> CrisisWe were very early <strong>in</strong> warn<strong>in</strong>g about <strong>the</strong> likelihood of a hous<strong>in</strong>gmarket crash. We had begun to caution our clients <strong>in</strong> late 2005about potential trouble ahead. One of our clients, a national firm,had significant exposure to that segment of <strong>the</strong> economy. Ouranalysis was hotly debated with<strong>in</strong> <strong>the</strong> firm because, if we were right,it would require a significant change <strong>in</strong> <strong>the</strong>ir corporate strategy toprepare for <strong>the</strong> tough times ahead. The firm lightened up on debtf<strong>in</strong>anc<strong>in</strong>g and expansion plans, which, at <strong>the</strong> time, was an extremelyunpopular decision <strong>in</strong> <strong>the</strong> markets. With leverage and expansionheld down, profit growth stagnated; and with it, so did <strong>the</strong> shareprice. This was <strong>in</strong> <strong>the</strong> midst of a ris<strong>in</strong>g stock market and ever<strong>in</strong>creas<strong>in</strong>gleverage. The decision contributed to calls for <strong>the</strong> resignationof <strong>the</strong> CEO. Hous<strong>in</strong>g <strong>in</strong>ventory began to stabilize <strong>in</strong> <strong>the</strong>middle of 2006, and <strong>the</strong> consensus was that <strong>the</strong> ‘‘hous<strong>in</strong>g cycle hadbottomed.’’ This implied that <strong>the</strong> CEO had made <strong>the</strong> wrong call,which was a contribut<strong>in</strong>g factor <strong>in</strong> his departure.Although some believed hous<strong>in</strong>g had bottomed at that po<strong>in</strong>t, wecont<strong>in</strong>ued convey<strong>in</strong>g to our clients a decidedly downbeat long-term
LARRY LINDSEY 11hous<strong>in</strong>g and economic forecast. In mid-2007, we warned <strong>the</strong>m that‘‘a collapse of subprime lend<strong>in</strong>g back to its historical pace could take$1.5 million off annual home sales <strong>in</strong> <strong>the</strong> aggregate.’’ Worse, weextended our forecast for <strong>the</strong> hous<strong>in</strong>g downturn, writ<strong>in</strong>g that ‘‘ourassumption has been that 2008 would be <strong>the</strong> bottom of <strong>the</strong> hous<strong>in</strong>gmarket. But it is not clear how <strong>the</strong> <strong>in</strong>ventory overhang will correctitself by <strong>the</strong>n.’’ We went on to warn that ‘‘<strong>the</strong>re is still a substantialdownside risk that <strong>the</strong> weight of <strong>in</strong>ventories will f<strong>in</strong>ally cause homeprices to crack.’’ At that time, <strong>the</strong> Case Shiller <strong>in</strong>dex had house pricesdown only 5 percent, while most forecasts were <strong>in</strong>dicat<strong>in</strong>g thathous<strong>in</strong>g had bottomed.Fortunately, <strong>the</strong> new CEO of <strong>the</strong> client firm was conv<strong>in</strong>ced by ouranalysis, and <strong>the</strong> firm cont<strong>in</strong>ued to reduce its exposure to a stillpotentialand prospective hous<strong>in</strong>g decl<strong>in</strong>e. In retrospect, it was our<strong>in</strong>dependence that had been crucial to this outcome. Had we beenphysically housed <strong>in</strong> corporate headquarters or had we been membersof <strong>the</strong> board, our ability to be self-regulat<strong>in</strong>g would have beencompromised. At a m<strong>in</strong>imum, we would likely have been perceivedas tak<strong>in</strong>g sides <strong>in</strong> office politics, with <strong>the</strong> possibility that our ownposition with<strong>in</strong> <strong>the</strong> firm would have been jeopardized. Indeed, it wasour <strong>in</strong>dependence that most likely provided <strong>the</strong> credibility to ourforecast that tipped <strong>the</strong> scales with<strong>in</strong> <strong>the</strong> firm.The Next Shoe to DropAno<strong>the</strong>r quality needed to thrive <strong>in</strong> times of crisis is objectivity.Although sometimes confused with <strong>in</strong>dependence, this attribute isactually far harder to achieve. Whereas, <strong>in</strong>dependence is a physicaltrait—at least on an organizational chart—objectivity is a state ofm<strong>in</strong>d. It requires that you do not get caught up <strong>in</strong> <strong>the</strong> moment. Andeven <strong>the</strong> best of us is <strong>in</strong>fluenced by what is happen<strong>in</strong>g around us.Momentum trad<strong>in</strong>g is an extreme view of this, which implicitlyassumes that <strong>New</strong>ton’s law that ‘‘an object <strong>in</strong> motion will stay <strong>in</strong>motion’’ applies here as well, at least until some outside force affects
12 THRIVING IN THE NEW ECONOMYit. Moreover, we all have a tendency to talk our book—and an evendeeper psychological need to be right. This tends to keep us <strong>in</strong> ourpositions longer than we should be. On <strong>the</strong> o<strong>the</strong>r hand, <strong>the</strong>re is alsoan <strong>in</strong>cl<strong>in</strong>ation to overcompensate for this, which turns us <strong>in</strong>tonervous Nellies and changes our view with each piece of datathat happens to go <strong>the</strong> o<strong>the</strong>r way.Objectivity requires perspective. It requires know<strong>in</strong>g what dataare important and what are not and know<strong>in</strong>g when <strong>the</strong>re is a criticalmass of contrary evidence to force one to change one’s view. By far,<strong>the</strong> most useful tools <strong>in</strong> acquir<strong>in</strong>g a perspective is a knowledge andsense of history. History, by def<strong>in</strong>ition, takes you out of <strong>the</strong>moment. By far <strong>the</strong> biggest trap that caused many to lose objectivity<strong>in</strong> <strong>the</strong> months lead<strong>in</strong>g up to <strong>the</strong> current crisis was <strong>the</strong> widespreadview <strong>in</strong> <strong>the</strong> economics profession and <strong>in</strong> f<strong>in</strong>ancial markets that wewere <strong>in</strong> <strong>the</strong> midst of a ‘‘Great Moderation.’’ However, <strong>the</strong> GreatModeration was actually a historical moment last<strong>in</strong>g 25 years, not apermanent development.As we saw <strong>the</strong> crisis unfold<strong>in</strong>g <strong>in</strong> June 2007, we sent our clients amessage titled ‘‘The Next Shoe to Drop: Credit Spreads.’’ We notedthat too much confidence can depress returns to risk and lead tocapital be<strong>in</strong>g diverted <strong>in</strong>to projects that will, on average, losemoney. F<strong>in</strong>ancial assets had risen <strong>in</strong>value,whichraisedwealthto-<strong>in</strong>comeratios and <strong>the</strong>refore consumption-to-<strong>in</strong>come ratios,<strong>the</strong>reby depress<strong>in</strong>g new sav<strong>in</strong>gs. We predicted that spreads wouldrise and that ironically, this would take a good deal of pressure off<strong>the</strong> yield curve <strong>in</strong> <strong>the</strong> riskless market, lead<strong>in</strong>g to a rally <strong>in</strong> governmentbonds and a lower Fed funds rate. On September 12, wepredicted that <strong>the</strong> Fed would beg<strong>in</strong> a series of rate cuts at <strong>the</strong>irTuesday meet<strong>in</strong>g, with an <strong>in</strong>itial 50 basis po<strong>in</strong>t cut, but noted thateven this cut would be unlikely to unfreeze credit markets; we Author’s note: The ‘‘Great Moderation’’ is a phrase used to describe <strong>the</strong> post-Reaganperiod <strong>from</strong> roughly 1981 to 2007, dur<strong>in</strong>g which <strong>in</strong>terest rates and credit spreads droppedand equity premiums rose sharply.
LARRY LINDSEY 13fur<strong>the</strong>r predicted a series of cuts <strong>in</strong> Fed funds to at least 3.5 percent.More than 90 percent of analysts surveyed had predicted just a25 basis po<strong>in</strong>t cut. At its October meet<strong>in</strong>g, <strong>the</strong> Fed cut only aquarter po<strong>in</strong>t and declared <strong>the</strong> risks to be ‘‘balanced.’’ We warnedour clients that although this might be <strong>the</strong> case, <strong>the</strong> risks had notgone away—and that <strong>the</strong> Federal Open Market Committee(FOMC) would soon change its views.Law of Un<strong>in</strong>tended ConsequencesOne of history’s great lessons is that policy makers, <strong>in</strong> both <strong>the</strong>public and private sectors, tend to underestimate <strong>the</strong> costs <strong>in</strong>volvedwhen <strong>the</strong>y contemplate <strong>the</strong> actions necessary to address some adversechange <strong>in</strong> circumstances. Although this is due <strong>in</strong> part to long periodsof condition<strong>in</strong>g to <strong>the</strong> relationships and magnitudes that existedbefore <strong>the</strong> crisis, an equally important cause of <strong>the</strong> underestimationis <strong>the</strong> Law of Un<strong>in</strong>tended Consequences. Even <strong>the</strong> most carefullydesigned policy responses <strong>in</strong>volve unforeseen results, and <strong>in</strong> a crisis,<strong>the</strong>re is not <strong>the</strong> time for as careful a consideration of <strong>the</strong> consequencesof policy as might be ideal.Risks <strong>in</strong> Believ<strong>in</strong>g <strong>in</strong> Solely on HistoryHowever, just as knowledge of history provides a tremendousadvantage <strong>in</strong> try<strong>in</strong>g to be objective, <strong>the</strong>re are huge risks <strong>in</strong> believ<strong>in</strong>gtoo literally that history repeats itself. This is most apparent today <strong>in</strong>a widespread view that we are <strong>in</strong> for ano<strong>the</strong>r Great Depression.Our company has never been <strong>in</strong> that camp. Our forecast at <strong>the</strong> endof 2007 called for a peak unemployment rate of about 10.5 percentbefore it would beg<strong>in</strong> to decl<strong>in</strong>e <strong>in</strong> <strong>the</strong> middle of 2010. That is,of course, a tough recession; but it is not a repeat of <strong>the</strong> 1930s. Policydecisions do, however, have <strong>the</strong>ir effects. For example, <strong>in</strong> earlyFebruary 2009, we predicted a ‘‘Second Quarter Bounce’’ long
14 THRIVING IN THE NEW ECONOMYbefore any green shoots began to be discussed, much less appeared.The reason was <strong>the</strong> size of <strong>the</strong> fiscal stimulus plan that had beenpassed. But because of its <strong>in</strong>efficient design, we also warned ourclients that this might <strong>in</strong>duce a bond market sell-off and that <strong>the</strong>lack of efficient design would mean that any near-term bouncewould likely not lead to a susta<strong>in</strong>ed recovery. Thus, <strong>the</strong> role ofhistory <strong>in</strong> help<strong>in</strong>g ma<strong>in</strong>ta<strong>in</strong> objectivity <strong>in</strong> any <strong>in</strong>dustry is a complicatedone.The way we approach this challenge is to imag<strong>in</strong>e ourselves asfuture historians writ<strong>in</strong>g about <strong>the</strong> events of <strong>the</strong> present. This causesus to contemplate an outcome, which we as future historians have <strong>the</strong>advantage of know<strong>in</strong>g with 20/20 h<strong>in</strong>dsight, and <strong>the</strong>n work back toestablish a cha<strong>in</strong> of events that led to that outcome. When you dothat, you have to visualize how someth<strong>in</strong>g is go<strong>in</strong>g to happen anddecide whe<strong>the</strong>r or not your vision is realistic. If it is not realistic, youreject it. Thus, only a small fraction of <strong>the</strong> speculative ‘‘futurehistories’’ one considers actually make it <strong>in</strong>to <strong>the</strong> range of plausiblescenarios. For example, if one imag<strong>in</strong>es a future history of rapideconomic expansion <strong>in</strong> 2010—as <strong>the</strong> adm<strong>in</strong>istration and many <strong>in</strong> <strong>the</strong>economics profession believe—one has to imag<strong>in</strong>e a sharp decl<strong>in</strong>e <strong>in</strong><strong>the</strong> personal sav<strong>in</strong>g rate. There is no way to stand <strong>in</strong> December 2010with a rapidly grow<strong>in</strong>g economy without hav<strong>in</strong>g had consumers resistrais<strong>in</strong>g <strong>the</strong>ir sav<strong>in</strong>gs and choos<strong>in</strong>g to spend <strong>in</strong>stead. Is this plausible?It is certa<strong>in</strong>ly possible, but given <strong>the</strong> widespread wealth destructionand high degree of unemployment-<strong>in</strong>duced economic uncerta<strong>in</strong>ty, itis a much less plausible scenario than assum<strong>in</strong>g a fur<strong>the</strong>r <strong>in</strong>crease <strong>in</strong><strong>the</strong> sav<strong>in</strong>g rate. So we tend to differ with most forecasters regard<strong>in</strong>g<strong>the</strong> speed and tim<strong>in</strong>g of <strong>the</strong> recovery.This future-history approach doesn’t guarantee that you will havepicked <strong>the</strong> right future, but it does facilitate objectivity. Oncepresent-day events occurred that differed <strong>from</strong> what you imag<strong>in</strong>ed,that is, once <strong>the</strong> world ended up somewhere o<strong>the</strong>r than where youthought it was go<strong>in</strong>g to end up, you would know that, objectively,you were wrong.
LARRY LINDSEY 15Candor Is KeyIt is so important <strong>in</strong> bus<strong>in</strong>ess to remember that you are not justdeal<strong>in</strong>g with economic data and trends; you are also deal<strong>in</strong>g withpeople. You must be honest with your clients, no matter howunpleasant <strong>the</strong> news is. Candor requires that you state your objectiveand <strong>in</strong>dependent op<strong>in</strong>ion to someone who may not want to hear it.Your analysis may, <strong>in</strong> fact, implicitly be tell<strong>in</strong>g someone, ‘‘You’rewrong.’’ What makes candor particularly challeng<strong>in</strong>g <strong>in</strong> <strong>the</strong> consult<strong>in</strong>gworld is that <strong>the</strong> person to whom you are be<strong>in</strong>g candid ispay<strong>in</strong>g you.There are, of course, some obvious po<strong>in</strong>ters on how to deliver <strong>the</strong>candid but undesirable message. One should always be polite, striveto listen carefully, and rema<strong>in</strong> objective and analytic. Try not todefend your message simply because it is yours, but <strong>in</strong>stead because<strong>the</strong> facts warrant it. No one should believe that candor is easy. Itreally depends on <strong>the</strong> client, and what you may conclude is that yourproduct or service is really not for everyone. One obvious placewhere candor gets tough is <strong>the</strong> discussion of politics.Politics entail risks to our clients; thus, <strong>the</strong>y should receive ourbest judgment on what <strong>the</strong> numbers say <strong>the</strong> outcome of an electionis—and what that outcome is likely to mean for policy. Predict<strong>in</strong>g<strong>the</strong> outcome of an election is very much like economic forecast<strong>in</strong>g;it is data-<strong>in</strong>tensive and requires both <strong>in</strong>dependence and objectivityto do it right. We called both <strong>the</strong> 2004 and 2008 election resultsalmost precisely correctly, err<strong>in</strong>g on <strong>the</strong> popular vote marg<strong>in</strong> bothtimes by only a few tenths of a percent. In 2008, we missed by as<strong>in</strong>gle electoral vote—<strong>the</strong> first district of Nebraska, which voted forObama, although <strong>the</strong> state voted for McCa<strong>in</strong> (we had not brokendown <strong>the</strong> outcome to <strong>the</strong> congressional district level).But deliver<strong>in</strong>g that result was not easy. Our Democratic clientswere none too pleased with our yearlong predictions of <strong>the</strong> 2004race, given <strong>the</strong>ir distaste for Bush; and our Republican clients werenot happy with our view that Obama was go<strong>in</strong>g to w<strong>in</strong> easily. There
16 THRIVING IN THE NEW ECONOMYwere times dur<strong>in</strong>g both elections when <strong>the</strong> polls of <strong>the</strong> moment werecall<strong>in</strong>g <strong>the</strong> reverse result. But aga<strong>in</strong>, future history suggested thatlook<strong>in</strong>g back <strong>from</strong> <strong>the</strong> perspective of after Election Day and try<strong>in</strong>g tochart a path to that outcome made that contrary result implausible.The Next PhaseThe next phase of <strong>the</strong> economic crisis was <strong>the</strong> f<strong>in</strong>anc<strong>in</strong>g phase.Although <strong>the</strong> economy overall did not deleverage, some leverage wasmoved <strong>from</strong> <strong>the</strong> private sector to <strong>the</strong> public sector. The lost privatesector leverage represented a general recognition of lower assetvalues—and an offsett<strong>in</strong>g, public sector-f<strong>in</strong>anced reduction <strong>in</strong>liabilities. As a result, <strong>the</strong> private sector was not made fundamentallybetter off, <strong>in</strong> that its net worth did not <strong>in</strong>crease. Instead, <strong>the</strong> hole thathad emerged <strong>in</strong> its balance sheet was recognized, or partiallyrecognized, and <strong>the</strong> <strong>in</strong>stitutions that faced <strong>in</strong>solvency issues as aresult were rescued by a debt-f<strong>in</strong>anced <strong>in</strong>jection of capital <strong>from</strong> <strong>the</strong>government. From <strong>the</strong> po<strong>in</strong>t of view of <strong>the</strong> national balance sheet,<strong>the</strong> country is <strong>the</strong>refore poorer.This reduction <strong>in</strong> wealth necessitates a slow<strong>in</strong>g of economicactivity. It should happen primarily <strong>in</strong> <strong>the</strong> consumption spend<strong>in</strong>gof <strong>the</strong> household sector, because this more than any o<strong>the</strong>r sectorsaw a reduction <strong>in</strong> wealth that was not offset by government. Inparticular, we anticipate sav<strong>in</strong>g rates to cont<strong>in</strong>ue to <strong>in</strong>crease ashouseholds seek to rebuild <strong>the</strong>ir balance sheets. By contrast, officialforecasts anticipate that <strong>the</strong> sav<strong>in</strong>g rate will fall aga<strong>in</strong> and return to<strong>the</strong> levels seen <strong>in</strong> <strong>the</strong> middle of <strong>the</strong> decade. If those official forecaststurn out to be analytically wrong, <strong>the</strong>n economic growth will face atremendous headw<strong>in</strong>d go<strong>in</strong>g forward—and we should see a subpareconomic performance at least through 2010 and possibly longer. So<strong>the</strong> analytic po<strong>in</strong>t for markets should be to determ<strong>in</strong>e whe<strong>the</strong>rhousehold sav<strong>in</strong>gs will fall <strong>in</strong> <strong>the</strong> face of deteriorat<strong>in</strong>g balance sheetsand high unemployment, as <strong>the</strong> adm<strong>in</strong>istration and most officialforecasts presume, or whe<strong>the</strong>r it will rise. If officials are wrong and
LARRY LINDSEY 17<strong>the</strong>ir budgetary and economic projections turn out to be too rosy,<strong>the</strong> second analytic challenge will be to determ<strong>in</strong>e how economicleaders will respond.Our view is that <strong>the</strong> household sav<strong>in</strong>g rate will ultimately rise to 8to 10 percent and <strong>the</strong> unemployment rate will rise to double-digitlevels. If this is correct, how <strong>the</strong>n will <strong>the</strong> adm<strong>in</strong>istration and o<strong>the</strong>rpublic sector decision makers respond? How will markets react? Weanticipate that leaders will use more rhetoric and political management.Of course, as a future historian look<strong>in</strong>g back on <strong>the</strong> path thatproduces this outcome, one must rema<strong>in</strong> alert to possible changesthat would signal a different outcome.One such change would be an actual sharp decl<strong>in</strong>e <strong>in</strong> <strong>the</strong> personalsav<strong>in</strong>g rate that many now have built <strong>in</strong>to <strong>the</strong>ir forecasts. That wouldmean more robust economic growth over <strong>the</strong> near term. Although itwould produce real long-term challenges to <strong>the</strong> country, <strong>the</strong> temporaryrelief provided by a lower sav<strong>in</strong>g rate would likely take someof <strong>the</strong> pressure off <strong>the</strong> political developments described previously. Asecond such change would be a shift <strong>in</strong> <strong>the</strong> balance of decisionmak<strong>in</strong>gpower with<strong>in</strong> <strong>the</strong> adm<strong>in</strong>istration away <strong>from</strong> rhetoriticiansand political managers and toward analytic experts.If history is any guide, <strong>the</strong>re will be a series of major personnelshake-ups over <strong>the</strong> next couple of years. It will be <strong>in</strong>terest<strong>in</strong>g to seewhich leadership types ga<strong>in</strong> ground and which lose ground.Grappl<strong>in</strong>g with <strong>the</strong> CrisisOne of <strong>the</strong> advantages that our firm offers is that all of <strong>the</strong> pr<strong>in</strong>cipalsat The L<strong>in</strong>dsey Group have spent time work<strong>in</strong>g for different politicalleaders as well as be<strong>in</strong>g <strong>in</strong>volved <strong>in</strong> f<strong>in</strong>ancial markets. And with<strong>in</strong>creas<strong>in</strong>g power flow<strong>in</strong>g to Wash<strong>in</strong>gton, this should prove crucial.Our experience develops a deeply seated sense of realism aboutleadership. In particular, it emphasizes <strong>the</strong> po<strong>in</strong>t that nobody isperfect. There are two corollaries to this observation about leadership:First, it means that leaders will tend to perform well at some
18 THRIVING IN THE NEW ECONOMYtasks and not so well at o<strong>the</strong>rs. In general, successful leaders tend touse <strong>the</strong> skills <strong>the</strong>y have <strong>in</strong> abundance to compensate for <strong>the</strong>irshortcom<strong>in</strong>gs. Second, <strong>the</strong> universality of imperfection meansthat when one has a leader who th<strong>in</strong>ks he or she is perfect—oralmost perfect—or if <strong>the</strong>re is a media perception that this is <strong>the</strong> case,mistakes are likely to be made and expectations are almost certa<strong>in</strong> tobe disappo<strong>in</strong>ted. This is not a disparagement of any particular<strong>in</strong>dividual; ra<strong>the</strong>r, it is an <strong>in</strong>dependent, objective, and candid viewof <strong>the</strong> difficulties leaders are go<strong>in</strong>g to have <strong>in</strong> grappl<strong>in</strong>g with <strong>the</strong>current crisis.One should start <strong>the</strong> analysis with leadership style. Of <strong>the</strong> threetypes of leadership described here—managerial, rhetorical, andanalytic—<strong>the</strong> current adm<strong>in</strong>istration appears to have <strong>the</strong> first two<strong>in</strong> abundance. The rhetorical powers of President Obama aresecond to none. He exceeds those of Bill Cl<strong>in</strong>ton, and at leastrivals those of Ronald Reagan. Many analysts of leadership skillsthat are required of a President put this rhetorical power as first<strong>in</strong> importance. After all, President Barak Obama must conv<strong>in</strong>cemembers of Congress and <strong>the</strong> public at large of <strong>the</strong> importance ofhis agenda. There is no doubt that President Obama has done this,given <strong>the</strong> size of his mandate <strong>in</strong> November; his ability to produceelectoral coattails, which gave his party a very comfortable majority<strong>in</strong> Congress; and his propensity s<strong>in</strong>ce <strong>the</strong> <strong>in</strong>auguration to turn thatmajority <strong>in</strong>to legislation.Indeed, <strong>the</strong> ability to move legislation through quickly is ano<strong>the</strong>rrem<strong>in</strong>der of <strong>the</strong> skills <strong>the</strong> adm<strong>in</strong>istration has <strong>in</strong> political management.Although <strong>the</strong> president does not appear to manage per se, and<strong>in</strong>stead devotes his time to maximiz<strong>in</strong>g <strong>the</strong> use of his rhetorical skills,he has hired a tremendously successful team of political managers <strong>in</strong><strong>the</strong> likes of Rahm Emanuel, Valerie Jarrett, and David Axelrod.These three were <strong>in</strong>strumental <strong>in</strong> his upset victory over HillaryCl<strong>in</strong>ton <strong>in</strong> <strong>the</strong> contest for <strong>the</strong> Democratic presidential nom<strong>in</strong>ation,and <strong>the</strong>y ran a virtually flawless general election contest aga<strong>in</strong>st JohnMcCa<strong>in</strong>. They are people who know how to move <strong>the</strong> political
LARRY LINDSEY 19process to deliver on <strong>the</strong> rhetorical leadership that is PresidentObama’s strong suit. In addition, <strong>the</strong>y collectively enforce a degreeof message discipl<strong>in</strong>e over adm<strong>in</strong>istration personnel that is fargreater and more successful than that developed by <strong>the</strong> Bill Cl<strong>in</strong>tonor George W. Bush White Houses (and nei<strong>the</strong>r Cl<strong>in</strong>ton nor Bushwere particularly slackers <strong>in</strong> this regard).What is less clear at this po<strong>in</strong>t is whe<strong>the</strong>r <strong>the</strong> adm<strong>in</strong>istration hasdeveloped real analytic powers. There is no doubt that <strong>the</strong>y haveextremely talented <strong>in</strong>dividuals who possess such powers <strong>in</strong> both <strong>the</strong>economic and <strong>the</strong> foreign policy areas. But <strong>the</strong> balance of powerwith<strong>in</strong> <strong>the</strong> adm<strong>in</strong>istration and <strong>the</strong> process of decision mak<strong>in</strong>g isdriven far more by <strong>the</strong> managerial and rhetorical demands ofleadership than <strong>the</strong> analytic. In <strong>the</strong> economic area, this tendencyfor rhetoric to get ahead of analysis showed up <strong>in</strong> <strong>the</strong> stimulus bill.To <strong>the</strong>ir credit, adm<strong>in</strong>istration officials contacted a good variety ofeconomic forecasters, <strong>in</strong>clud<strong>in</strong>g me, on <strong>the</strong> appropriate size of <strong>the</strong>stimulus package. I concurred on <strong>the</strong> size that ultimately wasproposed: $800 billion. But <strong>the</strong> adm<strong>in</strong>istration’s analytic workstopped <strong>the</strong>re. It <strong>the</strong>n turned over <strong>the</strong> craft<strong>in</strong>g of <strong>the</strong> details of <strong>the</strong>stimulus bill to <strong>the</strong> Congress, and more precisely, to <strong>the</strong> appropriationscommittees <strong>in</strong> Congress. These are <strong>the</strong> reptilian bra<strong>in</strong>s of <strong>the</strong>political process whose s<strong>in</strong>gle thought is to spend on <strong>the</strong> projects <strong>the</strong>members of <strong>the</strong> committee and <strong>the</strong>ir friends want. The result was anabsolute disaster: money appropriated to areas that would have littlebenefit to <strong>the</strong> economy or job-creation effect. This conclusion waswidespread among budget analysts, <strong>in</strong>clud<strong>in</strong>g <strong>the</strong> CongressionalBudget Office, which noted that <strong>the</strong> long time lag on spend<strong>in</strong>gmade this a particularly <strong>in</strong>efficient piece of ‘‘stimulus.’’The <strong>in</strong>efficiency of <strong>the</strong> stimulus bill and <strong>the</strong> o<strong>the</strong>r spend<strong>in</strong>g thathas gone through Congress is produc<strong>in</strong>g an un<strong>in</strong>tended consequencethat is go<strong>in</strong>g to drive <strong>the</strong> economy, markets, and, <strong>in</strong>directly,public policy <strong>in</strong> <strong>the</strong> months ahead. This <strong>in</strong>efficiencyproduces <strong>the</strong> comb<strong>in</strong>ation of a weak recovery—particularly on<strong>the</strong> jobs front—and sharply ris<strong>in</strong>g budget deficits. These higher
20 THRIVING IN THE NEW ECONOMYdeficits, <strong>in</strong> turn, put pressure on <strong>in</strong>terest rates. To attract <strong>the</strong>necessary funds to f<strong>in</strong>ance <strong>the</strong> deficit, rates must rise <strong>in</strong> order toattract capital <strong>from</strong> abroad or crowd out private domestic <strong>in</strong>vestmentor debt-f<strong>in</strong>anced consumption.Leadership <strong>in</strong> <strong>the</strong> F<strong>in</strong>anc<strong>in</strong>g PhaseThus, <strong>the</strong> economics of <strong>the</strong> f<strong>in</strong>anc<strong>in</strong>g phase of this crisis is <strong>in</strong>extricablyl<strong>in</strong>ked to <strong>the</strong> political handl<strong>in</strong>g of <strong>the</strong> crisis. In contemplat<strong>in</strong>g<strong>the</strong> likely actions of <strong>the</strong> adm<strong>in</strong>istration, it is worth consider<strong>in</strong>ghow <strong>the</strong>y view <strong>the</strong>mselves—and how <strong>the</strong>ir allies view <strong>the</strong>m. Themost common phrase used <strong>in</strong> Wash<strong>in</strong>gton and <strong>in</strong> <strong>the</strong> ma<strong>in</strong>streammedia is that <strong>the</strong>y are ‘‘pragmatists,’’ a moniker <strong>the</strong>y’ve earnedbecause <strong>the</strong>y have shown a will<strong>in</strong>gness to compromise. For example,it became obvious on <strong>the</strong> Cap-and-Trade scheme that <strong>the</strong> oppositionby current emitters of carbon and <strong>the</strong>ir customers wouldblock what was basically a ‘‘carbon tax’’ approach. So <strong>the</strong> adm<strong>in</strong>istrationgave up on collect<strong>in</strong>g revenue <strong>from</strong> Cap and Trade and used85 percent of <strong>the</strong> supposed proceeds as a give back to <strong>the</strong> polluterswho were object<strong>in</strong>g to <strong>the</strong> proposal. This is pragmatic, but it hasun<strong>in</strong>tended consequences. The $80 billion per year that wasexpected to be collected—and that was a key part of <strong>the</strong> president’slong-run budget—has just been given away. This only fur<strong>the</strong>rweakens <strong>the</strong> analytic position of <strong>the</strong> fiscal policy position of <strong>the</strong>country and <strong>the</strong> adm<strong>in</strong>istration.So, pragmatism is not analytical, and it is quite different <strong>from</strong>realism. A pragmatist is a rhetorical leader or political manager whohas been mugged by reality. An analytic realist might have noted <strong>the</strong><strong>in</strong>compatibility of count<strong>in</strong>g on carbon tax revenue that was crafted<strong>in</strong> a way that would have ensured its political defeat, while apragmatist plows forward anyway and compromises when forced to.Apply this pragmatism to <strong>the</strong> possibility that <strong>the</strong> economy doesnot expand as <strong>the</strong> adm<strong>in</strong>istration expects because of a householddesire to <strong>in</strong>crease sav<strong>in</strong>gs. The analyst would have a plan B <strong>in</strong> place.
LARRY LINDSEY 21A pragmatist waits for reality to hit and <strong>the</strong>n deals with it <strong>in</strong> a waythat seems right at <strong>the</strong> time. The one th<strong>in</strong>g a pragmatist can’t do isadmit that he or she was wrong and take back what was proposed totry a new approach. Rhetorical and managerial leaders don’t do this.Like Chuck Pr<strong>in</strong>ce, <strong>the</strong>y will keep danc<strong>in</strong>g as long as <strong>the</strong> music isplay<strong>in</strong>g; and if <strong>the</strong>y have enough power, <strong>the</strong>y will do all <strong>the</strong>y can tomake sure that <strong>the</strong> band keeps play<strong>in</strong>g.This does not mean that <strong>the</strong>y can’t adapt or compromise. Oneobvious possibility would be to go on offense and say that what wasdone was right, but too small <strong>in</strong> magnitude, so what is needed is todo more of <strong>the</strong> same, that is, to use <strong>the</strong> formidable rhetorical andpolitical management skills of <strong>the</strong> adm<strong>in</strong>istration to pass ano<strong>the</strong>rstimulus bill. A number of analysts, particularly on <strong>the</strong> left, havealready called for do<strong>in</strong>g so. Although this is a possibility, it isunlikely to be <strong>the</strong> path of least resistance for <strong>the</strong> political process orfor <strong>the</strong> markets. The markets pose <strong>the</strong> most obvious impediment.They are already react<strong>in</strong>g to <strong>the</strong> massive f<strong>in</strong>anc<strong>in</strong>g needs that <strong>the</strong>first stimulus bill and o<strong>the</strong>r pieces of legislation created by driv<strong>in</strong>g<strong>in</strong>termediate and long-term <strong>in</strong>terest rates substantially higher. Thisis crowd<strong>in</strong>g out o<strong>the</strong>r economic activities and mak<strong>in</strong>g particulartrouble <strong>in</strong> <strong>the</strong> bond market. So it would be questionable, to say<strong>the</strong> least, on economic and f<strong>in</strong>ancial grounds to simply do more of<strong>the</strong> same.But <strong>the</strong>re is a separate political factor that probably blocksexplor<strong>in</strong>g this avenue. Politicians respond to <strong>the</strong> behavioral characteristicof, ‘‘if it feels good, do it.’’ Trouble is, this avenue didn’t feelso good. In general, <strong>the</strong> political feedback has been poor, with votersask<strong>in</strong>g tough questions about <strong>the</strong> <strong>in</strong>efficacy of what was passed and<strong>the</strong> ‘‘str<strong>in</strong>gs’’ that were attached. Thus, tak<strong>in</strong>g <strong>the</strong> offensive <strong>in</strong> fiscalmatters seems unlikely; a defensive response seems more so.Economically and <strong>in</strong> markets, all of this will come toge<strong>the</strong>r <strong>in</strong> areversal of <strong>the</strong> Great Moderation. That 25-year historical moment<strong>in</strong>creased private risk tak<strong>in</strong>g as <strong>the</strong> perceived risk<strong>in</strong>ess of publicdecision mak<strong>in</strong>g decl<strong>in</strong>ed. The leverage created by that private risk
22 THRIVING IN THE NEW ECONOMYtak<strong>in</strong>g and <strong>the</strong> asset prices supported by it rema<strong>in</strong> <strong>in</strong> place, but thisleverage is <strong>in</strong>appropriate for <strong>the</strong> new era. As more power devolves toWash<strong>in</strong>gton, <strong>the</strong> market risks associated with policy formation<strong>in</strong>crease. This means that risk premiums must rise across <strong>the</strong> board.Equity risk premiums will rise because more of <strong>the</strong> volatility ofeconomic performance will come <strong>from</strong> discrete political decisionsra<strong>the</strong>r than more gradual market ones. Credit and term structure riskpremiums will also rise as uncerta<strong>in</strong>ties about future monetary andfiscal policy <strong>in</strong>crease. All th<strong>in</strong>gs equal, this could also mean a lowerequilibrium level for <strong>the</strong> foreign exchange value of <strong>the</strong> dollar.Prosper<strong>in</strong>g <strong>in</strong> this <strong>New</strong> <strong>Economy</strong>As more power is shifted to Wash<strong>in</strong>gton, <strong>the</strong> challenge for <strong>in</strong>vestorsbecomes more difficult. Some are advocat<strong>in</strong>g a policy of ‘‘<strong>in</strong>vest with<strong>the</strong> government and you can’t go broke.’’ This would lead one to putmoney <strong>in</strong> <strong>the</strong> new partly nationalized sectors of <strong>the</strong> economy, such as<strong>the</strong> large money center banks, <strong>the</strong> auto companies, and probablyparts of <strong>the</strong> health care <strong>in</strong>dustry. This does not seem like a good wayto <strong>in</strong>itiate <strong>the</strong> f<strong>in</strong>anc<strong>in</strong>g phase of an economic crisis. Although <strong>the</strong>sefirms are surviv<strong>in</strong>g because <strong>the</strong>y get money <strong>from</strong> Uncle Sam, UncleSam himself is runn<strong>in</strong>g out of borrow<strong>in</strong>g capacity. Even if his newwards <strong>in</strong> <strong>the</strong> private sector don’t go broke, <strong>the</strong>y won’t be allowed tobe exceptionally profitable ei<strong>the</strong>r. Those profits will be appropriatedto fill o<strong>the</strong>r missions that Wash<strong>in</strong>gton needs accomplished.The central issue for America will be to pay its bills—particularlyits overseas debt. This will mean that America’s exporters will have avery important role to fill. The likely decl<strong>in</strong>e <strong>in</strong> global faith <strong>in</strong> <strong>the</strong>dollar will help <strong>the</strong>m along. If one th<strong>in</strong>ks about those th<strong>in</strong>gs <strong>in</strong>which America already has a comparative advantage—agriculture,aircraft, enterta<strong>in</strong>ment, and technology—<strong>the</strong> new economy willrequire <strong>the</strong>m to be even more profitable than <strong>in</strong> <strong>the</strong> past.But a broader and more hands-on government will also mean arollback <strong>in</strong> <strong>the</strong> areas of <strong>the</strong> economy that have benefited <strong>from</strong>
LARRY LINDSEY 23f<strong>in</strong>ancial <strong>in</strong>termediation. Home ownership rates are unlikely torega<strong>in</strong> <strong>the</strong>ir recent peaks. Indeed, <strong>in</strong> terms of metrics like squarefeet of liv<strong>in</strong>g space per person, we have probably seen peaks that maynever be atta<strong>in</strong>ed aga<strong>in</strong>, or if so, only after decades of recovery. It isworth keep<strong>in</strong>g <strong>in</strong> m<strong>in</strong>d that <strong>the</strong> total stock of hous<strong>in</strong>g <strong>in</strong>vestmentdid not keep up with depreciation <strong>from</strong> 1929 through 1945, despitea grow<strong>in</strong>g population.F<strong>in</strong>ance itself is likely to change and become less <strong>in</strong>termediated.Institutions that were set up to br<strong>in</strong>g borrower and lender toge<strong>the</strong>r<strong>in</strong> an <strong>in</strong>creas<strong>in</strong>gly complex f<strong>in</strong>ancial arrangement have been significantlydiscredited, because <strong>the</strong> real value of <strong>the</strong>ir <strong>in</strong>volvementgenerally was less than <strong>the</strong> fees <strong>the</strong>y charged. In <strong>the</strong> new economy,we suspect that private arrangements will become more common asentanglement with highly regulated f<strong>in</strong>ancial <strong>in</strong>termediaries becomesless attractive. Moreover, given recent <strong>in</strong>stitutional failures,traits such as <strong>in</strong>dependence, objectivity, and candor will be valuedmore than marquee names <strong>in</strong> <strong>the</strong> <strong>in</strong>termediation arena.The new economy will also be one <strong>in</strong> which new economicleadership will emerge. Although we do not believe that America’sbest days are beh<strong>in</strong>d us, <strong>the</strong> confluence of ris<strong>in</strong>g political control overeconomic matters <strong>in</strong> <strong>the</strong> midst of this f<strong>in</strong>anc<strong>in</strong>g phase means thatnear term, <strong>the</strong> relative economic power of America will wane. Ourrelationships as a firm reflect this. We are rapidly develop<strong>in</strong>gcontacts and do<strong>in</strong>g bus<strong>in</strong>ess <strong>in</strong> South and East Asia and Arabia.It is worth keep<strong>in</strong>g <strong>in</strong> m<strong>in</strong>d that f<strong>in</strong>ancial and economic relationships<strong>in</strong> <strong>the</strong>se areas tend not to be <strong>in</strong>stitutionalized, and only lightly<strong>in</strong>termediated. Trust—and a long experience with <strong>the</strong> <strong>in</strong>dividualswith whom one does bus<strong>in</strong>ess—is vital. It is particularly <strong>in</strong>terest<strong>in</strong>gthat what we would have considered an ‘‘underdeveloped’’ f<strong>in</strong>ancialmarketplace <strong>in</strong> <strong>the</strong>se areas is actually <strong>the</strong> k<strong>in</strong>d of model to which wewill gradually evolve <strong>in</strong> this f<strong>in</strong>anc<strong>in</strong>g phase of <strong>the</strong> crisis.The greatest question <strong>in</strong> <strong>the</strong>se areas is whe<strong>the</strong>r a dollar-basedglobal economy will cont<strong>in</strong>ue or whe<strong>the</strong>r <strong>the</strong> whole concept of apure fiat-money system will also be a casualty of <strong>the</strong> recent crisis.
24 THRIVING IN THE NEW ECONOMYCurrent talk of a ‘‘currency basket’’ replac<strong>in</strong>g <strong>the</strong> dollar seemsmisplaced. The problem <strong>the</strong> dollar has is that it is thought to besubject to political manipulation <strong>in</strong> order to meet <strong>the</strong> near-termeconomic needs of <strong>the</strong> United States. Substitut<strong>in</strong>g a basket of suchcurrencies, each politically manipulated by its own government,hardly seems like a compell<strong>in</strong>g substitute. The more press<strong>in</strong>gquestion is whe<strong>the</strong>r one of <strong>the</strong> newly emerg<strong>in</strong>g countries decidesthat it can offer a real competitor to <strong>the</strong> dollar by mov<strong>in</strong>g away<strong>from</strong> a fiat-based system toward one that represents a more purestore of value. Some form of specie-based currency may turn out tobe a real possibility <strong>in</strong> our new economic era if global faith <strong>in</strong> <strong>the</strong>dollar erodes.
2Steve ForbesWhen it comes to <strong>the</strong> marriageof politics and <strong>the</strong>economy, Steve Forbes,former presidential candidate;chairman, president,and CEO of Forbes; andeditor-<strong>in</strong>-chief of Forbesmagaz<strong>in</strong>e; is one of <strong>the</strong>best authorities <strong>in</strong> <strong>the</strong> <strong>in</strong>dustry.The company’s flagshippublication, Forbes, is<strong>the</strong> nation’s lead<strong>in</strong>g bus<strong>in</strong>essmagaz<strong>in</strong>e, with a U.S.circulation of 919,742. Ithas 11 local language editionsthat reach a worldwideaudience of morethan 5 million readers. Steve’s charisma and economicknowledge are embraced by many around <strong>the</strong> world.25
26 THRIVING IN THE NEW ECONOMYSeptember 2008 was <strong>the</strong> culm<strong>in</strong>ation of a series of disasters<strong>in</strong> government policies, start<strong>in</strong>g with <strong>the</strong> weak-dollar policyof <strong>the</strong> Bush Adm<strong>in</strong>istration and <strong>the</strong> Federal Reserve. The hous<strong>in</strong>gbubble would never have reached <strong>the</strong> size it did had it not been for<strong>the</strong> Fed’s actions. Fannie Mae and Freddie Mac stoked <strong>the</strong> flames ofthis crisis with more than $1 trillion <strong>in</strong> junk mortgage guarantees.This crisis was exacerbated by <strong>the</strong> government’s <strong>in</strong>consistency—byfirst sav<strong>in</strong>g <strong>the</strong> operations of Bear Stearns but <strong>the</strong>n by lett<strong>in</strong>gLehman Bro<strong>the</strong>rs, which was <strong>in</strong>f<strong>in</strong>itely more important and consequential,go under. It was very clear by that <strong>in</strong>famous Septemberweekend that we were <strong>in</strong> <strong>the</strong> midst of a f<strong>in</strong>ancial panic, <strong>the</strong> likes ofwhich we had not seen s<strong>in</strong>ce <strong>the</strong> 1930s. We had experienced manydisasters before, but not on this scale.The Bush Adm<strong>in</strong>istration’s flounder<strong>in</strong>g became clear <strong>in</strong> <strong>the</strong>spr<strong>in</strong>g of 2008. This cont<strong>in</strong>ued on <strong>in</strong>to <strong>the</strong> summer with FannieMae, Freddie Mac, and AIG com<strong>in</strong>g under scrut<strong>in</strong>y. The Adm<strong>in</strong>istrationneeded to stop twiddl<strong>in</strong>g its thumbs and hop<strong>in</strong>g for <strong>the</strong>best and needed to take action. But with <strong>the</strong> failure of LehmanBro<strong>the</strong>rs, it was obvious that President Bush, Treasury SecretaryHank Paulson, and Fed Chairman Ben Bernanke didn’t know what<strong>the</strong>y were do<strong>in</strong>g. It was clear that no preparations were made at all,nor did <strong>the</strong>se people understand <strong>the</strong> utter destructiveness ofapply<strong>in</strong>g mark-to-market account<strong>in</strong>g rules to <strong>the</strong> regulatory capitalof banks and life <strong>in</strong>surance companies. Ano<strong>the</strong>r policy blunder is<strong>the</strong> repeal of <strong>the</strong> uptick rule. The short sell<strong>in</strong>g of securities wasbanned dur<strong>in</strong>g <strong>the</strong> Great Depression for good reason. However,this ban was lifted <strong>in</strong> 2007. The Securities and Exchange Commission(SEC) is still sitt<strong>in</strong>g on this. Author’s note: The uptick rule was adopted by <strong>the</strong> Securities and Exchange Commission <strong>in</strong>1938 and removed <strong>in</strong> 2007. It prevented <strong>the</strong> short-sell<strong>in</strong>g of securities unless <strong>the</strong>y are onan uptick.
STEVE FORBES 27Def<strong>in</strong><strong>in</strong>g <strong>the</strong> <strong>New</strong> <strong>Economy</strong>The economy, battered by post-credit crisis 2007 and post–Lehman2008, is ready to grow aga<strong>in</strong>—if <strong>the</strong> government could just get its acttoge<strong>the</strong>r. Clearly, <strong>the</strong> Obama Adm<strong>in</strong>istration does not understand<strong>the</strong> need for a stable dollar; has no appreciation of <strong>the</strong> destructivenessof tax <strong>in</strong>creases; is still try<strong>in</strong>g to nationalize health care; is still try<strong>in</strong>gto push cap-and-trade; and still won’t ratify new trade agreementssuch as those with Colombia and South Korea (particularly importantbecause <strong>the</strong> world is toy<strong>in</strong>g with protectionism more and moreand <strong>the</strong> Adm<strong>in</strong>istration is do<strong>in</strong>g noth<strong>in</strong>g to stop it).Kick-Start<strong>in</strong>g <strong>the</strong> <strong>New</strong> <strong>Economy</strong>Short term, <strong>the</strong> Fed needs to live up to its reputation; that is, it mustpump liquidity <strong>in</strong>to mortgage-backed securities and packages ofcar loans and credit card loans. Although <strong>the</strong> Fed and <strong>the</strong> Adm<strong>in</strong>istrationhave talked about mak<strong>in</strong>g <strong>the</strong>se moves, precious little hasbeen done. The Fed’s balance sheet is now smaller than it was <strong>in</strong>December. (See Figure 2.1.)Figure 2.1Credit Extended through Federal Reserve Liquidity FacilitiesAll Liquidity FacilitiesTerm Auction CreditCommercial Paper Fund<strong>in</strong>g Facility$BillionsCentral Bank Liquidity Swaps1,8001,6001,4001,2001,00080060040020005-Nov-08 17-Dec-08 31-Jan-09 11-Mar-09 22-Apr-09 31-May-09 8-Jul-09 19-Aug-09 30-Sep-09Source: Federal Reserve
28 THRIVING IN THE NEW ECONOMYUs<strong>in</strong>g History as a Guide for <strong>the</strong> FutureTo thrive <strong>in</strong> this new economy, you have to do two th<strong>in</strong>gs immediatelyand simultaneously: tighten your belt <strong>in</strong> <strong>the</strong> short term,reduc<strong>in</strong>g expenses and reorganiz<strong>in</strong>g operations to meet current shorttermconditions, and move forward with <strong>in</strong>itiatives and make <strong>in</strong>vestments<strong>in</strong> areas and projects that will build your future.Forbes magaz<strong>in</strong>ehadexperiencewiththis<strong>in</strong>2001.After<strong>the</strong>events of 9/11 <strong>the</strong> economy slid <strong>in</strong>to a recession and cont<strong>in</strong>ued todecl<strong>in</strong>e. The advertis<strong>in</strong>g bus<strong>in</strong>ess began fall<strong>in</strong>g off a cliff. Advertis<strong>in</strong>g<strong>in</strong> Forbes decreased by 40 percent. And <strong>the</strong> company waslos<strong>in</strong>g boatloads of money <strong>in</strong> our new web site venture. Wedecided never<strong>the</strong>less to cont<strong>in</strong>ue to pump money <strong>in</strong>to our website. O<strong>the</strong>r players however, froze and did noth<strong>in</strong>g. When <strong>the</strong>recovery came <strong>in</strong> 2003, Forbes.com did magnificently because of<strong>the</strong> long-term <strong>in</strong>itiatives we already had <strong>in</strong> place. In fact, <strong>in</strong> 2003<strong>the</strong> web site made more money than <strong>the</strong> pr<strong>in</strong>t side of <strong>the</strong> bus<strong>in</strong>ess.Today, Forbes.com has almost 20 million unique visitors a month.Today, we have to apply <strong>the</strong> same strategy: cop<strong>in</strong>g with <strong>the</strong> shorttermproblems while not los<strong>in</strong>g sight of <strong>the</strong> need to take <strong>in</strong>itiativesfor <strong>the</strong> future.We are currently launch<strong>in</strong>g new tools and resources on <strong>the</strong> website while cont<strong>in</strong>u<strong>in</strong>g to expand our network, both onl<strong>in</strong>e and <strong>in</strong>pr<strong>in</strong>t. On May 21, 2009, we launched Forbes <strong>in</strong> India, and it is offto a great start. We now have 11 local editions of Forbes. In Aprilof 2009, we launched ForbesWoman on <strong>the</strong> Web. This site isdevoted to women <strong>in</strong> bus<strong>in</strong>ess. There is also a publication to goalong with <strong>the</strong> web site. Essentially, we learned that <strong>in</strong> a downeconomy you have to both tighten your belt and plant seeds for <strong>the</strong>future, which is tough to do.Today’s economic atmosphere is much more <strong>in</strong>tense. Beforethis crisis, most people had no doubts about <strong>the</strong> future of pr<strong>in</strong>t.People weren’t worried about <strong>the</strong> survival of <strong>the</strong> bank<strong>in</strong>g system.They weren’t concerned about what <strong>the</strong> government was go<strong>in</strong>g to
STEVE FORBES 29do regard<strong>in</strong>g General Motors. But you can’t get caught up <strong>in</strong> justcop<strong>in</strong>g with immediate conditions and try<strong>in</strong>g to get by. You alsohave to plan for <strong>the</strong> future—only block<strong>in</strong>g and tackl<strong>in</strong>g will not helpyou grow <strong>in</strong> times of crisis.Future of Magaz<strong>in</strong>esThankfully for our company, magaz<strong>in</strong>es are <strong>in</strong> a different world thannewspapers. <strong>New</strong>s is a commodity now, and people want it <strong>in</strong>stantly,search<strong>in</strong>g for it on <strong>the</strong>ir handhelds. However, people still doread magaz<strong>in</strong>es. Our readership both nationally and overseas hasactually never been better, never been higher. When people readmagaz<strong>in</strong>es, <strong>the</strong>y do so with a different frame of m<strong>in</strong>d; it’s a relaxedframe of m<strong>in</strong>d. They like <strong>the</strong> tactile flexibility of magaz<strong>in</strong>es.Ad spend<strong>in</strong>g <strong>in</strong> <strong>the</strong> first half of 2009 was terrible and wasrem<strong>in</strong>iscent of <strong>the</strong> tough bus<strong>in</strong>ess climate follow<strong>in</strong>g 9/11. But earlier,<strong>in</strong> 2008, Forbes began mak<strong>in</strong>g positive changes <strong>in</strong> <strong>the</strong> way wemarketed both <strong>the</strong> web site and <strong>the</strong> magaz<strong>in</strong>e. We actually <strong>in</strong>tegrated<strong>the</strong> market<strong>in</strong>g and advertis<strong>in</strong>g of both.Most of <strong>the</strong> content on our web site does not appear <strong>in</strong> <strong>the</strong>magaz<strong>in</strong>e. Because <strong>the</strong> Internet allows for more immediacy, <strong>the</strong>re’sa far broader range of content onl<strong>in</strong>e than is available <strong>in</strong> a magaz<strong>in</strong>e.Video has also become a major component of Forbes.com. In <strong>the</strong>fall of 2008, we launched a video feature called Intelligent Invest<strong>in</strong>g.I sit down with people such as Jack Bogle for a half-hour<strong>in</strong>terview—this has proven to be very popular. You can see <strong>the</strong> sameapproach on CNBC.On <strong>the</strong> magaz<strong>in</strong>e side, we are able to do th<strong>in</strong>gs graphically and <strong>in</strong>depth, even though our stories are always short and to <strong>the</strong> po<strong>in</strong>t.Graphics give credibility to a story. The amaz<strong>in</strong>g part of this isthat even though people go to <strong>the</strong> Web for quick <strong>in</strong>formation, <strong>the</strong>yalso go <strong>the</strong>re to get more <strong>in</strong>formation on topics <strong>the</strong>y’ve read about<strong>in</strong> a magaz<strong>in</strong>e.
30 THRIVING IN THE NEW ECONOMYLook<strong>in</strong>g Ahead to <strong>the</strong> FutureIt is impossible to predict where we will be 10 years <strong>from</strong> now. Noone could have foreseen an event like 9/11, or <strong>the</strong> massive growthof <strong>the</strong> Web and <strong>the</strong> impact it would have on so many <strong>in</strong>dustries.We have also seen <strong>the</strong> rise of such phenomena as social networks,Google, and products like <strong>the</strong> iPod, as well as <strong>the</strong> catastrophiceconomic crisis that began <strong>in</strong> <strong>the</strong> summer of 2007.As long as you ma<strong>in</strong>ta<strong>in</strong> <strong>the</strong> flexibility to adjust and adapt whenunforeseen circumstances arise, you can map a long-term strategy tohelp you reach your bus<strong>in</strong>ess goals. Our strategy is to cont<strong>in</strong>ue todevelop our web site <strong>in</strong> terms of creat<strong>in</strong>g new features and newproducts, especially proprietary products that <strong>in</strong>crease value. Wealso own o<strong>the</strong>r sites, <strong>in</strong>clud<strong>in</strong>g Investopedia, and hold a majority <strong>in</strong>RealClearPolitics, which is a great aggregator of political articles.There is a lot of opportunity to grow. And as I mentioned earlier, weare also expand<strong>in</strong>g overseas—both <strong>in</strong> pr<strong>in</strong>t and onl<strong>in</strong>e.The relationship between media and culture <strong>in</strong> o<strong>the</strong>r countries is avery sensitive th<strong>in</strong>g. One does not dare develop bus<strong>in</strong>ess <strong>in</strong> Ch<strong>in</strong>a,for example, without hav<strong>in</strong>g a local partner <strong>the</strong>re. And until recentlyIndia has traditionally been quite restrictive as well. But Indiachanged its rules govern<strong>in</strong>g publications <strong>in</strong> <strong>the</strong> fall of 2008, amove that enabled Forbes to come <strong>in</strong> as Forbes India. We arework<strong>in</strong>g with Network18, which is <strong>the</strong> CNBC affiliate <strong>in</strong> India.Whe<strong>the</strong>r <strong>the</strong> medium you use to reach your market is television,radio, pr<strong>in</strong>t, or onl<strong>in</strong>e, it is <strong>the</strong> way you execute your strategy thatwill ultimately determ<strong>in</strong>e your success or failure. There is not oneapproach that will work for everyone. But <strong>in</strong> turbulent times,everyone will be up for a while and <strong>the</strong>n down aga<strong>in</strong>. In a crisis likethis, everyone is go<strong>in</strong>g to be hard hit. But when th<strong>in</strong>gs level outaga<strong>in</strong>, <strong>the</strong>re are those who will do well and those who will fall by<strong>the</strong> wayside.Edison was right: 1 percent <strong>in</strong>spiration, 99 percent perspiration.
3DavidMalpassFormer chief economist atBear Stearns and currentpresident of Encima Global,David Malpass, providesa wealth of <strong>in</strong>sighton recently transformedeconomic policies. In2005, 2006, and 2007,while at Bear Stearns,Mr. Malpass ranked second<strong>in</strong> <strong>the</strong> InstitutionalInvestor rank<strong>in</strong>g of WallStreet economists. Priorto his time <strong>the</strong>re, Davidworked <strong>in</strong> Wash<strong>in</strong>gtoneconomic policy positionsfor n<strong>in</strong>e years. He held several economic positionsdur<strong>in</strong>g <strong>the</strong> Reagan and Bush Adm<strong>in</strong>istrations between(cont<strong>in</strong>ued)31
32 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)February 1984 and January 1993, <strong>in</strong>clud<strong>in</strong>g serv<strong>in</strong>g as deputyassistant treasury secretary for develop<strong>in</strong>g nations,deputy assistant secretary of state, Republican staff directorof Congress’s Jo<strong>in</strong>t Economic Committee, and senior analystfor taxes and trade at <strong>the</strong> Senate Budget Committee.David worked on a variety of economic, budgetary, and<strong>in</strong>ternational issues <strong>in</strong> his government roles: <strong>the</strong> 1986 taxcut, <strong>the</strong> Gramm-Rudman budget laws of 1990, severalcongressional budget resolutions, <strong>the</strong> sav<strong>in</strong>gs and loanbailout of <strong>the</strong> 1990s, <strong>the</strong> North American Free Trade Agreement(NAFTA), <strong>the</strong> Brady Plan for develop<strong>in</strong>g country debtat <strong>the</strong> end of <strong>the</strong> 1980s, and <strong>the</strong> fast-track trade authorityprocess enacted <strong>in</strong> 2001. He was a member of <strong>the</strong> government’sSenior Executive Service and testified frequentlybefore Congress. Here, David offers his <strong>in</strong>sight and analysison global economic and political trends, with <strong>in</strong>vestmentresearch spann<strong>in</strong>g equities, fixed <strong>in</strong>come, commodities,and currencies.In March 2008, <strong>the</strong> Fed was <strong>in</strong> rate-cutt<strong>in</strong>g mode, whichturned out to be a reasonable short-term buy<strong>in</strong>g opportunity.Why? Over <strong>the</strong> decades, situations where<strong>in</strong> <strong>the</strong> monetarypolicies are loosened have been generally favorable times for<strong>in</strong>vest<strong>in</strong>g. Also, <strong>in</strong>vest<strong>in</strong>g after crises has, <strong>in</strong> most cases, madesense for Americans—for example, after 9/11, after HurricaneKatr<strong>in</strong>a, and after <strong>the</strong> 2007 securitization wipeout, which extendedup to <strong>the</strong> Bear Stearns takeover by J.P. Morgan. Ofcourse, <strong>the</strong> weak dollar and high oil prices dur<strong>in</strong>g <strong>the</strong> summerof 2008 and Lehman Bro<strong>the</strong>rs’ bankruptcy created a second—andmore severe—crisis.The sector valuations considered mostattractivehaveshiftedover <strong>the</strong> decades. Technology was favored <strong>in</strong> <strong>the</strong> 1990s, <strong>the</strong>n
DAVID MALPASS 33f<strong>in</strong>ancial services through 2006. The August 2007 breakdown ofsecuritization had a very harsh effect on f<strong>in</strong>ancial services companies.I had a complete change of view to <strong>the</strong> negative <strong>in</strong> August2007 based on <strong>the</strong> breakdown of how f<strong>in</strong>ance was be<strong>in</strong>g done. Justas <strong>the</strong> burst of <strong>the</strong> NASDAQ bubble <strong>in</strong> 2001 caused a long-termslow period for technology stocks, <strong>the</strong> same happened to f<strong>in</strong>ancialservices <strong>in</strong> August 2007. The crisis was a fundamental negativechange for <strong>the</strong> entire sector. Separately, materials and commoditystocks cont<strong>in</strong>ued to be very strong through July 2008 based on <strong>the</strong>weak dollar policy of <strong>the</strong> United States.I wrote three articles for <strong>the</strong> Wall Street Journal <strong>in</strong> late 2007through March 2008 that criticized <strong>the</strong> Bush adm<strong>in</strong>istration’sdollar-weaken<strong>in</strong>g policy. Although that policy had positive implicationsfor oil, oil stocks, and o<strong>the</strong>r commodity stocks, it wasdetrimental to <strong>the</strong> rest of <strong>the</strong> economy due to higher raw materialscosts and <strong>the</strong> <strong>in</strong>flation impact. Inflation hit 5.6 percent <strong>in</strong> July 2008,which was very harmful to many sectors.Markets Post Lehman Bro<strong>the</strong>rsI was surprised and dismayed by <strong>the</strong> bankruptcy of Lehman Bro<strong>the</strong>rs;<strong>the</strong> market was completely unprepared for that development. Itmarked a major negative <strong>in</strong>flection po<strong>in</strong>t for <strong>the</strong> U.S. economy andfor <strong>the</strong> market outlook. The day after Lehman Bro<strong>the</strong>rs declaredbankruptcy, <strong>the</strong> commercial paper market stopped function<strong>in</strong>g. Themarket between banks for <strong>in</strong>terbank loans stopped function<strong>in</strong>g. Evenn<strong>in</strong>e months later, markets have not fully repaired.F<strong>in</strong>d<strong>in</strong>g Inflection Po<strong>in</strong>tsI try to identify major <strong>in</strong>flection po<strong>in</strong>ts <strong>in</strong> my analysis of <strong>the</strong> market.Dur<strong>in</strong>g most months of <strong>the</strong> year, <strong>the</strong>re’s not a major change ofdirection with<strong>in</strong> <strong>the</strong> market. People are trad<strong>in</strong>g week by week with<strong>in</strong> arelatively cont<strong>in</strong>uous market, so f<strong>in</strong>d<strong>in</strong>g <strong>the</strong> turn<strong>in</strong>g po<strong>in</strong>t is a critical
34 THRIVING IN THE NEW ECONOMYissue. After Lehman Bro<strong>the</strong>rs’ bankruptcy, I took <strong>the</strong> view that <strong>the</strong>economy would quickly hit a brick wall. The goal was to make clear<strong>in</strong> <strong>in</strong>vestors’ m<strong>in</strong>ds <strong>the</strong> extent of <strong>the</strong> changes <strong>the</strong>y would see post–Lehman Bro<strong>the</strong>rs—and one way to do that was to compare it to <strong>the</strong>August 2007 <strong>in</strong>flection po<strong>in</strong>t. In August 2007, I had a major conferencecall where I gave a negative change of view, which was someth<strong>in</strong>gthat was uncharacteristic for me given my usual optimism. I <strong>the</strong>nexpla<strong>in</strong>ed <strong>the</strong> Lehman Bro<strong>the</strong>rs’ bankruptcy and <strong>the</strong> economic downturnwould be five to ten times worse than <strong>the</strong> August 2007 crisis.<strong>New</strong> <strong>Economy</strong> StrategyFrom <strong>the</strong> standpo<strong>in</strong>t of <strong>in</strong>vestment strategy, <strong>the</strong> bankruptcy ofLehman Bro<strong>the</strong>rs created <strong>the</strong> most deeply negative environmentthat we’ve had s<strong>in</strong>ce <strong>the</strong> Asia crisis <strong>in</strong> 1998—<strong>the</strong> deflation crisis thatswept <strong>the</strong> world and lasted through 2002. The normal range forassets allocated to equities is 30 to 60 or 70 percent. After LehmanBro<strong>the</strong>rs declared bankruptcy, people were forced to th<strong>in</strong>k <strong>in</strong> termsof a negative allocation, a ‘‘net short’’ k<strong>in</strong>d of a position to guardaga<strong>in</strong>st <strong>the</strong> extent of <strong>the</strong> economic contraction. Investors arenormally optimistic about <strong>the</strong> long run, which has been an accurateoutlook for American <strong>in</strong>vestors s<strong>in</strong>ce 1982. The Volcker-Reagannexus <strong>in</strong> 1981 that focused on reduc<strong>in</strong>g <strong>in</strong>flation helped create abasically favorable dis<strong>in</strong>flation environment that lasted until LehmanBro<strong>the</strong>rs declared bankruptcy. After that we found ourselves <strong>in</strong>an environment where people had to th<strong>in</strong>k about be<strong>in</strong>g net short—someth<strong>in</strong>g that’s now an available strategy because of <strong>the</strong> ultrashortexchange-traded funds (ETFs). Author’s note: ETFs or Exchange Traded Funds are funds that can track a basket of assetslike an <strong>in</strong>dex fund, a commodity, or an <strong>in</strong>dex. It is traded like a stock on a stock exchange.This type of fund gives <strong>in</strong>vestors <strong>the</strong> ability to sell <strong>the</strong> fund short while hav<strong>in</strong>g <strong>the</strong>diversification of own<strong>in</strong>g an <strong>in</strong>dex fund. An example of an ETF is <strong>the</strong> S&P 500 Index,<strong>the</strong> Spider (SPDR).
DAVID MALPASS 35We have to identify what exactly caused <strong>the</strong> downturn <strong>in</strong> <strong>the</strong>markets. The cost of capital is higher, <strong>the</strong> size of government isbigger, and <strong>the</strong> potential growth of <strong>the</strong> economy has been reduced.Growth comes <strong>from</strong> <strong>the</strong> private sector. The shift toward governmentdom<strong>in</strong>ance of <strong>the</strong> economy lowers expectations for productivity andGross Domestic Product (GDP) growth as well as expectations forcorporate earn<strong>in</strong>gs growth <strong>in</strong>to <strong>the</strong> future. This will rema<strong>in</strong> so untilthose factors—<strong>the</strong> higher cost of capital and <strong>the</strong> bigger public sectorrelative to <strong>the</strong> private sector—can be reversed.We are <strong>in</strong> a long-term dim<strong>in</strong>ished environment that will takesome time to rebuild <strong>in</strong>to ano<strong>the</strong>r, better earn<strong>in</strong>gs environment.The economy hit a brick wall after Lehman Bro<strong>the</strong>rs and went <strong>in</strong>toan extended free fall—one that will take a lot of time to recover<strong>from</strong>. The message to our clients is to not reach too far for <strong>the</strong>green shoots and to be cautious <strong>in</strong> <strong>the</strong>ir <strong>in</strong>vestments given both <strong>the</strong>Wash<strong>in</strong>gton policies (which keep gett<strong>in</strong>g worse) and <strong>the</strong> effects <strong>in</strong><strong>the</strong> real economy. For example, <strong>the</strong> shift<strong>in</strong>g of bank and creditmarket lend<strong>in</strong>g toward <strong>the</strong> elite and away <strong>from</strong> small bus<strong>in</strong>essesmeans that <strong>the</strong> credit allocation function is mov<strong>in</strong>g toward largercompanies and governments and away <strong>from</strong> <strong>in</strong>novation andentrepreneurism. That aga<strong>in</strong> signifies that it will take an extendedperiod of time to work this out.Ano<strong>the</strong>r observation is that given <strong>the</strong> distortion of prices thatoccurred between 2005 and 2007, due to <strong>the</strong> Federal Reserve’smistakes on <strong>in</strong>terest rates, it will take more time for us to establish abasel<strong>in</strong>e for prices for commodities and o<strong>the</strong>r assets with<strong>in</strong> <strong>the</strong>economy. This means a long period of sort<strong>in</strong>g out price levels, whichcreates opportunities. The successful stock pickers will f<strong>in</strong>d companiesthat benefit <strong>from</strong> those price dislocations.In <strong>the</strong> first half of 2009, we experienced an almost month-bymonthdeterioration of <strong>the</strong> economy as reflected <strong>in</strong> jobless claimsand <strong>in</strong>ability to roll over debt. Nei<strong>the</strong>r banks nor credit marketshave recovered <strong>the</strong>ir full functionality <strong>from</strong> Lehman Bro<strong>the</strong>rs’bankruptcy.Thoughimprov<strong>in</strong>g,wearestill<strong>in</strong>anevolv<strong>in</strong>gcrisis,
36 THRIVING IN THE NEW ECONOMYand it’s probably too early to make long-term <strong>in</strong>vestment plans.After stock prices fell as severely as <strong>the</strong>y did <strong>in</strong> February 2009, <strong>the</strong>irvaluations were cheap. The problem is that <strong>the</strong> earn<strong>in</strong>gs are go<strong>in</strong>gthrough a fundamental change post–Lehman, so it is still too earlyto try to buy stocks based on valuation at this po<strong>in</strong>t. We are still <strong>in</strong>that chaotic period after <strong>the</strong> all-out free fall. People will be moresuccessful <strong>in</strong> do<strong>in</strong>g value-based <strong>in</strong>vest<strong>in</strong>g late <strong>in</strong> 2009.
4Jack BogleIt’s my job at CNBC tobook <strong>the</strong> big news makersand to create andproduce must-see newsevents—one of which is<strong>the</strong> ‘‘Squawk F<strong>in</strong>ancialSummit.’’ For one hour,we br<strong>in</strong>g some of <strong>the</strong> biggestWall Street nameson <strong>the</strong> CNBC programSquawk Box to talk about<strong>the</strong> news of <strong>the</strong> day andhow it is affect<strong>in</strong>g <strong>the</strong>markets, but more importantly, to look at opportunities.My f<strong>in</strong>ancial summit comprises mutual fund legend,Vanguard founder, and former CEO Jack Bogle; BlackRockvice chairman and global chief <strong>in</strong>vestment officer of equitiesBob Doll; bond k<strong>in</strong>g PIMCO’s manag<strong>in</strong>g director PaulMcCulley; and strategist and president of Goldman’s GlobalMarkets Institute Abby Joseph Cohen.(cont<strong>in</strong>ued)37
38 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)Jack Bogle is truly one of Wall Street’s legends. Boglefounded Vanguard <strong>in</strong> 1974, and under his leadership<strong>the</strong> company grew <strong>in</strong>to <strong>the</strong> second largest mutual fundcompany <strong>in</strong> <strong>the</strong> world. Jack is a no-nonsense k<strong>in</strong>d of guy; hetells it like he sees it.Today’s turbulence reflects <strong>in</strong> important measure <strong>the</strong> failureof our commercial and <strong>in</strong>vestment banks to consider<strong>the</strong> extraord<strong>in</strong>ary risks of <strong>the</strong> securities <strong>the</strong>y were creat<strong>in</strong>g andmarket<strong>in</strong>g—and earn<strong>in</strong>g billions <strong>in</strong> fees and commissions, even as<strong>the</strong>y were left with tens of billions of dollars, even hundreds ofbillions, on <strong>the</strong>ir own balance sheets. Given Wall Street’s everpress<strong>in</strong>gneed to have someth<strong>in</strong>g, anyth<strong>in</strong>g, to sell <strong>in</strong> <strong>the</strong> way of‘‘new product,’’ it is hardly surpris<strong>in</strong>g that <strong>the</strong>se collateralized debtobligations (CDOs) became ever more complex, with even moredeeply concealed risk. In league with rat<strong>in</strong>g agencies registeredwith <strong>the</strong> Securities and Exchange Commission (SEC)—whichwere evidently paid some $400,000 for each issue on which<strong>the</strong>y placed <strong>the</strong>ir imprimatur—an estimated $1 trillion of newCDOs were created entirely out of subprime mortgages. Although<strong>in</strong>dividually <strong>the</strong>se mortgages were of dubious credit quality, <strong>the</strong>CDOs created various ‘‘tranches,’’ with about 75 percent rated top<strong>in</strong>vestment grade AAA, on <strong>the</strong> assumption that any defaults wouldimpair only <strong>the</strong> lower-rated series. Alchemy? No, lead is still lead,not gold.Liquidity PutsHow, I wonder (and I’m sure that you wonder too), could <strong>the</strong>seagencies have been so unm<strong>in</strong>dful, so cavalier, so craven about <strong>the</strong>credit risks that so quickly came home to roost? And how much
JACK BOGLE 39more is yet to be disclosed about <strong>the</strong> deteriorat<strong>in</strong>g market prices of<strong>the</strong>se complex <strong>in</strong>struments?We’llknowsomeday.Butwehaveallheard<strong>the</strong>sadly<strong>in</strong>formativeanecdotes of former chairman of <strong>the</strong> giant Citigroup CharlesPr<strong>in</strong>ce on <strong>the</strong> situation <strong>in</strong> <strong>the</strong> summer of 2007, as questions about<strong>the</strong> propriety of his firm’s decision were raised: ‘‘As long as <strong>the</strong>musicisplay<strong>in</strong>g,you’vegottogetupanddance.We’restilldanc<strong>in</strong>g.’’ (Citigroup director Robert Rub<strong>in</strong> had never heard of <strong>the</strong>‘‘liquidity put.’’ As 2007 ended, Citigroup disclosed that <strong>the</strong>yheld some $25 billion of <strong>the</strong>se <strong>in</strong>struments.) For Merrill Lynch,<strong>the</strong> write-down was $22 billion. Follow<strong>in</strong>g a long period of cheapcredit and rife credit availability—and borrowers with high confidenceand low collateral—we are beg<strong>in</strong>n<strong>in</strong>g to pay <strong>the</strong> price, evenas our economy itself faces a whole plethora of o<strong>the</strong>r risks createdby our f<strong>in</strong>ancial system.Rise of <strong>the</strong> F<strong>in</strong>ancial SystemThe rise of <strong>the</strong> f<strong>in</strong>ancial sector is one of <strong>the</strong> seldom-told tales of <strong>the</strong>recent era. Twenty-five years ago, f<strong>in</strong>ancials accounted for onlyabout 5 percent of <strong>the</strong> earn<strong>in</strong>gs of <strong>the</strong> 500 giant corporations thatcompose <strong>the</strong> Standard & Poor’s (S&P) 500 Stock Index. Fifteenyears ago, <strong>the</strong> f<strong>in</strong>ancial sector share had risen to 10 percent; <strong>the</strong>n to20 percent <strong>in</strong> 1997 and to a near-peak level of 27 percent <strong>in</strong> 2006.(See Figure 4.1.)If we add to this total <strong>the</strong> earn<strong>in</strong>gs of <strong>the</strong> f<strong>in</strong>ancial affiliates of ourgiant manufacturers (th<strong>in</strong>k General Electric Capital, for example, or<strong>the</strong> auto f<strong>in</strong>anc<strong>in</strong>g arms of General Motors and Ford), f<strong>in</strong>ancialearn<strong>in</strong>gs likely exceeded one-third of <strong>the</strong> annual earn<strong>in</strong>gs of <strong>the</strong> S&P Author’s note: A liquidity put is <strong>the</strong> right of holders <strong>in</strong> collateralized debt obligation(CDO) to sell back a CDO to its issuer at <strong>the</strong> orig<strong>in</strong>al price. In 2007, it was circulated <strong>in</strong> <strong>the</strong>news that Citigroup had $25 billion <strong>in</strong> liquidity puts, which greatly <strong>in</strong>creased <strong>the</strong>irexposure to subprime mortgages.
40 THRIVING IN THE NEW ECONOMYFigure 4.1Twentieth Century Stock Returns by <strong>the</strong> DecadeSource: The Vanguard Group500. In fact, <strong>the</strong> f<strong>in</strong>ancial sector is by far our nation’s lead<strong>in</strong>ggenerator of corporate profits, larger even than <strong>the</strong> comb<strong>in</strong>ed profitsof our huge energy and health care sectors, and almost three times asmuch as ei<strong>the</strong>r <strong>in</strong>dustrials or <strong>in</strong>formation technology.To some degree, of course, <strong>the</strong> growth of <strong>the</strong> f<strong>in</strong>ancial sector reflectsnot just <strong>the</strong> rise <strong>in</strong> demand for f<strong>in</strong>ancial services (<strong>the</strong> mutual fund<strong>in</strong>dustry is a good example) but also <strong>the</strong> fact that many privatelyowned firms have become publicly owned, <strong>in</strong>clud<strong>in</strong>g <strong>in</strong>vestmentbank<strong>in</strong>g firms, mutual fund managers (once mutual <strong>in</strong>surance companies),and even our stock exchanges. For example, <strong>the</strong>re were 56stocks <strong>in</strong> <strong>the</strong> S&P f<strong>in</strong>ancial sector <strong>in</strong> 1989, <strong>in</strong>clud<strong>in</strong>g 28 banks; <strong>in</strong>2007, <strong>the</strong>re were 92 stocks, but only 26 banks. The comb<strong>in</strong>ation ofpublic ownership and earn<strong>in</strong>gs growth has been dramatic. Theearn<strong>in</strong>gs of fund manager T. Rowe Price rose <strong>from</strong> $4 million <strong>in</strong>1981 to $582 million <strong>in</strong> <strong>the</strong> 12 months end<strong>in</strong>g on June 30, 2007.In any event, we’re mov<strong>in</strong>g, or so it seems, toward becom<strong>in</strong>g acountry where we’re no longer mak<strong>in</strong>g anyth<strong>in</strong>g. We’re merelytrad<strong>in</strong>g pieces of paper, swapp<strong>in</strong>g stocks and bonds back and forth
JACK BOGLE 41with one ano<strong>the</strong>r, and pay<strong>in</strong>g our f<strong>in</strong>ancial croupiers a veritablefortune. We’re also add<strong>in</strong>g even more costs by creat<strong>in</strong>g ever morecomplex f<strong>in</strong>ancial derivatives <strong>in</strong> which huge and unfathomable risksare be<strong>in</strong>g built <strong>in</strong>to our f<strong>in</strong>ancial system. ‘‘When enterprise becomes<strong>the</strong> bubble on a whirlpool of speculation,’’ as <strong>the</strong> great Britisheconomist John Maynard Keynes warned us more than 70 years ago,<strong>the</strong> consequences may be dire. ‘‘When <strong>the</strong> capital development ofa country becomes a by-product of <strong>the</strong> activities of a cas<strong>in</strong>o, <strong>the</strong> job(of capitalism) is likely to be ill-done’’ (1936).Economic ResiliencySo <strong>the</strong> risks are high; <strong>the</strong> uncerta<strong>in</strong>ties rife. Yet perhaps we’ll make itthrough. After all, throughout our more than 230-year history,America has always done exactly that. Perhaps, once aga<strong>in</strong>, oursociety and our economy will cont<strong>in</strong>ue to reflect <strong>the</strong> resilience that<strong>the</strong>y have demonstrated <strong>in</strong> <strong>the</strong> past, often aga<strong>in</strong>st all odds. Andperhaps we’ll come to our collective senses and develop <strong>the</strong> courageto take arms aga<strong>in</strong>st this sea of troubles I’ve described and byoppos<strong>in</strong>g <strong>the</strong>m, end <strong>the</strong>m. If we do, <strong>the</strong> stock market will undoubtedlyrespond and resume <strong>the</strong> upward course that is based on <strong>the</strong><strong>in</strong>tr<strong>in</strong>sic economic value of bus<strong>in</strong>ess growth.Successful Invest<strong>in</strong>gSuccessful <strong>in</strong>vest<strong>in</strong>g is not about <strong>the</strong> stock market, but ra<strong>the</strong>r aboutown<strong>in</strong>g all of America’s bus<strong>in</strong>esses and reap<strong>in</strong>g <strong>the</strong> huge rewardsprovided by <strong>the</strong> dividends and earn<strong>in</strong>gs growth of our nation’s—and, for that matter, our world’s—corporations. For <strong>in</strong> <strong>the</strong> very longrun, it is how bus<strong>in</strong>esses actually perform that determ<strong>in</strong>es <strong>the</strong> returnon our <strong>in</strong>vested capital. Dividend yields, plus earn<strong>in</strong>gs growth,account for substantially 100 percent of <strong>the</strong> return on stocks. Putano<strong>the</strong>r way, <strong>in</strong> <strong>the</strong> words of Warren Buffett: ‘‘The most that owners
42 THRIVING IN THE NEW ECONOMY<strong>in</strong> <strong>the</strong> aggregate can earn between now and Judgment Day is what<strong>the</strong>ir bus<strong>in</strong>ess <strong>in</strong> <strong>the</strong> aggregate earns.’’ Illustrat<strong>in</strong>g <strong>the</strong> po<strong>in</strong>t withBerkshire Hathaway—<strong>the</strong> publicly owned <strong>in</strong>vestment company hehas run for 40 years—Buffett says, ‘‘When <strong>the</strong> stock temporarilyover-performs or under-performs <strong>the</strong> bus<strong>in</strong>ess, a limited number ofshareholders—ei<strong>the</strong>r sellers or buyers—receive out-sized benefits at<strong>the</strong> expense of those <strong>the</strong>y trade with. But over time, <strong>the</strong> aggregatega<strong>in</strong>s made by Berkshire shareholders must of necessity match <strong>the</strong>bus<strong>in</strong>ess ga<strong>in</strong>s of <strong>the</strong> company.’’How often <strong>in</strong>vestors lose sight of that eternal pr<strong>in</strong>ciple! Yet <strong>the</strong>record is clear. History, if only we would take <strong>the</strong> trouble to look atit, reveals <strong>the</strong> remarkable, if essential, l<strong>in</strong>k between <strong>the</strong> cumulativelong-term returns earned by bus<strong>in</strong>ess—<strong>the</strong> annual dividend yieldplus <strong>the</strong> annual rate of earn<strong>in</strong>gs growth—and <strong>the</strong> cumulative returnsearned by <strong>the</strong> U.S. stock market. Th<strong>in</strong>k about that certa<strong>in</strong>ty for amoment. Can you see that it is simple common sense?Still need proof? Just look at <strong>the</strong> record s<strong>in</strong>ce <strong>the</strong> twentiethcentury began. The average annual total return on stocks was 9.6percent, virtually identical to <strong>the</strong> <strong>in</strong>vestment return of 9.5 percent—4.5 percent <strong>from</strong> dividend yield and 5 percent <strong>from</strong> earn<strong>in</strong>gsgrowth. That t<strong>in</strong>y difference of 0.1 percent per year arose <strong>from</strong>what I call speculative return, depend<strong>in</strong>g on how one looks at it.Perhaps it is merely statistical noise, or perhaps it reflects a generallyupward long-term trend <strong>in</strong> stock valuations, a will<strong>in</strong>gness of <strong>in</strong>vestorsto pay higher prices for each dollar of earn<strong>in</strong>gs at <strong>the</strong> end of <strong>the</strong>period than at <strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g.Emotional Invest<strong>in</strong>gStock market returns sometimes get well ahead of bus<strong>in</strong>ess fundamentals(as <strong>in</strong> <strong>the</strong> late 1920s, <strong>the</strong> early 1970s, and <strong>the</strong> late 1990s).But it has been only a matter of time until, as if drawn by gravity,<strong>the</strong>y soon return back to earth (as <strong>in</strong> <strong>the</strong> mid-1940s, <strong>the</strong> late 1970s,and <strong>the</strong> 2003 market lows). (See Figure 4.2.)
JACK BOGLE 43Figure 4.2Twentieth Century Stock Returns, by <strong>the</strong> Decade (% per Year)Source: The Vanguard GroupIn our foolish focus on <strong>the</strong> short-term stock market distractions of<strong>the</strong> moment, we, too, often overlook this long history. We ignore <strong>the</strong>fact that when <strong>the</strong> returns on stocks depart materially <strong>from</strong> <strong>the</strong> longtermnorm, it is rarely because of <strong>the</strong> economics of <strong>in</strong>vest<strong>in</strong>g—<strong>the</strong>earn<strong>in</strong>gs growth and dividend yields of our corporations. Ra<strong>the</strong>r, <strong>the</strong>reason that annual stock returns are so volatile is largely because of<strong>the</strong> emotions of <strong>in</strong>vest<strong>in</strong>g.We can measure <strong>the</strong>se emotions by <strong>the</strong> price-to-earn<strong>in</strong>gs (P/E)ratio, which represents <strong>the</strong> number of dollars <strong>in</strong>vestors are will<strong>in</strong>gto pay for each dollar of earn<strong>in</strong>gs. As <strong>in</strong>vestor confidence waxes andwanes, P/E multiples rise and fall. When greed holds sway, we seevery high P/E ratios. When hope prevails, P/E ratios are moderate.When fear is <strong>in</strong> <strong>the</strong> saddle, P/E ratios are very low. Back and forth,over and over aga<strong>in</strong>, sw<strong>in</strong>gs <strong>in</strong> <strong>the</strong> emotions of <strong>in</strong>vestors momentarilyderail <strong>the</strong> long-range upward trend <strong>in</strong> <strong>the</strong> economics of <strong>in</strong>vest<strong>in</strong>g.
44 THRIVING IN THE NEW ECONOMYAlthough <strong>the</strong> prices we pay for stocks often lose touch with <strong>the</strong>reality of corporate values, <strong>in</strong> <strong>the</strong> long run, reality rules. So, although<strong>in</strong>vestors seem to <strong>in</strong>tuitively accept that <strong>the</strong> past is <strong>in</strong>evitably aprologue to <strong>the</strong> future, any past stock market returns that have<strong>in</strong>cluded a high speculative stock return component are a deeplyflawed guide to what lies ahead. To understand why past returns donot foretell <strong>the</strong> future, we need only <strong>the</strong> words of John MaynardKeynes written 70 years ago: ‘‘It is dangerous . . . to apply to <strong>the</strong>future <strong>in</strong>ductive arguments based on past experience, unless one candist<strong>in</strong>guish <strong>the</strong> broad reasons why past experience was what it was.’’But if we can dist<strong>in</strong>guish <strong>the</strong> reasons <strong>the</strong> past was what it was,<strong>the</strong>n, we can establish reasonable expectations about <strong>the</strong> future.Keynes helped us make this dist<strong>in</strong>ction by po<strong>in</strong>t<strong>in</strong>g out that <strong>the</strong> stateof long-term expectation for stocks is a comb<strong>in</strong>ation of enterprise(‘‘forecast<strong>in</strong>g <strong>the</strong> prospective yield of assets over <strong>the</strong>ir whole life’’)and speculation (‘‘forecast<strong>in</strong>g <strong>the</strong> psychology of <strong>the</strong> market’’) (TheGeneral Theory, Chapter 12). I’m well familiar with those words;55 years ago, I <strong>in</strong>corporated <strong>the</strong>m <strong>in</strong> my senior <strong>the</strong>sis at Pr<strong>in</strong>cetonUniversity, written (providentially for my lifetime career thatfollowed) on <strong>the</strong> mutual fund <strong>in</strong>dustry. It was titled The EconomicRole of <strong>the</strong> Investment Company.After almost 55 years <strong>in</strong> this bus<strong>in</strong>ess, I have little convictionabout how to forecast <strong>the</strong>se sw<strong>in</strong>gs <strong>in</strong> <strong>in</strong>vestor emotions, nor can Ipredict when <strong>the</strong>y will occur. However, it is clear that when P/Eratios are high (say, above 25), <strong>the</strong>y are apt ultimately to decl<strong>in</strong>e; andwhen <strong>the</strong>y are low (say, below 12), <strong>the</strong>y are apt ultimately to rise. Butlargely because <strong>the</strong> arithmetic of <strong>in</strong>vest<strong>in</strong>g is so basic, I can forecast<strong>the</strong> long-term economics of <strong>in</strong>vest<strong>in</strong>g with remarkably high odds ofsuccess. Why? Simply, it is <strong>in</strong>vestment returns—<strong>the</strong> earn<strong>in</strong>gs anddividends generated by American bus<strong>in</strong>ess—that are almost entirelyresponsible for <strong>the</strong> returns delivered <strong>in</strong> our stock market. Putano<strong>the</strong>r way, while <strong>the</strong> momentary prices we pay for stocks areoften out of touch with reality—<strong>the</strong> <strong>in</strong>tr<strong>in</strong>sic values of our corporations—<strong>in</strong><strong>the</strong> long run, is based on reality.
JACK BOGLE 45My advice to you is to ignore <strong>the</strong> short-term noise of ouremotions reflected <strong>in</strong> our f<strong>in</strong>ancial markets and <strong>in</strong>stead focus on<strong>the</strong> productive long-term economics of our corporate bus<strong>in</strong>esses.Shakespeare could have been describ<strong>in</strong>g <strong>the</strong> <strong>in</strong>explicable hourly anddaily—sometimes even yearly or longer—fluctuations <strong>in</strong> <strong>the</strong> stockmarket when he wrote, ‘‘[It is] like a tale told by an idiot, full ofsound and fury, signify<strong>in</strong>g noth<strong>in</strong>g.’’ The path to <strong>in</strong>vestment successis to get out of <strong>the</strong> expectations market of stock prices and cast yourlot with <strong>the</strong> real market of bus<strong>in</strong>ess. Simply heed <strong>the</strong> timelessdist<strong>in</strong>ction made by Benjam<strong>in</strong> Graham, legendary <strong>in</strong>vestor, authorof The Intelligent Investor, and mentor to Warren Buffett. He wasright on <strong>the</strong> money when describ<strong>in</strong>g <strong>the</strong> essential reality of <strong>in</strong>vest<strong>in</strong>g:‘‘In <strong>the</strong> short run <strong>the</strong> stock market is a vot<strong>in</strong>g mach<strong>in</strong>e . . . (but) <strong>in</strong><strong>the</strong> long run it is a weigh<strong>in</strong>g mach<strong>in</strong>e.’’Rid<strong>in</strong>g Out <strong>the</strong> RiskLet me conclude by acknowledg<strong>in</strong>g that I’m conservative, andwell . . . gett<strong>in</strong>g on <strong>in</strong> years. I’ve followed my own advice andam about 80 percent <strong>in</strong> bonds and 20 percent <strong>in</strong> stocks—allVanguard and overwhelm<strong>in</strong>gly <strong>in</strong> <strong>in</strong>dex funds. But each of us isdifferent. So even if risks are high and uncerta<strong>in</strong>ties abound, we mustconsider not only <strong>the</strong> probabilities of our <strong>in</strong>vestment decisions but<strong>the</strong> consequences that we face if we are wrong. This, of course, is <strong>the</strong>famous Pascal Wager, conceived as a bet on whe<strong>the</strong>r or not Godexists. (Pascal concluded that, consider<strong>in</strong>g <strong>the</strong> consequences, <strong>the</strong>safer bet was that He existed.) As Peter Bernste<strong>in</strong> expla<strong>in</strong>ed <strong>the</strong>wager, ‘‘consider<strong>in</strong>g <strong>the</strong> consequences of be<strong>in</strong>g wrong is essential <strong>in</strong>decision-mak<strong>in</strong>g under uncerta<strong>in</strong>ty.’’ So I urge you all not only toweigh <strong>the</strong> probabilities of where our markets and our economy areheaded <strong>in</strong> this age of turbulence and uncerta<strong>in</strong>ty, but also to weigh<strong>the</strong> consequences to your own portfolios if you are wrong. If youfollow <strong>the</strong>se rules, you’ll be able to ride out today’s risks anduncerta<strong>in</strong>ties with favorable results.
5Bob DollBob Doll, vice chairmanand global chief <strong>in</strong>vestmentofficer of equitiesof BlackRock, is aSquawk Box regular atCNBC and key member of <strong>the</strong> ‘‘Squawk Box F<strong>in</strong>ancialSummit,’’ as well as many of our market segments. AtBlackRock, Bob manages <strong>the</strong> flagship Large Cap SeriesFunds, is a member of <strong>the</strong> firm’s executive committee,and served a term on <strong>the</strong> board of directors <strong>from</strong> 2006through February 2009. Before <strong>the</strong> merger of BlackRockwith Merrill Lynch Investment Managers (MLIM) <strong>in</strong> 2006,Bob served as president and chief <strong>in</strong>vestment officer ofMLIM. He was also previously <strong>the</strong> chief <strong>in</strong>vestment officer ofOppenheimer Funds.On Squawk Box, we have referred to Bob as ‘‘<strong>the</strong> trilliondollar man,’’ because he and <strong>the</strong> o<strong>the</strong>r portfolio managersat BlackRock collectively manage over $1.3 trillion <strong>in</strong>client assets. The f<strong>in</strong>ancial crises of 2008 and 2009 havechallenged Bob and his colleagues, as never-before-seen(cont<strong>in</strong>ued)47
48 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)market conditions threw <strong>the</strong> world <strong>in</strong>to unprecedentedturmoil. The strategies that Bob discusses <strong>in</strong> his story arewhat he credits for his company’s cont<strong>in</strong>ued success.In retrospect, I th<strong>in</strong>k we first realized that we were at <strong>the</strong>beg<strong>in</strong>n<strong>in</strong>g of someth<strong>in</strong>g serious <strong>in</strong> early 2008. I was tak<strong>in</strong>gpart <strong>in</strong> one of BlackRock’s daily research calls, where all portfolioteams across all discipl<strong>in</strong>es and all geographic regions discusscommon factors affect<strong>in</strong>g our markets. For some time, we hadbeen hear<strong>in</strong>g our fixed-<strong>in</strong>come teams talk about problems <strong>in</strong> creditmarkets, and we had begun to see some subprime mortgageproblems emerge. I remember say<strong>in</strong>g that equity markets hadnot been reflect<strong>in</strong>g <strong>the</strong>se problems. Prices weren’t go<strong>in</strong>g up anymore,but <strong>the</strong>y weren’t yet dropp<strong>in</strong>g significantly ei<strong>the</strong>r. We hadno <strong>in</strong>kl<strong>in</strong>g <strong>in</strong> any way, shape, or form that it would get as bad as itdid—or that a massive recession had already begun. We did,however, start to recognize that credit was a problem, acknowledgedthatitwasprobablygo<strong>in</strong>gtogetworsebeforeitgotbetter,and surmised that credit issues were likely to keep <strong>the</strong> economy<strong>from</strong> grow<strong>in</strong>g. Follow<strong>in</strong>g those realizations, we began to reduceour positions <strong>in</strong> f<strong>in</strong>ancials. We started rotat<strong>in</strong>g out of cyclicality,and we lowered <strong>the</strong> beta <strong>in</strong> our portfolios. Of course, we wouldhave done much more of this if we had had a clue as to how bad itwas go<strong>in</strong>g to get. But, at least at <strong>the</strong> marg<strong>in</strong>, those were <strong>the</strong>strategies we began us<strong>in</strong>g <strong>in</strong> our portfolios as we began to convey amore cautious message to our clients.It wasn’t until <strong>the</strong> summer of 2008 that we started hav<strong>in</strong>g somerealissues.Atthatpo<strong>in</strong>t,ithadbecomeclearthat<strong>the</strong>creditissuesthat our fixed-<strong>in</strong>come teams had been talk<strong>in</strong>g about for some timewere threaten<strong>in</strong>g global market stability. In July and August 2008,we saw some of <strong>the</strong> credit problems emerge. The markets were notoperat<strong>in</strong>g normally, <strong>the</strong> Fed was forced to take action, and <strong>the</strong>
BOB DOLL 49equity markets began hav<strong>in</strong>g more significant setbacks. That was<strong>the</strong> po<strong>in</strong>t at which our clients began wonder<strong>in</strong>g, ‘‘Hey, what’sreally go<strong>in</strong>g on here?’’ I don’t recall many of <strong>the</strong>m ask<strong>in</strong>g us a lot ofquestions <strong>in</strong> <strong>the</strong> first half of 2008; that occurred more frequentlydur<strong>in</strong>g <strong>the</strong> summer, when markets were significantly affected. Iremember that even as recently as Labor Day <strong>in</strong> 2008 <strong>the</strong>re was awidespread debate—both with<strong>in</strong> BlackRock and among <strong>in</strong>vestors<strong>in</strong> general—as to whe<strong>the</strong>r <strong>the</strong> United States (and <strong>the</strong> rest of <strong>the</strong>world) would experience a recession.Bythatpo<strong>in</strong>t,ofcourse,wehadseen<strong>the</strong>collapseofBearStearns, but this was still well before Lehman Bro<strong>the</strong>rs declaredbankruptcy. In retrospect, it’s clear that <strong>the</strong> collapse of LehmanBro<strong>the</strong>rs marked a critical <strong>in</strong>flection po<strong>in</strong>t; and follow<strong>in</strong>g <strong>the</strong>collapse, <strong>the</strong> economy seemed to go <strong>from</strong> not so healthy todownright sick.From Waterfall Decl<strong>in</strong>e to Base Build<strong>in</strong>gWe came to realize very quickly that <strong>the</strong> mood had shifted. Wordssuch as depression, defaults, and bankruptcies became a part of our dailyconversations as we discussed our portfolios. As <strong>the</strong> equity marketsbegan <strong>the</strong>ir September/October 2008 meltdown, we were wonder<strong>in</strong>ghow far and how fast <strong>the</strong> markets would drop. We have all livedthrough bear markets; typically, bear market decl<strong>in</strong>es of 50 percenttake a couple of years to develop, but this decl<strong>in</strong>e happened <strong>in</strong> as<strong>in</strong>gle year. This bear market was fast, and it was brutal. Along <strong>the</strong>way, a number of important lows were hit, first on October 10 and<strong>the</strong>n on November 21. At each po<strong>in</strong>t, as portfolio managers, we wereask<strong>in</strong>g, ‘‘Is this <strong>the</strong> end? Are stocks now cheap enough to warrantbuy<strong>in</strong>g, or will markets go even lower?’’S<strong>in</strong>ce stocks peaked <strong>in</strong> <strong>the</strong> fall of 2007, each new low wasaccompanied by an <strong>in</strong>crease <strong>in</strong> <strong>the</strong> new low list on <strong>the</strong> <strong>New</strong> YorkStock Exchange (NYSE). On <strong>the</strong> afternoon of Thursday, October 9,
50 THRIVING IN THE NEW ECONOMYFigure 5.1Standard & Poor’s 500 IndexS&P 5001,4001,3001,2001,1001,000900800700600Jun 2008S&P 500: June 2008–June 2009Jul 2008Aug 2008Sep 2008Oct 2008Nov 2008Dec 2008Jan 2009DateFeb 2009Mar 2009Apr 2009May 2009Jun 2009Source: BlackRock2008, we started see<strong>in</strong>g some extremely heavy sell<strong>in</strong>g and <strong>the</strong> marketwas <strong>in</strong> capitulation mode as people were beg<strong>in</strong>n<strong>in</strong>g to give up. Thenext day, <strong>the</strong> new low list on <strong>the</strong> NYSE reached 1,860 stocks—<strong>the</strong>biggest new low list we had ever seen. Follow<strong>in</strong>g that low, <strong>the</strong> marketdid what it always seems to do dur<strong>in</strong>g bear markets—it bounced,tried to stabilize, failed, and moved lower.By November 21, <strong>the</strong> Standard & Poor’s (S&P) 500 Stock Indexwas down almost ano<strong>the</strong>r 100 po<strong>in</strong>ts <strong>from</strong> its October 10 low,mean<strong>in</strong>g that stocks had dropped approximately 15 percent <strong>in</strong> fiveweeks. Significantly, however, <strong>the</strong> new low list shrunk <strong>in</strong> half.There’s an old say<strong>in</strong>g that you never hear <strong>the</strong> bell r<strong>in</strong>g<strong>in</strong>g at <strong>the</strong>bottom; but I remember th<strong>in</strong>k<strong>in</strong>g that on November 21, we mayhave heard someth<strong>in</strong>g. The new low pattern had changed, and Ith<strong>in</strong>k it was a signal.At <strong>the</strong> time, we postulated that <strong>the</strong> ‘‘waterfall decl<strong>in</strong>e’’ patternthat had been <strong>in</strong> place for several months was about to change <strong>in</strong>toa months’ long, sideways ‘‘base-build<strong>in</strong>g’’ pattern, marked by highlevels of volatility. And that’s exactly what happened. From
BOB DOLL 51November 21 to early January, <strong>the</strong> stock market had quite a run to<strong>the</strong> upside and appreciated by more than 20 percent. At <strong>the</strong> time,somepeoplethoughtthat<strong>the</strong>worstwasbeh<strong>in</strong>d<strong>the</strong>m,butstocks<strong>the</strong>n sank fur<strong>the</strong>r and <strong>the</strong> S&P reached a new bottom of 666 onMarch 6, 2009. From that po<strong>in</strong>t, stocks began a rebuild<strong>in</strong>gprocess, and by <strong>the</strong> end of March, we had begun to believethat <strong>the</strong> March 6 low would, <strong>in</strong> fact, mark <strong>the</strong> ultimate low for<strong>the</strong> bear market.Look<strong>in</strong>g Ahead: Deflation versus ReflationDeterm<strong>in</strong><strong>in</strong>g <strong>the</strong> future course of action of <strong>the</strong> stock market isobviously a difficult proposition, but it is someth<strong>in</strong>g that we believeis important to do to help guide our <strong>in</strong>vestment decisions. Inaddition, our clients always want to hear our thoughts on wheremarkets are go<strong>in</strong>g. So at <strong>the</strong> start of every year, we develop a series of10 predictions cover<strong>in</strong>g our forecasted views of <strong>the</strong> economy, <strong>the</strong>markets, and factors that may affect our <strong>in</strong>vestment portfolios. For2009, we expanded that list to 12 predictions given <strong>the</strong> number ofissues fac<strong>in</strong>g <strong>in</strong>vestors. (See Figure 5.2.)When we develop <strong>the</strong>se predictions, we typically try to f<strong>in</strong>d aunify<strong>in</strong>g <strong>the</strong>me that helps tie <strong>the</strong>m all toge<strong>the</strong>r. For 2009, <strong>the</strong> ma<strong>in</strong><strong>the</strong>me was <strong>the</strong> tug-of-war between deflation and reflation. Deflationaryforces first emerged with <strong>the</strong> implosion of low-qualitymortgages—a contagion that eventually spread to all mortgagesand <strong>the</strong>n to debt markets <strong>in</strong> general. Likewise, <strong>the</strong> deflation contagionspread to all markets around <strong>the</strong> world as we saw massivedecl<strong>in</strong>es <strong>in</strong> residential real estate, commodity prices, equity prices,and, f<strong>in</strong>ally, economic growth.Reflationary policies were a direct response to <strong>the</strong>se deflationaryfactors. Policy makers around <strong>the</strong> world began to enact widespreadmonetary and fiscal stimulus measures to try to rescue us all <strong>from</strong><strong>the</strong>messthatwehadgottenourselves<strong>in</strong>to.Thedebatebecame:
52 THRIVING IN THE NEW ECONOMYFigure 5.22009 Predictions1. The U.S. economy faces its first nom<strong>in</strong>al GDP decl<strong>in</strong>e <strong>in</strong> 50years.2. Global growth falls below 2% for <strong>the</strong> first time s<strong>in</strong>ce 1991.3. Inflation falls close to zero <strong>in</strong> many developed countries, butwidespread deflation is avoided.4. The U.S. Treasury curve ends 2009 higher and steeper thanwhere it began.5. Earn<strong>in</strong>gs fall by a double-digit percentage aga<strong>in</strong> <strong>in</strong> 2009, <strong>the</strong>first back-to-back years s<strong>in</strong>ce <strong>the</strong> 1930s.6. High-yield, municipal, and <strong>in</strong>vestment-grade corporate bondspreads narrow <strong>in</strong> 2009.7. U.S. stocks record a double-digit percentage ga<strong>in</strong> <strong>in</strong> 2009.8. U.S. stocks outperform European stocks while emerg<strong>in</strong>gmarkets outperform developed ones.9. Energy, Health Care, and Information Technology to outperformUtilities, F<strong>in</strong>ancials, and Materials.10. Stock market volatility rema<strong>in</strong>s elevated as periodic doubledigitpercentage rallies and decl<strong>in</strong>es occur.11. Oil and o<strong>the</strong>r commodities bottom and move higher by yearendas emerg<strong>in</strong>g market economies beg<strong>in</strong> to recover.12. The U.S. Federal budget deficit soars past $1 trillion as <strong>the</strong>government cont<strong>in</strong>ues to grow.The op<strong>in</strong>ions presented are those of Bob Doll, as of June 2009, and may change assubsequent conditions vary.Source: BlackRock‘‘Which will w<strong>in</strong>? Reflation or deflation?’’ Our answer to <strong>the</strong>question was—and is—that although reflation and deflation willeach w<strong>in</strong> some battles, <strong>in</strong> <strong>the</strong> end, reflation should eventually w<strong>in</strong><strong>the</strong> war.
BOB DOLL 53Reach<strong>in</strong>g a BottomIn our m<strong>in</strong>ds, this deflation versus reflation discussion wasdirectly related to <strong>the</strong> question of whe<strong>the</strong>r or not we had seen<strong>the</strong> true bottom <strong>in</strong> stocks for this cycle. The worst period for<strong>the</strong> markets occurred <strong>in</strong> early 2009 amid <strong>the</strong> widespread debatesover <strong>the</strong> proper role of government <strong>in</strong> solv<strong>in</strong>g <strong>the</strong> bank<strong>in</strong>gcrisis. There was an <strong>in</strong>tense fear that <strong>the</strong> federal governmentwould nationalize significant segments of <strong>the</strong> nation’s bank<strong>in</strong>gsystem. There was also a great deal of confusion regard<strong>in</strong>g what <strong>the</strong>Federal Reserve, <strong>the</strong> Treasury, Congress, and <strong>the</strong> Obama adm<strong>in</strong>istrationwere go<strong>in</strong>g to do to tackle all of <strong>the</strong> problems affect<strong>in</strong>g<strong>the</strong> markets.It was at <strong>the</strong> height of this uncerta<strong>in</strong>ty that <strong>the</strong> S&P dropped tothat 666 level. That was when we began to see some additionalclarity emerge about <strong>the</strong> Fed’s mortgage purchase program, <strong>the</strong>Treasury’s Public-Private Investment Program, as well as signsthat <strong>the</strong> worst of <strong>the</strong> recession may have passed. Given thisbackdrop, stocks surged approximately 50 percent <strong>in</strong> <strong>the</strong> subsequentmonths. Clearly, stocks had entered <strong>in</strong>to oversold territoryand were pric<strong>in</strong>g <strong>in</strong> a more negative environment than probablyexisted. In retrospect, it seems that an S&P of 666 was discount<strong>in</strong>ga depression scenario, which became clear, would not be <strong>the</strong> case.What we were fac<strong>in</strong>g was more of a nasty recession, and one thatwe now believe has ended.The question still rema<strong>in</strong>s whe<strong>the</strong>r <strong>the</strong> post-March 2009 environmentis more of a bear market rally or a new bull market.The answer depends to a large degree on your def<strong>in</strong>ition. If by‘‘bull market’’ you mean that stocks have to reach a new all-timehigh, <strong>the</strong>n no, we don’t expect <strong>the</strong> current rally to drive <strong>the</strong> S&Pabove <strong>the</strong> 1,500 mark any time soon. In <strong>the</strong> short term, <strong>the</strong> 50percent rise may have overshot <strong>the</strong> mark a bit and markets mayhave gotten ahead of <strong>the</strong>mselves; but over <strong>the</strong> long term, we don’tbelieve we have seen <strong>the</strong> end of what we are view<strong>in</strong>g as a cyclical
54 THRIVING IN THE NEW ECONOMYbull market. There is still a lot of cash on <strong>the</strong> sidel<strong>in</strong>es, and many<strong>in</strong>vestors are still look<strong>in</strong>g for entry po<strong>in</strong>ts to <strong>the</strong> market, which webelieve provides a favorable backdrop for <strong>the</strong> market’s long-termprospects. Look<strong>in</strong>g back to <strong>the</strong> predictions we discussed earlier,you will see that one of <strong>the</strong>m calls for a double-digit percentage<strong>in</strong>crease for <strong>the</strong> S&P 500 Index this year. In March, it appeared<strong>the</strong>re was little chance of gett<strong>in</strong>g this one right, but as <strong>the</strong> year getscloser to a close, we are quite confident that we will score this one<strong>in</strong> <strong>the</strong> ‘‘correct’’ column. While we would not be surprised to seesome sort of market correction occur at any po<strong>in</strong>t, we rema<strong>in</strong>optimistic that stocks will end 2009 with double-digit percentagega<strong>in</strong>s.The Road to RecoveryGiven that we now believe <strong>the</strong> recession has ended and are expect<strong>in</strong>ga double-digit rise <strong>in</strong> <strong>the</strong> S&P 500 Index <strong>in</strong> 2009, <strong>the</strong> naturalquestion to ask is, ‘‘What will this recovery look like?’’ First, weexpect <strong>the</strong> economic recovery to be slow and below trend. There isstill a massive amount of deleverag<strong>in</strong>g that has to happen on <strong>the</strong>parts of both <strong>the</strong> consumer and <strong>the</strong> f<strong>in</strong>ancial system, which webelieve will prevent a quick return to robust growth levels.From an equity market perspective, it is also important torecognize that <strong>the</strong> recent rally has been uneven. Lower-quality,more cyclical <strong>in</strong>vestments have drastically outperformed, andhigher-quality companies have lagged. This trend is not susta<strong>in</strong>able.A cont<strong>in</strong>uation of <strong>the</strong> rally will require a broaden<strong>in</strong>g <strong>in</strong> terms ofsectors and <strong>in</strong>dividual names. These are a few of <strong>the</strong> ma<strong>in</strong> reasons weexpect to see some pend<strong>in</strong>g consolidation, which would hopefullygive <strong>the</strong> markets a chance to regroup before resum<strong>in</strong>g a more broadbasedupturn.Tak<strong>in</strong>g a look at some similar historical time periods can alsohelp provide some perspective on what we’re look<strong>in</strong>g for <strong>in</strong> <strong>the</strong>
BOB DOLL 55Figure 5.3S&P 500 History TableFive-Year Periods of Negative ReturnsReturnNext Five Years1927–1931 5.1% 22.5%1928–1932 12.5% 14.3%1929–1933 11.2% 10.7%1930–1934 9.9% 10.9%1937–1941 7.5% 17.9%1970–1974 2.4% 14.8%1973–1977 0.2% 14.1%1998–2002 0.6% 12.8%Average 14.8%Worst 10.7%Source: SBBI 2006 YearbookPast performance is no guarantee of future results. It is not possible to <strong>in</strong>vest directly <strong>in</strong>an <strong>in</strong>dex. Performance is represented by SBBI’s Large Company Stocks (1926–1955)and <strong>the</strong> S&P 500 Index (1956–2008), a market capitalization-weighted <strong>in</strong>dex whichmeasures price movements of <strong>the</strong> common stock of 500 large US companies withlead<strong>in</strong>g <strong>in</strong>dustries.marketsover<strong>the</strong>longerterm.(SeeFigure5.3.)S<strong>in</strong>ce<strong>the</strong>GreatDepression, <strong>the</strong>re have been n<strong>in</strong>e 5-year time periods—many ofwhich overlap—<strong>in</strong> which U.S. stocks experienced negative returns.It seems quite likely that when we update this chart <strong>in</strong> 2010, we’lladd a tenth, s<strong>in</strong>ce <strong>the</strong> S&P 500 Index will almost certa<strong>in</strong>ly benegative <strong>from</strong> 2004 to 2009.The important po<strong>in</strong>t about this data is what happens <strong>in</strong> <strong>the</strong> fiveyearperiods follow<strong>in</strong>g <strong>the</strong>se downturns. In each case, stocks were upby double-digit percentages. Although we have no way of know<strong>in</strong>gfor certa<strong>in</strong> what <strong>the</strong> next five years will hold, it is likely that <strong>the</strong>environment will look a lot more like <strong>the</strong> right side of this chart than<strong>the</strong> left.
56 THRIVING IN THE NEW ECONOMYWhen Flat Isn’t FlatThere is ano<strong>the</strong>r way to look at <strong>the</strong> markets through a historical lensthat can also provide some perspective for today’s <strong>in</strong>vestors. Many<strong>in</strong>vestors remember <strong>the</strong> 1970s as a ‘‘lost decade’’ for stocks; and<strong>in</strong>deed, between 1966 and 1982, <strong>the</strong> U.S. stock market was essentiallyflat. (See Figure 5.4.) Is it possible that we could experienceano<strong>the</strong>r flat 16-year period? We believe it is and argue that it iscerta<strong>in</strong>ly a possibility that we’re <strong>in</strong> <strong>the</strong> midst of one right now.For <strong>the</strong> sake of argument, let’s assume that <strong>the</strong> tech bubble peak<strong>in</strong> 2000 was <strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g of ano<strong>the</strong>r flat 16-year period. (SeeFigure 5.5.) From that po<strong>in</strong>t, we had a three-year bear market thatlasted until 2003; a four-year bull market that ended <strong>in</strong> October2007 and that brought stocks to a slightly higher level than where<strong>the</strong>y were <strong>in</strong> 2000; and <strong>the</strong>n <strong>the</strong> <strong>in</strong>tense and rapid collapse of ourcurrent situation. In this scenario, <strong>the</strong>n, we would be just past <strong>the</strong>mid-po<strong>in</strong>t of our 16-year period. From a return perspective,however, we would need to experience an average annual returnof 12.8 percent for stocks to return to 2000 levels by 2016. TheFigure 5.4 Dow Jones Industrial Average 1966–19821,100Dow Jones Industrial Average1,000900800700600500Dec 1965Dec 1966Source: BlackRockDec 1967Dec 1968Dec 1969Dec 1970Dec 1971Dec 1972Dec 1973Dec 1974Dec 1975DateDec 1976Dec 1977Dec 1978Dec 1979Dec 1980Dec 1981Dec 1982
BOB DOLL 57Figure 5.516 Flat Years: Can It Happen Aga<strong>in</strong>?2000–2016 2007–20231,8001,50015521,8001,5001557S&P 5001,20090060030066612.8%return(price only)S&P 5001,2009006003006666.1% return(price only)00Mar 2000Mar 2002Mar 2004Mar 2006Mar 2008Mar 2010Mar 2012Mar 2014Mar 2016Oct 2007Oct 2010Oct 2013Oct 2016Oct 2019Oct 2022DateDateSource: BlackRockpo<strong>in</strong>t here is that although history would record <strong>the</strong> period <strong>from</strong>2000 to 2016 as a flat environment <strong>in</strong> which stocks went nowhere,<strong>in</strong>vestors who were able to enter or reenter <strong>the</strong> markets <strong>in</strong> 2009would have enjoyed some excellent returns.
6Abby JosephCohenRound<strong>in</strong>g out <strong>the</strong>‘‘Squawk Box F<strong>in</strong>ancialSummit’’ is senior Investmentstrategist and presidentof <strong>the</strong> GlobalMarkets Institute at GoldmanSachs, Abby JosephCohen. Abby started hercareer as an economistfor <strong>the</strong> Federal ReserveBoard <strong>in</strong> Wash<strong>in</strong>gton,DC, and <strong>the</strong>n worked formajorf<strong>in</strong>ancialfirmsasaneconomist and quantitativestrategist. She jo<strong>in</strong>edGoldman Sachs <strong>in</strong> 1990and was <strong>the</strong> firm’s chief U.S. <strong>in</strong>vestment strategist formany years; she was regularly ranked as <strong>the</strong> top strategiston Wall Street. Her role gradually shifted <strong>in</strong> <strong>the</strong> mid-2000s as(cont<strong>in</strong>ued)59
60 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)she assumed <strong>in</strong>creas<strong>in</strong>g responsibilities for <strong>the</strong> firm’s researchon long-term issues affect<strong>in</strong>g <strong>the</strong> economy andmarkets, <strong>in</strong>clud<strong>in</strong>g public policy. These have <strong>in</strong>cluded demographics,pensions, long-term sav<strong>in</strong>g, account<strong>in</strong>g, healthcare, and climate change. In late 2007, she became presidentof <strong>the</strong> Global Markets Institute, <strong>the</strong> firm’s <strong>in</strong>ternal th<strong>in</strong>ktank. In 2008, her protege, David Kost<strong>in</strong>, became Goldman’sU.S. stock market strategist. Abby cont<strong>in</strong>ues to beone of <strong>the</strong> most quoted f<strong>in</strong>ancial experts <strong>in</strong> <strong>the</strong> field andprovides us with her op<strong>in</strong>ion on <strong>the</strong> economy of late.The story—at least for me and o<strong>the</strong>rs at Goldman Sachs—began well before September 2008. Our research beganto identify potential anomalies, especially <strong>in</strong> some credit markets,<strong>in</strong> late 2005. In fact, <strong>the</strong> year-ahead reports that we preparedfor clients <strong>in</strong> 2005 and 2006 <strong>in</strong>dicated areas where we thought <strong>the</strong>rewere imbalances, especially <strong>in</strong> <strong>the</strong> mispric<strong>in</strong>g of risk and<strong>in</strong> unsusta<strong>in</strong>able growth <strong>in</strong> some sectors of <strong>the</strong> economy. Forexample, we noted some concerns about segments of <strong>the</strong> householdsector, which <strong>in</strong>cluded <strong>the</strong> deterioration of <strong>the</strong> average balance sheetfor families; recogniz<strong>in</strong>g that overspend<strong>in</strong>g and excessive borrow<strong>in</strong>gwere occurr<strong>in</strong>g <strong>in</strong> some <strong>in</strong>come categories. This was particularly <strong>the</strong>case for middle-<strong>in</strong>come and lower-middle-<strong>in</strong>come households forwhom <strong>in</strong>flation-adjusted <strong>in</strong>come growth had been stagnant forseveral years but whose spend<strong>in</strong>g rose, fueled by ris<strong>in</strong>g debt levels.Our economics team was also concerned about some hous<strong>in</strong>gmarkets, such as those <strong>in</strong> areas of notable <strong>in</strong>ward migration, like<strong>the</strong> Sunbelt region of <strong>the</strong> Southwestern United States.Much of my work tries to <strong>in</strong>tegrate<strong>the</strong>economicenvironmentwith <strong>the</strong> performance of f<strong>in</strong>ancial markets. In comb<strong>in</strong>ation withmy early tra<strong>in</strong><strong>in</strong>g on <strong>the</strong> quantitative side, this means that we try to
ABBY JOSEPH COHEN 61approach market analysis <strong>in</strong> a discipl<strong>in</strong>ed way. We apply ourma<strong>the</strong>matically based valuation tools to equity markets, fixed<strong>in</strong>comemarkets, and o<strong>the</strong>r <strong>in</strong>vestment categories. At year-end2005, we expressed concern that lower-quality bonds were offer<strong>in</strong>gyields that were too low relative to higher-quality issues. Investorswere not gett<strong>in</strong>g <strong>the</strong> usual extra yield, or risk premium, for hold<strong>in</strong>gsecurities of lower-quality issuers. For example, lower-rated corporatebonds often sold at yields not much above those of highlyrated bonds. This raised some yellow flags because you wouldnormally expect a riskier issuer to pay more to borrow thosefunds. Stated differently, <strong>the</strong> prices of <strong>the</strong> lower-rated bondswere too high. In addition, o<strong>the</strong>rs at <strong>the</strong> firm who looked atmortgage securities were conclud<strong>in</strong>g that a similar situation haddeveloped <strong>in</strong> those markets. Many borrowers with poor creditrat<strong>in</strong>gs had access to debt at low rates that seemed out of kilter with<strong>the</strong> risk be<strong>in</strong>g taken on by <strong>the</strong> lenders. We tracked <strong>the</strong>se apparentdiscrepancies <strong>in</strong> 2006 and 2007 and concluded that <strong>the</strong> mispric<strong>in</strong>gwas becom<strong>in</strong>g more <strong>in</strong>tense. Among <strong>the</strong> concerns was <strong>the</strong>potential impact of <strong>the</strong> economic slowdown that we expected tooccur. The view of our economics team was that <strong>the</strong> gross domesticproduct (GDP) would be much weaker <strong>in</strong> 2008 than consensusprojections <strong>in</strong>dicated.Stay<strong>in</strong>g Ahead of <strong>the</strong> CurveWe rout<strong>in</strong>ely try to f<strong>in</strong>d holes <strong>in</strong> our forecasts. By <strong>the</strong> end of 2007,we were actively discuss<strong>in</strong>g many alternative scenarios, some of <strong>the</strong>mquite ugly. Our research teams were assign<strong>in</strong>g <strong>in</strong>creas<strong>in</strong>gly higherprobabilities to <strong>the</strong> likelihood of a recession. In early 2008, <strong>the</strong>official Goldman Sachs forecast changed to an outright recession.We thought that a sharp downturn with <strong>the</strong> ferocity that ultimatelydeveloped was a possibility, but not <strong>the</strong> most likely outcome.
62 THRIVING IN THE NEW ECONOMYHere’s an important po<strong>in</strong>t: Our economists were concerned veryearly about many issues that ultimately unfolded <strong>in</strong> unpleasantways. Even so, <strong>the</strong> magnitude of <strong>the</strong> recession and <strong>the</strong> severity of<strong>the</strong> f<strong>in</strong>ancial market dislocations were surpris<strong>in</strong>g. For example,we had expected problems <strong>in</strong> <strong>the</strong> mortgage f<strong>in</strong>ance markets. Wehad expected problems <strong>in</strong> <strong>the</strong> hous<strong>in</strong>g market. We had expected amoderate recession. But we did not foresee <strong>the</strong> freez<strong>in</strong>g of f<strong>in</strong>ancialmarkets or <strong>the</strong> sharp drop <strong>in</strong> economic activity. We became moreconcerned <strong>in</strong> March 2008, at <strong>the</strong> time of <strong>the</strong> failure of Bear Stearns.The dearth of liquidity dur<strong>in</strong>g that period was an <strong>in</strong>dication of howquickly some markets could stop function<strong>in</strong>g <strong>in</strong> a normal way. Webecame more alarmed <strong>in</strong> <strong>the</strong> summer of 2008.September MeltdownAlthough our analytical teams were prepared for a moderate recession,<strong>the</strong> market developments <strong>in</strong> September 2008 were moreextreme than most had expected. Simply stated, both equity andfixed-<strong>in</strong>come markets were no longer function<strong>in</strong>g properly. Therewas little if no liquidity, and buyers and sellers had difficulty f<strong>in</strong>d<strong>in</strong>gsuitable transaction prices.We do a lot of scenario analysis <strong>in</strong> which we try to stress ourconclusions by explor<strong>in</strong>g <strong>the</strong> outcomes of tough and out-ofconsensusassumptions. This test<strong>in</strong>g technique has become <strong>in</strong>creas<strong>in</strong>glycommon. Indeed, <strong>the</strong> recently concluded stress testsfor <strong>the</strong> nation’s largest banks used this approach of assum<strong>in</strong>g anunfriendly operat<strong>in</strong>g environment to gauge <strong>the</strong> impact on <strong>the</strong>banks’ soundness. As analysts us<strong>in</strong>g this ‘‘kick <strong>the</strong> tires’’ process,we consciously try to identify assumptions and scenarios that aredifferent <strong>from</strong> <strong>the</strong> base case that webelievetobemostlikely.InSeptember 2008, economic and market developments were mov<strong>in</strong>galong <strong>the</strong> l<strong>in</strong>es of <strong>the</strong> ugliest alternative scenarios that we hadconsidered. The gloomy scenarios that we had thought were
ABBY JOSEPH COHEN 63possible, but unlikely, had become probable. Many people around<strong>the</strong> firm deserve praise for respond<strong>in</strong>g to <strong>the</strong> shift<strong>in</strong>g situation asquicklyas<strong>the</strong>ydid.Thedifficultcircumstances <strong>in</strong> September andOctober <strong>in</strong>cluded <strong>the</strong> seiz<strong>in</strong>g up of money markets and o<strong>the</strong>r fixed<strong>in</strong>comemarkets. Volatility rose to exceptionally high levels forboth bonds and stocks, roughly five times normal.Handl<strong>in</strong>g Intense SituationsGoldman Sachs is a large firm, with several different divisions. Iwork <strong>in</strong> <strong>the</strong> Global Investment Research division, and we are keptapart <strong>from</strong> many o<strong>the</strong>r commercial activities that are occurr<strong>in</strong>gwith<strong>in</strong> <strong>the</strong> firm. We focus on provid<strong>in</strong>g analysis and projections toour clients. Dur<strong>in</strong>g <strong>the</strong> crisis <strong>in</strong> 2008 to 2009, our research teamsaround <strong>the</strong> world moved quickly to adjust forecasts and recommendationsto clients. We vigorously tracked and reported on marketdevelopments dur<strong>in</strong>g <strong>the</strong> <strong>in</strong>tense volatility and confusion of <strong>the</strong>period. Some of our <strong>in</strong>ternal heroes were <strong>in</strong> our treasury andcontrollers’ functions, people who had responded quickly to <strong>the</strong>market dislocations.NimbleDur<strong>in</strong>g <strong>the</strong> market tumult, it became clear that certa<strong>in</strong> assets werenot worth as much as <strong>in</strong>vestors, lenders, or market makers hadpreviously thought. Goldman Sachs did not wait to write down <strong>the</strong>value of <strong>the</strong>se assets; we adhered closely to mark-to-market account<strong>in</strong>g.Although this sounds like a technicality or bor<strong>in</strong>g detail, it is anessential component of be<strong>in</strong>g nimble. I would equate mark-tomarketaccount<strong>in</strong>g to send<strong>in</strong>g <strong>the</strong> canary <strong>in</strong>to <strong>the</strong> coal m<strong>in</strong>e. Wemark to market on a cont<strong>in</strong>uous basis. We don’t wait till <strong>the</strong> end of<strong>the</strong> month; we don’t wait until <strong>the</strong> end of <strong>the</strong> week; and <strong>in</strong> somecases, we don’t even wait until <strong>the</strong> end of <strong>the</strong> day. If we see that anasset has lost value, we mark it down.
64 THRIVING IN THE NEW ECONOMYBe<strong>in</strong>g nimble on account<strong>in</strong>g also allowed us to be nimble <strong>in</strong>respond<strong>in</strong>g to <strong>the</strong> market distress <strong>in</strong> September. In h<strong>in</strong>dsight,everyth<strong>in</strong>g is simple and easy to see. A critical factor that dist<strong>in</strong>guishedsome firms dur<strong>in</strong>g <strong>the</strong> worst of <strong>the</strong> f<strong>in</strong>ancial crisis was notwhe<strong>the</strong>r <strong>the</strong>y anticipated all <strong>the</strong> problems, but how quickly <strong>the</strong>yreacted once <strong>the</strong>se problems surfaced.In Global Investment Research, our focus was on work<strong>in</strong>g withour clients and develop<strong>in</strong>g a steady stream of analysis dur<strong>in</strong>g <strong>the</strong>rapidly chang<strong>in</strong>g period. Our <strong>in</strong>dustry analysts, that is, those responsiblefor analyz<strong>in</strong>g specific <strong>in</strong>dustries and companies, were oftensubstantially ahead of o<strong>the</strong>rs <strong>in</strong> adjust<strong>in</strong>g <strong>the</strong>ir earn<strong>in</strong>gs estimates andrecommendations on buy<strong>in</strong>g and sell<strong>in</strong>g specific securities. This wasalso <strong>the</strong> case for our colleagues who prepare credit research, that is,research on corporate fixed <strong>in</strong>come based on <strong>the</strong> fundamentals of <strong>the</strong>underly<strong>in</strong>g companies issu<strong>in</strong>g <strong>the</strong> bonds.In general, we took a very conservative approach toward ownershipof equities and o<strong>the</strong>r corporate securities dur<strong>in</strong>g this period.This was not based on <strong>the</strong> downward price momentum but on <strong>the</strong>deteriorat<strong>in</strong>g fundamental performance of <strong>the</strong> underly<strong>in</strong>g companies.In a deep recession, what were <strong>the</strong>ir revenues likely to be? Whatabout <strong>the</strong>ir earn<strong>in</strong>gs? Cash flow?My colleague Michael Moran has done an enormous amount ofdetailed work on <strong>the</strong> impact of <strong>the</strong> f<strong>in</strong>ancial crisis on corporateaccount<strong>in</strong>g, <strong>in</strong>clud<strong>in</strong>g <strong>the</strong> pension status at major U.S. companies asa consequence of economic and f<strong>in</strong>ancial market weakness. And<strong>the</strong>re are o<strong>the</strong>r issues; for example, what happens to balance sheets?Or to <strong>the</strong> impairment of goodwill? One positive outcome of <strong>the</strong>disruption of <strong>the</strong> past couple of years has been <strong>the</strong> recognition that<strong>the</strong> quality and timel<strong>in</strong>ess of data reported on balance sheets and<strong>in</strong>come statements is critical and that effective <strong>in</strong>vestment decisionmak<strong>in</strong>g is l<strong>in</strong>ked to good understand<strong>in</strong>g of account<strong>in</strong>g. Not surpris<strong>in</strong>gly,account<strong>in</strong>g has long been an area of emphasis for us <strong>in</strong>Global Investment Research.
ABBY JOSEPH COHEN 65Be Out of Consensus, If AppropriateWe were also helped by our read<strong>in</strong>ess to take views that were outof consensus, if that’s where our research led us—someth<strong>in</strong>g thatour senior managers encouraged. Often, analysts will not wandertoo far <strong>from</strong> <strong>the</strong> conceived wisdom of <strong>the</strong> crowd, but suchconsensus views are already largely baked <strong>in</strong>to <strong>the</strong> stock marketand o<strong>the</strong>r f<strong>in</strong>ancial asset prices. Research analysts can providereal value when <strong>the</strong>y start <strong>from</strong> scratch, us<strong>in</strong>g primary data sources,to develop differentiated conclusions <strong>in</strong> which <strong>the</strong>y have confidence.This applies not just to equity-oriented research but also tocredit research. Much of <strong>the</strong> market disruption <strong>in</strong> 2007 to 2008was l<strong>in</strong>ked to credit, and it was extraord<strong>in</strong>arily useful to have<strong>in</strong>ternal expertise. The credit team helped us to better and morequickly understand <strong>the</strong> dimensions of <strong>the</strong> systemic problems thathad developed.This has been an extraord<strong>in</strong>ary period, with <strong>the</strong> most severe partstart<strong>in</strong>g <strong>in</strong> September 2008. There have been extreme marketmoves, extreme shifts <strong>in</strong> <strong>the</strong> U.S. and global economies, and majorpolitical changes. The 2008 U.S. presidential election has beenfollowed by a series of policy <strong>in</strong>itiatives that could mark significantchanges <strong>in</strong> several areas, <strong>in</strong>clud<strong>in</strong>g energy, climate, health care, andf<strong>in</strong>ancial regulation.We’re try<strong>in</strong>g to anticipate <strong>the</strong> longer-term implications of <strong>the</strong>economic and credit crisis. Although we recognize that <strong>the</strong>re isstill much to be done before <strong>the</strong>re is a return to ‘‘normal,’’ we mustalso recognize that <strong>the</strong>re will likely be a new normal. Among <strong>the</strong>factors to monitor will be: (1) <strong>the</strong> role of <strong>the</strong> United States <strong>in</strong><strong>the</strong> global economy and f<strong>in</strong>ancial markets; (2) sources of domesticeconomic growth, especially as <strong>the</strong> household sav<strong>in</strong>gs rate has risen;and (3) <strong>in</strong>vestor confidence <strong>in</strong> <strong>the</strong> proper function<strong>in</strong>g of markets.Our research focus will be on <strong>the</strong> longer view, try<strong>in</strong>g to ignore<strong>the</strong> noise of short-term market developments.
66 THRIVING IN THE NEW ECONOMYManag<strong>in</strong>g Clients’ ExpectationsMy professional goal is to be helpful to clients by convey<strong>in</strong>g anunderstand<strong>in</strong>g of economic and market prospects based on <strong>the</strong>best available analysis. Although it may be enterta<strong>in</strong><strong>in</strong>g to provideprovocative or amus<strong>in</strong>g statements, it is more mean<strong>in</strong>gful to share<strong>in</strong>sights, concerns, and conclusions. Perhaps <strong>the</strong> most important keyto success is to correctly identify <strong>the</strong> critical variables, those factorsthat will ultimately drive <strong>the</strong> economy and markets. Some <strong>in</strong>vestorsget caught up <strong>in</strong> try<strong>in</strong>g to forecast many data po<strong>in</strong>ts with falseprecision. It is better to identify and emphasize <strong>the</strong> few factors thatwill really matter and concentrate on why <strong>the</strong>y are important and<strong>the</strong> ways <strong>in</strong> which <strong>the</strong>y are l<strong>in</strong>ked.Many of our clients aim to take a long-term view, perhapsbecause <strong>the</strong>ir needs are also long term. These clients <strong>in</strong>cludecorporations, pension funds, and charitable <strong>in</strong>stitutions and <strong>the</strong>irendowments. We guide <strong>the</strong>m, not <strong>in</strong> terms of trad<strong>in</strong>g tacticsbetween now and next Tuesday, but on how <strong>the</strong>y might th<strong>in</strong>kabout broad changes <strong>in</strong> <strong>the</strong> structure of <strong>the</strong> global economy (forexample, <strong>the</strong> <strong>in</strong>creased importance of <strong>the</strong> BRIC nations [Brazil,Russia, India, and Ch<strong>in</strong>a]) and <strong>the</strong> structure of global capitalmarkets (for example, <strong>the</strong> impact of multilateral f<strong>in</strong>ancial regulationon cross-border flows).We th<strong>in</strong>k that <strong>the</strong> recession ended <strong>in</strong> <strong>the</strong> summer of 2009; andour research analysts at Goldman Sachs are actively contemplat<strong>in</strong>gsome of <strong>the</strong> changes that may follow dur<strong>in</strong>g <strong>the</strong> recovery. Forexample, our economics teams are analyz<strong>in</strong>g issues such as <strong>the</strong>relative growth rates of different nations and <strong>the</strong> likely consequencesfor foreign trade, protectionism, and currencies. Prior to<strong>the</strong> crisis, we had already begun work on <strong>the</strong> longer-term trendslikely to evolve <strong>in</strong> <strong>the</strong> U.S. economy <strong>in</strong> <strong>the</strong> com<strong>in</strong>g decade. It ispossible that responses to <strong>the</strong> crisis may result <strong>in</strong> faster progress onseveral fronts than would have occurred without <strong>the</strong> catalyst ofdifficult economic times. Important examples <strong>in</strong>clude moves
ABBY JOSEPH COHEN 67toward greater energy efficiency and faster development of alternativeenergy sources.We’ve done much work for <strong>the</strong> past decade on energy, climatechange, and environmental factors, throughout Goldman Sachs.Many clients greeted our <strong>in</strong>itial work with yawns of dis<strong>in</strong>terest.It’s been fasc<strong>in</strong>at<strong>in</strong>g to watch <strong>the</strong> explosion <strong>in</strong> <strong>in</strong>terest nowexpressed by <strong>in</strong>vestors and corporations alike. Over <strong>the</strong> past coupleof years, <strong>the</strong> debate over climate change has come to life, and hasswitched <strong>from</strong> ‘‘Is it real?’’ to ‘‘What should we do?’’ Congress isconsider<strong>in</strong>g serious new legislation <strong>in</strong> 2009. Venture capitalistshave shifted <strong>the</strong>ir attention to energy efficiency and climateremediation. Many pension sponsors and not-for-profit endowmentsare anxious to allocate funds to assets that demonstrategood environmental, social, and governance citizenship (ESGcitizenship). Ano<strong>the</strong>r long-term topic of our research has beenhealth care expenditures, <strong>in</strong>clud<strong>in</strong>g <strong>the</strong> post-retiree obligationspaid for by corporations and <strong>the</strong> government. The impact at <strong>the</strong>federal government level is notable because of Medicare; <strong>the</strong>seliabilities may prove to be four to seven times larger than thoseof Social Security. Also of concern is <strong>the</strong> underfund<strong>in</strong>g of <strong>the</strong>post-retirement plans for state and local government employees.Corporate plans seem to be better funded, with notable exceptions<strong>in</strong> <strong>in</strong>dustries that are <strong>in</strong> duress, such as <strong>the</strong> auto <strong>in</strong>dustry. Thisissue has now come to <strong>the</strong> forefront due to <strong>the</strong> Obama adm<strong>in</strong>istration’sproposed overhaul of health care, and it has beenexacerbated by <strong>the</strong> problems faced by autoworkers and o<strong>the</strong>rswho are concerned about <strong>the</strong>ir health care coverage now as well asat retirement. Environmental, social, and governance citizenship or ESG Citizenship is <strong>in</strong>vest<strong>in</strong>g <strong>in</strong>funds that are socially responsible such as <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> green technologies or lower<strong>in</strong>g yourcompany’s carbon footpr<strong>in</strong>t. In addition to environmental issues, corporate governanceand social issues are also part of an ESG bus<strong>in</strong>ess model.
68 THRIVING IN THE NEW ECONOMYMany state and local governments today are fac<strong>in</strong>g significantf<strong>in</strong>ancial problems because of <strong>the</strong> cyclical downturn. A majorrecession means lessened tax revenues and <strong>in</strong>creased costs as countercyclicalspend<strong>in</strong>g programs, such as unemployment <strong>in</strong>surance,kick <strong>in</strong>. But even past <strong>the</strong> recession, <strong>the</strong>se long-term retirementobligations may represent a significant burden.Even if GDP turns positive <strong>in</strong> <strong>the</strong> near future, <strong>the</strong> labor marketsmay rema<strong>in</strong> weak for an extended period. The unemploymentsituation may cont<strong>in</strong>ue to create dramatic difficulties for manyfamilies and <strong>the</strong> communities <strong>in</strong> which <strong>the</strong>y live. Is <strong>the</strong>re a possiblesilver l<strong>in</strong><strong>in</strong>g to this crisis? Before we explore that, let’s understandthat, due to unemployment and stagnant wages, <strong>the</strong> discomfort willcont<strong>in</strong>ue for many families for some time to come.Us<strong>in</strong>g a Crisis to Your AdvantageMany people are now paraphras<strong>in</strong>g White House Chief of StaffRahm Emmanuel’s comment about not ‘‘wast<strong>in</strong>g a crisis.’’ Severalcompanies, not-for-profit <strong>in</strong>stitutions, and o<strong>the</strong>r organizations areus<strong>in</strong>g this difficult time to identify <strong>the</strong>ir core missions. Manyare seek<strong>in</strong>g to focus on narrower but more achievable goals. Eventhose organizations not fac<strong>in</strong>g existential risk view <strong>the</strong> currentenvironment as an opportunity to identify and emphasize comparativeadvantages and strengths. This is ultimately for <strong>the</strong> good.Classical economists like Joseph Schumpeter viewed periods ofeconomic duress as opportunities. His term was creative destruction,a time <strong>in</strong> which activities that were of only marg<strong>in</strong>al benefitdo not survive. It is possible for <strong>in</strong>stitutions to redirect resources,capital, and, very importantly, people <strong>in</strong>to o<strong>the</strong>r activities thatcould create better growth. To accomplish this as a nation,additional attention should be paid to education and retra<strong>in</strong><strong>in</strong>gof workers, especially those who are currently unemployed orunderemployed. We recently published a research report show<strong>in</strong>g
ABBY JOSEPH COHEN 69that middle-<strong>in</strong>come wages <strong>in</strong> <strong>the</strong> United States stopped grow<strong>in</strong>gseveral years ago, at about <strong>the</strong> time <strong>the</strong> average level of educationatta<strong>in</strong>ment stopped ris<strong>in</strong>g.Invest<strong>in</strong>g <strong>in</strong> GreenThe economic and market crises have set <strong>the</strong> stage for morethoughtful discussions about susta<strong>in</strong>able growth policies. We seenotable opportunities for economic growth and <strong>in</strong>vestment returns<strong>in</strong> <strong>the</strong> related categories of energy efficiency and broadened useof renewable energy sources. The United States is <strong>the</strong> world’slargest user and importer of energy. This has implications for ourforeign policy, and our potential vulnerability is decreased by<strong>in</strong>creased energy <strong>in</strong>dependence. These issues have moved to <strong>the</strong>front burner for policy makers <strong>in</strong> <strong>the</strong> White House and Congress,along with health care.Many corporations and <strong>in</strong>dividual states have been address<strong>in</strong>genergy use and climate impact for several years. The Obamaadm<strong>in</strong>istration has put world-class scientists Steven Chu andJohn Holdren <strong>in</strong> charge of <strong>the</strong> nation’s energy and science policies.This bodes well for good decision mak<strong>in</strong>g. The United States hasalready announced its <strong>in</strong>tention to take a leadership role <strong>in</strong> <strong>the</strong>upcom<strong>in</strong>g Copenhagen discussions, which are <strong>the</strong> follow-up to <strong>the</strong>earlier Kyoto Protocol on climate change. It also appears that Ch<strong>in</strong>awill move forward with its own greener policies; this is criticalbecause that nation is now <strong>the</strong> world’s largest emitter of greenhousegases, <strong>in</strong>clud<strong>in</strong>g carbon dioxide.Fac<strong>in</strong>g <strong>the</strong> Problem Head OnHistory clearly shows that economic transitions can be very pa<strong>in</strong>ful.This is especially true when prior excesses must be corrected andwhen long-term structural changes affect <strong>the</strong> viability of some
70 THRIVING IN THE NEW ECONOMY<strong>in</strong>dustries and bus<strong>in</strong>ess models. I don’t mean to m<strong>in</strong>imize this truthat all. The current transition will cont<strong>in</strong>ue to be uncomfortable, butwe will ultimately emerge on <strong>the</strong> o<strong>the</strong>r side. I believe that manycapable policy makers <strong>in</strong> Wash<strong>in</strong>gton have understood <strong>the</strong> depthand dimensions of <strong>the</strong> jo<strong>in</strong>t economic and f<strong>in</strong>ancial market crisesand have shown great wisdom—but not perfection—<strong>in</strong> <strong>the</strong> stepsthat have been taken as a result. The economy has not yet recovered,but it looks less bleak. Markets are not yet normal, but <strong>the</strong>y’remov<strong>in</strong>g more normally. There is <strong>the</strong> recognition on both sides of <strong>the</strong>political aisle that greater attention and fund<strong>in</strong>g may be needed tokick-start certa<strong>in</strong> activities, such as enhanced education and researchand development (R&D) <strong>in</strong> energy. The most important th<strong>in</strong>gabout solv<strong>in</strong>g a problem is recogniz<strong>in</strong>g that you have it. The pastcouple of years have revealed many problems that were previouslyignored, and we have begun to respond.
7Paul McCulleyPaul McCulley is a manag<strong>in</strong>gdirector, generalistportfolio manager,and member of <strong>the</strong> <strong>in</strong>vestmentcommittee atPIMCO, a global <strong>in</strong>vestmentmanagement firmco-founded by bondguru Bill Gross. Their clientsrange <strong>from</strong> universitiesto municipalities topension funds to centralbanks. Paul is also <strong>in</strong>charge of PIMCO’s shorttermbond desk, leads itscyclical economic forums,and is <strong>the</strong> author of <strong>the</strong> monthly research publication GlobalCentral Bank Focus. Prior to jo<strong>in</strong><strong>in</strong>g PIMCO <strong>in</strong> 1999, he waschief economist for <strong>the</strong> Americas at UBS Warburg. Paul’sf<strong>in</strong>ancial knowledge and ability to anticipate trends before<strong>the</strong>y happen make him one of <strong>the</strong> most listened-to f<strong>in</strong>ancialexperts <strong>in</strong> <strong>the</strong> country.71
72 THRIVING IN THE NEW ECONOMYThe first and most important th<strong>in</strong>g for people who are active<strong>in</strong> <strong>the</strong> markets—as well as ‘‘regular’’ citizens—to recognizeis that <strong>the</strong> f<strong>in</strong>ancial crisis has been an epoch-chang<strong>in</strong>g event.Although a number of elements of this change have occurredover <strong>the</strong> past couple of years—<strong>the</strong> subprime crisis, <strong>the</strong> creditcrisis, massive deleverag<strong>in</strong>g, and so forth—th<strong>in</strong>gs really reached anew level after Lehman Bro<strong>the</strong>rs went to its watery death onSeptember 15, 2008.Every economy strikes a balance between <strong>the</strong> dual <strong>in</strong>fluences of<strong>the</strong> democratic process and <strong>the</strong> marketplace; or, as I like to put it, aneconomy is a weighted average of <strong>the</strong> <strong>in</strong>visible hand of <strong>the</strong> marketsand <strong>the</strong> visible fist of governments. There is always tension between<strong>the</strong> <strong>in</strong>visible hand and <strong>the</strong> visible fist for a very simple reason:Capitalism is a cumulative vot<strong>in</strong>g process. The more dollars youhave, <strong>the</strong> more votes you have; that’s reflected by <strong>the</strong> simple fact thatyour boss goes to fancier restaurants than you do. That is acumulative vot<strong>in</strong>g process, whereas democracy is, at its core, asocialist vot<strong>in</strong>g process: one person, one vote. So, <strong>the</strong>re is <strong>in</strong>herenttension between <strong>the</strong> <strong>in</strong>fluences on capitalism and democracy, but<strong>the</strong>y need each o<strong>the</strong>r.The Need for CapitalismA democracy needs capitalism to allocate resources based on aprofit motive, because <strong>the</strong> government is not very good at allocat<strong>in</strong>gresources. Central plann<strong>in</strong>g has not stood <strong>the</strong> test of time, but<strong>the</strong> capitalist process of creative destruction has, and we’ve foundthat governments actually need <strong>the</strong> private market. Likewise,capitalism needs government for one simple reason: to helpma<strong>in</strong>ta<strong>in</strong> <strong>the</strong> rule of law and property rights.Capitalism cannot <strong>in</strong>herently def<strong>in</strong>e a credible rule of law,because aga<strong>in</strong>, it is a cumulative vot<strong>in</strong>g process. If you left it to<strong>the</strong> capitalist system to make up <strong>the</strong> rule of law, it would create asituation<strong>in</strong>which<strong>the</strong>qualityofyour justice is related to <strong>the</strong>
PAUL MCCULLEY 73money you have to buy that justice, a situation that is obviouslynot tenable or credible. So democracy’s gift to capitalism is <strong>the</strong>rule of law, and <strong>the</strong> basic proposition is that no one is above<strong>the</strong> rule of law. That is why, periodically, we have seen peoplewho were formally famous for <strong>the</strong>ir fancy suits with verticalp<strong>in</strong>stripes later hav<strong>in</strong>g to do <strong>the</strong> ‘‘perp walk’’ wear<strong>in</strong>g horizontalp<strong>in</strong>stripes. Such th<strong>in</strong>gs re<strong>in</strong>force <strong>the</strong>factthatnobodyisabove<strong>the</strong>rule of law.Over <strong>the</strong> past 25 years, <strong>the</strong> <strong>in</strong>visible hand of <strong>the</strong> marketplace was <strong>in</strong>its ascendancy, and <strong>the</strong> visible fist of government was <strong>in</strong> retreat. So fora quarter century, we were actually tilt<strong>in</strong>g <strong>the</strong> weights more towardcapitalism and less toward government. The catchwords for thatphenomenon were deregulation and globalization. But <strong>the</strong> deregulated,globalized f<strong>in</strong>ancial system took <strong>the</strong> <strong>in</strong>visible hand way too farand created a monstrous debt-deflation risk. Only <strong>the</strong> governmentcan actually meet <strong>the</strong> forces of deflation with adequate counterforceof reflationary policies. It does so primarily by pr<strong>in</strong>t<strong>in</strong>g money, butalso through its power to tax and borrow.Essentially, this current crisis required that <strong>the</strong> governmentsector substitute itself for <strong>the</strong> broken <strong>in</strong>visible hand, which istruly a regime shift. That br<strong>in</strong>gs us to our current situation—onewhere<strong>in</strong> capitalism is <strong>in</strong> retreat and government is <strong>in</strong> ascendancy—someth<strong>in</strong>g that is a hugely important po<strong>in</strong>t for bus<strong>in</strong>esses, <strong>in</strong>vestors,andcitizens.The25-yearbullmarket<strong>in</strong>capitalismhascometo an ignom<strong>in</strong>ious end, and we have begun a new bull market<strong>in</strong> government.The <strong>New</strong> <strong>Economy</strong>Whe<strong>the</strong>r you like or dislike <strong>the</strong> ascendancy of government andretreat of markets is a philosophical issue. But as a factual matter,it’s happen<strong>in</strong>g; and we must adjust our strategies to reflect <strong>the</strong>change <strong>in</strong> <strong>the</strong> relationship between <strong>the</strong> <strong>in</strong>visible hand of <strong>the</strong> visiblefist. There will be slower potential economic growth, because
74 THRIVING IN THE NEW ECONOMYdeeper government <strong>in</strong>volvement <strong>in</strong> <strong>the</strong> economy means we’ll losesome of <strong>the</strong> dynamic productivity ga<strong>in</strong>s that we’ve achievedthrough <strong>the</strong> process of creative destruction. So first and foremost,<strong>the</strong>se transformations mean that over <strong>the</strong> next 5 to 10 years,growth is not go<strong>in</strong>g to be as robust as it was dur<strong>in</strong>g <strong>the</strong> 25 years ofascendancy of <strong>the</strong> <strong>in</strong>visible hand.The second outcome is that we are go<strong>in</strong>g to have more regulation.The American people, through <strong>the</strong> democratic process, haveespoused a ‘‘never aga<strong>in</strong>’’ mentality, which means that <strong>the</strong>re willbe str<strong>in</strong>gs attached to <strong>the</strong> bailouts that we, <strong>the</strong> people, have provided.Investors and companies will have to operate know<strong>in</strong>g that <strong>the</strong>y arego<strong>in</strong>g to be liv<strong>in</strong>g <strong>in</strong> a much more regulated economy than <strong>the</strong>y hadbeen. This also has a damp<strong>in</strong>g effect on economic growth.The third outcome is that we are go<strong>in</strong>g to see a modest pullback<strong>in</strong> <strong>the</strong> globalization process. We are go<strong>in</strong>g to kill it, so I’m notworried about a repeat of past mistakes like a Smoot-Hawley Actof 2010. But when governments have to step up to <strong>the</strong> plate tobail out broken markets, it tends to have a nationalistic flavor. Thisis obviously <strong>the</strong> case <strong>in</strong> <strong>the</strong> United States and <strong>in</strong> o<strong>the</strong>r countriesaround <strong>the</strong> globe as well.If governments are go<strong>in</strong>g to put taxpayers’ money at risk, <strong>the</strong>yhave to ensure that citizens are <strong>the</strong> predom<strong>in</strong>ant beneficiaries. Thiscauses governments to act <strong>in</strong> a nationalistic fashion, because citizensare <strong>the</strong> ones who vote. So U.S. citizens, for example, will want toreceive an outsized benefit <strong>from</strong> U.S. bailouts, which is <strong>in</strong>herentlynationalistic. Author’s note: Smoot-Hawley was officially known as <strong>the</strong> Tariff Act of 1930, which raisedU.S. import duties on more than 20,000 imported goods to record rates. Although <strong>in</strong>itially<strong>the</strong> act seemed to be a success because of a sharp <strong>in</strong>crease <strong>in</strong> construction contracts,<strong>in</strong>dustrial production, and factory payrolls, global retaliation to <strong>the</strong> act led to <strong>the</strong>dismantl<strong>in</strong>g of global trade. In 1932, both Smoot and Hawley were defeated for reelection,which has been largely blamed on <strong>the</strong> controversial tariff.
PAUL MCCULLEY 75Emerg<strong>in</strong>g OpportunitiesInvestors today face a handful of key issues, <strong>the</strong> biggest of which isthat a more regulated economy with lower potential growth is go<strong>in</strong>gto have implications on what is considered a normalized stock priceto-earn<strong>in</strong>gs(P/E) multiple. Stocks will have a lower normalized P/Emultiple, so I th<strong>in</strong>k <strong>in</strong>vestors have to th<strong>in</strong>k <strong>in</strong> terms of what it meansto go for growth.The growth that we will see on a global basis will be <strong>in</strong> emerg<strong>in</strong>geconomies, which are likely go<strong>in</strong>g to accelerate efforts to builddomestic consumption and move away <strong>from</strong> <strong>the</strong> mercantilistmodel. The mercantilist model required <strong>the</strong> U.S. consumers toshop till <strong>the</strong>y dropped, but <strong>the</strong> problem is that that <strong>the</strong>y haveshopped, and now, dropped. Emerg<strong>in</strong>g economies will need tohave more homespun growth, someth<strong>in</strong>g that is happen<strong>in</strong>g <strong>in</strong>Ch<strong>in</strong>a now and beg<strong>in</strong>n<strong>in</strong>g to happen <strong>in</strong> India and Brazil.These changes <strong>in</strong> emerg<strong>in</strong>g markets won’t come overnight,but as we look toward <strong>the</strong> next 10 years, develop<strong>in</strong>g countrieswill move directionally away <strong>from</strong> mercantilism and toward amodel of domestic demand and <strong>in</strong>creas<strong>in</strong>g standards of liv<strong>in</strong>gfor workers. There should come a day when a guy who makesflat-screen TVs <strong>in</strong> Ch<strong>in</strong>a doesn’t put one <strong>in</strong> a box and ship it to<strong>the</strong> United States, but ra<strong>the</strong>r puts it <strong>in</strong> <strong>the</strong> truck and takes ithome to actually enjoy <strong>the</strong> fruits of his own labor. So I amenthusiastic on <strong>the</strong> structural secular <strong>the</strong>me with respect to emerg<strong>in</strong>gmarkets.Investment StrategiesFor asset allocation, <strong>in</strong>vestors will want to ma<strong>in</strong>ta<strong>in</strong> lower equityconcentrations <strong>in</strong> this ‘‘new normal’’ than <strong>the</strong>y did <strong>in</strong> <strong>the</strong> old normaland, with<strong>in</strong> <strong>the</strong> context of a reduced equity allocation, an evengreater weight <strong>in</strong> emerg<strong>in</strong>g market equities. I have noth<strong>in</strong>g particularlywarm and fuzzy to say about government bonds <strong>in</strong> terms of
76 THRIVING IN THE NEW ECONOMYfixed <strong>in</strong>come, but I th<strong>in</strong>k bonds of quite heavily regulated privatesector entities—especially <strong>the</strong> bank<strong>in</strong>g system—will offer relativevalue. We are mov<strong>in</strong>g more toward a utility model <strong>in</strong> <strong>the</strong> bank<strong>in</strong>gsector, as opposed to a Wild West model, which calls for a biggerallocation to high-grade corporate bonds than has historically been<strong>the</strong> case.With respect to currencies, emerg<strong>in</strong>g markets offer significantopportunities. After hav<strong>in</strong>g been beaten down dur<strong>in</strong>g <strong>the</strong> height of<strong>the</strong> crisis, emerg<strong>in</strong>g market currencies are likely to rebound to reflect<strong>the</strong> greater growth potential <strong>in</strong>herent <strong>in</strong> that sector. So when I saypeople should have more exposure to emerg<strong>in</strong>g market equities anddebt, <strong>the</strong>y should have it broadly unhedged, mean<strong>in</strong>g that <strong>the</strong>y aretak<strong>in</strong>g non-dollar risk.How PIMCO Is <strong>Thriv<strong>in</strong>g</strong> <strong>in</strong> <strong>the</strong> <strong>New</strong> <strong>Economy</strong>As this crisis has been unfold<strong>in</strong>g, PIMCO has navigated <strong>the</strong> marketplacewith more alacrity than many of our competitors—because wewere focused squarely on defense. We know <strong>from</strong> experience that itpays to perform well dur<strong>in</strong>g a crisis because it helps to pick upmarket share.But as <strong>the</strong> crisis cont<strong>in</strong>ues on its course, we’re mov<strong>in</strong>g cautiouslytoward opportunities to play offense. This doesn’t necessarily meantak<strong>in</strong>g big risks, but ra<strong>the</strong>r recogniz<strong>in</strong>g that we are mov<strong>in</strong>g toward a‘‘new normal’’ <strong>in</strong> which our strategies will emphasize safe highqualityyield <strong>in</strong> <strong>the</strong> portfolio, as opposed to tak<strong>in</strong>g big bets on<strong>in</strong>terest rates. Obviously, we had a 25-year bull market <strong>in</strong> Treasuries,and players that were long <strong>in</strong> <strong>the</strong> markets that did pretty well. But<strong>the</strong> story has changed s<strong>in</strong>ce credit has been repriced <strong>from</strong> <strong>the</strong>nosebleed levels where it traded before <strong>the</strong> crisis. We now actuallybelieve that many parts of <strong>the</strong> credit market are priced attractivelyrelative to risk. On <strong>the</strong> equity side, <strong>the</strong>re should also be a focus onyield amid a revival <strong>in</strong> susta<strong>in</strong>able dividends, and stocks that paydividends are go<strong>in</strong>g to trade at a premium.
PAUL MCCULLEY 77Be<strong>in</strong>g an EducatorThere are obviously many lessons to be learned <strong>from</strong> <strong>the</strong> crisis, andit’s as important as ever for an asset manager like PIMCO to play <strong>the</strong>role of trusted advisor to clients. We are not just do<strong>in</strong>g an assignmentfor our clients; we are act<strong>in</strong>g as <strong>the</strong>ir partner to help <strong>the</strong>m workthrough what <strong>the</strong>y need to do <strong>in</strong> this new world.Among <strong>the</strong> fundamental issues <strong>in</strong> <strong>the</strong> United States right now is<strong>the</strong> need to reth<strong>in</strong>k asset allocation. A lot of <strong>in</strong>vestors had moved towhat is colloquially known as <strong>the</strong> Harvard or Yale model ofportfolio construction, <strong>in</strong> which <strong>the</strong>y ma<strong>in</strong>ta<strong>in</strong>ed big allocationsto illiquid and private <strong>in</strong>struments, such as private equity andhedge funds. The crisis has been particularly brutal for <strong>the</strong>se typesof illiquid <strong>in</strong>struments, which is one of <strong>the</strong> reasons so manycolleges and universities with endowments that are highly illiquidor o<strong>the</strong>rwise locked up have to issue taxable debt to get through <strong>the</strong>liquidity crunch. Clearly, <strong>the</strong>se <strong>in</strong>vestors are go<strong>in</strong>g to view assetallocation differently go<strong>in</strong>g forward, and <strong>the</strong>y’re go<strong>in</strong>g to need helpbuild<strong>in</strong>g portfolios that are not as susceptible to market crises.Some of <strong>the</strong> greatest <strong>in</strong>ternational shifts will come <strong>in</strong> terms of<strong>the</strong> approach <strong>in</strong>vestors take to <strong>the</strong> fixed-<strong>in</strong>come market as opposedto <strong>the</strong> asset allocation paradigm itself. Prior to <strong>the</strong> crisis, <strong>the</strong>shadow bank<strong>in</strong>g system and structured f<strong>in</strong>ance <strong>in</strong>dustry had gonevery global. Many <strong>in</strong>vestors outside <strong>the</strong> United States were buy<strong>in</strong>gvarious forms of structured credit that was stamped triple-A byMoody’s and Standard and Poor’s (S&P) 500 Stock Index, onlyto f<strong>in</strong>d out that it was not triple-A—and that <strong>the</strong>y had boughta pig <strong>in</strong> a poke. So <strong>the</strong> nature of <strong>the</strong> shadow bank<strong>in</strong>g systemand structured products was a critical issue that we have had toexpla<strong>in</strong> to <strong>in</strong>ternational clients more often than domestic ones.We’re also spend<strong>in</strong>g a great deal of time expla<strong>in</strong><strong>in</strong>g <strong>the</strong> mechanicsof <strong>the</strong> <strong>in</strong>novative new policies be<strong>in</strong>g carried out by <strong>the</strong> big three:<strong>the</strong> Treasury, <strong>the</strong> Fed, and <strong>the</strong> Federal Deposit Insurance Corporation(FDIC).
78 THRIVING IN THE NEW ECONOMY<strong>Thriv<strong>in</strong>g</strong> <strong>in</strong> <strong>the</strong> <strong>New</strong> <strong>Economy</strong>Investors can thrive <strong>in</strong> <strong>the</strong> new economy, but <strong>the</strong>y must accept threeideas to do so. The first is that you always need an adequate defense,especially aga<strong>in</strong>st ‘‘tail risks’’ that, although <strong>in</strong>frequent, can bedevastat<strong>in</strong>g to a portfolio. The second is that you have to embrace<strong>the</strong> fact that <strong>the</strong> world is chang<strong>in</strong>g and won’t simply revert back tohow it looked over <strong>the</strong> past few decades. The third is that you mustaccept that <strong>the</strong> offensive plays—<strong>the</strong> attractive <strong>in</strong>vestment returns—<strong>in</strong> this new world aren’t go<strong>in</strong>g to be <strong>in</strong> <strong>the</strong> places that conventionalwisdom has tra<strong>in</strong>ed us to look for <strong>the</strong>m.
8Ron BaronWhe<strong>the</strong>r <strong>the</strong> stock marketis ris<strong>in</strong>g or fall<strong>in</strong>g,Baron Funds founderRon Baron never losessight of his long-termobjective. With a timehorizon of five years oroften longer, Ron andhis firm <strong>in</strong>vest on behalf of <strong>the</strong>ir shareholders primarily <strong>in</strong>small and mid-sized growth companies, and <strong>the</strong> managementswho run those bus<strong>in</strong>esses. The companies thatattract Ron are f<strong>in</strong>ancially strong, are well managed, andhave prospects to become significantly larger. Ron and hisfirm use a bottom-up, <strong>in</strong>tense company research strategyand try to <strong>in</strong>vest <strong>in</strong> companies at what <strong>the</strong>y believe areattractive prices.When <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> growth companies, Ron uses a valueorientedpurchase discipl<strong>in</strong>e. Short-term market fluctuationsusually don’t disturb him. If Baron Funds believes<strong>the</strong> fundamentals that justified an <strong>in</strong>vestment haven’tchanged, <strong>the</strong>y will hold that <strong>in</strong>vestment and may even(cont<strong>in</strong>ued)79
80 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)buy more. This flies <strong>in</strong> <strong>the</strong> face of <strong>the</strong> response usually madeby rule-based <strong>in</strong>vestors who sell when stock prices fall,assum<strong>in</strong>g <strong>the</strong>y must have made a mistake. Ron’s longtermapproach and focus require him to study <strong>the</strong> bigpicture: Just because a bus<strong>in</strong>ess is earn<strong>in</strong>g less money oreven los<strong>in</strong>g money for a short period does not mean thatbus<strong>in</strong>ess’s viability or long-term growth prospects arethreatened. In most cases, Ron expects Baron Funds’ current<strong>in</strong>vestments to recover <strong>the</strong> value <strong>the</strong>y have lost between<strong>the</strong> fall of 2007 and <strong>the</strong> spr<strong>in</strong>g of 2009 dur<strong>in</strong>g <strong>the</strong>next several years.Ron Baron was smitten with stocks at age 13, when he<strong>in</strong>vested his $1,000 bar mitzvah gifts and, <strong>in</strong> a ris<strong>in</strong>g market,immediately began to make money. Add<strong>in</strong>g to his <strong>in</strong>vestmentswith earn<strong>in</strong>gs <strong>from</strong> shovel<strong>in</strong>g snow, wait<strong>in</strong>g tables,serv<strong>in</strong>g as a lifeguard, and sell<strong>in</strong>g ice cream—like so manystudents today—he helped pay his college tuition. Ronofficially began his career <strong>in</strong> f<strong>in</strong>ance <strong>in</strong> 1970. He has witnessednumerous recessions and stock market ‘‘panics’’:<strong>the</strong> extended bear market of 1973 to 1974, <strong>the</strong> crash <strong>in</strong>1987, <strong>the</strong> free fall after 9/11, and countless o<strong>the</strong>r marketdysfunctions both <strong>in</strong> <strong>the</strong> United States and abroad. Ever <strong>the</strong>optimist, Ron says that no matter how bleak our economy’sprospects may seem, our country and its economy havealways recovered <strong>from</strong> distress<strong>in</strong>g circumstances s<strong>in</strong>ce itsfound<strong>in</strong>g. He subscribes to Warren Buffett’s philosophythat ‘‘pessimism is <strong>the</strong> friend of <strong>the</strong> <strong>in</strong>vestor’’ and to RonaldReagan’s motto that ‘‘America’s best days lie ahead’’;accord<strong>in</strong>gly, he believes that ‘‘2009 offers <strong>in</strong>vestors <strong>the</strong>best opportunities of my lifetime.’’ Although he beganwork<strong>in</strong>g <strong>in</strong> f<strong>in</strong>ance years ago, Ron’s passion and excitementabout <strong>in</strong>vest<strong>in</strong>g still keep him up at night, especially now,with so many stocks at levels he f<strong>in</strong>ds unusually attractive.
RON BARON 81Look<strong>in</strong>g back, I th<strong>in</strong>k this crisis had many similarities towhat happened follow<strong>in</strong>g <strong>the</strong> Crash of 1929. I thought ourgovernment had learned <strong>the</strong> lessons of <strong>the</strong> 1930s and that tragicperiods like that would be conf<strong>in</strong>ed to history books. I didn’t th<strong>in</strong>kwe would see such th<strong>in</strong>gs aga<strong>in</strong>: a f<strong>in</strong>ancial cha<strong>in</strong> reaction withcont<strong>in</strong>u<strong>in</strong>g negative feedback that could cause an extraord<strong>in</strong>arilyweak economy for an extended period. However, Lehman Bro<strong>the</strong>rs’bankruptcy on September 15, 2008, was <strong>the</strong> catalyst for just such af<strong>in</strong>ancial cha<strong>in</strong> reaction. This is because Lehman Bro<strong>the</strong>rs’ balancesheet was so large—just like AIG’s—that virtually all <strong>the</strong> o<strong>the</strong>r largef<strong>in</strong>ancial firms with whom it had done bus<strong>in</strong>ess were adverselyaffected when it failed.When <strong>the</strong> stock market began to plunge day after day afterSeptember 15, real-time news coverage on television, <strong>the</strong> Internet,and newspapers brought <strong>the</strong>se events <strong>in</strong>to everyone’s liv<strong>in</strong>g roomon a daily basis and <strong>in</strong> terrify<strong>in</strong>g detail. It was like watch<strong>in</strong>g acatastrophe; it seemed surreal. The result<strong>in</strong>g fear <strong>in</strong> America andworldwideand<strong>the</strong>lossofconfidence <strong>in</strong> our capacity to deal withcrises caused stock markets here andgloballytocont<strong>in</strong>uetofall.Investors, consumers, and bus<strong>in</strong>esspeople reacted, economieseverywhere fell <strong>in</strong>to a deep recession, and stocks fell fur<strong>the</strong>r. Itcouldn’t have been clearer to us what was happen<strong>in</strong>g when onecorporation after ano<strong>the</strong>r <strong>in</strong> which we had <strong>in</strong>vested began to tell us<strong>the</strong>y were cutt<strong>in</strong>g expenses, reduc<strong>in</strong>g employment, and cutt<strong>in</strong>gcapital expenditures. That would clearly reduce consumer confidenceand purchases, which would lead to even more bus<strong>in</strong>ess costreductions, which would lead to even lower consumer confidence,and so on. It rem<strong>in</strong>ded me of <strong>the</strong> reported meet<strong>in</strong>g early <strong>in</strong> <strong>the</strong>twentieth century between Henry Ford, <strong>the</strong> founder of FordMotor Company, and Walter Reu<strong>the</strong>r, <strong>the</strong> head of <strong>the</strong> UnitedAuto Workers union, <strong>in</strong> one of Ford’s new plants. ‘‘Do you see allthose workers, Mr. Reu<strong>the</strong>r? Some day all <strong>the</strong>ir jobs will be doneby mach<strong>in</strong>es,’’ Ford told Reu<strong>the</strong>r. ‘‘Just who do you expect to buyyour cars <strong>the</strong>n, Mr. Ford?’’ Reu<strong>the</strong>r replied. When bus<strong>in</strong>esses cut
82 THRIVING IN THE NEW ECONOMYjobs, <strong>the</strong>re are obviously fewer customers for <strong>the</strong>ir products. This isan immutable rule.The situation with Lehman Bro<strong>the</strong>rs brought to m<strong>in</strong>d WarrenBuffett’s comments regard<strong>in</strong>g <strong>the</strong> propensity for one to rely uponsomeone else’s promise: that <strong>the</strong> promise is no better than <strong>the</strong>ability and desire of <strong>the</strong> person mak<strong>in</strong>g it to fulfill it. LehmanBro<strong>the</strong>rs had made commercial promises to many upon which <strong>the</strong>yrelied to establish o<strong>the</strong>r commercial and contractual commitments.Many of those to whom Lehman Bro<strong>the</strong>rs had made <strong>the</strong>sepromises—promises it would now be unable to fulfill—and thosecounterparties could be greatly affected. But by how much? Noone seemed to know. Lehman Bro<strong>the</strong>rs was so large. It was difficultto understand how <strong>the</strong> government could allow it to fail. But, forsome reason, it did.After Lehman Bro<strong>the</strong>rs’ failure, it became clear how dangerouslyleveraged our economy had become, and how leverag<strong>in</strong>g hadbeen an important driver of our growth over <strong>the</strong> past 30 years.Borrow<strong>in</strong>g allowed people to buy th<strong>in</strong>gs <strong>the</strong>y could not havebought o<strong>the</strong>rwise; it made assets more valuable than <strong>the</strong>y evermight have been. This trend could have ended at any time, even5 or 10 years ago. Indebtedness <strong>in</strong> our economy <strong>in</strong>creased<strong>from</strong> about 170 percent of <strong>the</strong> gross domestic product (GDP)<strong>in</strong> 1982 to 350 percent of <strong>the</strong> GDP <strong>in</strong> 2009. We simply could notsupport that <strong>in</strong>debtedness if ei<strong>the</strong>r <strong>in</strong>terest rates <strong>in</strong>creased or <strong>the</strong>economy faltered.Learn<strong>in</strong>g <strong>from</strong> MistakesEveryone makes mistakes when circumstances change rapidly, sowe of course made some dur<strong>in</strong>g <strong>the</strong> past 18 months. How did wereact? On <strong>the</strong> marg<strong>in</strong>, we tried to make <strong>the</strong> portfolios we managedmore resistant to <strong>the</strong> Great Recession of 2009. We reduced our<strong>in</strong>vestments <strong>in</strong> bus<strong>in</strong>esses that used leverage or required access tocapital markets. We reduced our <strong>in</strong>vestments <strong>in</strong> bus<strong>in</strong>esses that
RON BARON 83provide consumers with nonessential products and services. We<strong>in</strong>creased our <strong>in</strong>vestments <strong>in</strong> education, health care, and <strong>in</strong>frastructureand were even more opportunistic than usual when purchas<strong>in</strong>g<strong>in</strong>vestments. Despite <strong>the</strong> recession, at year-end 2008, weexpected more than half <strong>the</strong> companies <strong>in</strong> which we had <strong>in</strong>vestedto have higher earn<strong>in</strong>gs <strong>in</strong> 2009 than <strong>the</strong>y did <strong>in</strong> 2008. We havealso recognized losses that we could use to shelter future <strong>in</strong>vestmentearn<strong>in</strong>gs.No SleepI speak with our employees; I speak with executives of companies <strong>in</strong>which we <strong>in</strong>vest; and, I speak with my family and with my friends.My best friends are <strong>in</strong>dividuals with whom I’ve been close nearlymy entire life. One of my best friends, Jack, is a doctor who nowlives <strong>in</strong> Palo Alto. We’ve been friends s<strong>in</strong>ce I was 11 or 12 years old.A few months ago, he said to me, ‘‘Ronnie, I have been <strong>in</strong>vest<strong>in</strong>gwith you for 30 years. Because of that, I am f<strong>in</strong>e and have a lot ofmoney; but after this year about half as much as I had. I could easilylive on that; but I just can’t live on noth<strong>in</strong>g.’’ Jack is one of <strong>the</strong> mostlaid-back people I know, but he wasn’t sleep<strong>in</strong>g well. I told himthat although I am rarely upset by market movements and economicforecasts, <strong>the</strong>re were times when I also didn’t sleep well. Mywife and my closest colleagues, both of whom are usually fairlyhard to upset, have also had a difficult time sleep<strong>in</strong>g. Regardless,dur<strong>in</strong>g most of this period I have been <strong>in</strong> very good spirits and haveviewed events as provid<strong>in</strong>g us with what I have called <strong>the</strong> best<strong>in</strong>vestment opportunities of my lifetime.Look<strong>in</strong>g for LeadershipAfter Lehman Bro<strong>the</strong>rs collapsed, I told our researchers that ourcountry was go<strong>in</strong>g to emerge <strong>from</strong> this difficult period and that
84 THRIVING IN THE NEW ECONOMYit was more important than ever to focus on research <strong>in</strong>stead ofworry<strong>in</strong>g about what is unpredictable. We research bus<strong>in</strong>esses. Weanalyze companies and study people. We try to f<strong>in</strong>d people withwhom we want to <strong>in</strong>vest, and who we th<strong>in</strong>k are smart, hard-work<strong>in</strong>g,and honest, and we bet on <strong>the</strong>m. F<strong>in</strong>d great bus<strong>in</strong>esses with really bigopportunities and people who can make those bus<strong>in</strong>esses become alot larger. It doesn’t matter how great <strong>the</strong> opportunity is; unlessyou f<strong>in</strong>d someone who is go<strong>in</strong>g to realize that opportunity for <strong>the</strong>bus<strong>in</strong>ess, it’s not go<strong>in</strong>g to happen. There couldn’t be a better timeto do research, I told our staff, than when <strong>the</strong>re is so much turmoiland uncerta<strong>in</strong>ty—and so many are concerned with los<strong>in</strong>g <strong>the</strong>irjobs that <strong>the</strong>y’re not do<strong>in</strong>g <strong>the</strong>ir jobs. If we can’t f<strong>in</strong>d great <strong>in</strong>vestmentideas now, I remarked, we’ll never be able to f<strong>in</strong>d great<strong>in</strong>vestment ideas.Realiz<strong>in</strong>g OpportunitiesWe have been <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> education companies s<strong>in</strong>ce 1990. Theidea when we started <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> for-profit colleges 19 years agowas that <strong>the</strong>y awarded you <strong>the</strong> same accredited degree that youwould receive when you went to a state college or <strong>the</strong> top privatecolleges and universities. Students could attend for-profit collegesfor less than it would cost to go to a state college. Not only wasit less expensive, but it was easier to ga<strong>in</strong> admission.Two examples of company leadership that attracted us wereDeVry’s Ron Taylor and Strayer Education’s Rob Silberman.The market value of DeVry <strong>in</strong> 1990, when we began to <strong>in</strong>vest <strong>in</strong>that bus<strong>in</strong>ess, was about $100 million. It has s<strong>in</strong>ce grown more thanthirty-fold, to more than $3 billion. DeVry was even selected toreplace General Motors Corporation <strong>in</strong> <strong>the</strong> S&P 500 Stock Index!DeVry’s Ron Taylor and Strayer Education’s Rob Silberman careabout whe<strong>the</strong>r <strong>the</strong>ir students graduate and can get jobs when <strong>the</strong>ydo, earn<strong>in</strong>g twice as much as <strong>the</strong>y could before <strong>the</strong>y attended those
RON BARON 85colleges. Nei<strong>the</strong>r executive was attempt<strong>in</strong>g to maximize <strong>the</strong>ir enrollmentsand short-term profits; <strong>the</strong>y were simply try<strong>in</strong>g to make sure<strong>the</strong>ir students were receiv<strong>in</strong>g a high-quality education. Many ofDeVry’s students were <strong>the</strong> first <strong>in</strong> <strong>the</strong>ir families to attend college.Often <strong>the</strong> children of immigrants or m<strong>in</strong>orities who were <strong>the</strong>product of an <strong>in</strong>adequate high school education, <strong>the</strong>y were unlikelyto be successful. DeVry provided <strong>the</strong>m with courses <strong>in</strong> remedialread<strong>in</strong>g, English as a first language, and math skills that should havebeen taught <strong>in</strong> high school or maybe even grammar school. Theymade sure that <strong>the</strong>ir students would actually have <strong>the</strong> skills <strong>the</strong>yneeded to succeed <strong>in</strong> college. Strayer requires that its students takelaboratory and science courses to make certa<strong>in</strong> <strong>the</strong>y receive a wellroundededucation. Although some of <strong>the</strong>se programs were notprofitable, <strong>the</strong>y gave students tools to be successful both <strong>in</strong> collegeand upon graduation.Steve Wynn is a CEO with whom I have been <strong>in</strong>vest<strong>in</strong>g s<strong>in</strong>ce1980. I was <strong>in</strong>troduced to Steve by Jay Pritzker, <strong>the</strong> founder ofGlobal Hyatt Corporation. ‘‘Steve Wynn? What k<strong>in</strong>d of name isthat for a guy <strong>in</strong> cas<strong>in</strong>os? Is he a comic strip character?’’ I wanted toknow. Jay said, ‘‘No. No, this is a guy you have to meet. He’s <strong>the</strong> bestoperator <strong>in</strong> his <strong>in</strong>dustry.’’ Well, I met Steve <strong>in</strong> 1980 and have been<strong>in</strong>vest<strong>in</strong>g with him s<strong>in</strong>ce. We <strong>in</strong>vested about $135 million <strong>in</strong> 2001<strong>in</strong> Wynn Resorts, have received perhaps $80 million <strong>in</strong> dividendsand had earned more than $1 billion before we gave up about35 percent of that amount s<strong>in</strong>ce November 2007.Why do we th<strong>in</strong>k Steve is a great manager? One of Baron Funds’outside directors, Alex Yemenidjian, is a mutual friend of Steve’s andm<strong>in</strong>e. As someone who previously worked for Kirk Kerkorian aschairman of MGM Grand, <strong>the</strong> cas<strong>in</strong>o hotel bus<strong>in</strong>ess, and MGMStudios, Alex claims <strong>the</strong> only guy who really gets it right <strong>in</strong> Las Vegasis Steve Wynn. That is because Steve wants to be certa<strong>in</strong> that whenhis guests visit his hotels, <strong>the</strong>y are treated well and want to return.Wynn Las Vegas is different than o<strong>the</strong>r properties, Alex expla<strong>in</strong>s,because when you stay <strong>the</strong>re, you feel like you are stay<strong>in</strong>g at a
86 THRIVING IN THE NEW ECONOMYcountry <strong>in</strong>n run by its proprietor who lives upstairs. Steve does<strong>in</strong>deed live <strong>the</strong>re, knows all <strong>the</strong> people who work for him, andensures that <strong>the</strong>y provide <strong>the</strong> services he would expect to provide tofriends and family guests com<strong>in</strong>g to visit him.An example of this was back <strong>in</strong> <strong>the</strong> 1970s, a wealthy <strong>in</strong>dividual<strong>from</strong> Japan visited Steve’s Atlantic City cas<strong>in</strong>o hotel and requesteda l<strong>in</strong>e of credit, which Steve approved. They gave that <strong>in</strong>dividual a$10 or $15 million credit l<strong>in</strong>e, which, <strong>in</strong> <strong>the</strong> 1970s, was anextraord<strong>in</strong>ary amount of money. It was also a lot of money tolose if <strong>the</strong> customer won a substantial amount of money. Well,<strong>the</strong> <strong>in</strong>dividual won $10 million that weekend. When Steve’s hotelguest arrived home <strong>in</strong> Tokyo, <strong>the</strong>re was a Rolls-Royce <strong>in</strong> hisdriveway, wrapped <strong>in</strong> a p<strong>in</strong>k ribbon with a note <strong>from</strong> Steveattached. ‘‘Thank you very much for visit<strong>in</strong>g our cas<strong>in</strong>o. Welook forward to serv<strong>in</strong>g you aga<strong>in</strong>.’’ Well, that person returnedto Steve’s Golden Nugget a couple of weeks later. He lost allthose w<strong>in</strong>n<strong>in</strong>gs and an additional $15 million.Steve knows that is <strong>the</strong> way you treat people if you want <strong>the</strong>m toalways stay <strong>in</strong> your hotel, and he is highly regarded <strong>in</strong> his community.He takes good care of his employees, who <strong>in</strong> return take goodcare of his customers. If you are not concerned about your reputation<strong>in</strong> your community, you won’t attract great employees whowill treat your customers well. And it doesn’t really matter howmuch your earn<strong>in</strong>gs <strong>in</strong>crease <strong>in</strong> any given quarter; you are ultimatelygo<strong>in</strong>g to fail. Steve is <strong>the</strong> perfect example of someone who has <strong>the</strong>vision to run a successful hospitality bus<strong>in</strong>ess.<strong>Thriv<strong>in</strong>g</strong> StrategiesMost people run bus<strong>in</strong>esses to maximize earn<strong>in</strong>gs and profits <strong>in</strong><strong>the</strong> short term. The executives with whom we prefer to <strong>in</strong>vestth<strong>in</strong>k about <strong>the</strong> long term. They put money <strong>in</strong>to <strong>the</strong>ir bus<strong>in</strong>esseseven when it could potentially endanger profitability <strong>in</strong> <strong>the</strong> short
RON BARON 87term. Their objective is to <strong>in</strong>vest <strong>in</strong> order to create competitiveadvantage for <strong>the</strong>ir bus<strong>in</strong>ess so that it can become much larger <strong>in</strong><strong>the</strong> long term.Our office is very welcom<strong>in</strong>g. Why have we made <strong>the</strong> effort tomake it so? It’s because we believe that if you give someone light,pretty space, and a view, <strong>the</strong>y will be happier; <strong>the</strong>y will feel better;<strong>the</strong>y will act positively; and <strong>the</strong>y will become friendly with oneano<strong>the</strong>r. They will be excited about <strong>the</strong>ir jobs and proud to have<strong>the</strong>ir children and spouses visit on a weekend to see where <strong>the</strong>y work.Our fellow employees’ families and parents come by all <strong>the</strong> time.One of <strong>the</strong> results of hav<strong>in</strong>g such a pleasant work environment is<strong>the</strong> tendency to show respect for your fellow workers. They arebetter employees. They work harder, and <strong>the</strong>y treat our customers,<strong>the</strong> shareholders of our mutual funds, better. Our reputation <strong>in</strong> <strong>the</strong>community is solid. As a result, we are able to hire great employees;<strong>the</strong>y treat our customers well, and <strong>the</strong> owners of our family bus<strong>in</strong>essare do<strong>in</strong>g well. If you do not put effort <strong>in</strong>to those o<strong>the</strong>r th<strong>in</strong>gs, youwill fail. A good manager is someone who th<strong>in</strong>ks about all of <strong>the</strong>seaspects of bus<strong>in</strong>ess, and that’s what we’re look<strong>in</strong>g for. That’s <strong>the</strong>sort of personality that you must have; ra<strong>the</strong>r than be<strong>in</strong>g short-termoriented, you must look at <strong>the</strong> long term.For years, our country has not had a long-term plan. The chiefexecutive of S<strong>in</strong>gapore is 80 years old. He has a 100-year plan! <strong>New</strong>York City had never had a plan. Michael Bloomberg was electedMayor and <strong>the</strong> city now has a 35-year plan. I read <strong>in</strong> <strong>the</strong> newspaperthis week that <strong>the</strong> head of <strong>the</strong> <strong>New</strong> York City teachers union hadbeen concerned about Bloomberg’s control over education <strong>in</strong> <strong>New</strong>York City. But, accord<strong>in</strong>g to this <strong>in</strong>dividual, s<strong>in</strong>ce Bloombergwrested control over our city’s schools, look what has happenedto our city’s student population. Student math test scores <strong>in</strong> <strong>New</strong>York City schools have skyrocketed. So have o<strong>the</strong>r metrics measur<strong>in</strong>geducation outcomes. Mayor Bloomberg’s long-term plan is tomake people <strong>in</strong> <strong>New</strong> York healthier, to make it impossible to smoke
88 THRIVING IN THE NEW ECONOMY<strong>in</strong> restaurants, to tax carbonated soda, to keep you <strong>from</strong> dr<strong>in</strong>k<strong>in</strong>gdiet sodas because <strong>the</strong>y are unhealthy. Bloomberg wants to havehealthier people, trimmer people, and no diabetes. In addition tobenefitt<strong>in</strong>g our populace directly, our health care bill will be less.Mayor Bloomberg has a plan.President Obama also has a plan. You might not agree with allparts of it, but he has one; he has a vision for where he wants to takeour country. He wants to make our country different than it hasbeen. We have been us<strong>in</strong>g too much carbon energy for a long time. Ithas become too expensive to cont<strong>in</strong>ue to do so. We have beensend<strong>in</strong>g our money overseas to pay for energy, giv<strong>in</strong>g foreigners aclaim on our assets. This has been hurt<strong>in</strong>g our dollar and is allow<strong>in</strong>gforeigners to buy our assets on <strong>the</strong> cheap. By sell<strong>in</strong>g our assetscheaply, we have been damag<strong>in</strong>g our economy; we have beenmak<strong>in</strong>g our country less safe by rely<strong>in</strong>g on nations who are notour friends to provide us with what is necessary to operate oureconomy. Along <strong>the</strong> way, we have been damag<strong>in</strong>g our environment.President Obama is try<strong>in</strong>g to make America more efficient <strong>in</strong> itsuse of energy. He’s go<strong>in</strong>g to make our economy less leveraged; he’sgo<strong>in</strong>g to make our f<strong>in</strong>ancial <strong>in</strong>stitutions stronger. Right now, wehave banks that want to pay back <strong>the</strong>ir Troubled Asset ReliefProgram (TARP) money. But <strong>the</strong> government has responded,‘‘Not so fast.’’ They won’t permit <strong>the</strong>m to pay it back until <strong>the</strong>ycan show <strong>the</strong> government that <strong>the</strong>y’re solvent and can raise equitymoney <strong>from</strong> public <strong>in</strong>vestors. Why is <strong>the</strong> President do<strong>in</strong>g this? Tomake sure that <strong>the</strong>se companies really are solvent and that <strong>the</strong>y arenot go<strong>in</strong>g to cause a repeat of <strong>the</strong> f<strong>in</strong>ancial crisis we are now <strong>in</strong> <strong>the</strong>process of resolv<strong>in</strong>g. This is great, what our government is do<strong>in</strong>g.Obama Adm<strong>in</strong>istration Invest<strong>in</strong>gThere is a terrific opportunity <strong>in</strong> w<strong>in</strong>d power, which is produced on<strong>the</strong> great pla<strong>in</strong>s of America, <strong>in</strong> <strong>the</strong> middle of <strong>the</strong> country. The users
RON BARON 89of w<strong>in</strong>d power are <strong>the</strong> guys who live on <strong>the</strong> coasts. But how do youget <strong>the</strong> energy <strong>the</strong>re? You need transmission. We have an <strong>in</strong>vestment<strong>in</strong> ITC Hold<strong>in</strong>gs, <strong>the</strong> largest, and only <strong>in</strong>dependent, publiclyowned, electricity transmission company. It was a sp<strong>in</strong> out <strong>from</strong>Detroit Edison.Get ExcitedWhen <strong>the</strong> market falls as much as it has recently, you can throw adart and virtually anyth<strong>in</strong>g you hit is go<strong>in</strong>g to make you money <strong>in</strong><strong>the</strong> short term. The trick is to f<strong>in</strong>d someth<strong>in</strong>g that is not go<strong>in</strong>g to goup just <strong>in</strong> <strong>the</strong> short term. In fact, s<strong>in</strong>ce <strong>the</strong> U.S. market bottomed <strong>in</strong>early March 2009, stocks of lower-quality bus<strong>in</strong>esses have <strong>in</strong>creased<strong>in</strong> price more than those of higher-quality bus<strong>in</strong>esses. This is becauselow-quality, highly leveraged bus<strong>in</strong>esses were left for dead by<strong>in</strong>vestors—and <strong>the</strong>y did not die. But what are <strong>the</strong> opportunitiesfor those companies for <strong>the</strong> long term? There is <strong>in</strong>vestment opportunityfor <strong>the</strong> long term <strong>in</strong> education, mak<strong>in</strong>g sure that people canafford to be educated and make our nation more productive andmore competitive <strong>in</strong> <strong>the</strong> world.Health care is ano<strong>the</strong>r big <strong>in</strong>vestment opportunity. We recentlyvisited genetic test<strong>in</strong>g company Gen-Probe <strong>in</strong> California; <strong>the</strong>y toldus about <strong>the</strong>ir new prostate cancer test called PCA 3 (prostatecancer gene 3). Instead of a prostate-specific antigen (PSA) culturetest, which takes two or three weeks to obta<strong>in</strong> results with onlyokay accuracy (you get a lot of false-positive and false-negativeresults), Gen-Probe’s genetic test will give you results <strong>in</strong> twoor three hours—and it is 99 percent accurate. I <strong>in</strong>quired as towhy <strong>the</strong>y still do a PSA test if it is <strong>in</strong>accurate, is expensive, andtakes three weeks versus three hours to get results. I was told <strong>the</strong>reason is that we have an <strong>in</strong>frastructure <strong>in</strong> America that makes agreat deal of money <strong>from</strong> PSA tests—tests that are <strong>in</strong>accurate,expensive, and obsolete. This scientist expla<strong>in</strong>ed to us that many
90 THRIVING IN THE NEW ECONOMYbelieve almost one-third of <strong>the</strong> amountofmoneyspentonmedicalcare <strong>in</strong> our country is wasted.Invest<strong>in</strong>g CriteriaWe at Baron Funds are pla<strong>in</strong>-vanilla <strong>in</strong>vestors who employ a verysimple strategy: f<strong>in</strong>d a bus<strong>in</strong>ess that can double <strong>in</strong> size <strong>in</strong> four or fiveyears by provid<strong>in</strong>g an important service that o<strong>the</strong>rs cannot easilyprovide to a clientele who could not o<strong>the</strong>rwise obta<strong>in</strong> that service atan attractive price. We are try<strong>in</strong>g to f<strong>in</strong>d bus<strong>in</strong>esses that are or canbecome very profitable, operated by <strong>in</strong>dividuals we like. It’s assimple as that.We tell our clients that we are bett<strong>in</strong>g on someone.We are bett<strong>in</strong>g on <strong>the</strong> people who run bus<strong>in</strong>esses with bigopportunities to work hard to make <strong>the</strong>ir bus<strong>in</strong>esses become larger.People understand that, and <strong>the</strong>y say okay, I got it. That soundsreasonable to me. This takes me back to high school. When you areyoung, you know who <strong>the</strong> smartest kid <strong>in</strong> your class is; you knowwhom you like <strong>the</strong> best. You know who you th<strong>in</strong>k is honest. Andthat’s all this is. This bus<strong>in</strong>ess is about bett<strong>in</strong>g on people, aboutbett<strong>in</strong>g on people who have <strong>the</strong> long-term vision and are will<strong>in</strong>g tosacrifice short-term profits to make <strong>the</strong>ir bus<strong>in</strong>ess impregnable over<strong>the</strong> long term. That’s what this is all about.
9Ken LangoneNo one embodies orembraces <strong>the</strong> entrepreneurialspirit morethan Ken Langone. Cofounderof The HomeDepot and chairmanand CEO of InvemedAssociates, as well as aformer <strong>New</strong> York StockExchange (NYSE) Board member, Ken is an <strong>in</strong>spiration tomany students who want to succeed. To help pay for histuition at Bucknell University, Ken worked as a caddie, ditchdigger, and a butcher’s assistant. Major<strong>in</strong>g <strong>in</strong> economicsand political science, Ken f<strong>in</strong>ished <strong>in</strong> three and a half years.He <strong>the</strong>n went to NYU, work<strong>in</strong>g full-time dur<strong>in</strong>g <strong>the</strong> day atEquitable Life Assurance Company and attend<strong>in</strong>g courses atnight.Thepart-timeeven<strong>in</strong>gprogramisstillproudlycalled<strong>the</strong>‘‘Langone Program.’’Ken has decades of experience br<strong>in</strong>g<strong>in</strong>g companiespublic. The first deal of his career was <strong>the</strong> IPO launch ofRoss Perot’s company Electronic Data Systems, and <strong>the</strong>n of(cont<strong>in</strong>ued)91
92 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)course, his most prom<strong>in</strong>ent deal: The Home Depot. Ken’spulse on <strong>the</strong> economy spans not only <strong>from</strong> his Invemed<strong>in</strong>vestments but also <strong>from</strong> his board seats of Yum! Brandsand Unified. Ken’s <strong>in</strong>vestment bank, Invemed Associates,ei<strong>the</strong>r takes m<strong>in</strong>ority stakes <strong>in</strong> small cap companies, <strong>in</strong>vests<strong>in</strong> buyouts, or start-up companies. The key to Ken’s success,and you’ll read about it <strong>in</strong> a few m<strong>in</strong>utes, is that Invemeddoes not use leverage <strong>in</strong> mak<strong>in</strong>g any of its <strong>in</strong>vestments. Kenis a long-term <strong>in</strong>vestor, usually hold<strong>in</strong>g companies for 5 to10 years <strong>in</strong> <strong>the</strong> firm’s portfolio.Ken’s entrepreneurial experience and <strong>the</strong> challenges hehas faced and conquered have made him who he is today.As I sat <strong>in</strong> his office wait<strong>in</strong>g to start <strong>the</strong> <strong>in</strong>terview, I waslook<strong>in</strong>g at <strong>the</strong> photos on his long side table. And among<strong>the</strong> photos <strong>the</strong>re was one <strong>in</strong> particular that jumped out tome: a small frame that looked like a dartboard with aphoto of Eliot Spitzer <strong>in</strong> it. Ken has chosen to take <strong>the</strong> highroad when it comes to his battle with <strong>the</strong> disgraced ‘‘LuvGov’’ and former <strong>New</strong> York Attorney General who unsuccessfullyprosecuted him for <strong>the</strong> controversial paypackage of former NYSE chief Dick Grasso.Ken is very passionate about what he does, and you canhear it <strong>in</strong> his words. He never loses sight of his objective,and his criteria and approach to bus<strong>in</strong>ess are what <strong>in</strong>vestorsgravitate toward.Bear Stearns was really <strong>the</strong> contagion that had gone <strong>from</strong><strong>the</strong> firm’s hedge funds and spread its way to o<strong>the</strong>r firmsthroughout <strong>the</strong> entire system. When Bear Stearns’ hedge funds hit<strong>the</strong> wall <strong>in</strong> <strong>the</strong> summer of 2007, it was clear one of <strong>the</strong> reasons<strong>the</strong>y were hav<strong>in</strong>g problems was that <strong>the</strong> people manag<strong>in</strong>g thosefunds did not fully understand <strong>the</strong> degree of risk <strong>in</strong> what <strong>the</strong>ywere buy<strong>in</strong>g. For whatever reason <strong>the</strong>se people were <strong>in</strong> <strong>the</strong>se
KEN LANGONE 93securities—maybe <strong>the</strong>y were depend<strong>in</strong>g on rat<strong>in</strong>gs or <strong>the</strong>y thought<strong>the</strong>y knew what <strong>the</strong>y were do<strong>in</strong>g or <strong>the</strong>y thought <strong>the</strong>y could make alot of money—<strong>the</strong>y ended up be<strong>in</strong>g f<strong>in</strong>ancially exposed beyond whatI th<strong>in</strong>k <strong>the</strong>ir calculations <strong>in</strong>dicated.Whe<strong>the</strong>r it was structured <strong>in</strong>vestment vehicles (SIVs), creditdefault swaps, or collateral debt obligations, it didn’t matter. Therewere layers upon layers of leverage be<strong>in</strong>g added to a system, whichmeant that when it froze up, you were <strong>in</strong> trouble. So we fast-forwardto Bear Stearns’ demise, or should I say its fire sale, to J.P. Morgan.By <strong>the</strong>n, <strong>the</strong> forest fire was rag<strong>in</strong>g. Morgan Stanley, Goldman Sachs,Merrill Lynch—<strong>the</strong>y all went right down. It was clear that much of<strong>the</strong> activity of <strong>the</strong> past five or six years was <strong>in</strong> f<strong>in</strong>ancial <strong>in</strong>strumentswhere <strong>the</strong> risks were far greater. The collateral risk, <strong>the</strong> <strong>in</strong>terl<strong>in</strong>kedrisk between one firm and ano<strong>the</strong>r firm, was profound. I have nevertrafficked <strong>in</strong> that k<strong>in</strong>d of paper. I never understood it. I don’t buywhat I don’t understand.At <strong>the</strong> time, I said to myself, ‘‘Someth<strong>in</strong>g bad is happen<strong>in</strong>g rightnow.’’ The <strong>in</strong>struments <strong>the</strong>mselves created a problem. Nobodyunderstood how <strong>the</strong>y worked. But it was made a far moreprofound problem by <strong>the</strong> sheer size of <strong>the</strong> total amount of thisoutstand<strong>in</strong>g paper. It was stagger<strong>in</strong>g. And it’d gone beyondAmerica’s shores. It had gone to communities <strong>in</strong> Scand<strong>in</strong>aviancountries that were gett<strong>in</strong>g racked by values that were almostevaporat<strong>in</strong>g. It became a guess<strong>in</strong>g game of who would survive andwho would not.From <strong>the</strong> time Bear Stearns was sold, throughout <strong>the</strong> entire nextsix months until Lehman Bro<strong>the</strong>rs was allowed to go bankrupt, itwas clear that <strong>the</strong> rangers were look<strong>in</strong>g for a way to conta<strong>in</strong> thisforest fire. The lesson we all got <strong>from</strong> <strong>the</strong> depression was that a lackof liquidity only exacerbates <strong>the</strong> problem. So to <strong>the</strong> government’scredit, it <strong>in</strong>undated <strong>the</strong> markets—I mean swamped <strong>the</strong> markets,flaunted <strong>the</strong>m, with cash of various sizes and ways of gett<strong>in</strong>g <strong>the</strong>money <strong>in</strong>. For example, it had <strong>the</strong> Troubled Asset Relief Program(TARP) money, <strong>the</strong>n it had <strong>the</strong> Term Asset-Backed Securities
94 THRIVING IN THE NEW ECONOMYLoan Facility (TALF) money, and before <strong>the</strong> TARP money, it wasgo<strong>in</strong>g to loan money to <strong>the</strong> banks to make loans, which I found abit contradictory because that’s what got us <strong>in</strong> trouble. Too manypeople were borrow<strong>in</strong>g money that <strong>the</strong>y couldn’t pay back.Economic RealityAs <strong>the</strong> economy began to respond to this f<strong>in</strong>ancial crisis, peoplereactedbypull<strong>in</strong>g<strong>the</strong>irhorns<strong>in</strong>.GeneralMotorsandFordwereon <strong>the</strong> edge. Ford is a different story. I push Ford over to <strong>the</strong> sidebecause Ford borrowed a lot of money—a lot of older money—and still has it. When sales of automobiles tanked, dropp<strong>in</strong>g <strong>from</strong>$12 million a year to $11 million, <strong>the</strong>n to $10 million, and nowit looks like $9.5 million, GM’s and Chrylser’s market shareseroded. They both ended up need<strong>in</strong>g to be put <strong>in</strong>to bankruptcy,but not before <strong>the</strong> government gave <strong>the</strong>m significant sums ofmoney <strong>in</strong> December 2008. I said it <strong>the</strong>n and will say it aga<strong>in</strong> now:There was a strong feel<strong>in</strong>g that Chrysler and General Motorsshould have been allowed to go bankrupt <strong>in</strong> December 2008.But <strong>the</strong> government gave <strong>the</strong>m someth<strong>in</strong>g like $60 or $80 billion.Will <strong>the</strong> government ever get it back? Who knows. In orderfor General Motors to be worth $50 billion, and assum<strong>in</strong>g <strong>the</strong>500 million shares of stock outstand<strong>in</strong>g was <strong>the</strong>re and not wipedout <strong>in</strong> bankruptcy, <strong>the</strong> stock would have to go to $100 a share. Idon’t see it <strong>in</strong> <strong>the</strong> cards.So we have put ourselves <strong>in</strong> a position where we have dissipatedenormous pools of assets; we have exchanged <strong>the</strong>m for assets suchas homes and cars that have had a significant erosion <strong>in</strong> value. Howdoyoudealwiththat?IreadanarticlethatstatedthatDetroitis try<strong>in</strong>g to get people to consolidate, live on blocks, so that <strong>the</strong>ycan at least offer some degree of municipal services, such as refusecollection, light<strong>in</strong>g, fire, police—<strong>the</strong> whole bit. But if you have one
KEN LANGONE 95block that has 3 homes on it, and you have ano<strong>the</strong>r block that has40 homes but only 2 or 3 are occupied, it doesn’t make sense toscatter out. So I th<strong>in</strong>k <strong>the</strong> next th<strong>in</strong>g I am concerned about ismunicipalities that are go<strong>in</strong>g to wake up and say we can’t provideservices because we don’t have <strong>the</strong> money. They haven’t got <strong>the</strong> taxbase. Worse, <strong>the</strong> population is sparse, and what do you do?California has serious problems. Are we go<strong>in</strong>g to ask our federalgovernment to bail out <strong>the</strong> municipalities <strong>in</strong> California? Or <strong>the</strong>municipalities <strong>in</strong> <strong>New</strong> York? I hope not. I hope we do not get tothat po<strong>in</strong>t. The president said properly <strong>in</strong> early June 2009 that wedo not have any more money. At least we understand that if wepr<strong>in</strong>t any more money, we are almost guarantee<strong>in</strong>g <strong>the</strong> problemsthat I am concerned about.So none of us alive, none of us, and I am go<strong>in</strong>g to be 74, have seenanyth<strong>in</strong>g like this. It is all new. We are look<strong>in</strong>g at an environmentwhere huge sums of paper called money are flood<strong>in</strong>g <strong>the</strong> system.That was a necessary condition for activity <strong>in</strong> September 2008. TheFed is monetiz<strong>in</strong>g <strong>the</strong> federal government’s debt. That typicallyleads to <strong>in</strong>flation. All of us who remember <strong>the</strong> 1970s rememberstagflation. We had an economy that was stagnant and prices thatwere go<strong>in</strong>g through <strong>the</strong> roof, not because of supply and demand butbecause of this enormous flood of cash.When I read <strong>in</strong> <strong>the</strong> paper that <strong>the</strong> government is go<strong>in</strong>g to startallow<strong>in</strong>g some of <strong>the</strong> f<strong>in</strong>ancial <strong>in</strong>stitutions to repay <strong>the</strong> TARPmoney, I found that very constructive. But that doesn’t takeaway <strong>from</strong> <strong>the</strong> fact that we have a fundamental underly<strong>in</strong>g problem,which is this surge of cash com<strong>in</strong>g. And I don’t know how we canhave a robust economy with our two biggest <strong>in</strong>dustries—hous<strong>in</strong>gand autos—<strong>in</strong> <strong>the</strong> tank.Now maybe I am wrong, but I do not see <strong>the</strong> automobile <strong>in</strong>dustryreally perk<strong>in</strong>g up for a couple of years. I th<strong>in</strong>k you look at supply anddemand of homes, and we probably have a three-year w<strong>in</strong>dow. Yetthrough it all, I am optimistic. The first step to solv<strong>in</strong>g a problem is
96 THRIVING IN THE NEW ECONOMYto acknowledge that you have a problem. We are do<strong>in</strong>g that. Thesecond step is to determ<strong>in</strong>e what technique to use to address <strong>the</strong>problem. What can I do to try to solve <strong>the</strong> problem? I am veryconcerned that we have gone beyond reasonable limits <strong>in</strong> fund<strong>in</strong>g all<strong>the</strong>se different <strong>in</strong>stitutions. I am not sure I agree with this notion. Iknow we had to do it to prevent a depression. But I am stillconcerned about it.<strong>New</strong> <strong>Economy</strong> StrategyThrough this entire crisis, start<strong>in</strong>g at <strong>the</strong> onset all <strong>the</strong> way through<strong>the</strong> advance phase <strong>in</strong> September, I made sure Invemed Associatesstayed highly liquid. We made sure our credit and our cash hadjumped big time. It stayed at that level because we have significant<strong>in</strong>vestments, ei<strong>the</strong>r m<strong>in</strong>e or <strong>the</strong> firm’s, and if <strong>the</strong>re was an<strong>in</strong>vestment opportunity we would have a chance to participate.Butmoreimportantly,wemadecerta<strong>in</strong>thatwewerenotdependenton <strong>the</strong> banks for whatever capital means we had.Hopefully <strong>the</strong> wickedness of this entire period is go<strong>in</strong>g to make iteasier for people to be m<strong>in</strong>dful of <strong>the</strong> fact that leverage needs to havelimitations. The guy who rents you money expects to get his money.We are now learn<strong>in</strong>g how much damage has been done. It is like aperson <strong>in</strong> a head-on collision—<strong>the</strong> recovery is go<strong>in</strong>g to take longerthan he th<strong>in</strong>ks. Our eyes are now wide open. I am not sure I agreewith this surge of paper. I am not sure I would not say, ‘‘Wait am<strong>in</strong>ute, <strong>the</strong> idea is not to get this th<strong>in</strong>g back up where it was. Theidea is to sort of get it back up on a sound foot<strong>in</strong>g, and <strong>the</strong>n go <strong>from</strong><strong>the</strong>re.’’ I would feel a lot better about that.Debt has its place. That said, I hope all of us understand <strong>the</strong> risksof excess leverage, and of excess borrow<strong>in</strong>g. When you live <strong>in</strong> sucha way that your survival depends on <strong>the</strong> sun sh<strong>in</strong><strong>in</strong>g each and everyday, you are liv<strong>in</strong>g on <strong>the</strong> edge of a very unrealistic expectation.
KEN LANGONE 97Invest<strong>in</strong>g CriteriaI am always look<strong>in</strong>g for opportunities. One person’s pa<strong>in</strong> isano<strong>the</strong>r person’s pleasure. We are look<strong>in</strong>g for companies withvery strong balance sheets, with good and protectable cash flows.Companies whose management has demonstrated <strong>the</strong> will<strong>in</strong>gnessor<strong>the</strong>desiretohavesomeformofshareholder reward—hopefullydividends, but maybe buybacks. We are look<strong>in</strong>g for companiesthat can susta<strong>in</strong> <strong>the</strong>mselves and <strong>the</strong>ir capital needs. Because I th<strong>in</strong>knowweallknowthat<strong>the</strong>bankshavebeenbadlywounded.Many of <strong>the</strong>m are now so-called penny stocks. But that’s okay. Iam look<strong>in</strong>g for companies with balance sheets that are so strongthat <strong>the</strong> cash <strong>the</strong>y have is close to or greater than <strong>the</strong> price of <strong>the</strong>stock. One of <strong>the</strong> companies we <strong>in</strong>vest <strong>in</strong> is called SourceForge.That is <strong>the</strong> old VA L<strong>in</strong>ux. Then <strong>the</strong>re’s <strong>the</strong> textile company calledUnified, for which I am a member of <strong>the</strong> board. I am hopeful thatwe will be able to get someth<strong>in</strong>g done <strong>the</strong>re. We certa<strong>in</strong>ly have agood management team <strong>in</strong> place at Unified. F<strong>in</strong>ancially, we haveour back to <strong>the</strong> wall; we have some significant debt, but <strong>the</strong> cashflow is good. We are keep<strong>in</strong>g <strong>the</strong> facilities <strong>in</strong> tip-top shape.Regrettably, <strong>the</strong> textile <strong>in</strong>dustry is mov<strong>in</strong>g offshore—not entirely,but a significant percentage that impacts it. O<strong>the</strong>r sectors that Ikeep an eye on are education and medical technology, or biotechdevices. I also look at health care stocks <strong>in</strong> general and some retailcompanies. I always have my eyes open for th<strong>in</strong>gs. I have moretime now to contemplate an <strong>in</strong>vestment than I did before because<strong>the</strong>marketsarenotmov<strong>in</strong>gthatquickly.
10Peter CohenPeter Cohen, founder of<strong>the</strong> $7.5 billion alternativeasset managementcompany Ramius, is yetano<strong>the</strong>r great economicm<strong>in</strong>d. Peter was also <strong>the</strong>formerchairmanandchiefexecutive of ShearsonLehman Bro<strong>the</strong>rs <strong>from</strong>1983 to 1999 and hasserved on many boardsof directors, <strong>in</strong>clud<strong>in</strong>g<strong>the</strong> <strong>New</strong> York Stock Exchange,L-3 Communications Hold<strong>in</strong>gs, American Express,Olivetti SpA, and Telecom SpA.Despite <strong>the</strong> challenges that still lie ahead <strong>in</strong> <strong>the</strong> f<strong>in</strong>ancialservices <strong>in</strong>dustry, Peter’s strategies have enabled hiscompany to grow where o<strong>the</strong>rs are claw<strong>in</strong>g <strong>the</strong>ir way tosurvive. In June 2009, Ramius announced its purchase of<strong>in</strong>vestment boutique firm Cowen Group <strong>in</strong> a ‘‘reverse(cont<strong>in</strong>ued)99
100 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)merger,’’ referred to as such because Ramius exchangeda substantial portion of its assets and liabilities for a 71percent controll<strong>in</strong>g stake <strong>in</strong> <strong>the</strong> newly comb<strong>in</strong>ed company.This $195 million deal opened a new door for Peter andprovided access to <strong>the</strong> public markets and <strong>the</strong> ability toforge a path <strong>in</strong> <strong>the</strong> beaten-down <strong>in</strong>vestment bank<strong>in</strong>gsector. Peter claims that this deal represents what <strong>the</strong>future of Wall Street will look like.The orig<strong>in</strong>s of this crisis go back a good many years before<strong>the</strong> September 2008 meltdown. It was apparent that accessto credit was sp<strong>in</strong>n<strong>in</strong>g out of control, leverage <strong>in</strong> <strong>the</strong> global systemwas irresponsibly excessive, and companies were be<strong>in</strong>g bought <strong>in</strong>private equity transactions at unprecedented valuations f<strong>in</strong>ancedwith an unheard-of amount of leverage. We would look at <strong>the</strong>situation and say, we can’t work it; it can’t be done—yet itcont<strong>in</strong>ued. We saw <strong>the</strong> first real cracks <strong>in</strong> February 2007, with<strong>the</strong> residential mortgage-backed securities (RMBS) market. Infairness, most people—ourselves <strong>in</strong>cluded—believed that <strong>the</strong>problem was pr<strong>in</strong>cipally isolated to subprime mortgages, where<strong>the</strong>re had been tremendous abuse that bordered on illegality. Webelieved prime jumbo and conform<strong>in</strong>g mortgages were probablyokay. As much as we read about how global leverage was go<strong>in</strong>g tooverwhelm <strong>the</strong> system, it kept grow<strong>in</strong>g. We’re paid to managemoney and not to be totally out of <strong>the</strong> markets, even though onecouldlookbackandsay,‘‘Geez,maybeweshouldhaveturnedeveryth<strong>in</strong>g <strong>in</strong>to cash.’’We do a lot of different th<strong>in</strong>gs for our clients. In addition to anumber of liquid market strategies, we buy real estate, we make loanson real estate, <strong>in</strong>vest <strong>in</strong> oil and gas bus<strong>in</strong>esses, conduct privateplacements <strong>in</strong> public companies, and execute some small privateequity deals—but we do <strong>the</strong>m without leverage. We thought that
PETER COHEN 101although we weren’t totally immune <strong>from</strong> problems, we weresomewhat safely on <strong>the</strong> fr<strong>in</strong>ge of <strong>the</strong> leverage mania. And when<strong>the</strong> problem came home to roost, although it might st<strong>in</strong>g, it wasn’tgo<strong>in</strong>g to be <strong>the</strong> awful bite that it turned out to be for everybody’sportfolios, <strong>in</strong>clud<strong>in</strong>g ours.Anticipat<strong>in</strong>g <strong>the</strong> CrisisBy and large, and with rare exception, everybody underestimated<strong>the</strong> severity of what was really tak<strong>in</strong>g place. We had <strong>in</strong>formalconversations at <strong>the</strong> <strong>New</strong> York Federal Reserve Bank. We talkedto <strong>the</strong>m about <strong>the</strong> leverage; weren’t <strong>the</strong>y worried about it? Inparticular, weren’t <strong>the</strong>y worried about some of <strong>the</strong> securities firms?Hav<strong>in</strong>g run a big security firm myself, <strong>the</strong> idea of 30, 40, or 50 timesleverage—and what <strong>the</strong>y were leveraged aga<strong>in</strong>st—was attentiongett<strong>in</strong>g.It seemed that it was only a matter of time until <strong>the</strong> issuebecame a problem.We visited <strong>the</strong> Fed <strong>in</strong> December 2007 and asked if <strong>the</strong>y wereth<strong>in</strong>k<strong>in</strong>g about mak<strong>in</strong>g liquidity available to securities firms whenand if <strong>the</strong>y needed it. They <strong>in</strong>formed us that <strong>the</strong>y didn’t see it as alikely scenario, stat<strong>in</strong>g that <strong>the</strong> Fed had not opened <strong>the</strong> discountw<strong>in</strong>dow to securities firms s<strong>in</strong>ce <strong>the</strong> Depression and it wasn’tlikely to happen aga<strong>in</strong>. Then, all of a sudden—Bear Stearns is on<strong>the</strong>ir doorstep on <strong>the</strong> verge of implod<strong>in</strong>g. Even <strong>the</strong>n, we thoughtthat <strong>the</strong> problem was primarily specific to Bear Stearns. We didn’tth<strong>in</strong>k it was systemic of <strong>the</strong> entire <strong>in</strong>dustry yet, because Bear Stearnswas <strong>the</strong> lead<strong>in</strong>g mortgage securitization firm. It seemed natural thats<strong>in</strong>ce mortgages were now start<strong>in</strong>g to unravel, if <strong>the</strong>re is go<strong>in</strong>g to be aproblem, <strong>the</strong>y were <strong>the</strong> ones who were go<strong>in</strong>g to have it. So <strong>the</strong> BearStearns problem erupts but is resolved through a Fed facility andmerger with J.P. Morgan. We were actually somewhat relieved,because we thought <strong>the</strong> regulators now understood <strong>the</strong> problem and,hav<strong>in</strong>g dealt with Bear Stearns, would handle any new problems as
102 THRIVING IN THE NEW ECONOMYwell. In fact, everyone took a certa<strong>in</strong> amount of solace <strong>from</strong> <strong>the</strong>irbehavior when <strong>the</strong>y saved Bear Stearns. We believed <strong>the</strong>y didunderstand <strong>the</strong> situation that was unfold<strong>in</strong>g <strong>in</strong> Wash<strong>in</strong>gton.They opened <strong>the</strong> discount w<strong>in</strong>dow. The world re-normalized prettyquickly by <strong>the</strong> spr<strong>in</strong>g of 2008.House <strong>in</strong> OrderFrom an <strong>in</strong>vestment po<strong>in</strong>t of view, we were actually <strong>in</strong> good shapethrough August 2008. Our performance was up or even <strong>in</strong> everyth<strong>in</strong>gwe did, even though <strong>the</strong>re was <strong>in</strong>creas<strong>in</strong>g volatility, especially<strong>in</strong> July. When Lehman Bro<strong>the</strong>rs began to take <strong>the</strong> spotlight, weassumed that <strong>the</strong> Fed—hav<strong>in</strong>g exhibited a high degree of prudenceabout Bear Stearns—would reach <strong>the</strong> same conclusion about LehmanBro<strong>the</strong>rs, if necessary.After Bear Stearns, we attempted to more deeply understandhow everybody with whom we did bus<strong>in</strong>ess was funded. Wewanted to be comfortable <strong>in</strong> our <strong>in</strong>teractions with LehmanBro<strong>the</strong>rs, Goldman Sachs, or anyone else. We went through avery exhaustive process, with Lehman Bro<strong>the</strong>rs especially, to tryto understand <strong>the</strong>ir entire liquidity fund<strong>in</strong>g strategy. We concludedthat <strong>the</strong>y had termed out all of <strong>the</strong>ir long-term debt andhad substantial liquidity and excess collateral <strong>the</strong>y could take to<strong>the</strong> Fed. Coupled with <strong>the</strong> idea that <strong>the</strong> Fed was <strong>in</strong>formed enoughto understand <strong>the</strong> implications of a failure, we concluded thatLehman Bro<strong>the</strong>rs would probably be okay.We decreased our exposure to Lehman Bro<strong>the</strong>rs <strong>from</strong> be<strong>in</strong>g one ofour larger prime brokers to be<strong>in</strong>g a third prime broker beh<strong>in</strong>dGoldman Sachs and Morgan Stanley. In our conversations withpeople at <strong>the</strong> Fed, we stated that lett<strong>in</strong>g Lehman Bro<strong>the</strong>rs fail wouldbe catastrophic; <strong>the</strong> systemic risk was too high. We told <strong>the</strong>m thatwe hoped <strong>the</strong>y understood <strong>the</strong> complexity of <strong>the</strong> plumb<strong>in</strong>g <strong>in</strong> <strong>the</strong><strong>in</strong>dustry that connected <strong>the</strong> f<strong>in</strong>ancial system. It wasn’t until later
PETER COHEN 103that week that we started to believe <strong>the</strong> regulators could potentiallymake a mistake by lett<strong>in</strong>g <strong>the</strong> firm go, that <strong>the</strong>y really didn’t understandwhat was go<strong>in</strong>g to happen. The weekend before LehmanBro<strong>the</strong>rs’ failure, we kept reiterat<strong>in</strong>g to those we knew at <strong>the</strong> Fed—whomever we could get to—not to let this happen; we did not believe<strong>the</strong>y understood how bad it would get.The truth about what happened is not clear to me; I’m not sureanyone’s really ever go<strong>in</strong>g to know except <strong>the</strong> people <strong>in</strong>volved. Idon’t th<strong>in</strong>k <strong>the</strong>re was any conspiracy by <strong>the</strong> rest of Wall Street tosee Lehman Bro<strong>the</strong>rs fail. I don’t know if Hank Paulson had anyk<strong>in</strong>d of problem with Dick Fuld, but even if he did, he’s toosmart to make a decision based on personal feel<strong>in</strong>gs. It was just alapse of judgment on <strong>the</strong> part of <strong>the</strong> decision makers, whoever<strong>the</strong>y were. They simply didn’t understand <strong>the</strong> risks and somehowfelt <strong>the</strong> moral hazard issue to which everyone kept referr<strong>in</strong>g wasso important that <strong>the</strong>y would let somebody fail, and deal with <strong>the</strong>consequences afterward.It was a horrific mistake. Although <strong>the</strong> f<strong>in</strong>ancial fallout wouldhave still been substantial even if Lehman Bro<strong>the</strong>rs had been saved,it wouldn’t have happened with <strong>the</strong> speed and magnitude it did.The situation caught <strong>the</strong> regulators completely unaware, because<strong>the</strong>y seemed panicked after <strong>the</strong> market’s reaction. The LehmanBro<strong>the</strong>rs’ failure happened on a Monday; on Tuesday, <strong>the</strong> Fed andTreasury suddenly had AIG on <strong>the</strong>ir plate. They knew <strong>the</strong>y hadtosaveAIG,butat<strong>the</strong>sametime,<strong>the</strong>ymade<strong>the</strong>statementthat<strong>the</strong>y had no legal authority to save Lehman Bro<strong>the</strong>rs. The Fed andTreasury bailed out AIG <strong>the</strong> next day. In fact, by Tuesday, <strong>the</strong>ywere lend<strong>in</strong>g money to Lehman Bro<strong>the</strong>rs aga<strong>in</strong>st collateral, which<strong>the</strong>y could have done on Monday. Then on Wednesday, <strong>the</strong>market went <strong>in</strong>to a meltdown. On Thursday <strong>the</strong> Fed and Treasuryannounced <strong>the</strong> Troubled Asset Relief Program (TARP), which was<strong>in</strong>vented overnight. No one had any idea how it would work; it wasclear it had not previously been on <strong>the</strong> draw<strong>in</strong>g board.
104 THRIVING IN THE NEW ECONOMYAll about LeverageIt started to become clear to everybody fairly quickly that thiswasn’t just a subprime problem anymore. It was really a systemicleverage problem across <strong>the</strong> entire f<strong>in</strong>ancial system. As peoplestarted digg<strong>in</strong>g more deeply, it was apparent that both <strong>the</strong> U.S.and European banks had significant problems. It went way beyondsubprime for U.S. banks. They not only had all <strong>the</strong> commercialmortgages that were held on balance sheet, but also had all <strong>the</strong>securitized commercial mortgages, credit card receivables, homeequity loans, and more. These were big problems and on top of<strong>the</strong>m was <strong>the</strong> Madoff event, which fractured everybody’s confidence.It spurred a complete meltdown of confidence <strong>in</strong> <strong>the</strong>system, which was reflected <strong>in</strong> <strong>the</strong> markets.After Christmas 2008, I returned to work assum<strong>in</strong>g that Januaryand February were just go<strong>in</strong>g to be more of <strong>the</strong> same. We werenot out of <strong>the</strong> woods, although everybody thought with 2008 beh<strong>in</strong>dus and 2009 be<strong>in</strong>g a new year, we were all go<strong>in</strong>g to make it back. ButI didn’t believe that. The equity markets had two difficult months at<strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g of 2009, but a tremendous bounce beg<strong>in</strong>n<strong>in</strong>g <strong>in</strong>March. President Obama has done a very good job of try<strong>in</strong>g totalk <strong>the</strong> economy and confidence up. His actions, along with <strong>the</strong>government pour<strong>in</strong>g money <strong>in</strong>to one th<strong>in</strong>g after ano<strong>the</strong>r, took <strong>the</strong>‘‘crisis tone’’ out of <strong>the</strong> country and <strong>the</strong> f<strong>in</strong>ancial markets.Analyz<strong>in</strong>g <strong>the</strong> Situation and Creat<strong>in</strong>g OpportunityAs we were go<strong>in</strong>g through this, we asked ourselves, ‘‘What does thisall mean?’’ We concluded that life as everyone knew it was over <strong>in</strong>this country both <strong>in</strong> our personal and bus<strong>in</strong>ess lives—at least for along time to come. People were go<strong>in</strong>g to start sav<strong>in</strong>g money aga<strong>in</strong>;<strong>the</strong>y were go<strong>in</strong>g to be more frugal. The general sentiment wasthat we were return<strong>in</strong>g to a 1950s to 1960s value system; Americawas go<strong>in</strong>g to live differently. The credit markets became totally
PETER COHEN 105dysfunctional <strong>in</strong> <strong>the</strong> middle of this, unlike anyth<strong>in</strong>g that’s everhappened <strong>in</strong> <strong>the</strong> past. We saw that as an opportunity, however,because <strong>the</strong> lack of credit would separate <strong>the</strong> w<strong>in</strong>ners and losers.For example, we have a list of criteria we use when look<strong>in</strong>g for<strong>in</strong>vestments. We consider <strong>the</strong> yields of <strong>in</strong>vestment-grade, highqualitycompanies that have good bus<strong>in</strong>esses—with good cashflow, even <strong>in</strong> a severe recession; liquidity on <strong>the</strong>ir balance sheets;access to capital; and access to credit based on committed butundrawn backup l<strong>in</strong>es. Short-duration yields of companies weresell<strong>in</strong>g at much higher yields than <strong>the</strong> long-dated paper of <strong>the</strong> samecompany. So we made a decision to start shift<strong>in</strong>g our assets away<strong>from</strong> everyth<strong>in</strong>g that we could and <strong>in</strong>to credit. We have shifted onethirdof our assets <strong>in</strong>to credit. Go<strong>in</strong>g forward <strong>from</strong> here, given <strong>the</strong>rally, equities will be difficult. The likelihood is that equities willdecl<strong>in</strong>e aga<strong>in</strong> before all of this is over.Where to Put Your MoneyOne of <strong>the</strong> few places you can safely put your money and get ayield is <strong>in</strong> reasonably short-dated corporate credits of high quality.Two-year maturities are short-term securities, so <strong>in</strong>stead of gett<strong>in</strong>ga half percent return, you are go<strong>in</strong>g to get 4 or 5 percent. Thereare one-offs where you get paid more, and some opportunities thatmay arise where you can make a 7 or 8 percent return with a highdegree of comfort. We have acted accord<strong>in</strong>gly and cont<strong>in</strong>ue tomove <strong>in</strong> that direction.It is also a good idea to own some gold. I believe that gold isartificially suppressed by central banks, because if gold were $2,000 Author’s note: Short-term securities are securities that range <strong>from</strong> one to four years. Thesesecurities are more liquid. They can be bonds, corporation notes, commercial paper,municipal notes, and banker’s acceptances, which are also known as cashier’s checks. Thesesecurities can be turned <strong>in</strong>to cash at <strong>the</strong> orig<strong>in</strong>al purchas<strong>in</strong>g price or better on <strong>the</strong> openmarket. Investors can also leave <strong>the</strong> security to mature and <strong>the</strong>n re<strong>in</strong>vest <strong>in</strong>to ano<strong>the</strong>r shorttermmaturity.
106 THRIVING IN THE NEW ECONOMYper ounce, <strong>the</strong> world would be <strong>in</strong> panic and confidence <strong>in</strong> f<strong>in</strong>ancialassets challenged. But one day, gold could just spike, and that wouldshake <strong>the</strong> f<strong>in</strong>ancial foundation of <strong>the</strong> world.We have also become much more proactive <strong>in</strong> our macro-trad<strong>in</strong>gactivities. There is a difference of op<strong>in</strong>ion <strong>in</strong>ternally as to whe<strong>the</strong>r<strong>the</strong> bigger problem is deflation or <strong>in</strong>flation. At <strong>the</strong> end of <strong>the</strong> day,<strong>in</strong>flation becomes a bigger problem, although <strong>the</strong> tim<strong>in</strong>g is uncerta<strong>in</strong>.Whe<strong>the</strong>r it’s next week or two years <strong>from</strong> now, it’s com<strong>in</strong>g;<strong>the</strong> government can’t pr<strong>in</strong>t money and issue debt <strong>the</strong> way it iswithout creat<strong>in</strong>g enormous impetus for <strong>in</strong>flation. And it’s go<strong>in</strong>g tohappen worldwide, because everybody is do<strong>in</strong>g <strong>the</strong> same th<strong>in</strong>g.Even Ch<strong>in</strong>a, with all of its good news and proactive stimulusprograms, has serious problems. Japan has serious problems. Koreahas serious problems. Europe has terrible problems. So <strong>the</strong> pr<strong>in</strong>t<strong>in</strong>gpresses are roll<strong>in</strong>g. Central banks and governments desperately wantto avoid <strong>the</strong> world fall<strong>in</strong>g <strong>in</strong>to a deflationary trap, which is reallyhard to fix. This is where <strong>the</strong>re’s pressure <strong>in</strong> our current environment,because people do not want to spend money. They’re sav<strong>in</strong>gmoney. All you have to do is go up and down Lex<strong>in</strong>gton Avenue orMadison Avenue and you see this. You travel to Europe, and noAmericans are around. Airl<strong>in</strong>e traffic is contract<strong>in</strong>g, and retail salesare weak, except at <strong>the</strong> very low end. But <strong>the</strong> government did whatit had to do to avert a f<strong>in</strong>ancial catastrophe.<strong>New</strong> Age <strong>in</strong> Bus<strong>in</strong>essThe notion that <strong>the</strong> Fed will know exactly when to pull back thisliquidity <strong>in</strong> time to stop <strong>in</strong>flation is a difficult one—because nobodyknows. We’re experienc<strong>in</strong>g a period of government <strong>in</strong>tervention <strong>in</strong>bus<strong>in</strong>ess and <strong>the</strong> markets. The more you raise taxes and <strong>the</strong> more youtake purchas<strong>in</strong>g power out of <strong>the</strong> economy, <strong>the</strong> more people save,because <strong>the</strong>y are afraid. We are a consumer-driven economy. If <strong>the</strong>consumer doesn’t spend, this economy can’t grow. Marry that to
PETER COHEN 107what is happen<strong>in</strong>g on <strong>the</strong> state level, where every state’s budget istotally unbalanced and state revenues are collaps<strong>in</strong>g. Their budgetdeficits are swell<strong>in</strong>g. So you th<strong>in</strong>k <strong>the</strong> worst is beh<strong>in</strong>d us? No, it isnot. Who is go<strong>in</strong>g to bail out <strong>the</strong> states, and how much is that go<strong>in</strong>gto cost? The public pension funds systems, which millions of peoplerely on to live, are underfunded as well.You can go on and on with <strong>the</strong> amount of wealth destruction thattook place, and with no yields <strong>in</strong> <strong>the</strong> marketplace. Corporatepensions are fac<strong>in</strong>g <strong>the</strong> same obstacles; <strong>the</strong>se are two substantialnew problems. They got so battered last year—as did endowments,charities, and <strong>in</strong>surance companies—that it’s questionable as to how<strong>the</strong>y are go<strong>in</strong>g to meet <strong>the</strong>ir obligations. So <strong>the</strong> real question is are<strong>the</strong> states go<strong>in</strong>g to raise taxes and take more purchas<strong>in</strong>g power outof <strong>the</strong> system so <strong>the</strong>y can par down <strong>the</strong>ir deficits? Less purchas<strong>in</strong>gpower means no economic recovery. We are <strong>in</strong> a terrible trap, and<strong>the</strong> government has no choice but to pr<strong>in</strong>t money and lend. Thereckon<strong>in</strong>g is upon us. The quality of life <strong>in</strong> this country has todecrease. The next generations are not go<strong>in</strong>g to have <strong>the</strong> opportunities,<strong>in</strong> my op<strong>in</strong>ion, that m<strong>in</strong>e had.Protect<strong>in</strong>g WealthThe focus is no longer on mak<strong>in</strong>g money. It’s all about not los<strong>in</strong>git, and protect<strong>in</strong>g wealth. If <strong>in</strong>flation returns, you do not wantto own debt; you want to be a debtor. That’s why we keepdurations short. But for <strong>the</strong> over-leveraged consumer, sav<strong>in</strong>g asmuch as possible and pay<strong>in</strong>g down debt is of paramount importance.This is hard to do, because wages are decl<strong>in</strong><strong>in</strong>g, work<strong>in</strong>ghours are decreas<strong>in</strong>g, and two-person household <strong>in</strong>comes arebecom<strong>in</strong>g one-person <strong>in</strong>comes. Unemployment cont<strong>in</strong>ues torise, and quality of life <strong>in</strong> <strong>the</strong> United States is decreas<strong>in</strong>g; andyou have to th<strong>in</strong>k really carefully about what to do with money andwhere to put money.
108 THRIVING IN THE NEW ECONOMYAt <strong>the</strong> same time, <strong>the</strong>re are flar<strong>in</strong>g geopolitical issues. Is Korea aproblem? Who knows. Is Iran a problem? Who knows. Is Israelgo<strong>in</strong>g to stand by and let Iran develop a nuclear weapon? I doubt it.The European Central Bank is worried about <strong>in</strong>flation, so <strong>the</strong>y’rehold<strong>in</strong>g rates higher than maybe <strong>the</strong>y should—which is good for<strong>the</strong>ir savers <strong>in</strong> a way, but bad for <strong>the</strong>ir system because <strong>the</strong>re’s notenough liquidity flow<strong>in</strong>g through Europe. The American Centurywas <strong>the</strong> 1900s, and it’s over. This century will belong to Asia. Theyhad been wait<strong>in</strong>g for years for this to come, and it’s here. They willhave plenty of problems, but <strong>the</strong>ir people are go<strong>in</strong>g to be muchbetter at handl<strong>in</strong>g <strong>the</strong>m than we are.Lead<strong>in</strong>g by ExampleOur bus<strong>in</strong>ess is an <strong>in</strong>stitutional bus<strong>in</strong>ess. We have a limited numberof <strong>in</strong>dividual retail-type accounts. S<strong>in</strong>ce December 2008, I’ve been<strong>in</strong>undated with people who tell me: ‘‘I don’t know what to do withmy money.’’ ‘‘I can’t take half a percent <strong>in</strong> treasuries.’’ ‘‘I’ve lost somuch money. What do I do?’’ They ask me what I am do<strong>in</strong>g. I tell<strong>the</strong>m I don’t own any stocks; I own gold, and I own a lot ofcorporate debt, a lot of short-dated corporate debt. I’m just try<strong>in</strong>g toprotect my capital and get a decent yield on my money while I waitfor <strong>the</strong> world to sort itself out. And all of a sudden <strong>the</strong>y say, ‘‘F<strong>in</strong>e—do that for me.’’ I’ve received a substantial amount of money <strong>from</strong>friends who just want safety with some yield.The fact is that we all need to adjust our lifestyles. We arepreach<strong>in</strong>g this advice to all our young people. Don’t expect tomake <strong>the</strong> k<strong>in</strong>d of money you made before, because it’s not go<strong>in</strong>g tobe <strong>the</strong>re. Rais<strong>in</strong>g money <strong>in</strong>stitutionally is almost impossible rightnow, except for credit strategies. They don’t want to hear aboutprivate equity. They don’t want to hear about real estate. They don’twant to hear about exotic strategies. They want <strong>the</strong>ir money back,and <strong>the</strong>y don’t want to be <strong>in</strong> a fund. They want to be <strong>in</strong> a separate
PETER COHEN 109account, an account that allows <strong>the</strong>m to see <strong>the</strong>ir money and know itbelongs to <strong>the</strong>m. And <strong>the</strong>y want to do all this without pay<strong>in</strong>g <strong>the</strong> oldk<strong>in</strong>d of fees. That’s what’s happen<strong>in</strong>g now.Characteriz<strong>in</strong>g <strong>the</strong> <strong>New</strong> <strong>Economy</strong>The new economy is one of very modest growth, if any, for quite awhile. We are all go<strong>in</strong>g to be lead<strong>in</strong>g more frugal lives. Everyone isreth<strong>in</strong>k<strong>in</strong>g everyth<strong>in</strong>g <strong>the</strong>y do. People are go<strong>in</strong>g to eat at morebasic k<strong>in</strong>ds of restaurants. It won’t be <strong>the</strong> watch du jour. If BernieMadoff paid $4,000 for a pair of pants, that may be <strong>the</strong> last pair ofpants that were sold at that price. Who needs to buy a new carevery two or three years? Buy a car every four years. Or buy a usedcar with a factory warranty on it. Cars don’t wear out anymore.And how many suits does anyone really need? How many shirtsdoes anyone have to have? How many of anyth<strong>in</strong>g does anyoneneed? We were seduced <strong>in</strong>to buy<strong>in</strong>g to excess through advertis<strong>in</strong>gand peer pressure. It’s not a natural lifestyle and doesn’t exist <strong>in</strong>most o<strong>the</strong>r places.We’re fac<strong>in</strong>g a much less consumer-oriented society. People arego<strong>in</strong>g to return to more core values about life. It’s also go<strong>in</strong>g to behard, because <strong>the</strong> jobs are not here anymore. That’s why you have arecord number of applicants for college, law school, and medicalschool. I just hope that people see eng<strong>in</strong>eer<strong>in</strong>g as a career path so thatwe get people go<strong>in</strong>g back to start <strong>in</strong>vent<strong>in</strong>g and manufactur<strong>in</strong>gth<strong>in</strong>gs aga<strong>in</strong> <strong>in</strong> this country.Strategies to Thrive <strong>in</strong> <strong>the</strong> <strong>New</strong> <strong>Economy</strong>There will be a reshap<strong>in</strong>g of <strong>the</strong> f<strong>in</strong>ancial <strong>in</strong>dustry <strong>in</strong> <strong>the</strong> neweconomy. The big <strong>in</strong>vestment banks are ei<strong>the</strong>r part of a bank, or<strong>the</strong>y’ve become a bank like Goldman Sachs and Morgan Stanley.They’re large, <strong>the</strong>y’re somewhat unwieldy, <strong>the</strong>y have a lot of red
110 THRIVING IN THE NEW ECONOMYtape, and people would ra<strong>the</strong>r be somewhere perhaps smaller. So<strong>the</strong>re is go<strong>in</strong>g to be a reemergence of smaller, broad-based, middletierfirms that will be <strong>in</strong> <strong>the</strong> underwrit<strong>in</strong>g bus<strong>in</strong>ess, <strong>the</strong> advisorybus<strong>in</strong>ess, <strong>the</strong> sales and trad<strong>in</strong>g bus<strong>in</strong>ess, and <strong>the</strong> <strong>in</strong>vestment managementbus<strong>in</strong>ess, which is where all <strong>the</strong>se firms orig<strong>in</strong>ally started.Our firm has never been <strong>in</strong> <strong>the</strong> underwrit<strong>in</strong>g bus<strong>in</strong>ess. We’ve neverbeen <strong>in</strong> <strong>the</strong> corporate advisory bus<strong>in</strong>ess, and sales and trad<strong>in</strong>g werenever part of our bus<strong>in</strong>ess. We were <strong>in</strong>vestors. We will cont<strong>in</strong>ue to be<strong>in</strong>vestors, but we will also do more of those o<strong>the</strong>r th<strong>in</strong>gs. We’ll useour capital to broaden our bus<strong>in</strong>ess, and we will be able to attractreally talented people away <strong>from</strong> <strong>the</strong> big firms who will come withadjusted expectations.The biggest problem <strong>the</strong> people <strong>in</strong> our <strong>in</strong>dustry succumbed to wasgett<strong>in</strong>g <strong>the</strong>ir W-2 and <strong>the</strong>ir IQ confused, but <strong>the</strong>y’re sort<strong>in</strong>g thatout. People will work for less; <strong>the</strong>y will work harder, and <strong>the</strong>y willth<strong>in</strong>k out of <strong>the</strong> box and be creative. There is plenty to do <strong>in</strong> thisenvironment because you have companies that are go<strong>in</strong>g to fail,companies that will need restructur<strong>in</strong>g, and companies that willsucceed by roll<strong>in</strong>g up o<strong>the</strong>r companies. There’s go<strong>in</strong>g to be a lotgo<strong>in</strong>g on. The 1970s were a difficult time but a lot happened; andyou could make a lot of money <strong>in</strong> <strong>the</strong> 1970s. I th<strong>in</strong>k we are go<strong>in</strong>g toreturn to that type of environment.Look<strong>in</strong>g for OpportunityLike many o<strong>the</strong>r people, we assess what’s go<strong>in</strong>g on and where weshould be every day. Sometimes a very obvious opportunity arises,like our decision to be <strong>in</strong> credit space; and now we’re <strong>in</strong> it. Someo<strong>the</strong>r opportunities are a little more subtle. For <strong>in</strong>stance, <strong>the</strong> big<strong>in</strong>vestment banks are capital constra<strong>in</strong>ed today because <strong>the</strong>y haveto deleverage. That means <strong>the</strong> amount of money that <strong>the</strong>y have on<strong>the</strong>ir proprietary trad<strong>in</strong>g desks to facilitate bond transactions andoption transactions are simply not <strong>the</strong>re. So <strong>the</strong>re are voids that wecan fill. This becomes a function of f<strong>in</strong>d<strong>in</strong>g <strong>the</strong> right people to
PETER COHEN 111partner with. We get general ideas about th<strong>in</strong>gs we want to do,and <strong>the</strong>n we see if we can f<strong>in</strong>d people who fit those ideas. If wedo, we try to explore it. There’s go<strong>in</strong>g to be a re-equalization <strong>in</strong>this country dur<strong>in</strong>g which we are go<strong>in</strong>g to have to convert debtto equity and are go<strong>in</strong>g to have to rebuild balance sheets. Thismeans <strong>the</strong> underwrit<strong>in</strong>g bus<strong>in</strong>ess will come back at some po<strong>in</strong>t.You have to figure out how to be <strong>in</strong> that bus<strong>in</strong>ess and how toprovide advice.Go<strong>in</strong>g Forward to <strong>the</strong> PastI have friends who are CEOs at some big companies, and <strong>the</strong>y aregenerally not <strong>in</strong>terested <strong>in</strong> talk<strong>in</strong>g to a younger person <strong>from</strong> one of<strong>the</strong> big firms because <strong>the</strong>y th<strong>in</strong>k <strong>the</strong>re’s an ulterior motive. Theybelieve that person wants to write a ticket, get paid, and move on.They th<strong>in</strong>k <strong>the</strong> person doesn’t really care what happens. The futureof bus<strong>in</strong>ess will be based on <strong>the</strong> past. The 1960s and 1970s—<strong>the</strong>days of people like Felix Rohatyn and Pete Peterson, who gave advicethat sometimes resulted <strong>in</strong> bus<strong>in</strong>ess but sometimes did not—willcome back. I predict a more client-oriented bus<strong>in</strong>ess than it hasbeen, someth<strong>in</strong>g for which we’ve already seen evidence. We sawGleacher Partners merge <strong>in</strong>to this little public company calledBroadpo<strong>in</strong>t Securities, where<strong>in</strong> <strong>the</strong> CEO took his advisory bus<strong>in</strong>essand merged it to a broker-dealer. Investment management firmCitadel just hired a bunch of bankers <strong>from</strong> Merrill Lynch, andFortress is look<strong>in</strong>g for people like that as well. Many of us believe thisis where it’s go<strong>in</strong>g and are try<strong>in</strong>g to get ahead. You just have to figureout where to put your first stake <strong>in</strong> <strong>the</strong> ground.Examples of Keep<strong>in</strong>g Your M<strong>in</strong>d and Bra<strong>in</strong>Open to Good IdeasYou can’t design time frames. You can get lucky and accomplishsometh<strong>in</strong>g very quickly, or it may take years to complete. Who
112 THRIVING IN THE NEW ECONOMYknows. What I do know is you have to show up every day at work;you have to be <strong>the</strong>re every day to f<strong>in</strong>d opportunity. You have to beconstantly alert to what <strong>the</strong> possibilities are. Good ideas are allaround all <strong>the</strong> time, if you’re pay<strong>in</strong>g attention.I can th<strong>in</strong>k of many examples of this; a funny one occurred <strong>in</strong>October 1995. It was 5:00 A.M., and I was up watch<strong>in</strong>g a CNBC<strong>in</strong>terview with <strong>the</strong> CEO of a company named Magna Copper.He couldn’t have been more bor<strong>in</strong>g. The <strong>in</strong>terviewer said, ‘‘SoMr. So-and-So, yesterday you reported earn<strong>in</strong>gs were up 100percent for <strong>the</strong> quarter; what can we expect look<strong>in</strong>g forward?’’And <strong>the</strong> fellow replies, ‘‘Well, I don’t know exactly, but probablyfor <strong>the</strong> next eight quarters we would expect similar comparisons.We opened up this m<strong>in</strong>e <strong>in</strong> Peru, and <strong>the</strong> results are better thanexpected; and this m<strong>in</strong>e <strong>in</strong> Arizona is better than expected.’’ Hewent on to discuss a few more issues. He was factual but flat. YetI’m listen<strong>in</strong>g to this, and I th<strong>in</strong>k, ‘‘Did I really just hear what thisman just said?’’So I go <strong>in</strong> <strong>the</strong> office, and I f<strong>in</strong>d Magna Copper. The stock is $17a share. It’s a convertible preferred, with a 4 percent dividend,trad<strong>in</strong>g flat—no premium for <strong>the</strong> convertible. I did a littleresearch, and based on what this fellow said, this company issell<strong>in</strong>g at two times <strong>the</strong> future cash flow. So I buy some of <strong>the</strong>preferred stock, and I’m gett<strong>in</strong>g paid a dividend of $4 while I own<strong>the</strong> stock. Meanwhile, I have some research done and develop an<strong>in</strong>vestment view. This went on for two or more months. I keptadd<strong>in</strong>g to it. The stock crept a little bit higher, a little bit higher,and just before Christmas, aga<strong>in</strong> I am <strong>in</strong> <strong>the</strong> apartment watch<strong>in</strong>gTV and along comes a break<strong>in</strong>g news flash <strong>from</strong> CNBC. It saysMagna Copper is be<strong>in</strong>g acquired by Broken Hill, a big Australianm<strong>in</strong><strong>in</strong>g company, for $34 a share.This fellow be<strong>in</strong>g <strong>in</strong>terviewed on CNBC—whose name Icannot recall—proved my po<strong>in</strong>t about pay<strong>in</strong>g attention. I made100 percent of my money on what was a pretty mean<strong>in</strong>gful positionfor me, and it was because I was up listen<strong>in</strong>g at 5:00 A.M. and paid
PETER COHEN 113attention to a m<strong>in</strong><strong>in</strong>g executive talk<strong>in</strong>g about copper, which at <strong>the</strong>time was not very excit<strong>in</strong>g.There was ano<strong>the</strong>r time when I took my eight-year-old son (now31 and work<strong>in</strong>g for Ramius) to buy sneakers. We were <strong>in</strong> <strong>the</strong>shoe store, and as we were buy<strong>in</strong>g a pair of <strong>New</strong> Balance sneakers,my son beg<strong>in</strong>s tell<strong>in</strong>g me about how <strong>the</strong> Nike Air Jordans are<strong>the</strong> th<strong>in</strong>g. So I ask him, ‘‘Well, why aren’t you buy<strong>in</strong>g <strong>the</strong> AirJordans?’’ He replied, ‘‘Because I have a fat foot, Dad, and <strong>the</strong>yaren’t comfortable on me. The <strong>New</strong> Balance is a better sneakerforme;butI’mtell<strong>in</strong>gyou,thisNikeshoeisabigdeal.’’So as we were leav<strong>in</strong>g <strong>the</strong> store, he asks me, ‘‘How much is a shareof Nike?’’ I happened to know <strong>the</strong> answer, because we used to beNike’s bankers (this was back <strong>in</strong> <strong>the</strong> Shearson Lehman days). I toldhim that it was around $12 a share. He told me he had $300 savedup <strong>from</strong> walk<strong>in</strong>g a dog every day for a $1 a day. He asked if he couldbuy 100 shares of Nike and wanted to know how much it would be.I said to him, ‘‘Well, you figure it out,’’ and he came up with <strong>the</strong>correct response, $1,200. And <strong>the</strong>n he asked if I would lend him$900—and I agreed. So I put <strong>the</strong> $900 <strong>in</strong> his account, he gave mehis $300, and we bought 100 shares of Nike.But now he has my attention. So I start ask<strong>in</strong>g, what’s go<strong>in</strong>gon with this Air Jordan? Anyway, fast-forward to late Decemberof 1991, we sold <strong>the</strong> stock at around $71 per share. Profitable<strong>in</strong>formation can come <strong>from</strong> <strong>the</strong> least expected places, like shoeshopp<strong>in</strong>g with an eight-year-old.My son mentioned ano<strong>the</strong>r idea—much bigger than Nike—when he was around 15 years old, when he started discuss<strong>in</strong>g <strong>the</strong>Human Genome Project. Although he was never very big on science,he started talk<strong>in</strong>g to me about <strong>the</strong> genome project and mapp<strong>in</strong>ggenes, what that was go<strong>in</strong>g to mean, and about this company <strong>in</strong>Rockville, Maryland, called Human Genome Sciences. We lookedit up, and it was $14 per share. We bought some stock, and I startedto pay more attention to it. We added to it. That stock went to$450 before it was all over.
114 THRIVING IN THE NEW ECONOMYSo I’ll take <strong>in</strong>formation wherever I get it and run it down.W<strong>in</strong>n<strong>in</strong>g is all about show<strong>in</strong>g up. I know a lot of people who say<strong>the</strong>ydon’twanttogotoworkandclaimtohavenoth<strong>in</strong>gtodo<strong>the</strong>re. That’s not true. There is always someth<strong>in</strong>g to do at work—always. That is a philosophy that I follow, and that we follow. Andwhile I th<strong>in</strong>k we’re <strong>in</strong> for a really difficult time ahead, I’m reallyexcited that <strong>the</strong>re’ll be some great opportunities that will come outof it.
11When I started to assign my contacts to chapters <strong>in</strong> my book,a lot of <strong>the</strong>m asked me not to put <strong>the</strong>m <strong>in</strong> ‘‘Chapter 11,’’which is commonly known as a ‘‘reorganized’’ bankruptcy. GeneralMotors and Chrysler are <strong>the</strong> two big examples <strong>in</strong> this f<strong>in</strong>ancialfallout. No CEO wants his or her name associated with <strong>the</strong> words‘‘Chapter 11.’’ So <strong>in</strong>stead, I have opted not to highlight anyone <strong>in</strong>this chapter. So let’s turn <strong>the</strong> page, and go to Chapter 12.115
12Jerry YorkWhen people hear <strong>the</strong>name Jerry York, <strong>the</strong>yth<strong>in</strong>k of his experience <strong>in</strong><strong>the</strong> auto <strong>in</strong>dustry. Yorkonce served as a chiefaide to billionaire <strong>in</strong>vestorKirk Kerkorian and his Trac<strong>in</strong>daInvestment Company.In a January 2006speech at <strong>the</strong> DetroitAuto Show, York recommendeda ‘‘drastic’’ rebuildat GM that <strong>in</strong>cludeddump<strong>in</strong>g its Saaband Hummer divisions(sound familiar?). He claimedthat ‘‘Saab and Hummer will not save GM.’’One month later, Kerkorian helped York get electedto <strong>the</strong> board of directors of General Motors <strong>in</strong> an effortto represent Trac<strong>in</strong>da’s 9.9 percent <strong>in</strong>vestment <strong>in</strong> <strong>the</strong> auto(cont<strong>in</strong>ued)117
118 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)company. He wanted to turn GM around and was alsohop<strong>in</strong>g that this move would form an alliance with Renault-Nissan. On October 6, 2006, after GM ended talks withRenault-Nissan, York resigned <strong>from</strong> <strong>the</strong> board. In his resignationletter, he said he had ‘‘grave reservations concern<strong>in</strong>g<strong>the</strong> ability of <strong>the</strong> company’s current bus<strong>in</strong>ess model tosuccessfully compete <strong>in</strong> <strong>the</strong> marketplace with those of<strong>the</strong> Asian producers.’’But contrary to this association, Jerry is more thanautos. He is <strong>the</strong> chairman and CEO of <strong>the</strong> private <strong>in</strong>vestmentcompany Harw<strong>in</strong>ton Capital, which specializes <strong>in</strong>technology, biotechnology, and real estate. Jerry helpedlead <strong>the</strong> turnaround at IBM when he served as <strong>the</strong> CFO for<strong>the</strong> company <strong>from</strong> 1993 to 1995. He also held o<strong>the</strong>rexecutive positions at Chrysler and currently sits on <strong>the</strong>boards of Apple, Tyco International Ltd., and Dana Hold<strong>in</strong>gsCorporation.Sitt<strong>in</strong>g down with Jerry gave me <strong>the</strong> opportunity to seehow truly thoughtful he is. One can hear him weigh <strong>the</strong>words as he speaks.The credit crisis began unfold<strong>in</strong>g <strong>in</strong> <strong>the</strong> summer of 2007,and I was greatly concerned. In fact, I decided <strong>in</strong> Juneand July of that year to significantly lighten up on <strong>the</strong> equitiesthat I owned. I told my various account managers and sold 40percent of <strong>the</strong> equities that I owned at that time. I put a substantialamount of that money <strong>in</strong>to municipal securities and left some ofit <strong>in</strong> cash.Fundamentally, <strong>the</strong> money that stayed <strong>in</strong> equities was <strong>the</strong> sharesof companies on whose boards I sit; I also held onto a lot of energystocks at that po<strong>in</strong>t <strong>in</strong> time. So it’s as though I told Mr. MoneyManager to hang on to <strong>the</strong>se and sell <strong>the</strong> rest.
JERRY YORK 119Analyz<strong>in</strong>g <strong>the</strong> SituationI had become very concerned about <strong>the</strong> potential impact of tightenedlend<strong>in</strong>g standards on bus<strong>in</strong>ess activity. I felt it could lead tosome very significant slowdowns <strong>in</strong> <strong>the</strong> economy. Interest<strong>in</strong>gly, <strong>in</strong>March 2008, I gave <strong>the</strong> keynote speech at CFO Magaz<strong>in</strong>e’s annualevent, and I presented quite a negative view. One th<strong>in</strong>g I cautionedto <strong>the</strong> various f<strong>in</strong>ancial executives <strong>in</strong> attendance was <strong>the</strong> need tounderstand <strong>the</strong>ir counter party risk and any derivative <strong>in</strong>strumentsthat <strong>the</strong>y have. One of <strong>the</strong> top folks at CFO Magaz<strong>in</strong>e called me outlate <strong>in</strong> <strong>the</strong> summer of 2008 and said, ‘‘My God, you really nailed thisth<strong>in</strong>g.’’ I replied, ‘‘No, actually; I was too optimistic.’’ By <strong>the</strong> time Ireceived that call, <strong>the</strong> Bear Stearns situation was look<strong>in</strong>g grim, and ofcourse, shortly <strong>the</strong>reafter <strong>the</strong> Lehman Bro<strong>the</strong>rs’ meltdown occurred.Lehman Bro<strong>the</strong>rs’ Downfall and Manag<strong>in</strong>gthrough <strong>the</strong> TurmoilI assumed that <strong>the</strong> situation with Lehman Bro<strong>the</strong>rs would be similarto that with Bear Stearns; that is, I assumed <strong>the</strong> government wouldstep <strong>in</strong>. In retrospect, it was a grave mistake for <strong>the</strong> government to letLehman Bro<strong>the</strong>rs go down <strong>the</strong> tubes, because that is what really put ahuge amount of fear <strong>in</strong>to <strong>the</strong> economy.At that po<strong>in</strong>t, I started sell<strong>in</strong>g more equities to lighten <strong>the</strong> load.As a result of earlier actions, I managed to get through 2008 with anegative return of 12 percent on my portfolios, which I th<strong>in</strong>k waspretty good <strong>in</strong> light of <strong>the</strong> market meltdown that took place <strong>from</strong>September to December. There were certa<strong>in</strong>ly a number of firmsthat had produced stellar results, but ma<strong>in</strong>ly by short<strong>in</strong>g <strong>the</strong>markets. You can make money no matter which way <strong>the</strong> marketis go<strong>in</strong>g if you make <strong>the</strong> right calls. Quite frankly, I have not donetoo well over <strong>the</strong> years short<strong>in</strong>g <strong>the</strong> market, so I don’t tend to do toomuch of that.
120 THRIVING IN THE NEW ECONOMYFuture of AutosThis has been a draconian situation with a huge decl<strong>in</strong>e. It began<strong>in</strong> <strong>the</strong> U.S. market, followed shortly <strong>the</strong>reafter <strong>in</strong> <strong>the</strong> Europeanmarkets, and even some of <strong>the</strong> Asian markets, most notably Japan.The drop-off <strong>in</strong> demand for autos has been nearly unprecedented.With <strong>the</strong> high fixed costs of <strong>the</strong>se companies, driven by <strong>the</strong>ir unioncontracts and <strong>the</strong>ir heavy <strong>in</strong>vestment requirements to be competitive<strong>in</strong> <strong>the</strong> bus<strong>in</strong>ess, it has just been a total meat gr<strong>in</strong>der for <strong>the</strong>m.The $64,000 question right now is: How much collateral damageis <strong>the</strong>re go<strong>in</strong>g to be <strong>in</strong> <strong>the</strong> supply base? Metaldyne and Visteon Corp.both filed for bankruptcy on May 28, 2009. They unfortunatelywere not alone. The question that now rema<strong>in</strong>s is how many moreauto parts makers will file?Credit Is K<strong>in</strong>gCredit is vital to any big-ticket consumer item, and my sense is thatit is very slowly start<strong>in</strong>g to loosen up. However, it is nowhere near asavailable as it used to be. There has been noth<strong>in</strong>g s<strong>in</strong>ce <strong>the</strong> GreatDepression that has been anyth<strong>in</strong>g like what’s go<strong>in</strong>g on now.Invest<strong>in</strong>g CriteriaMy <strong>in</strong>vest<strong>in</strong>g criteria depend on <strong>the</strong> particular type of security<strong>in</strong> which I’m plac<strong>in</strong>g funds. For example, I tend to <strong>in</strong>vest heavily<strong>in</strong> municipal securities. I stay away <strong>from</strong> municipal securitiesissued by <strong>in</strong>stitutions and states that are under extreme pressure.I do not own any Michigan, <strong>New</strong> Jersey, or California municipalsecurities. I prefer to stick to <strong>the</strong> states that don’t have seriousbudget problems.As far as equities go, it’s best <strong>in</strong> this type of market to stay away<strong>from</strong> anyth<strong>in</strong>g where revenues are dependent on credit availability.Any time I buy a stock, I also look at <strong>the</strong> maturity schedule of any
JERRY YORK 121debt <strong>the</strong>y have on <strong>the</strong>ir balance sheet. It’s a cautionary sign if <strong>the</strong>yhave any material debt maturities <strong>in</strong> <strong>the</strong> next 12 to 18 months. Youprobably don’t want to buy that type of equity.My <strong>in</strong>vest<strong>in</strong>g time frame is long term; I am not a trader <strong>in</strong>equities. I like to buy stocks and hold <strong>the</strong>m for three to five years.I don’t like to talk to my <strong>in</strong>vestment advisers every week, so to speak.I like to own stocks that I am very, very comfortable with on alonger-term basis.I th<strong>in</strong>k it is too early to be optimistic at this po<strong>in</strong>t. The market<strong>from</strong> <strong>the</strong> time of Lehman Bro<strong>the</strong>rs’ bankruptcy until probably <strong>the</strong>end of February 2009 was just an absolute meltdown. But on <strong>the</strong>o<strong>the</strong>r hand, I th<strong>in</strong>k most people, myself <strong>in</strong>cluded, are def<strong>in</strong>itelysleep<strong>in</strong>g better now than we were a few months ago.
Part TwoBANKING
13Kelly K<strong>in</strong>gS<strong>in</strong>ce <strong>the</strong> fall of BearStearns and LehmanBro<strong>the</strong>rs, <strong>the</strong> term bankhas become a dirty word.The historic $700 billion‘‘f<strong>in</strong>ancial’’ <strong>in</strong>dustry bailout<strong>in</strong> <strong>the</strong> fall of 2008acted as <strong>the</strong> backdropfor well-known CEOs los<strong>in</strong>g <strong>the</strong>ir jobs, and banks fail<strong>in</strong>g andbe<strong>in</strong>g seized by <strong>the</strong> Federal Deposit Insurance Corporation(FDIC) as a common Friday occurrence. Fears of ‘‘is my moneysafe?’’ were rampant after Wachovia and Wash<strong>in</strong>gton Mutualfailed. Then, <strong>in</strong> order to restore confidence, <strong>the</strong> FDIC raised<strong>the</strong> limit of deposit <strong>in</strong>surance on U.S. bank accounts <strong>from</strong>$100,000 to $250,000 per depositor.But dur<strong>in</strong>g this turmoil, a part of <strong>the</strong> <strong>in</strong>dustry was try<strong>in</strong>gto thrive—regional banks. I remember driv<strong>in</strong>g <strong>in</strong> to work <strong>in</strong><strong>the</strong> fall of 2008 and <strong>the</strong> w<strong>in</strong>ter of 2009 see<strong>in</strong>g signs such as‘‘Still Strong, Still Lend<strong>in</strong>g’’ hang<strong>in</strong>g above <strong>the</strong>ir doors. One(cont<strong>in</strong>ued)125
126 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)of <strong>the</strong> regional bank chief executive officers attempt<strong>in</strong>g tolead through this new economy is BB&T Corporation CEOKelly K<strong>in</strong>g.BB&T is no stranger to <strong>the</strong> conditions of <strong>the</strong> crisis we’refac<strong>in</strong>g right now. In fact, <strong>the</strong> bank successfully operateddur<strong>in</strong>g <strong>the</strong> Great Depression. Kelly has been with <strong>the</strong>company s<strong>in</strong>ce 1972 and began his tenure as CEO <strong>in</strong>January 2009 <strong>in</strong> <strong>the</strong> middle of <strong>the</strong> credit crisis. He hadserved as BB&T’s chief operat<strong>in</strong>g officer s<strong>in</strong>ce 2004.I met Kelly through one of my great f<strong>in</strong>ancial contacts,Donald Powell (who you’ll be read<strong>in</strong>g about a little later).Don was guest co-host<strong>in</strong>g a one-hour exclusive special onSquawk Box—a regional bank<strong>in</strong>g summit. On <strong>the</strong> panel wasKelly K<strong>in</strong>g. My pre-<strong>in</strong>terview with him for <strong>the</strong> show wasgreat, and I knew <strong>in</strong> my gut he would be an amaz<strong>in</strong>g guest.My gut is rarely wrong.So why did I choose to <strong>in</strong>clude Kelly’s—and BB&T’s—story <strong>in</strong> my book, ra<strong>the</strong>r than o<strong>the</strong>r regional banks? It was ano-bra<strong>in</strong>er; BB&T has adequate capital on its balance sheetfor acquisitions, mean<strong>in</strong>g it is <strong>in</strong> good health and poised togrow dur<strong>in</strong>g this time. The bank was ‘‘asked’’ to acceptTroubled Asset Relief Program (TARP) money along with<strong>the</strong> country’s o<strong>the</strong>r 18 largest banks and underwent <strong>the</strong>stress test. It was one of only n<strong>in</strong>e that ‘‘passed’’ <strong>the</strong> testand <strong>the</strong>refore was not required to raise additional capital.After <strong>the</strong> stress test results were announced, BB&T said itwould raise $1.5 billion, along with a large dividend cut andexist<strong>in</strong>g cash, to pay off <strong>the</strong> $3.1 billion it received <strong>in</strong> TARPfund<strong>in</strong>g. The bank was cleared by <strong>the</strong> government to payback its TARP money and exited <strong>the</strong> Troubled Asset ReliefProgram on June 17, 2009 when it paid <strong>the</strong> U.S. Treasurywith <strong>in</strong>terest.Nearly two months later, Montgomery, Alabama–basedColonial Bank, one of BB&T’s rivals, failed and was seized
KELLY KING 127by <strong>the</strong> FDIC on August 14. BB&T <strong>the</strong>n purchased Colonial’sloans, deposits, and most of its assets <strong>from</strong> <strong>the</strong> government.At that time, Colonial Bank was <strong>the</strong> sixth-largestbank failure <strong>in</strong> U.S. history. This acquisition gave BB&Tfur<strong>the</strong>r access to <strong>the</strong> Florida and Alabama markets, whichis part of its growth strategy. The structure of <strong>the</strong> deal alsoshielded BB&T <strong>from</strong> potential losses when <strong>the</strong> FDIC agreedto share losses with BB&T on $14 billion of <strong>the</strong> $22 billion<strong>in</strong> assets <strong>in</strong>cluded <strong>in</strong> this deal.Although <strong>in</strong>itially Kelly was shocked by <strong>the</strong> events at BearStearns and Lehman Bro<strong>the</strong>rs, he is optimistic on <strong>the</strong> futureof bank<strong>in</strong>g.Iwas very surprised to hear about <strong>the</strong> Bear Stearns messbecause, just a few years earlier, I had been <strong>in</strong> <strong>New</strong> Yorkand had a nice hour-long chat with ‘‘Ace’’ Greenberg, <strong>the</strong> formerchairman of <strong>the</strong> Executive Committee of The Bear Stearns Companies.We had a genu<strong>in</strong>ely good discussion about our companies’similarities. My <strong>in</strong>itial surprise was followed by shock when Irealized <strong>the</strong> magnitude of <strong>the</strong> subprime mess <strong>in</strong> Bear Stearns’ entireglobal portfolio. The reason I was surprised is because BB&T didnot offer subprime mortgages; we were not participat<strong>in</strong>g <strong>in</strong> thatprofit flow. In fact, most commercial banks like us were not. Themagnitude of what was go<strong>in</strong>g on <strong>in</strong> <strong>the</strong> securitization market,particularly around Residential Mortgage Backed Securities(RMBS) really astonished me.As <strong>the</strong> Bear Stearns debacle played out, it crystallized for me whata major problem we had. If a firm of <strong>the</strong> reputation, stature, andexperience of Bear Stearns can be taken out of <strong>the</strong> game literallyovernight, <strong>the</strong>re had to be some major and unusual—not to mentiondangerous—forces at play. Author’s note: Residential Mortgage Backed Securities are securities with com<strong>in</strong>g cash flow<strong>from</strong> residential debt. RMBS are a type of mortgage backed security.
128 THRIVING IN THE NEW ECONOMYThe Call to Let Lehman Bro<strong>the</strong>rs FailIt was a pretty risky step for <strong>the</strong> government to step <strong>in</strong> and subsidize<strong>the</strong> Bear Stearns transaction, because that meant it was clearlyhead<strong>in</strong>g down a slippery slope <strong>in</strong> terms of expand<strong>in</strong>g <strong>the</strong> ‘‘toobig to fail’’ concept.But when <strong>the</strong> government let Lehman Bro<strong>the</strong>rs go, I thought itwas <strong>the</strong> right th<strong>in</strong>g. Bear Stearns caught <strong>the</strong> government totally bysurprise, at least <strong>in</strong> my view. Out of shock, it’s reaction was, ‘‘Wecannot let <strong>the</strong>m fail’’; and so it put a deal toge<strong>the</strong>r overnight. When itlet Lehman Bro<strong>the</strong>rs go, as bad as it was—and as traumatic as I thoughtit would be—I still believe that <strong>the</strong> government made <strong>the</strong> right move.What startled me, however, was when <strong>the</strong> government came rightbeh<strong>in</strong>d Lehman Bro<strong>the</strong>rs and bailed out AIG. It appeared as though<strong>the</strong> government was flip-flopp<strong>in</strong>g, or pick<strong>in</strong>g w<strong>in</strong>ners and losers. Itbecame <strong>in</strong>creas<strong>in</strong>gly frustrat<strong>in</strong>g to see not only how big this problemwas but how misguided our government was <strong>in</strong> try<strong>in</strong>g to deal with it.Did <strong>the</strong> government really develop a strategic plan for deal<strong>in</strong>gwith <strong>the</strong> problem? Did <strong>the</strong> government really even know how big aproblem it was? Was it honest about how large a role politics wasplay<strong>in</strong>g <strong>in</strong> its decision mak<strong>in</strong>g? (From my vantage po<strong>in</strong>t, it certa<strong>in</strong>lylooked like politics was a big part of it.)But one of <strong>the</strong> th<strong>in</strong>gs I’ve learned after be<strong>in</strong>g <strong>in</strong> bus<strong>in</strong>ess for37 years is to be careful about second-guess<strong>in</strong>g people who havereally hard decisions to make when I may not have all <strong>the</strong> facts. Eventhough I had real reservations about <strong>the</strong>ir decisions, I had respectfor former Treasury Secretary Henry Paulson and Fed ChairmanBen Bernanke, and certa<strong>in</strong>ly appreciated <strong>the</strong> fact that this was anextremely tumultuous situation. I gave <strong>the</strong>m <strong>the</strong> benefit of <strong>the</strong> doubtand assumed <strong>the</strong>re must be a lot more to it than I knew.All of this turmoil left <strong>the</strong> market feel<strong>in</strong>g very uneasy. We savedBear Stearns, let Lehman Bro<strong>the</strong>rs fail, and <strong>the</strong>n saved AIG. So howbig is this problem and exactly how are we deal<strong>in</strong>g with it? Themarket certa<strong>in</strong>ly didn’t understand why we saved two and let one
KELLY KING 129fail. It didn’t understand <strong>the</strong> pervasiveness of <strong>the</strong> problem. All of thatcontributed significantly to <strong>the</strong> nervousness <strong>in</strong> <strong>the</strong> market. The crescendoof panic that started sett<strong>in</strong>g <strong>in</strong> gave way to an enormousliquidity scare for <strong>the</strong> next year or so.Us<strong>in</strong>g History as a GuideAt BB&T, we hunkered down and tried to figure out where <strong>the</strong><strong>in</strong>dustry might be head<strong>in</strong>g <strong>from</strong> here, <strong>in</strong>clud<strong>in</strong>g worst-case scenarios.Certa<strong>in</strong>ly, when IndyMac Federal Bank failed, and we watchedTV coverage of l<strong>in</strong>es of people wrapped around <strong>the</strong> park<strong>in</strong>g lotwait<strong>in</strong>g to f<strong>in</strong>d out where <strong>the</strong>ir money was, we knew a massivedepreciation <strong>in</strong> <strong>the</strong> f<strong>in</strong>ancial services <strong>in</strong>dustry was a possibility.We did not have any particular concerns about our own company.We’ve always tried to manage very conservatively, probably becauseof our past. As you may know, our bank is 137 years old. Dur<strong>in</strong>g <strong>the</strong>Great Depression, BB&T <strong>in</strong> Wilson, North Carol<strong>in</strong>a, was <strong>the</strong> onlybank <strong>in</strong> <strong>the</strong> Carol<strong>in</strong>as that stayed open amid all <strong>the</strong> o<strong>the</strong>r bankfailures and disasters of that period. So a big part of our heritage isliterally surviv<strong>in</strong>g a bank panic.In fact, at <strong>the</strong> height of <strong>the</strong> Great Depression—when people werecom<strong>in</strong>g <strong>in</strong> and tak<strong>in</strong>g out all of <strong>the</strong>ir money—<strong>the</strong>y would go to <strong>the</strong>post office <strong>in</strong> Wilson and convert <strong>the</strong>ir money <strong>in</strong>to postal moneyorders. They didn’t know that <strong>the</strong> post office banked with us too! Soyou had people tak<strong>in</strong>g <strong>the</strong>ir money out of our bank and go<strong>in</strong>g to <strong>the</strong>post office to get a money order. Then at night, <strong>the</strong> post office wouldturn around and br<strong>in</strong>g <strong>the</strong> money right back over to our bank. Itkept circulat<strong>in</strong>g between BB&T and <strong>the</strong> post office. And we neverclosed our doors.Because of that heritage, we’ve always believed <strong>in</strong> be<strong>in</strong>g reallyconservative and be<strong>in</strong>g prepared for any major crisis. And that’sexactly what has occurred s<strong>in</strong>ce <strong>the</strong> problems <strong>in</strong> our <strong>in</strong>dustry beganto unravel <strong>in</strong> 2008. When <strong>the</strong> worst of <strong>the</strong> liquidity crisis was
130 THRIVING IN THE NEW ECONOMYhappen<strong>in</strong>g, nobody would lend money to anybody. In fact, <strong>the</strong>rewere organizations br<strong>in</strong>g<strong>in</strong>g money to us at 0 percent <strong>in</strong>terest. We’dtell <strong>the</strong>m we didn’t need <strong>the</strong> money, and <strong>the</strong>y’d reply, ‘‘That’s f<strong>in</strong>e;we just want to put it <strong>in</strong> your bank.’’So o<strong>the</strong>r organizations viewed us as a safe haven throughout <strong>the</strong>ordeal, which was of course reward<strong>in</strong>g for us. However, I cont<strong>in</strong>uedto worry about <strong>the</strong> f<strong>in</strong>ancial system as a whole. Our f<strong>in</strong>ancialsystem is based on faith, and when <strong>the</strong> American public loses faith<strong>in</strong> <strong>the</strong> f<strong>in</strong>ancial system and <strong>the</strong> government’s ability to support it,it could lead to an absolute collapse across <strong>the</strong> <strong>in</strong>dustry.Be<strong>in</strong>g Prepared for a CrisisYou obviously have to be ready for a crisis; it’s too late when eventsare already underway. So even though we were very strong, wecont<strong>in</strong>ued to do all we could to prepare. For example, we built upour liquidity—not just to make sure we had enough, but also so we’dbe able to access it throughout that entire period. Our executive teamwas meet<strong>in</strong>g at least once a day, just to be sure we had our f<strong>in</strong>gers on<strong>the</strong> pulse of everyth<strong>in</strong>g occurr<strong>in</strong>g across <strong>the</strong> company. Obviously, itwas <strong>the</strong> most challeng<strong>in</strong>g environment of my career, unlike anyth<strong>in</strong>gI’d ever seen.What Went WrongThree th<strong>in</strong>gs truly ‘‘went wrong’’: First, we, <strong>the</strong> American publicoverconsumed, overspent, undersaved, underproduced, and leveredourselves to <strong>the</strong> hilt over <strong>the</strong> past 30 years. The consum<strong>in</strong>g publichad a role to play and <strong>the</strong>refore a lesson to learn.Second, our government took <strong>the</strong> public policy position thateverybody should own a home. And because it so aggressively pushedthat policy, it did substantial damage to <strong>the</strong> <strong>in</strong>vestment communityand <strong>the</strong> bank<strong>in</strong>g community, not to mention now-bankrupt Freddie
KELLY KING 131Mac and Fannie Mae. Third, <strong>the</strong> f<strong>in</strong>ancial services <strong>in</strong>dustry mademistakes too. Although our own bank fortunately did not, <strong>the</strong><strong>in</strong>dustry as a whole created some ra<strong>the</strong>r complex and sophisticatedproducts. In do<strong>in</strong>g so, it created a mechanism that allowed <strong>the</strong>country to lever itself without fully contemplat<strong>in</strong>g <strong>the</strong> consequencesof do<strong>in</strong>g so. F<strong>in</strong>ally, <strong>the</strong> regulatory community did not develop <strong>the</strong>sophisticated regulatory processes that were needed.But all of that doesn’t mean that America is bad, far <strong>from</strong> it. It justmeans we made some big mistakes that we’ll have to learn <strong>from</strong>. Itmeans we have an opportunity now to come out of this and be agreat country <strong>in</strong> <strong>the</strong> future like we’ve been <strong>in</strong> <strong>the</strong> past. What willmake <strong>the</strong> difference go<strong>in</strong>g forward is leadership, specifically leadership<strong>in</strong> bus<strong>in</strong>ess and government at all levels. Ultimately, when itcomes to big decisions, leadership always makes <strong>the</strong> difference.After all, even though a lot of <strong>the</strong> discussion of late has beenabout capital—capital shortages and so forth—you can give badleaders with bad strategies all <strong>the</strong> capital <strong>in</strong> <strong>the</strong> world and <strong>the</strong>y’llblow it. But if you give capital to good leaders who know how todevelop good strategies, <strong>the</strong>y will effectively use it to provide areasonable return to <strong>in</strong>vestors.Have <strong>the</strong>re been any lessons learned <strong>from</strong> this crisis at <strong>the</strong>governmental level? Maybe. At <strong>the</strong> regulatory level? I hope so. At<strong>the</strong> bus<strong>in</strong>ess community level? Absolutely. That’s because <strong>the</strong> bus<strong>in</strong>esscommunity does not have <strong>the</strong> luxury of pr<strong>in</strong>t<strong>in</strong>g money andsay<strong>in</strong>g th<strong>in</strong>gs without any culpability. In a free market system, when<strong>the</strong> bus<strong>in</strong>ess community makes mistakes, we pay <strong>the</strong> price.I was talk<strong>in</strong>g to <strong>the</strong> CEO of a major bank that failed recently andasked him how he was do<strong>in</strong>g. He said, ‘‘You know, I’m do<strong>in</strong>g f<strong>in</strong>e.I made a really terrible big debt acquisition <strong>in</strong> my company and Ipaid <strong>the</strong> price for it. But it was my mistake—it was a leadershipfailure—and I’m learn<strong>in</strong>g <strong>from</strong> that and mov<strong>in</strong>g on.’’ The reality isthat companies rise or fall based largely on <strong>the</strong>ir leadership. Baddecisions by leaders can have disastrous results. We’ve certa<strong>in</strong>ly seenthat lately.
132 THRIVING IN THE NEW ECONOMYTak<strong>in</strong>g TARPIn <strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g, <strong>the</strong> George W. Bush Adm<strong>in</strong>istration decided that<strong>the</strong> f<strong>in</strong>ancial situation was so dire that <strong>the</strong>y needed to step <strong>in</strong> andtake action. So <strong>the</strong>y <strong>in</strong>jected capital <strong>in</strong>to <strong>the</strong> healthy banks tostabilize <strong>the</strong> f<strong>in</strong>ancial system and to stimulate lend<strong>in</strong>g <strong>from</strong> those<strong>in</strong>stitutions. But <strong>the</strong> way it was presented to Congress was surreal.In essence, Congress was told that, ‘‘The Treasury is go<strong>in</strong>g to givemoney to healthy banks so that <strong>the</strong>y can make more loans.’’I have told people repeatedly that I have never seen one shortsentence with so many <strong>in</strong>accuracies <strong>in</strong> it. First of all, <strong>the</strong>y didn’t giveany money to anybody. It was a preferred stock <strong>in</strong>vestment with a5 percent amortized coupon, which was very expensive. The adm<strong>in</strong>istrationalso said <strong>the</strong>y were go<strong>in</strong>g to give it to only <strong>the</strong> healthy banks,which wasn’t at all <strong>the</strong> case because <strong>the</strong>y gave it to a lot of unhealthybanks as well. And <strong>the</strong>n <strong>the</strong>y said <strong>the</strong>y were putt<strong>in</strong>g <strong>the</strong> money <strong>in</strong> <strong>the</strong>healthy banks so that <strong>the</strong>y would make more loans. But <strong>the</strong> healthybanks were already mak<strong>in</strong>g loans! So noth<strong>in</strong>g <strong>in</strong> <strong>the</strong> aforementionedstatement was accurate, and <strong>the</strong> problem it caused was this: Congressheard that <strong>the</strong>se banks were gett<strong>in</strong>g this money so that <strong>the</strong>y wouldmake more loans. Congress <strong>in</strong>terpreted this as: ‘‘Now <strong>the</strong>y’ll have tomake <strong>the</strong> k<strong>in</strong>d of loans we want <strong>the</strong>m to make.’’ The next th<strong>in</strong>g youknow, <strong>the</strong> public is hear<strong>in</strong>g <strong>from</strong> Congress and <strong>the</strong> adm<strong>in</strong>istrationthat TARP money is taxpayer money and <strong>the</strong> banks are supposed tobe out <strong>the</strong>re grant<strong>in</strong>g any and all loans.So when every John Doe on <strong>the</strong> street didn’t get <strong>the</strong> loan hewanted, regardless of whe<strong>the</strong>r those loans made any sense or not, heranted and raved to Congress that banks weren’t do<strong>in</strong>g what <strong>the</strong>ywere supposed to be do<strong>in</strong>g with this ‘‘free’’ taxpayer money. And itturned <strong>in</strong>to a convoluted mess because it was so poorly presentedand expla<strong>in</strong>ed.BB&T has said all along that we never needed nor wanted anyTARP money. But it was very clear <strong>from</strong> Treasury and regulatorsthat we were expected to take <strong>the</strong> money. The way it was presented
KELLY KING 133even to us was that all <strong>the</strong> healthy banks would be gett<strong>in</strong>g thismoney. So if BB&T was <strong>the</strong> only healthy bank that didn’t take any,it might appear as though we weren’t a healthy bank. And s<strong>in</strong>ce wecouldn’t take that risk, we took <strong>the</strong> money.At first of course, <strong>the</strong>re were no str<strong>in</strong>gs attached to TARP/CapitalPurchase Plan (CPP) money. It was simply a preferred stock<strong>in</strong>vestment. But as everyth<strong>in</strong>g unfolded over <strong>the</strong> months follow<strong>in</strong>g,<strong>the</strong>re was a buildup of enormous negative sentiment. The averageperson on <strong>the</strong> street began to believe that banks are bad and thatTARP banks are really bad. As <strong>the</strong> story cont<strong>in</strong>ued to unfold, <strong>the</strong>stimulus bill—with its onerous compensation limitations—camealong. Then <strong>the</strong>re was all <strong>the</strong> rhetoric com<strong>in</strong>g out of Wash<strong>in</strong>gtonabout th<strong>in</strong>gs like employee recognition events and o<strong>the</strong>r normalbus<strong>in</strong>ess activities, just more unexpected entanglements that camewith TARP. My biggest concern was that government money <strong>in</strong>banks could politicize <strong>the</strong> lend<strong>in</strong>g process. That’s destructive for anycompany, and for <strong>the</strong> economy as a whole.Ano<strong>the</strong>r unfortunate part of this story is that <strong>the</strong> governmentmakes you take this money, and <strong>the</strong>n it makes you wait for approvalto pay <strong>the</strong> money back. We received approval <strong>in</strong> early June 2009 topay back <strong>the</strong> TARP money, certa<strong>in</strong>ly a milestone <strong>in</strong> all of this <strong>from</strong>our perspective. In addition to pay<strong>in</strong>g <strong>the</strong> pr<strong>in</strong>cipal, we had tonegotiate with <strong>the</strong> government to retire <strong>the</strong> warrants. So when it wasall said and done, we paid back more than <strong>the</strong> <strong>in</strong>itial $3.1 billion<strong>in</strong>vestment plus a f<strong>in</strong>al dividend payment of approximately $13.9million. Our total dividend payments under TARP were around$92.7 million. BB&T also took a charge of about $48 million <strong>in</strong> <strong>the</strong>second quarter of 2009 for <strong>the</strong> difference between <strong>the</strong> amortizedcost of <strong>the</strong> preferred stock and <strong>the</strong> repurchase price.Public BacklashThe public backlash l<strong>in</strong>gered for quite some time. One Juneweekend I was talk<strong>in</strong>g to someone who asked me what I did for
134 THRIVING IN THE NEW ECONOMYa liv<strong>in</strong>g. When I told him I was a banker, he asked me snidely, ‘‘Didyou guys take any of that TARP money?’’ Aga<strong>in</strong>, <strong>the</strong> publicperception is that TARP banks are <strong>the</strong> worst of <strong>the</strong> breed. And Idon’t blame <strong>the</strong> public for that sentiment, because I understand how<strong>the</strong>y came to that conclusion. They heard <strong>the</strong>ir presidents, o<strong>the</strong>rmembers of <strong>the</strong> Bush and Obama adm<strong>in</strong>istrations, and Congress sayover and over that banks were <strong>the</strong> problem and <strong>the</strong> creators of thismess. The American public has also heard that until we fix <strong>the</strong> badbanks, we cannot get <strong>the</strong> economy go<strong>in</strong>g. Too many peopleunfortunately believe anyth<strong>in</strong>g that comes out of Wash<strong>in</strong>gton. Soalthough I can understand <strong>the</strong> perspective of <strong>the</strong> American public,that misperception puts us <strong>in</strong> a terrible position.Keep<strong>in</strong>g <strong>the</strong> L<strong>in</strong>es of Communication OpenFor three days every June, I meet with thousands of our employees.Our management team visits and talks to our officers throughoutour 11-state (13 with <strong>the</strong> Colonial acquisition) footpr<strong>in</strong>t. Much ofour discussion <strong>in</strong> 2009 was about counter<strong>in</strong>g all <strong>the</strong> wrong <strong>in</strong>formation<strong>the</strong>y had heard with <strong>the</strong> truth about what was really go<strong>in</strong>g on.I want <strong>the</strong>m to know that <strong>the</strong>y’re not bad people. I want <strong>the</strong>mto know that, despite what <strong>the</strong>y may read <strong>in</strong> <strong>the</strong> newspapers or hearon <strong>the</strong> radio or see on TV. The vast majority of all <strong>the</strong> banks <strong>in</strong> thiscountry are still do<strong>in</strong>g <strong>the</strong> really good wholesome work we’ve alwaysdone. We’re out <strong>the</strong>re grant<strong>in</strong>g loans to people so that <strong>the</strong>y canachieve <strong>the</strong>ir dreams, goals, and hopes <strong>in</strong> life. We’re protect<strong>in</strong>g <strong>the</strong>irdeposits and provid<strong>in</strong>g <strong>the</strong>m with f<strong>in</strong>ancial products and services,such as <strong>in</strong>surance and small bus<strong>in</strong>ess loans. So we do really good work.In addition to that, our employees spend thousands of hourswork<strong>in</strong>g <strong>in</strong> <strong>the</strong> community with <strong>the</strong>ir local United Way andcountless o<strong>the</strong>r charitable organizations. In fact, on September 30,2009, our employees wrapped up an <strong>in</strong>spir<strong>in</strong>g two-month communityservice <strong>in</strong>itiative called <strong>the</strong> BB&T Lighthouse Project, <strong>the</strong> largestphilanthropic effort <strong>in</strong> our 137-year history. Work<strong>in</strong>g <strong>in</strong> teams,
KELLY KING 135employees across our corporation selected over 1,000 organizations<strong>in</strong> <strong>the</strong>ir local markets and helped over one million people. Ouremployees volunteered more than 40,000 hours pa<strong>in</strong>t<strong>in</strong>g, build<strong>in</strong>g,and repair<strong>in</strong>g homes; participat<strong>in</strong>g <strong>in</strong> homeless prevention programs;conduct<strong>in</strong>g school supply drives and food drives; and more. Weset aside $3 million and gave employees time off to carry out<strong>the</strong>ir projects.These employees should never feel bad about <strong>the</strong>mselves or our<strong>in</strong>dustry. I tell <strong>the</strong>m <strong>the</strong>y should be very proud of <strong>the</strong>mselves, <strong>the</strong>company <strong>the</strong>y work for, and <strong>the</strong>ir <strong>in</strong>dustry. It helps to hear a positivere<strong>in</strong>forcement of <strong>the</strong> truth. My biggest concern, though, is this:How do we get <strong>the</strong> American public to understand <strong>the</strong> truth?<strong>Thriv<strong>in</strong>g</strong> Game PlanTo come up with a BB&T game plan, we sat down and decided thatwe have to be crystal clear about what our immediate priorities are.Number one, we are <strong>in</strong> a short-term, focused strategic m<strong>in</strong>d-set.Number two, liquidity is absolutely our biggest priority. Numberthree, capital is <strong>the</strong> next priority. Number four is profitability.That order is somewhat unusual, because <strong>in</strong> <strong>the</strong> long term,profitability is really important. But I made it very clear to ourteam that <strong>in</strong> <strong>the</strong> short term, liquidity rises to <strong>the</strong> top of <strong>the</strong> list. Rightbeh<strong>in</strong>d that is strength of capital. If we had to deplete profitability <strong>in</strong>order to shore up liquidity and capital that would absolutely be <strong>the</strong>right th<strong>in</strong>g to do to survive.Strategically, we had to make sure that our people were fullyaware of what was go<strong>in</strong>g on as best we knew it. We <strong>in</strong>creased ourcommunication with our employees so that <strong>the</strong>y wouldn’t panicover what <strong>the</strong>y were hear<strong>in</strong>g on <strong>the</strong> street. Everybody watches andreads <strong>the</strong> news, and hears what’s go<strong>in</strong>g on. We had 1,500-plusf<strong>in</strong>ancial centers at <strong>the</strong> time and 30,000 employees. I wanted to besure that those employees did not assume <strong>the</strong> worst based on what<strong>the</strong>y were hear<strong>in</strong>g.
136 THRIVING IN THE NEW ECONOMYSo we <strong>in</strong>creased our communication with our entire employeebase. We told <strong>the</strong>m exactly what we knew and rem<strong>in</strong>ded <strong>the</strong>m aga<strong>in</strong>and aga<strong>in</strong> of how strong we were. We told <strong>the</strong>m we did not have anyliquidity concerns or capital concerns, and that regardless of howbleak <strong>the</strong> news may look, we were totally confident that we wouldget through everyth<strong>in</strong>g f<strong>in</strong>e. We also stressed to <strong>the</strong>m that <strong>the</strong>country would get through it f<strong>in</strong>e and that, <strong>in</strong> <strong>the</strong> end, we wouldhave all gone through a tough learn<strong>in</strong>g experience we wouldultimately grow <strong>from</strong>.We were very focused on communication because we realizedthat employees want to hear <strong>from</strong> top management as much aspossible, but never more so than when times are tough. In additionto hav<strong>in</strong>g myself and our top leaders address our employees, wealso felt it was important to hear directly <strong>from</strong> <strong>the</strong>m. So we <strong>in</strong>vited<strong>the</strong>m to send <strong>in</strong> any questions or concerns, and we answered asmany as we could on our <strong>in</strong>tranet and <strong>in</strong>ternal video.Seiz<strong>in</strong>g <strong>the</strong> OpportunitiesBe<strong>in</strong>g right <strong>in</strong> <strong>the</strong> backyard of (<strong>the</strong> former) Wachovia, we immediatelystarted see<strong>in</strong>g bus<strong>in</strong>ess opportunities. Wachovia started hav<strong>in</strong>gproblems pretty early on as all of this unfolded. The history betweenWachovia and BB&T dates back 100 years. Both companiescompeted aga<strong>in</strong>st each o<strong>the</strong>r, stemm<strong>in</strong>g <strong>from</strong> <strong>the</strong> fact that legacyWachovia was headquartered <strong>in</strong> W<strong>in</strong>ston-Salem, where BB&T isheadquartered now.Legacy Wachovia and BB&T have always been viewed as veryconservative and solid commercial banks. When legacy Wachoviasold itself to First Union <strong>in</strong> 2001 (First Union took <strong>the</strong> Wachovianame), <strong>the</strong> merger created a lot of turmoil, primarily becauseFirst Union and legacy Wachovia were almost 180 degrees apart<strong>in</strong> terms of culture and strategy. When <strong>the</strong> merger went through,everybody <strong>in</strong> bus<strong>in</strong>ess viewed it as a potential opportunity—notthatanybodyatthattimeexpected <strong>the</strong> comb<strong>in</strong>ed organization
KELLY KING 137to fail, but it was clear it was go<strong>in</strong>g to be a tough merger toput toge<strong>the</strong>r.Then <strong>in</strong> mid-2008, as <strong>the</strong> new Wachovia appeared to be on <strong>the</strong>verge of fail<strong>in</strong>g, we began to see a huge rush of legacy Wachoviaclients com<strong>in</strong>g to BB&T. They knew how similar our two organizationswere. They had stayed with <strong>the</strong> new Wachovia after <strong>the</strong>merger because <strong>the</strong>y wanted to give <strong>the</strong> comb<strong>in</strong>ed organization achance. But <strong>the</strong>n dur<strong>in</strong>g <strong>the</strong> merger process, many of <strong>the</strong> legacyWachovia employees were let go. So when <strong>the</strong> f<strong>in</strong>ancial problemsstarted occurr<strong>in</strong>g, <strong>the</strong> employees—and <strong>the</strong> relationships—simplyweren’t <strong>the</strong>re. On top of that, <strong>the</strong>re were questions about <strong>the</strong> newcompany’s f<strong>in</strong>ancial stability. With all of that as <strong>the</strong> backdrop, wesoon began to see a lot of bus<strong>in</strong>ess flow over to us <strong>from</strong> Wachovia.We have seen <strong>the</strong> same k<strong>in</strong>d of th<strong>in</strong>g play out with o<strong>the</strong>r<strong>in</strong>stitutions, such as Bank of America, although Wachovia certa<strong>in</strong>lywas <strong>the</strong> most pronounced example. The general turmoil <strong>in</strong> <strong>the</strong>market created additional opportunities for us. We rem<strong>in</strong>ded ouremployees that this is a difficult time <strong>in</strong> <strong>the</strong> <strong>in</strong>dustry, and we didn’twant to be scavengers. We would never tout <strong>the</strong> difficulties thato<strong>the</strong>r companies were hav<strong>in</strong>g as a means to w<strong>in</strong> new bus<strong>in</strong>ess. That’snever been a part of our values and culture.On <strong>the</strong> o<strong>the</strong>r hand, we always owe it to our shareholders to growour bus<strong>in</strong>ess. When your competitors are weak, you certa<strong>in</strong>ly try totake bus<strong>in</strong>ess away <strong>from</strong> <strong>the</strong>m if you can. So we stepped up our effortto call on <strong>the</strong> clients of <strong>the</strong> companies that were hav<strong>in</strong>g trouble. Were<strong>in</strong>forced our position <strong>in</strong> <strong>the</strong> marketplace, stress<strong>in</strong>g that we were <strong>the</strong>oldest bank <strong>in</strong> <strong>the</strong> Carol<strong>in</strong>as, very strong, very sound, with a longtrack record of stability.After all, we have been around for 137 years, and that resonatedvery well <strong>in</strong> <strong>the</strong> marketplace. Somewhere along <strong>the</strong> way, we launchedan advertis<strong>in</strong>g campaign with a new tagl<strong>in</strong>e that summed it up:‘‘BB&T, Best Bank <strong>in</strong> Town s<strong>in</strong>ce 1872.’’ We thought that thisstatement professionally emphasized our stability and our strengthrelative to o<strong>the</strong>rs who couldn’t honestly make that same claim.
138 THRIVING IN THE NEW ECONOMYThe ad campaign worked great. We know that it led to anaccelerated growth rate, and we have countless anecdotes of largercompanies and <strong>in</strong>dividuals mov<strong>in</strong>g <strong>the</strong>ir accounts over to us. Webelieve that thousands of o<strong>the</strong>rs we didn’t previously know moved<strong>the</strong>ir bus<strong>in</strong>ess to us because of how we were describ<strong>in</strong>g ourselves <strong>in</strong><strong>the</strong> marketplace. The strength and stability message was certa<strong>in</strong>ly <strong>the</strong>right one for <strong>the</strong> time, but I believe it actually just re<strong>in</strong>forced what<strong>the</strong> market already knew.Grow<strong>in</strong>g <strong>in</strong> <strong>the</strong> <strong>New</strong> <strong>Economy</strong>For <strong>the</strong> past 25 to 30 years, we went through a prolonged periodwhen many traditional commercial loans left <strong>the</strong> balance sheet andwent out <strong>in</strong>to <strong>the</strong> capital markets through <strong>the</strong> securitization process.This is known as dis<strong>in</strong>termediation. We are now beg<strong>in</strong>n<strong>in</strong>g a periodof what I call re<strong>in</strong>termediation, where a lot of that bus<strong>in</strong>ess that went<strong>in</strong>to <strong>the</strong> capital markets will be return<strong>in</strong>g to commercial bankbalance sheets. This will probably last for a decade or so and willpresent a real opportunity for really strong balance sheet growth forcommercial banks like BB&T. So despite <strong>the</strong> recession, <strong>the</strong>re’s nodeny<strong>in</strong>g that <strong>the</strong>re are numerous growth opportunities out <strong>the</strong>reright now. Com<strong>in</strong>g out of <strong>the</strong> recession and head<strong>in</strong>g <strong>in</strong>to a growthperiod will accentuate those opportunities.<strong>Thriv<strong>in</strong>g</strong> <strong>in</strong> <strong>the</strong> new economy to me is extraord<strong>in</strong>arily excit<strong>in</strong>g. Itake every opportunity to rem<strong>in</strong>d our employees that I have never beenas excited about <strong>the</strong> future of our <strong>in</strong>dustry and <strong>the</strong> future of BB&Tas I am today. The reason I’m so energized is because we’re go<strong>in</strong>gthrough this process of what I call ‘‘a return to fundamental bank<strong>in</strong>g.’’Over <strong>the</strong> past 25 years, <strong>the</strong> dis<strong>in</strong>termediation process dramaticallychanged <strong>the</strong> nature of bank<strong>in</strong>g. When I first started mak<strong>in</strong>g loans35 years ago, <strong>the</strong> commercial bank<strong>in</strong>g system (<strong>in</strong>clud<strong>in</strong>g thrifts)made about 80 percent of all <strong>the</strong> loans that were granted. Over time,it drifted down to about 30 percent. Where did <strong>the</strong> rest of <strong>the</strong> loansgo? Out through <strong>the</strong> securitization process <strong>in</strong>to <strong>the</strong> capital markets,
KELLY KING 139where <strong>the</strong>re were major problems. The <strong>in</strong>vestors <strong>in</strong> <strong>the</strong>se capitalmarkets products (securities) perceived, understandably, that <strong>the</strong>ywere buy<strong>in</strong>g AAA bonds; after all, that’s <strong>the</strong> way <strong>the</strong>y were rated. As aresult, <strong>the</strong>y had very little capital <strong>in</strong> <strong>the</strong>ir reserves to cover anydeterioration <strong>in</strong> <strong>the</strong> asset quality. Of course, as we now know, <strong>the</strong>ywere not truly AAA bonds. They were bad loans.So <strong>the</strong> downward pric<strong>in</strong>g pressure on lend<strong>in</strong>g <strong>in</strong> <strong>the</strong> bank<strong>in</strong>g<strong>in</strong>dustry for <strong>the</strong> past 30 years has been enormous. The same loan thatI made 35 years ago <strong>in</strong> Charlotte, North Carol<strong>in</strong>a—until recently—went down <strong>in</strong> price by 300 basis po<strong>in</strong>ts, or 3 percent. That is adramatic change. So <strong>the</strong> bank<strong>in</strong>g <strong>in</strong>dustry was defeated <strong>in</strong> two ways.We lost <strong>in</strong> volume, and <strong>the</strong> spreads were beaten down because of <strong>the</strong>securitization process.However, we’re now prepar<strong>in</strong>g to undergo this re<strong>in</strong>termediationprocess, a return to fundamental bank<strong>in</strong>g. We’ll see more volumecom<strong>in</strong>g back, at better prices, and actually with better structured terms.So our future <strong>in</strong> lend<strong>in</strong>g looks dramatically better. And although not asdramatic, our future also looks significantly brighter on <strong>the</strong> liabilityside. More people are tak<strong>in</strong>g <strong>the</strong>ir money out of <strong>the</strong> stock market andputt<strong>in</strong>g it back <strong>in</strong> <strong>the</strong>ir banks to <strong>in</strong>vest <strong>in</strong> CDs. I have heard manypeople over <strong>the</strong>se years, particularly senior citizens, say, ‘‘I would nevertake money out of <strong>the</strong> bank and put it <strong>in</strong> <strong>the</strong> stock market.’’ But <strong>the</strong>ywere actually putt<strong>in</strong>g <strong>the</strong>ir money <strong>in</strong> mutual funds; <strong>the</strong>y simply neverunderstood that meant <strong>the</strong>y were <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> <strong>the</strong> stock market. Sadly,<strong>the</strong>y lost an enormous amount of <strong>the</strong>ir pr<strong>in</strong>cipal, and we’re see<strong>in</strong>g <strong>the</strong>mby <strong>the</strong> thousands come back out of <strong>the</strong> stock market. They’re putt<strong>in</strong>g<strong>the</strong>ir money back <strong>in</strong>to CDs, where <strong>the</strong>y can get a lower, but fair rateand feel safe and secure <strong>in</strong> <strong>the</strong>ir deposits. In <strong>the</strong> future, this re<strong>in</strong>termediationwill help us on <strong>the</strong> loan and <strong>the</strong> deposit side.Ano<strong>the</strong>r piece of excit<strong>in</strong>g news <strong>from</strong> our company’s po<strong>in</strong>t of viewis that this huge economic crisis is creat<strong>in</strong>g a shakeout and separationbetween weaker and stronger banks. Many of <strong>the</strong> weaker banks haveclosed, and will cont<strong>in</strong>ue to fail, until this ongo<strong>in</strong>g consolidationprocess is completed. So <strong>the</strong>re will be far fewer regional players <strong>in</strong> <strong>the</strong>
140 THRIVING IN THE NEW ECONOMYmarketplace, <strong>the</strong>refore mak<strong>in</strong>g <strong>the</strong> competition better and healthier.The result is more volume, better spreads, and less irrationalcompetition, someth<strong>in</strong>g that seems quite promis<strong>in</strong>g to me.Look<strong>in</strong>g toward <strong>the</strong> future, <strong>the</strong> only th<strong>in</strong>g that tempers myoptimism slightly is my grave concern about <strong>the</strong> trend com<strong>in</strong>gout of Wash<strong>in</strong>gton. Although I th<strong>in</strong>k our economy is poised toemerge <strong>from</strong> this recession and experience a number of years of solidand steady economic growth, that outlook can and will be dramaticallychanged if we stray away <strong>from</strong> <strong>the</strong> fundamentals of capitalism.The government is now runn<strong>in</strong>g parts of <strong>in</strong>dustry and is gett<strong>in</strong>gmore and more <strong>in</strong>volved. I am afraid market forces will not beallowed to work <strong>in</strong>dependently. That is very, very scary to me.However, I’m an optimist, and I believe that Americans will make<strong>the</strong> right choices <strong>in</strong> select<strong>in</strong>g <strong>the</strong>ir leaders to counter <strong>the</strong>se trends.Hopefully, we’ll become more balanced <strong>in</strong> terms of putt<strong>in</strong>g a focusback on <strong>the</strong> pr<strong>in</strong>ciples that have made this country so great,specifically freedom, capitalism, and free enterprise.<strong>Thriv<strong>in</strong>g</strong> CriteriaWe consider several th<strong>in</strong>gs here, <strong>the</strong> first of which are our strategicobjectives <strong>in</strong> terms of how we want our balance sheet to look. Oncewe decide on <strong>the</strong> asset structure we want go<strong>in</strong>g forward, we <strong>the</strong>nanalyze specific asset decisions. We do a very sophisticated <strong>in</strong>ternalreturn cash-flow analysis to decide on <strong>the</strong> types of <strong>in</strong>vestments wewant to make. Similar to <strong>the</strong> process we use with acquisitions, it is avery complicated cash-flow analysis. It’s less complicated with a newbuild<strong>in</strong>g or someth<strong>in</strong>g similar, but still pretty sophisticated.If it’s a loan, you’re look<strong>in</strong>g at <strong>the</strong> <strong>in</strong>ternal rate of return on thatloan, based on <strong>the</strong> capital allocated. Bottom l<strong>in</strong>e, our approach is tolook at <strong>the</strong> risk-adjusted return on capital.
14DonaldPowellWe all know <strong>the</strong> wheels ofcredit freez<strong>in</strong>g up created<strong>the</strong> mess we’re <strong>in</strong> now.However, <strong>the</strong>re is lend<strong>in</strong>ggo<strong>in</strong>g on <strong>in</strong> <strong>the</strong> bank<strong>in</strong>g<strong>in</strong>dustry. The personwhom I contact <strong>the</strong> mostto ga<strong>in</strong> perspective andknowledge <strong>in</strong> f<strong>in</strong>ancialsis former Federal DepositInsurance Corporation(FDIC) Chairman DonaldPowell. Don was sworn <strong>in</strong>as <strong>the</strong> eighteenth FDICchair and served <strong>from</strong>2001 to 2005. Don took<strong>the</strong> helm at <strong>the</strong> FDIC just weeks before <strong>the</strong> 9/11 terroristattacks and one month after one of <strong>the</strong> nation’s most costly(cont<strong>in</strong>ued)141
142 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)bank failures of <strong>the</strong> past decade. The staff back <strong>the</strong>n hadbeen cut <strong>in</strong> half because of consolidation of <strong>the</strong> bank<strong>in</strong>g<strong>in</strong>dustry, but Don was up to <strong>the</strong> challenge.Don Powell is no stranger to adversity. His bank, <strong>the</strong> FirstNational Bank of Amarillo, almost failed <strong>in</strong> <strong>the</strong> late 1980s.But due to <strong>the</strong> strategies he will outl<strong>in</strong>e <strong>in</strong> this chapter, hewas able to get his company back on track. In June 2009,Don was elected to <strong>the</strong> board of Bank of America. Federalregulators urged Bank of America to recruit new boardmembers who had both ‘‘risk management and f<strong>in</strong>ancialservices expertise.’’ Don was one of four new directorselected five weeks after shareholders ousted CEO KenLewis as chairman. Don has always been vocal about hisconcerns about many issues, <strong>in</strong>clud<strong>in</strong>g <strong>the</strong> makeup andregulatory measurements of capital, <strong>the</strong> lack of accountabilityof <strong>the</strong> credit agencies, and <strong>the</strong> lack of competitors <strong>in</strong><strong>the</strong> space. Don has ma<strong>in</strong>ta<strong>in</strong>ed his long-held op<strong>in</strong>ion that‘‘too-big-to-fail’’ is not good public policy. ‘‘All <strong>in</strong>stitutionsshould be held to <strong>the</strong> same standards.’’ However, Don alsorecognizes <strong>the</strong> importance of <strong>the</strong> systemic risk. A creditcard bank failed when he was FDIC chair, and he had todevise a plan for how to close <strong>the</strong> book on <strong>the</strong> cardholders.Don says a well thought out game plan is necessary tolimit downside. . . .The events of 9/11 occurred with<strong>in</strong> weeks of my arrival at <strong>the</strong>FDIC, and as a result, <strong>the</strong> bank<strong>in</strong>g <strong>in</strong>dustry played a veryimportant role <strong>in</strong> protect<strong>in</strong>g national security. The crisis was not anormal bank<strong>in</strong>g crisis of safety and soundness, but ra<strong>the</strong>r a concernabout terrorists us<strong>in</strong>g <strong>the</strong> bank<strong>in</strong>g system to f<strong>in</strong>ance <strong>the</strong>ir activities.There was real concern that <strong>the</strong>y might attempt to dismantle <strong>the</strong>f<strong>in</strong>ancial structure of America. So we at <strong>the</strong> FDIC—toge<strong>the</strong>r witho<strong>the</strong>r bank<strong>in</strong>g regulators and <strong>the</strong> Treasury—were deal<strong>in</strong>g with <strong>the</strong>
DONALD POWELL 143issue of how to protect <strong>the</strong> nation’s bank<strong>in</strong>g system aga<strong>in</strong>st threats tonational security. Today’s crisis is more about economic andf<strong>in</strong>ancial fundamentals, not a national security concern. It’s adifferent economic crisis than <strong>the</strong> one follow<strong>in</strong>g 9/11, becausethis one extended beyond U.S. markets. The global economy was<strong>in</strong> a severe recession.From a bank<strong>in</strong>g perspective, <strong>the</strong>re were many concerns, <strong>in</strong>clud<strong>in</strong>gliquidity <strong>in</strong> a depression-era type of run on banks. We saw evidenceof that at IndyMac Federal Bank and at o<strong>the</strong>r banks as well. Itwas <strong>in</strong>terest<strong>in</strong>g <strong>in</strong> that people did not want cashier’s checks; <strong>the</strong>ywanted cash. There were widespread concerns about money, andpeople wanted cash <strong>in</strong> hand.Uncle Sam to <strong>the</strong> RescueThe markets wanted <strong>the</strong> government to <strong>in</strong>tercede and to supportliquidity and <strong>the</strong> safety of deposits <strong>in</strong> f<strong>in</strong>ancial <strong>in</strong>stitutions. TheFederal Reserve did many positive th<strong>in</strong>gs, and <strong>the</strong> FDIC’s <strong>in</strong>suranceof all transaction accounts was extremely positive. People didn’t haveto worry about go<strong>in</strong>g to <strong>the</strong> bank and gett<strong>in</strong>g <strong>the</strong>ir money. Andalthough some did, this measure still brought a lot of stability to <strong>the</strong>marketplace.<strong>Thriv<strong>in</strong>g</strong> <strong>in</strong> <strong>the</strong> <strong>New</strong> <strong>Economy</strong>Capital, capital, and capital! A liquidity crisis is a crisis only if youhave asset quality problems; <strong>the</strong>refore banks that did not have assetquality problems did not have liquidity problems. Banks that havean abundance of capital can always wea<strong>the</strong>r a liquidity crisis oran asset quality crisis. This is not a fun time to be <strong>in</strong> <strong>the</strong> bank<strong>in</strong>gbus<strong>in</strong>ess, especially <strong>the</strong> past couple of years. The fall of 2008was hopefully <strong>the</strong> low po<strong>in</strong>t, and <strong>the</strong>re was a lot of panic <strong>in</strong> <strong>the</strong>marketplace dur<strong>in</strong>g that time.
144 THRIVING IN THE NEW ECONOMYPlann<strong>in</strong>g AheadThe most important th<strong>in</strong>g is to have a plan. Everybody <strong>in</strong> <strong>the</strong>organization, <strong>in</strong>clud<strong>in</strong>g all stockholders, must understand whatyou’re do<strong>in</strong>g too. Then you have to execute, and you have to bediscipl<strong>in</strong>ed about it. You cannot panic. You cannot give up. Youcannot go back and second-guess; you must go forward. You have tomake sure people believe <strong>in</strong> your plan, not only <strong>the</strong> shareholders orthose who supply additional capital, but your employee base and, ofcourse, your customers. If <strong>the</strong> team members are not believers, anddoubt <strong>the</strong> plan’s effectiveness <strong>in</strong> any way, you will fail.Qualities of a LeaderLeadership is vital; it provides hope and stability. We usuallyknow it when we see it. Leaders don’t panic. Leaders have ice <strong>in</strong><strong>the</strong>ir ve<strong>in</strong>s. Leaders are discipl<strong>in</strong>ed and have a plan—and <strong>the</strong>yexecute. If <strong>the</strong> facts change, <strong>the</strong>y change <strong>the</strong>ir course. Leaders set<strong>the</strong> tone, and more importantly, <strong>the</strong>y lead through example . . .<strong>the</strong>y walk <strong>the</strong> talk!Leaders must be able to stand <strong>the</strong> heat. They sometimes have tolook people <strong>in</strong> <strong>the</strong> eye and say, we thought about do<strong>in</strong>g that anddecided not to participate, because we th<strong>in</strong>k a product/action hasabnormal risk and would not be long-term beneficial to our shareholders.That is hard to do, especially when <strong>the</strong>re is much pressure toperform with peers, but leaders don’t follow <strong>the</strong> crowd; andsometimes <strong>the</strong>se decisions can have consequences.Future of Bank<strong>in</strong>gIn <strong>the</strong> future, commercial bank<strong>in</strong>g will return to a more meat andpotatoes or more basic method of operat<strong>in</strong>g, and it won’t participate<strong>in</strong> exotic products that <strong>the</strong>y really don’t understand orappreciate. They will revert to accept<strong>in</strong>g deposits and mak<strong>in</strong>g
DONALD POWELL 145loans. Of course, <strong>the</strong>re will always be services such as <strong>in</strong>surance,trust, and o<strong>the</strong>r non<strong>in</strong>terest products that <strong>the</strong>y’ll cont<strong>in</strong>ue to offerto customers; and although <strong>the</strong> large <strong>in</strong>stitutions will always be<strong>in</strong>volved <strong>in</strong> some measure of <strong>in</strong>vestment bank<strong>in</strong>g, <strong>the</strong>y too will bemore cautious. I predict that we are go<strong>in</strong>g to put a premium oncapital, and we are not go<strong>in</strong>g to worry about <strong>in</strong>creas<strong>in</strong>g ourearn<strong>in</strong>gs per share every quarter. We are go<strong>in</strong>g to make moredecisions based on long-term ra<strong>the</strong>r than short-term focus. Weare go<strong>in</strong>g to have long-term rewards, someth<strong>in</strong>g that shareholderswill recognize, appreciate, and understand. And management willstart chang<strong>in</strong>g <strong>the</strong> way <strong>the</strong>y manage.The Untold StoryThere may be an untold story here, which is that we need to rem<strong>in</strong>dourselves that <strong>the</strong> bank<strong>in</strong>g bus<strong>in</strong>ess is not go<strong>in</strong>g to go away. It iscritical to <strong>the</strong> free enterprise system. It is one of <strong>the</strong> fundamentalpillars of American life. We must have a bank<strong>in</strong>g system. We need todo some th<strong>in</strong>gs differently, of course, but those who would say banksare go<strong>in</strong>g to go away are simply wrong. They’re go<strong>in</strong>g to be around,and <strong>the</strong>y’re go<strong>in</strong>g to be around forever.Game OnHere’s <strong>the</strong> game plan: There are always go<strong>in</strong>g to be bus<strong>in</strong>ess cycles.People will say ‘‘This time is different.’’ ‘‘The same th<strong>in</strong>g is notgo<strong>in</strong>g to happen to us.’’ ‘‘Our conditions are different.’’ ‘‘We havecontrols <strong>in</strong> place.’’ Well, that’s not true. There are always go<strong>in</strong>g to beups and downs. Those who prepare for, recognize, and understandthat fact will survive. A strong balance sheet—that is, one that is notleveraged and <strong>the</strong> capital section is ‘‘paid <strong>in</strong> capital’’ and ‘‘reta<strong>in</strong>edearn<strong>in</strong>gs’’—is critical. You also can’t get caught up <strong>in</strong> <strong>the</strong> w<strong>in</strong>d of,‘‘Well, everybody’s do<strong>in</strong>g it’’ or ‘‘We have to be <strong>in</strong> <strong>the</strong> game when
146 THRIVING IN THE NEW ECONOMY<strong>the</strong> game is be<strong>in</strong>g played.’’ That should not be <strong>the</strong> reason<strong>in</strong>g.Judgment, <strong>in</strong>tellect, and common sense will play a vital role go<strong>in</strong>gforward. We tend to forget what we’ve learned <strong>from</strong> <strong>the</strong> past; andalthough this crisis will pass, we cannot forget <strong>the</strong> pa<strong>in</strong>ful lessonsit taught.I used to give speeches when I was at <strong>the</strong> FDIC about how nowis<strong>the</strong>timetomaketoughdecisions,becauseyou’llbeforcedtomake <strong>the</strong>m <strong>in</strong> bad times and that’s not <strong>the</strong> time to do it. I meaneverybody reduces <strong>the</strong> workforce dur<strong>in</strong>g a downturn; everybodyrestricts <strong>the</strong>ir capital expenditures. Everybody cuts advertis<strong>in</strong>g. Butit’s best to do that when you are do<strong>in</strong>g well. There are always go<strong>in</strong>gto be down times. Yet we never seem to learn that lesson. There isalways go<strong>in</strong>g to be a downtime. It is not up forever, and it is notdown forever.As I stated before—and despite what some people claim—banksare not go<strong>in</strong>g away. Some will blame big banks, and some willblame small banks; some will blame regulators, and some willblame <strong>the</strong> Federal Reserve. But <strong>the</strong> truth is that we control our owndest<strong>in</strong>y. The fact is that you need to be prepared for tomorrow. It’sgo<strong>in</strong>g to be worse, and you’re <strong>the</strong> only one who can do anyth<strong>in</strong>gabout it.Banks, <strong>in</strong>clud<strong>in</strong>g <strong>the</strong> one I worked at <strong>in</strong> <strong>the</strong> 1980s, haveundoubtedly done some dumb th<strong>in</strong>gs. At <strong>the</strong> time, we didn’tth<strong>in</strong>k our actions were dumb, but even at <strong>the</strong> time we made certa<strong>in</strong>decisions, we knew we were tak<strong>in</strong>g unusual risk. But we thought,‘‘Gosh, this economy is so good, we can’t make a mistake.’’ Iremember be<strong>in</strong>g concerned dur<strong>in</strong>g <strong>the</strong> oil crisis of <strong>the</strong> 1980s andtell<strong>in</strong>gmywifethatIwasn’tsurewewouldalwaysbeabletobuyfuel for our automobile. I remember wait<strong>in</strong>g <strong>in</strong> l<strong>in</strong>e to fill my carand recall<strong>in</strong>g <strong>the</strong> fact that oil is a deplet<strong>in</strong>g asset. No alternativeproduct was <strong>in</strong> sight, and demand was strong; and yet oilplummeted to less than $15.00 a barrel. Don’t ever say certa<strong>in</strong>th<strong>in</strong>gs can’t happen, because anyth<strong>in</strong>g can happen. And you needto keep that <strong>in</strong> m<strong>in</strong>d while you’re plann<strong>in</strong>g for <strong>the</strong> future.
DONALD POWELL 147Thisisadef<strong>in</strong><strong>in</strong>gmoment;wewillneverbe<strong>the</strong>sameafterthis.Psychologists often say that you have five or six def<strong>in</strong><strong>in</strong>g moments<strong>in</strong> your life. This is a def<strong>in</strong><strong>in</strong>g moment <strong>in</strong> <strong>the</strong> economic life ofAmerica. We cannot let this downturn paralyze us or question ourtrust <strong>in</strong> <strong>the</strong> free enterprise system. We have to live; but we must doso with a better set of standards. Aga<strong>in</strong>, <strong>the</strong> problem is judgment;we must learn <strong>from</strong> our irresponsible behavior. You are alwaysgo<strong>in</strong>gtohavedownturns<strong>in</strong>afreeenterprisesystem,but<strong>the</strong>ydonot last forever. It’s like that old say<strong>in</strong>g: You can’t have a ra<strong>in</strong>bowuntil it ra<strong>in</strong>s.
15Cam F<strong>in</strong>eCam F<strong>in</strong>e is presidentand CEO of <strong>the</strong> IndependentCommunity Bankersof America (ICBA),which is <strong>the</strong> nationaltrade association thatrepresents communitybanks. But he is not anassociation CEO whohas never had sk<strong>in</strong> <strong>in</strong> <strong>the</strong> game. Prior to jo<strong>in</strong><strong>in</strong>g <strong>the</strong> ICBA,Cam was president and CEO of Midwest Independent Bank<strong>in</strong> Jefferson City, Missouri, which he also helped found <strong>in</strong>1985. He was also a budget analyst for <strong>the</strong> state of Missouri,and <strong>in</strong> 1981, he was appo<strong>in</strong>ted <strong>the</strong> director of <strong>the</strong> stateDivision of Taxation and Collection by former governor andcurrent U.S. Senator Christopher ‘‘Kit’’ Bond. In October2000, Cam was appo<strong>in</strong>ted to <strong>the</strong> Federal Advisory Councilof <strong>the</strong> Board of Governors of <strong>the</strong> Federal Reserve System,represent<strong>in</strong>g <strong>the</strong> 10th Federal Reserve District (Kansas City).(cont<strong>in</strong>ued)149
150 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)Cam’s knowledge and experience took him to <strong>the</strong> WhiteHouse <strong>in</strong> <strong>the</strong> spr<strong>in</strong>g of 2009 as one of <strong>the</strong> CEOs who metwith President Obama dur<strong>in</strong>g <strong>the</strong> famous banker’s meet<strong>in</strong>g.Cam’s outlook on <strong>the</strong> bank<strong>in</strong>g sector, specifically <strong>the</strong>regional banks, is <strong>in</strong>sightful and offers <strong>in</strong>vestors a groundfloor view of what’s go<strong>in</strong>g on.The extraord<strong>in</strong>ary events that occurred <strong>in</strong> <strong>the</strong> fall of 2008were presaged with a series of shocks to <strong>the</strong> nation’s f<strong>in</strong>ancialsystem that did not bode well for <strong>the</strong> more than 8,000 smaller andregional banks that constitute <strong>the</strong> community bank<strong>in</strong>g <strong>in</strong>dustry.Although <strong>the</strong> nation’s f<strong>in</strong>ancial system had been experienc<strong>in</strong>g stra<strong>in</strong>s<strong>in</strong>ce <strong>the</strong> fall of 2007, <strong>the</strong> f<strong>in</strong>ancial crisis broke out <strong>in</strong>to full publicview with <strong>the</strong> Federal Reserve’s bailout of Bear Stearns <strong>in</strong> March2008. The ICBA immediately condemned <strong>the</strong> Bear Stearns bailoutas dangerous overreach by <strong>the</strong> Federal Reserve that potentially putthousands of community banks on <strong>the</strong> hook for <strong>the</strong> f<strong>in</strong>ancial s<strong>in</strong>sof Wall Street.At <strong>the</strong> time, editorial writers and news show commentatorsgenerally praised <strong>the</strong> Federal Reserve, believ<strong>in</strong>g that <strong>the</strong> rescue ofBear Stearns would have a cathartic and stabiliz<strong>in</strong>g effect on WallStreet. But <strong>the</strong> pundits were wrong—and <strong>the</strong> crisis <strong>in</strong>tensified <strong>in</strong>to<strong>the</strong> spr<strong>in</strong>g and early summer of 2008. As <strong>the</strong> first quarter bank callreports and earn<strong>in</strong>gs announcements rolled out <strong>in</strong> late April andMay, it became apparent that <strong>the</strong> f<strong>in</strong>ancial waters were roiled.Bank<strong>in</strong>g <strong>in</strong>stitutions began to fail on a regular basis, and <strong>the</strong> crisisreached a boil<strong>in</strong>g po<strong>in</strong>t when IndyMac failed <strong>in</strong> July 2008. It was<strong>the</strong> largest bank failure <strong>in</strong> U.S. history to that po<strong>in</strong>t. The publicwas now not only fully aware of <strong>the</strong> f<strong>in</strong>ancial turmoil on WallStreet but also alarmed. So, too, was <strong>the</strong> ICBA and <strong>the</strong> communitybank<strong>in</strong>g <strong>in</strong>dustry.
CAM FINE 151Fall 2008—A September to RememberBlack Sunday—September 7, 2008In <strong>the</strong> weeks preced<strong>in</strong>g <strong>the</strong> September 7, 2008, government seizureof Fannie Mae and Freddie Mac, warn<strong>in</strong>g signs were abundant thatsometh<strong>in</strong>g dramatic was afoot for <strong>the</strong> two hous<strong>in</strong>g governmentsponsoredenterprises (GSEs). Rumors swirled <strong>in</strong> Wash<strong>in</strong>gtonabout government takeover of <strong>the</strong> hous<strong>in</strong>g GSEs. Beg<strong>in</strong>n<strong>in</strong>g abouta month prior to <strong>the</strong> September weekend seizure of Fannie Maeand Freddie Mac, Federal Hous<strong>in</strong>g F<strong>in</strong>ance Agency (FHFA)Director Lockhart and his new agency were unusually quiet.Statements <strong>from</strong> <strong>the</strong> FHFA and <strong>the</strong> Treasury were suddenly vagueand less reassur<strong>in</strong>g as to <strong>the</strong> health of <strong>the</strong> two hous<strong>in</strong>g giants. Thiswas <strong>in</strong> sharp contrast to statements made by both Lockhart andSecretary Paulson <strong>in</strong> <strong>the</strong> spr<strong>in</strong>g and early summer of 2008 thatboth Fannie Mae and Freddie Mac were ‘‘adequately capitalized’’and that any notion of a government takeover was ‘‘absurd.’’Although I knew that a government seizure of <strong>the</strong> GSEs was apossibility s<strong>in</strong>ce <strong>the</strong> July 2008 passage of HR 3221 (The Hous<strong>in</strong>gand Economic Recovery Act of 2008), I was surprised by <strong>the</strong>government repudiation of <strong>the</strong> GSE preferred stockholders. Wewere caught off guard because <strong>the</strong> Federal Reserve/Treasury hadprotected <strong>the</strong> preferred stockholders <strong>in</strong> <strong>the</strong> Bear Stearns bailout <strong>in</strong>March 2008; <strong>the</strong>refore, <strong>the</strong> same was expected <strong>from</strong> <strong>the</strong> Treasuryafter <strong>the</strong> government seizures of <strong>the</strong> hous<strong>in</strong>g GSEs.The key difference between <strong>the</strong> two events (<strong>the</strong> bailout of BearStearns and <strong>the</strong> seizures of Fannie Mae and Freddie Mac), ofcourse, was who held <strong>the</strong> preferred shares of <strong>the</strong> two companies. In<strong>the</strong> case of Bear Stearns, <strong>the</strong> preferred stock was held ma<strong>in</strong>ly byWall Street firms, not <strong>the</strong> least of which was Goldman Sachs(Secretary Paulson’s former firm) and JPMorgan Chase. In <strong>the</strong> caseof <strong>the</strong> hous<strong>in</strong>g GSEs, <strong>the</strong> preferred shares were more broadly held,and ma<strong>in</strong>ly by community and regional bank<strong>in</strong>g <strong>in</strong>stitutions (<strong>the</strong>‘‘too small to save’’). The dismissive and unconcerned attitude
152 THRIVING IN THE NEW ECONOMYshownbyTreasuryofficials<strong>in</strong><strong>the</strong>ir<strong>in</strong>itial public statements as to<strong>the</strong> damage that might be caused by <strong>the</strong> repudiation of <strong>the</strong>preferred shareholders (mostly community banks, which heldmore than $25 billion <strong>in</strong> GSE preferred shares) shocked andoutraged <strong>the</strong> community bank<strong>in</strong>g <strong>in</strong>dustry, to say <strong>the</strong> least. TheTreasury’s first public comment on <strong>the</strong> matter that ‘‘only a fewsmaller <strong>in</strong>stitutions will be affected’’ telegraphed a total lack of<strong>in</strong>stitutional knowledge with<strong>in</strong> <strong>the</strong> Treasury of <strong>the</strong> communitybank<strong>in</strong>g sector, its culture, and its ownership structure. To add<strong>in</strong>sult to <strong>in</strong>jury, <strong>the</strong> Treasury’s actions on that black Sunday,September 7, 2008, also repudiated earlier assurances <strong>from</strong> Lockhartand several Treasury officials—<strong>in</strong>clud<strong>in</strong>g Secretary Paulson—that <strong>the</strong> GSEs were structurally sound and adequately capitalized.Infact,aslateasApril2008,Lockhartwasquotedassay<strong>in</strong>gthata government takeover of <strong>the</strong> GSEs was ‘‘out of <strong>the</strong> question.’’ Feel<strong>in</strong>gs of outrage and betrayal coursed through <strong>the</strong> communitybank<strong>in</strong>g <strong>in</strong>dustry that September Sunday afternoon. As Presidentand CEO of <strong>the</strong> ICBA, I immediately issued a statement on Mondaymorn<strong>in</strong>g, September 8, 2008, about <strong>the</strong> consequences to <strong>the</strong>community bank<strong>in</strong>g <strong>in</strong>dustry, Ma<strong>in</strong> Street America, and consumersof <strong>the</strong> government’s seizure of <strong>the</strong> hous<strong>in</strong>g GSEs.‘‘Let Them Eat Cake’’Those famous words—attributed to Queen Marie Anto<strong>in</strong>ette ofFrance when told that her people were suffer<strong>in</strong>g and starv<strong>in</strong>g—perfectly sum up <strong>the</strong> seem<strong>in</strong>g attitude of <strong>the</strong> top f<strong>in</strong>ancial policymakers of <strong>the</strong> U.S. government when <strong>the</strong>y learned that scores ofcommunity banks could suffer <strong>from</strong> <strong>the</strong> abrupt nationalization of Author’s note: Lockhart’s statement was made just after Fannie Mae and Freddie Macagreed to raise equity. Lockhart has told me whatever he said was based on <strong>the</strong> assumptionthat <strong>the</strong>y were go<strong>in</strong>g to be successful. Freddie never did raise <strong>the</strong> equity.
CAM FINE 153<strong>the</strong> hous<strong>in</strong>g GSEs. When asked about <strong>the</strong> impact on <strong>the</strong> nation’sbank<strong>in</strong>g system, several top policy makers stated that <strong>the</strong> impactwould be immaterial to <strong>the</strong> bank<strong>in</strong>g system—only a few smallerbanks would be hurt. In effect, ‘‘Let <strong>the</strong>m eat cake.’’On Sunday, September 7, 2008—a day that will live <strong>in</strong> f<strong>in</strong>ancial<strong>in</strong>famy—<strong>the</strong> U.S. Treasury, <strong>the</strong> Federal Reserve Board, and <strong>the</strong>newly m<strong>in</strong>ted Federal Hous<strong>in</strong>g F<strong>in</strong>ance Agency (FHFA or as I call<strong>the</strong>m, <strong>the</strong> Triumvirate) nationalized two of <strong>the</strong> largest f<strong>in</strong>ancialfirms <strong>in</strong> <strong>the</strong> United States. In a move that would have made HugoChavez proud, <strong>the</strong> top f<strong>in</strong>ancial policy makers of <strong>the</strong> United Stateseng<strong>in</strong>eered a weekend coup and wiped out thousands of <strong>in</strong>dividualand <strong>in</strong>stitutional <strong>in</strong>vestors with <strong>the</strong> stroke of a pen. What’s more,<strong>the</strong> takeover came despite <strong>the</strong> fact that both Fannie Mae andFreddie Mac were still adequately capitalized under statute. Perhaps<strong>the</strong>se breathtak<strong>in</strong>g actions were necessary, perhaps not; onlytime will tell. However, what is truly outrageous to <strong>the</strong> ICBA andthousands of community bankers is <strong>the</strong> cavalier attitude that topU.S. f<strong>in</strong>ancial policy makers exhibited toward <strong>the</strong> communitybank<strong>in</strong>g <strong>in</strong>dustry.Would <strong>the</strong> Treasury, Federal Reserve, and FHFA have been ascavalier had Citigroup or JPMorgan Chase held $400 billion ofGSE preferred stock? I th<strong>in</strong>k we all know <strong>the</strong> answer to that. Theanswer has been confirmed time and aga<strong>in</strong> dur<strong>in</strong>g this currentf<strong>in</strong>ancial crisis. If you are a mega Wall Street firm—or if you aretoo ‘‘<strong>in</strong>terconnected’’ to Wall Street or world markets—yourcounterparties have noth<strong>in</strong>g to fear. Even your firm will be givenconsiderable forbearance. But if you are a community bank go<strong>in</strong>gabout your bus<strong>in</strong>ess serv<strong>in</strong>g your community, you are simply toosmall to be of concern. And if your balance sheet becomes impairedby actions of our government and through no fault of your own,well,be afraid...bevery afraid.Youare too smallto worryabout, my friend.Although <strong>the</strong>re is no doubt that every banker is responsible andaccountable for what is on <strong>the</strong> bank’s balance sheet, <strong>the</strong>re is no doubt
154 THRIVING IN THE NEW ECONOMYthat <strong>in</strong> recent years, bankers were encouraged to diversify <strong>the</strong>ir assets.In many cases, regulatory exam<strong>in</strong>ers and outside account<strong>in</strong>g firmscondoned—and <strong>in</strong> some cases, even encouraged—<strong>the</strong> purchase ofGSE preferred stock as a good asset for diversification. In fact, <strong>the</strong>stock was designed by <strong>the</strong> agencies for <strong>in</strong>stitutional <strong>in</strong>vestors andeven had built-<strong>in</strong> tax advantages to <strong>in</strong>duce purchases—all blessed by<strong>the</strong> government regulators. So, <strong>the</strong> actions taken that weekend and<strong>the</strong> subsequent statements by our government’s top f<strong>in</strong>ancial policymakers that ‘‘only a few smaller <strong>in</strong>stitutions will be affected’’ areparticularly egregious and outrageous to <strong>the</strong> scores of <strong>in</strong>stitutionsthat are affected.Community banks are <strong>the</strong> eng<strong>in</strong>es that, <strong>in</strong> many regions of thisnation, keep local markets go<strong>in</strong>g day to day. To simply write <strong>the</strong>moff as <strong>in</strong>consequential is outrageous to <strong>the</strong> ICBA and communitybankers everywhere. Wall Street cheered <strong>the</strong> action because WallStreet gets what it has wanted for years: <strong>the</strong> bludgeon<strong>in</strong>g to death of<strong>the</strong> GSEs, which Wall Street moneymakers have always resented.Now <strong>the</strong>y have a clear field <strong>in</strong> <strong>the</strong> mortgage markets to do <strong>the</strong>irwill—and community bankers and consumers beware. There is nowno impartial counterweight to keep <strong>the</strong> big guys honest.To paraphrase <strong>the</strong> words of an old country song: ‘‘Wall Street got<strong>the</strong> gold; Ma<strong>in</strong> Street got <strong>the</strong> shaft.’’ Every community banker <strong>in</strong>this nation, whe<strong>the</strong>r a member of <strong>the</strong> ICBA or not, should beextremely upset about how easily our policy makers dismiss billionsof dollars of GSE equity held <strong>in</strong> community banks as ‘‘only affect<strong>in</strong>ga few smaller <strong>in</strong>stitutions.’’ What precedent does this set for futurehits that community banks may take as <strong>the</strong> result of our government’sactions?We at <strong>the</strong> ICBA are th<strong>in</strong>k<strong>in</strong>g of ano<strong>the</strong>r famous quote: ‘‘I’m asmad as hell, and I’m not go<strong>in</strong>g to take it anymore.’’ Our focus iscommunity banks and only community banks; and we are go<strong>in</strong>g todo everyth<strong>in</strong>g <strong>in</strong> our power to protect and advance <strong>the</strong> communitybank<strong>in</strong>g po<strong>in</strong>t of view on this issue and any issue of vital concern to<strong>the</strong> franchise health of all community banks. I hope all community
CAM FINE 155banks—members and nonmembers alike—will jo<strong>in</strong> us <strong>in</strong> fight<strong>in</strong>gfor your franchise rights.The response <strong>from</strong> thousands of community banks was immediateand <strong>in</strong>tense. In short, <strong>the</strong>y were outraged. A feel<strong>in</strong>g ofgovernment betrayal followed close beh<strong>in</strong>d <strong>the</strong> outrage. E-mails,calls, and letters to <strong>the</strong> ICBA, <strong>the</strong> bank<strong>in</strong>g agencies, <strong>the</strong> Treasury,and Capitol Hill poured <strong>in</strong> by <strong>the</strong> thousands and did not let up forweeks. The mood with<strong>in</strong> <strong>the</strong> community bank<strong>in</strong>g sector quicklyturned to one of distrust of government agencies—especially <strong>the</strong>Treasury. And that sentiment has not abated to any significantdegree to this day.ICBA Grassroots EffortThe ICBA reaction to <strong>the</strong> events of September 2008 was immediateand overwhelm<strong>in</strong>g. On Monday morn<strong>in</strong>g, September 8, ICBA<strong>in</strong>itiated a multifront campaign to forcefully br<strong>in</strong>g communitybank<strong>in</strong>g <strong>in</strong>dustry issues and concerns to <strong>the</strong> attention of key policymakers throughout Wash<strong>in</strong>gton and to fully engage <strong>the</strong> communitybank<strong>in</strong>g sector <strong>in</strong> <strong>the</strong> loom<strong>in</strong>g battles ahead. The ICBA andour affiliated state bank<strong>in</strong>g associations have member banks <strong>in</strong>all 435 congressional districts. The ICBA would make sure that<strong>the</strong> community bank<strong>in</strong>g <strong>in</strong>dustry and Ma<strong>in</strong> Street America wouldnot be ignored <strong>in</strong> this f<strong>in</strong>ancial crisis and that our voices wouldbe heard by every s<strong>in</strong>gle member of Congress and key policymakers <strong>in</strong> <strong>the</strong> bank regulatory agencies and <strong>the</strong> adm<strong>in</strong>istration.(See Figure 15.1.)It was clear to me and to <strong>the</strong> ICBA leadership that <strong>the</strong> Treasury’sapa<strong>the</strong>tic—and at times harmful—actions toward communitybanks were driven by a complete lack of knowledge and empathyfor <strong>the</strong> community bank<strong>in</strong>g sector, its culture, and ownershipstructure. As a result, <strong>the</strong> ICBA launched an aggressive grassrootscampaign to reach more than 8,000 community banks nationwide.I recorded YouTube messages to our members for immediate
156 THRIVING IN THE NEW ECONOMYFigure 15.1ICBA Campaignimpact and recorded DVD messages for distribution to ourmembers to use at local community group meet<strong>in</strong>gs—and forfur<strong>the</strong>r distribution to <strong>in</strong>fluential persons and groups <strong>in</strong> <strong>the</strong>irlocal markets.
CAM FINE 157All 44 ICBA-affiliated state bank<strong>in</strong>g associations were contactedand asked to coord<strong>in</strong>ate <strong>the</strong>ir efforts with and through <strong>the</strong> ICBA.Ongo<strong>in</strong>g communication with key members of Congress was significantlyramped up after <strong>the</strong> August 2008 congressional break; andafter September 7, 2008, <strong>the</strong> ICBA appealed to our grassrootsmembership base to <strong>in</strong>tensify <strong>the</strong>ir direct contacts with <strong>the</strong>ir membersof Congress. These <strong>in</strong>tensified contacts cont<strong>in</strong>ued throughout<strong>the</strong> fall and to this day.Last fall, <strong>the</strong> ICBA and our member banks touched manymembers of Congress <strong>in</strong> numerous ways—e-mail, direct lettermail, phone calls, and personal visits. A vigorous public mediacampaign, <strong>in</strong>clud<strong>in</strong>g pr<strong>in</strong>t and media advertis<strong>in</strong>g, was <strong>in</strong>itiated. Ourcommunications department worked to set up <strong>in</strong>terviews for me andkey leadership community bankers on cable and broadcast newsshows, as well as with pr<strong>in</strong>t journalists. Our job was to heighten<strong>in</strong>dustry, government, and public awareness of <strong>the</strong> communitybank<strong>in</strong>g sector, its culture, and its issues. The ICBA’s job was(and is) to get <strong>the</strong> message out <strong>in</strong> a clear and forceful manner. Ino<strong>the</strong>r words, we needed to ‘‘get <strong>in</strong> people’s faces’’ with <strong>the</strong> communitybank<strong>in</strong>g po<strong>in</strong>t of view. I saw this as my unique responsibilityand challenge—and I still do.Ma<strong>in</strong> Street’s Economic PurposeAt <strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g of this crisis <strong>in</strong> <strong>the</strong> fall of 2007 and cont<strong>in</strong>u<strong>in</strong>g <strong>in</strong>to<strong>the</strong> fall of 2008, key policy makers at <strong>the</strong> Treasury, <strong>in</strong> <strong>the</strong> adm<strong>in</strong>istration,and <strong>in</strong> some of <strong>the</strong> bank regulatory agencies ignored <strong>the</strong>community bank<strong>in</strong>g <strong>in</strong>dustry and Ma<strong>in</strong> Street America. The numerousactions taken by <strong>the</strong> Treasury and <strong>the</strong> adm<strong>in</strong>istration <strong>in</strong> <strong>the</strong>fall of 2008 were totally centered on and for <strong>the</strong> benefit of WallStreet, regardless of <strong>the</strong> negative consequences that may befall <strong>the</strong>community bank<strong>in</strong>g sector or more broadly, Ma<strong>in</strong> Street America.The Paulson Treasury ignored <strong>the</strong> community bank<strong>in</strong>g <strong>in</strong>dustry<strong>in</strong> <strong>the</strong> <strong>in</strong>itial stages of <strong>the</strong> f<strong>in</strong>ancial crisis. There was no <strong>in</strong>stitutional
158 THRIVING IN THE NEW ECONOMYunderstand<strong>in</strong>g or comprehension of <strong>the</strong> structure, culture, or ownershipof community banks. In fact, it went fur<strong>the</strong>r; <strong>the</strong>re was no realappreciation for Ma<strong>in</strong> Street America and <strong>the</strong> banks that serve small,privately owned bus<strong>in</strong>esses. Everyth<strong>in</strong>g was Wall Street–centric—<strong>from</strong> <strong>the</strong> Fed’s <strong>in</strong>itial response to Bear Stearns, to <strong>the</strong> Treasury’shandl<strong>in</strong>g of <strong>the</strong> grow<strong>in</strong>g crisis dur<strong>in</strong>g <strong>the</strong> summer, to <strong>the</strong> Septemberseizure of <strong>the</strong> GSEs, to <strong>the</strong> first drafts of what would become <strong>the</strong>Troubled Asset Relief Program (TARP) bill. Noth<strong>in</strong>g <strong>in</strong> any of <strong>the</strong>Treasury’s actions <strong>from</strong> <strong>the</strong> fall of 2007 to <strong>the</strong> <strong>in</strong>troduction of<strong>the</strong> TARP bill <strong>in</strong> mid-September of 2008 showed any recognitionor understand<strong>in</strong>g of <strong>the</strong> community bank<strong>in</strong>g sector and smallbus<strong>in</strong>ess America. In short, if you were not publicly traded and aWall Street mega firm, you were <strong>in</strong>visible to <strong>the</strong> Paulson Treasury.My job and <strong>the</strong> ICBA’s job is to transform <strong>the</strong> views and attitudesof policy makers, both on <strong>the</strong> Hill and <strong>in</strong> <strong>the</strong> adm<strong>in</strong>istration. Achanged outlook toward <strong>the</strong> community bank<strong>in</strong>g sector had to comequickly, or community banks would be roadkill on <strong>the</strong> f<strong>in</strong>ancialrecovery highway. My overall strategy was to conv<strong>in</strong>ce policy makersthat <strong>the</strong> community bank<strong>in</strong>g sector was vital to <strong>the</strong> core economy of<strong>the</strong> nation and that ignor<strong>in</strong>g or harm<strong>in</strong>g <strong>the</strong> community bank<strong>in</strong>gsector also harmed small bus<strong>in</strong>esses and millions of consumers <strong>in</strong>thousands of smaller cities, towns, and rural areas of America. Inshort, policy makers needed to view <strong>the</strong> community bank<strong>in</strong>g sectoras be<strong>in</strong>g vital to <strong>the</strong> nation’s economic health and to <strong>the</strong> government’sf<strong>in</strong>ancial recovery efforts. To accomplish this, <strong>the</strong> ICBAneeded to ‘‘bark <strong>the</strong> loudest’’ and become very public. I needed todrive home <strong>the</strong> po<strong>in</strong>t that Wall Street is not <strong>the</strong> only street <strong>in</strong>America that counts.The ICBA StrategyTo carry out our strategy of be<strong>in</strong>g a relevant and active player <strong>in</strong>shap<strong>in</strong>g events, <strong>the</strong> ICBA and community banks had to first be seenas <strong>the</strong> ‘‘good guys,’’ or <strong>the</strong> ‘‘white hats.’’ So we developed <strong>the</strong>
CAM FINE 159‘‘common sense lender’’ and <strong>the</strong> ‘‘safe and stable’’ campaigns <strong>in</strong> <strong>the</strong>spr<strong>in</strong>g of 2008. Coupled with our pr<strong>in</strong>t advertisements that touted‘‘down home values’’ and ‘‘relationship’’ bank<strong>in</strong>g, <strong>the</strong> ICBA promoted<strong>the</strong> picture of ‘‘heartland America,’’ where common sensevalues and respect for each <strong>in</strong>dividual still held sway.At <strong>the</strong> core of our current strategies for expand<strong>in</strong>g <strong>the</strong> communitybank<strong>in</strong>g sector <strong>in</strong> <strong>the</strong> new economy of <strong>the</strong> future is <strong>the</strong> notionthat consumer choice and f<strong>in</strong>ancial diversity build economicstrength ra<strong>the</strong>r than dissipat<strong>in</strong>g it. That overwhelm<strong>in</strong>g f<strong>in</strong>ancialconcentration <strong>in</strong>to <strong>the</strong> hands of a few—a f<strong>in</strong>ancial oligarchy if youwill—limits consumer choice. In addition, unwarranted government<strong>in</strong>tervention, whe<strong>the</strong>r through direct ownership <strong>in</strong>terest orthrough stagger<strong>in</strong>g regulations, weakens ra<strong>the</strong>r than streng<strong>the</strong>nsour overall economy. As past crises and <strong>the</strong> current crisis have sobitterly demonstrated, <strong>the</strong> concentration of f<strong>in</strong>ancial resources <strong>in</strong>to<strong>the</strong> hands of a few has proved ru<strong>in</strong>ous to our nation’s f<strong>in</strong>ancialhealth. The ICBA has pressed this po<strong>in</strong>t with policy makers,members of Congress, and <strong>the</strong> general public.Through an <strong>in</strong>tense public media campaign to build awareness ofMa<strong>in</strong> Street America, we have made Ma<strong>in</strong> Street America a brand—a brand that harkens back to old-fashioned common sense andvalues such as <strong>in</strong>tegrity, honesty, and car<strong>in</strong>g for one’s neighbors. Wehave used an approach of multiple communications. We haveemployed a strategy of ‘‘be<strong>in</strong>g bigger than we are’’—by project<strong>in</strong>gstrength and stability. In recent years, policy makers at <strong>the</strong> toppositions of government have <strong>in</strong>creas<strong>in</strong>gly come straight <strong>from</strong> WallStreet or <strong>the</strong> mega firms. There is little or no understand<strong>in</strong>g of <strong>the</strong>community bank<strong>in</strong>g culture, ownership structure, or ‘‘small bus<strong>in</strong>ess’’nature of Ma<strong>in</strong> Street America. Today’s policy makers are allabout public companies, global f<strong>in</strong>ance, and ‘‘<strong>the</strong> street.’’My job is to get policy makers, members of Congress, and o<strong>the</strong>rimportant constituencies to ‘‘th<strong>in</strong>k small,’’ to see <strong>the</strong> ‘‘small picture’’if you will. They must understand that Wall Street is not <strong>the</strong> onlystreet that counts <strong>in</strong> America, that without <strong>the</strong> economic eng<strong>in</strong>es of
160 THRIVING IN THE NEW ECONOMYcommunity banks work<strong>in</strong>g on Ma<strong>in</strong> Street America, our nation’ssmall bus<strong>in</strong>esses—our ma<strong>in</strong> creators of new jobs—will falter andfail. Community banks are ‘‘systemically important’’ to <strong>the</strong> smallertowns, cities, and rural areas that <strong>the</strong>y serve. Ignor<strong>in</strong>g <strong>the</strong> communitybank<strong>in</strong>g sector puts our entire nation at risk.The ICBA has been successful <strong>in</strong> our efforts to create a positiveimage of community banks and bank<strong>in</strong>g. We have succeeded <strong>in</strong>br<strong>in</strong>g<strong>in</strong>g <strong>the</strong>se issues to <strong>the</strong> forefront <strong>in</strong> <strong>the</strong> policy debates <strong>in</strong>Wash<strong>in</strong>gton.Wehavemadeapositivedifferencefor<strong>the</strong>communitybank<strong>in</strong>g <strong>in</strong>dustry that will have last<strong>in</strong>g effects for generationsto come.Us<strong>in</strong>g Proven Pr<strong>in</strong>ciples of Bank<strong>in</strong>g asCore Strategies WorksWhy have community and smaller regional banks generally wea<strong>the</strong>red<strong>the</strong> f<strong>in</strong>ancial storm for nearly two years while mega banks havefloundered? Why have most community banks seen significantdeposit and loan growth? Why have earn<strong>in</strong>gs and return on equitybeen stable to grow<strong>in</strong>g <strong>in</strong> <strong>the</strong> majority of community banks? Theanswer is found <strong>in</strong> fundamental bank<strong>in</strong>g pr<strong>in</strong>ciples that are as old asbank<strong>in</strong>g itself.Three banks illustrate this po<strong>in</strong>t. Although <strong>in</strong> very differentmarkets, <strong>in</strong> review<strong>in</strong>g <strong>the</strong> balance sheets and performance characteristicsof MidSouth Bank, NA of Lafayette, Louisiana; UMB ofKansas City, Missouri; and Frost Bank of San Antonio, Texas, eachof <strong>the</strong> banks share certa<strong>in</strong> core bank<strong>in</strong>g practices that are central torunn<strong>in</strong>g successful bank<strong>in</strong>g operations.In all organizations, success beg<strong>in</strong>s with <strong>the</strong> leadership at <strong>the</strong> top;and MidSouth Bank, UMB, and Frost Bank each have strong,colorful, and dynamic chairmen. Each of <strong>the</strong>se chairmen haveimpressed <strong>the</strong>ir values and visions on <strong>the</strong>ir organizations and createdorganizational cultures that strictly adhere to a set of very basic corevalues that are observed <strong>from</strong> <strong>the</strong> chairman’s office to <strong>the</strong> teller
CAM FINE 161w<strong>in</strong>dow. Strong leadership at <strong>the</strong> top is <strong>the</strong> very first element thatmust be present for any bus<strong>in</strong>ess strategy to be successful.The key strategies employed by community banks that have beena formula for success for generations (through good times and bad)and that have proved so effective dur<strong>in</strong>g <strong>the</strong> current crisis arediscussed <strong>in</strong> <strong>the</strong> follow<strong>in</strong>g sections.Know Your Markets and Your Products—Don’t OverreachOne of <strong>the</strong> fundamental mistakes of <strong>the</strong> mega Wall Street firms isthat <strong>the</strong>y overreached and entered markets and <strong>in</strong>itiated products ofwhich <strong>the</strong>y had little or no knowledge. The chairmen of <strong>the</strong> threebanks mentioned earlier—Richard Evans of Frost Bank, Mar<strong>in</strong>erKemper of UMB Bank, and Rusty Cloutier of MidSouth Bank—allstuck to <strong>the</strong>ir markets and proven products. They were not temptedby quick ga<strong>in</strong>s to enter markets or <strong>in</strong>itiate products of which <strong>the</strong>yhad no real knowledge.Ma<strong>in</strong>ta<strong>in</strong> a Strong Capital BaseCore to <strong>the</strong> community bank culture is <strong>the</strong> ma<strong>in</strong>tenance of a strongleverage capital base. Capital as strategy is almost a novelty to <strong>the</strong> megaWall Street firms, but it has been employed very effectively by mostcommunity banks, <strong>in</strong>clud<strong>in</strong>g those highlighted here. Each of <strong>the</strong> communitybanks mentioned here<strong>in</strong> had equity capital that far exceededregulatory m<strong>in</strong>imums. As example, on March 31, 2009, Frost Bankheld 12.79 percent equity capital—more than twice <strong>the</strong> regulatoryrequirement. The o<strong>the</strong>r two banks have similar profiles. Communitybankers know that <strong>in</strong> a storm <strong>the</strong> safest of all harbors is capital.Know Your Capacity for Risk and Control It TightlyA key to succeed<strong>in</strong>g <strong>in</strong> bank<strong>in</strong>g—whe<strong>the</strong>r a mega bank or acommunity bank—is to know your <strong>in</strong>stitution’s capacity for risk.
162 THRIVING IN THE NEW ECONOMYIn its appetite for ever-greater returns and profit, Wall Street firmsseemly forgot that lesson. Certa<strong>in</strong>ly, UMB Bank of Kansas Citynever did and has pursued a conservative risk strategy that hasactually seen its stock rise over <strong>the</strong> past year. Most community banksfollow <strong>the</strong> UMB strategy of m<strong>in</strong>imiz<strong>in</strong>g <strong>the</strong>ir risks through tight<strong>in</strong>ternal controls and a risk-adverse cultural bias.Never Chase ProfitsAs <strong>the</strong> current crisis has so clearly illum<strong>in</strong>ated, chas<strong>in</strong>g profits is afool’s game. MidSouth Bank has prospered dur<strong>in</strong>g <strong>the</strong> currentf<strong>in</strong>ancial turmoil because it pursued a reasonable profit plan andnever chased profits to pump up its stock price or <strong>in</strong>flate its ratioslike so many Wall Street firms did over <strong>the</strong> past decade. As a sector,community banks have long adopted a strategy of steady earn<strong>in</strong>gsgrowth built on a solid bus<strong>in</strong>ess foundation.Don’t Be on <strong>the</strong> Bleed<strong>in</strong>g Edge—Never Chase Ra<strong>in</strong>bowsThe culture of community bank<strong>in</strong>g is conservative. In <strong>the</strong> eyes ofmost community bankers, only <strong>the</strong> foolish chase after ‘‘cutt<strong>in</strong>g-edgeproducts or markets.’’ As a strategy, community bankers like to beearly adapters of new <strong>in</strong>novations, but <strong>the</strong>y don’t like to be on <strong>the</strong>‘‘bleed<strong>in</strong>g edge.’’ The fundamental approach followed by <strong>the</strong> bankshighlighted here has been to be a second-generation adapter, not afirst-wave adapter. First-wave adapters tend to crash upon <strong>the</strong> rocksof <strong>in</strong>novation. That is not a strategy employed by community banks.Community banks do not chase ra<strong>in</strong>bows.Have a Strong-Willed Board Whose Members UnderstandYour Culture and Are Not Afraid to Speak Their M<strong>in</strong>dsA feature that is underappreciated by many f<strong>in</strong>ancial servicesobservers is that <strong>the</strong> typical community bank board is made up
CAM FINE 163of strong-m<strong>in</strong>ded bus<strong>in</strong>ess <strong>in</strong>dividuals who are not afraid to speak<strong>the</strong>ir m<strong>in</strong>ds. If <strong>the</strong> boards of any of <strong>the</strong> banks highlighted herebelieve that <strong>the</strong>ir managements are pursu<strong>in</strong>g flawed strategies, <strong>the</strong>yare not hesitant to speak out and take action, if necessary. The keyreason for this is because each board member has a personal<strong>in</strong>vestment and stake at risk <strong>in</strong> <strong>the</strong> <strong>in</strong>stitution. In most cases,community bank board members are key owners of <strong>the</strong> <strong>in</strong>stitution,with much of <strong>the</strong>ir personal net worth at stake. When you have ‘‘sk<strong>in</strong><strong>in</strong> <strong>the</strong> game,’’ you tend to be much more alert and sensitive to what ishappen<strong>in</strong>g <strong>in</strong> your organization.Never Overreach or Over-Leverage Your OrganizationAll three bank<strong>in</strong>g firms mentioned here never overreach or overleverage<strong>the</strong>ir firms. They know that to over-leverage a bank<strong>in</strong>g firmas a strategy has only one outcome <strong>in</strong> <strong>the</strong> long run: ru<strong>in</strong>! If onelooks beh<strong>in</strong>d each f<strong>in</strong>ancial <strong>in</strong>stitution’s failure, you will likely f<strong>in</strong>da firm that grew very rapidly and over-leveraged itself to <strong>the</strong> po<strong>in</strong>t offall<strong>in</strong>g over. As a sector, community bankers are loath to over-lever<strong>the</strong>mselves; and <strong>the</strong> success of <strong>the</strong> three banks here demonstrates thatslow, steady, and solid growth is <strong>the</strong> correct strategy to adapt. It maynot be sexy, but it is an effective and sound strategy that yields longtermresults for shareholders.Always Remember That You Are BankersA fundamental mistake and flawed strategy that <strong>the</strong> major firms onWall Street committed was that <strong>the</strong> CEOs and senior managersstopped th<strong>in</strong>k<strong>in</strong>g of <strong>the</strong>mselves as ‘‘bankers’’ and began to th<strong>in</strong>k of<strong>the</strong>mselves as ‘‘moneymen’’ or ‘‘f<strong>in</strong>anciers.’’ Big mistake. Thefundamentals of money and bank<strong>in</strong>g never change. Human naturenever changes. Once you stop th<strong>in</strong>k<strong>in</strong>g of yourself as a banker, badth<strong>in</strong>gs beg<strong>in</strong> to happen. In <strong>the</strong> community bank<strong>in</strong>g world, most
164 THRIVING IN THE NEW ECONOMYCEOs th<strong>in</strong>k of <strong>the</strong>mselves as bankers first and act on <strong>the</strong> fundamentalpr<strong>in</strong>ciples of bank<strong>in</strong>g.The eight fundamental strategies mentioned previously may seemsimple and common sense; and <strong>the</strong>y are. However, every one of<strong>the</strong>se ‘‘simple’’ bank<strong>in</strong>g strategies were violated by many of <strong>the</strong>major bank<strong>in</strong>g and <strong>in</strong>vestment houses on Wall Street and were neverfollowed by many non-bank f<strong>in</strong>ancial services providers. Thesestrategies are vital to <strong>the</strong> success of <strong>the</strong> banks I spoke about.It’s important <strong>in</strong> this new economy to stick to a formula that willkeep you focused to <strong>the</strong> goals at hand. No matter what <strong>the</strong> challenge,if you are true to your core pr<strong>in</strong>ciples, your foundation for successwill be strong.
16DonaldMarronPrivate equity <strong>in</strong>vestorand entrepreneur DonaldMarron has had hishand <strong>in</strong> <strong>the</strong> f<strong>in</strong>ancial servicesarena s<strong>in</strong>ce 1951.Donald is most noted forhis role as chairman andCEO of Pa<strong>in</strong>eWebberGroup <strong>from</strong> 1980 to2000. In 2000, Donald was <strong>the</strong> dealmaker beh<strong>in</strong>d Pa<strong>in</strong>e-Webber’s merger with UBS AG, which created <strong>the</strong> world’stop asset management firm. Today, he is thriv<strong>in</strong>g <strong>in</strong> <strong>the</strong> neweconomy with his private equity firm, Lightyear Capital,which he co-founded with his manag<strong>in</strong>g partner MarkVassallo. Specializ<strong>in</strong>g <strong>in</strong> f<strong>in</strong>ancial services companies,Lightyear Capital focuses on leveraged buyouts as wellas mak<strong>in</strong>g growth capital <strong>in</strong>vestments <strong>in</strong> f<strong>in</strong>ancial services(cont<strong>in</strong>ued)165
166 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)companies. In late spr<strong>in</strong>g of 2009, Lightyear Capital was partof a buyout consortium that <strong>in</strong>vested a total of $800 millionto acquire South Florida–based bank First Sou<strong>the</strong>rn. InNovember of 2009, Marron dove back <strong>in</strong>to <strong>the</strong> brokeragebus<strong>in</strong>ess with <strong>the</strong> acquisition of <strong>the</strong> ING Advisors networkand three of ING Advisor Networks five broker-dealers(F<strong>in</strong>ancial Network Investment Corporation, Multi-F<strong>in</strong>ancialSecurities Corporation, and PrimeVest F<strong>in</strong>ancial Services).Marron says it was a great <strong>in</strong>vestment for Lightyear, add<strong>in</strong>ghe sees great opportunity for <strong>the</strong> three firms as morecustomers and advisors migrate toward smaller, more nimble,and personalized brokerage firms <strong>in</strong> <strong>the</strong> new economy.Marron is an old-school bus<strong>in</strong>essman. He does not discussdeals until <strong>the</strong>y are officially done, a rarity <strong>in</strong> an agedur<strong>in</strong>g which private equity firms leak possible deals to <strong>the</strong>media only to see <strong>the</strong> deal blow up. It’s that standard andphilosophy that makes Marron a legend <strong>in</strong> <strong>the</strong> f<strong>in</strong>ancialservices arena, and that make his po<strong>in</strong>t of view and adviceso very valuable.When I first heard about Bear Stearns, I was <strong>in</strong> Berl<strong>in</strong> withmy family, which <strong>in</strong>cludes two small children (<strong>the</strong>n 12and 13). I was sitt<strong>in</strong>g <strong>the</strong>re watch<strong>in</strong>g television, most of which was<strong>in</strong> German. I immediately thought that this was a sem<strong>in</strong>al event,and here I was out of <strong>the</strong> United States, rely<strong>in</strong>g more on secondhandcommunication, really just bits and pieces. It was, <strong>the</strong>refore,difficult for me to sense <strong>the</strong> full scale of what was go<strong>in</strong>g on.However, it did help me to understand what <strong>the</strong> rest of <strong>the</strong> worldmight be experienc<strong>in</strong>g under those circumstances. I did th<strong>in</strong>kit was a game-chang<strong>in</strong>g event, so much so that I felt for ourresources. We had to make sure that <strong>the</strong>y were redeployed <strong>in</strong> <strong>the</strong>strongest hands.
DONALD MARRON 167We immediately began to assess whe<strong>the</strong>r Bear Stearns’ failure wasan isolated event or if this was <strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g of a cha<strong>in</strong> reaction. Inorder to determ<strong>in</strong>e that, we also had to assess what role private<strong>in</strong>dustry would play and what role <strong>the</strong> government would play. Onegreat comparison I heard was when <strong>the</strong> first bid was agreed to byJ.P. Morgan: two dollars a share to buy Bear Stearns was that <strong>the</strong> bidwas slightly more than <strong>the</strong> Yankees had paid A-Rod. So you look atthat and say, ‘‘Okay, that’s a private rescue; that’s fairly logical.’’ And<strong>the</strong>n you realize no, <strong>the</strong> government was <strong>in</strong>volved <strong>in</strong> a big way,provid<strong>in</strong>g <strong>the</strong> $29 billion non-recourse loan to J.P. Morgan to coverpossible losses on Bear Stearns’ less liquid assets. So you had to askyourself, ‘‘Where will it go?’’Bear Stearns was rescued not because it was too big to failbut ra<strong>the</strong>r because it was too <strong>in</strong>terconnected to fail; a standard manyth<strong>in</strong>k should have been applied to Lehman Bro<strong>the</strong>rs. And <strong>the</strong>effects of <strong>the</strong> acquisition were wide rang<strong>in</strong>g. Clearly, Bear Stearnswas a correspondent bus<strong>in</strong>ess that had networks and relationships,<strong>in</strong> prime brokerage, fixed <strong>in</strong>come, and <strong>the</strong> commercial realestate market.Advis<strong>in</strong>g ClientsOur clients were <strong>in</strong>terested <strong>in</strong> know<strong>in</strong>g as much as <strong>the</strong>y couldknow about what was happen<strong>in</strong>g and why. It became fairly clearthat <strong>the</strong> hous<strong>in</strong>g market, which had driven many of <strong>the</strong>se th<strong>in</strong>gs,was now a big contributor to this. You could see this <strong>in</strong> securitizations—whichled to <strong>the</strong> greater questions of: Who owned <strong>the</strong>seth<strong>in</strong>gs? Why did <strong>the</strong>y own <strong>the</strong>m? What were <strong>the</strong>y go<strong>in</strong>g to do with<strong>the</strong>m? And how was it go<strong>in</strong>g to work? So we were <strong>in</strong> touch with allof our <strong>in</strong>vestors and many of our companies. The second th<strong>in</strong>g wedid was raise <strong>the</strong> question of what k<strong>in</strong>d of portfolios you shouldhave <strong>in</strong> your own companies. We own several <strong>in</strong>surance andcasualty companies, so one of <strong>the</strong> th<strong>in</strong>gs we did immediatelywas assess <strong>the</strong>ir portfolios and get <strong>the</strong>m even more liquid.
168 THRIVING IN THE NEW ECONOMYFall of Lehman Bro<strong>the</strong>rsA lot of people share <strong>the</strong> view that <strong>the</strong> fall of Lehman Bro<strong>the</strong>rs wastruly a big shock. First of all, <strong>the</strong>re was a lot of confidence <strong>in</strong>Lehman Bro<strong>the</strong>rs’ CEO Dick Fuld; he was seen as a very ablemanager who had built <strong>the</strong> company <strong>in</strong>to <strong>the</strong> powerhouse it was.Second, <strong>the</strong>re were many weeks of speculation about whe<strong>the</strong>rLehman Bro<strong>the</strong>rs was go<strong>in</strong>g to be sold or take <strong>in</strong> a large sovereignwealth <strong>in</strong>vestment. Deep down, Fuld probably thought noth<strong>in</strong>gworse than a forced sale was go<strong>in</strong>g to happen. F<strong>in</strong>ally, <strong>the</strong>re wasshock about <strong>the</strong> way Lehman Bro<strong>the</strong>rs’ failure f<strong>in</strong>ally occurred.Right up until that weekend, many assumed that <strong>the</strong> governmentwould have to step <strong>in</strong>—not for <strong>the</strong> sake of Lehman Bro<strong>the</strong>rs itself,but because like Bear Stearns, it was l<strong>in</strong>ked to many o<strong>the</strong>r f<strong>in</strong>ancial<strong>in</strong>stitutions,both<strong>in</strong>thiscountryandaround<strong>the</strong>world.When<strong>the</strong>government did not step <strong>in</strong>, <strong>the</strong> Law of Un<strong>in</strong>tended Consequencestook over.United States Seizes Control of AIGThe AIG shock was equally big—if not bigger—than LehmanBro<strong>the</strong>rs’ bankruptcy. AIG had a reputation as an extraord<strong>in</strong>aryfirm under CEO Hank Greenberg’s leadership. This was a trulyglobal firm, with some of its orig<strong>in</strong>s <strong>in</strong> Ch<strong>in</strong>a. AIG touched tens ofmillions of people <strong>in</strong> <strong>the</strong> United States. The most ironic part aboutits fall was that its ma<strong>in</strong> bus<strong>in</strong>ess, <strong>in</strong>surance, <strong>in</strong>herently assumesstability. Insurance basically means that failure won’t happen; andeven if it does, you will be protected. And here was <strong>the</strong> nation’slead<strong>in</strong>g <strong>in</strong>surance company—seen by many people as <strong>the</strong> lead<strong>in</strong>gassessor of risk—fall<strong>in</strong>g to pieces.The government’s seizure of AIG didn’t impact Lightyear’sportfolio directly, but we own several companies (albeit much smallerthan AIG) that were <strong>in</strong> <strong>the</strong> property and casualty bus<strong>in</strong>ess. AIG wassuch a big player that we immediately started ask<strong>in</strong>g ourselves and
DONALD MARRON 169our companies to understand what <strong>the</strong> competitive landscape wouldlook like without AIG, and if we were positioned well.All of AIG’s problems raised <strong>the</strong> fundamental issue of <strong>the</strong> value ofguarantees, <strong>in</strong>surance, and credit default swaps. We all knew that<strong>the</strong> growth <strong>in</strong> credit default swaps was outstripp<strong>in</strong>g growth <strong>in</strong> anyo<strong>the</strong>r area of f<strong>in</strong>ancial products, and many of us questioned what<strong>the</strong> eventual impact would be. AIG’s failure to deal with <strong>the</strong> weightof its credit default swaps demonstrated to <strong>the</strong> world for <strong>the</strong> firsttime what impact <strong>the</strong>se contracts could have on a big company. Itput all organizations that held <strong>the</strong>se products on alert.A Crisis Like No O<strong>the</strong>rCrises <strong>in</strong> <strong>the</strong> f<strong>in</strong>ancial services <strong>in</strong>dustry, where I have been <strong>in</strong>volvedfor my entire career, happen periodically; and although <strong>the</strong>y neverlook <strong>the</strong> same, <strong>the</strong>y usually have <strong>the</strong> same impact. However, thiscrisis was different. Most of <strong>the</strong> prior crises were more or less led by<strong>the</strong> stock market. This one was <strong>the</strong> first fixed-<strong>in</strong>come and credit crisison a global basis. One of <strong>the</strong> pr<strong>in</strong>cipal factors that accelerated and<strong>in</strong>tensified this crisis was <strong>the</strong> fact that many of <strong>the</strong>se supposedlyliquid assets packaged by <strong>the</strong> banks and bought by <strong>in</strong>vestorsthroughout <strong>the</strong> world were <strong>in</strong> fact illiquid. Securitization of retailmortgages had become a very attractive <strong>in</strong>vestment product for<strong>in</strong>vestors. As a result, banks found <strong>in</strong>creas<strong>in</strong>g <strong>in</strong>centives and pressureto generate mortgages more and more quickly.Banks went <strong>from</strong> th<strong>in</strong>k<strong>in</strong>g of loans not as 30-year loans but as 45-to 60-day loans, and <strong>the</strong>y were hold<strong>in</strong>g <strong>the</strong>m just long enough for<strong>the</strong>m to be securitized and sold. In some cases, this resulted <strong>in</strong> lowerlend<strong>in</strong>g standards and lower credit standards, as <strong>the</strong>y focused more<strong>in</strong>tensely on high-marg<strong>in</strong> securitization revenue. Of course, <strong>the</strong> daycame when buyers were not <strong>in</strong>terested <strong>in</strong> <strong>the</strong>se products, and <strong>the</strong>banks were forced to keep <strong>the</strong> loans. The whole issue of liquidsecurities (whole mortgages) becom<strong>in</strong>g illiquid securities (mortgagebackedsecurities) contributed substantially to <strong>the</strong> crisis.
170 THRIVING IN THE NEW ECONOMYThis situation was exacerbated by <strong>the</strong> fact that <strong>the</strong> rat<strong>in</strong>g agencieshad assigned triple-A rat<strong>in</strong>gs to most of <strong>the</strong>se securitizations.Ultimately, we discovered that even <strong>the</strong> rat<strong>in</strong>g agencies did notreally fully understand <strong>the</strong> construction of <strong>the</strong>se securities, nor were<strong>the</strong>y able to measure <strong>the</strong> <strong>in</strong>herent value of liquidity.Wall Street, which was built over <strong>the</strong> past 100 years on <strong>the</strong>premise of mak<strong>in</strong>g illiquid assets liquid, had f<strong>in</strong>ally found a way tomake liquid assets illiquid. Mortgages on <strong>the</strong>ir own were highlysalable; mortgages packaged <strong>in</strong>to securitization became virtuallyunsalable toxic assets.Seiz<strong>in</strong>g OpportunityAfter we made an <strong>in</strong>vestment <strong>in</strong> Lloyd’s-based <strong>in</strong>surance companyAntares <strong>in</strong> late 2007, our <strong>in</strong>vestment committee began discuss<strong>in</strong>g<strong>the</strong> <strong>in</strong>vestment and operat<strong>in</strong>g risks that we and our portfoliocompanies would face <strong>in</strong> <strong>the</strong> com<strong>in</strong>g year. Once we felt comfortablethat we were protected <strong>in</strong> <strong>the</strong> com<strong>in</strong>g environment and had madesure that <strong>the</strong> portfolios of our <strong>in</strong>surance companies were liquid, wecarefully began review<strong>in</strong>g new <strong>in</strong>vestment opportunities. Our earlyconclusion was that <strong>the</strong> crisis was yet to play out to its full extent andthat given <strong>the</strong> Law of Un<strong>in</strong>tended Consequences, it would be veryhard to predict how broad <strong>the</strong> impact would be or how long it wouldlast. Therefore, we concluded that we should look at as manyopportunities as possible but make no <strong>in</strong>vestments unless <strong>the</strong>ywere especially compell<strong>in</strong>g. Among <strong>the</strong> opportunities we werereview<strong>in</strong>g, <strong>the</strong> bank<strong>in</strong>g <strong>in</strong>dustry stood out as an area of real <strong>in</strong>terest.In this context, we made only one <strong>in</strong>vestment <strong>in</strong> a company calledHigher One, which processes <strong>the</strong> proceeds of student loans. HigherOne is a very high growth company and has been relatively unaffectedby <strong>the</strong> crisis. We did, however, use <strong>the</strong> situation to study opportunities<strong>in</strong> <strong>in</strong>surance, bank<strong>in</strong>g, and money management, th<strong>in</strong>k<strong>in</strong>g that each of<strong>the</strong>se areas would be affected by this crisis—and <strong>in</strong> some of <strong>the</strong>se cases,might even provide good opportunities.
DONALD MARRON 171One of <strong>the</strong> first th<strong>in</strong>gs Lightyear did was assess <strong>the</strong> <strong>in</strong>vest<strong>in</strong>gopportunities <strong>in</strong> <strong>the</strong> bank<strong>in</strong>g <strong>in</strong>dustry. Early <strong>in</strong> 2008, our <strong>in</strong>vestmentcommittee decided that <strong>in</strong> order to take advantage of <strong>the</strong>seopportunities, Lightyear needed to assign a team of partners tofully understand <strong>the</strong> landscape and <strong>the</strong> risks with<strong>in</strong> <strong>the</strong> bank<strong>in</strong>gsystem. So <strong>the</strong>y got to work by call<strong>in</strong>g more than 200 banks andmeet<strong>in</strong>g with <strong>the</strong> managements of over 100 banks. It was a very<strong>in</strong>terest<strong>in</strong>g exercise, not just because of <strong>the</strong> deal possibilities, butbecause it gave us <strong>the</strong> chance to learn more about what wasimportant to bankers and what was important to <strong>the</strong>ir clients. Itgave us more <strong>in</strong>formation and put us <strong>in</strong> a good position to act whenwe felt <strong>the</strong> time was right.In our first meet<strong>in</strong>gs <strong>in</strong> late 2007 and early 2008 with <strong>the</strong>managements, we found most of <strong>the</strong>m say<strong>in</strong>g that <strong>the</strong>y really didn’tth<strong>in</strong>k <strong>the</strong>y were go<strong>in</strong>g to be affected by <strong>the</strong> situation and that <strong>the</strong>ywere not <strong>in</strong>terested <strong>in</strong> seek<strong>in</strong>g additional capital. Although we didn’tagree with this, we believed that we simply had to bide our time.Then, as <strong>the</strong> crisis unfolded <strong>in</strong> September and October 2008, <strong>the</strong>banks began to believe that <strong>the</strong>y might need capital, but <strong>the</strong>ythought <strong>the</strong>y could obta<strong>in</strong> it <strong>from</strong> <strong>the</strong> government (Troubled AssetRelief Program [TARP]) and get it cheaper and perhaps even moreeasily than <strong>the</strong>y could <strong>from</strong> private equity. Then months later, <strong>the</strong>ybegan to th<strong>in</strong>k that maybe tak<strong>in</strong>g money <strong>from</strong> <strong>the</strong> governmentwasn’t such a good idea after all. F<strong>in</strong>ally, <strong>the</strong>y decided that <strong>the</strong>y didneed private capital.This came a year after <strong>the</strong> United States and o<strong>the</strong>r countries beganfeel<strong>in</strong>g, <strong>in</strong>crementally, <strong>the</strong> impact of this crisis: <strong>the</strong> drastic sw<strong>in</strong>gs<strong>in</strong> <strong>the</strong> stock and bond markets, reduction <strong>in</strong> <strong>the</strong> availability of credit,decl<strong>in</strong>e <strong>in</strong> <strong>the</strong> price of houses, and grow<strong>in</strong>g unemployment. So <strong>the</strong>impact on <strong>the</strong>se community and local banks mirrored what wasoccurr<strong>in</strong>g throughout <strong>the</strong> country.In fact, we announced our first bank deal <strong>in</strong> May 2009. Lightyearand two o<strong>the</strong>r firms would be <strong>the</strong> major <strong>in</strong>vestors <strong>in</strong> an $800 million<strong>in</strong>fusion <strong>in</strong>to a Florida bank called First Sou<strong>the</strong>rn. This is essentially
172 THRIVING IN THE NEW ECONOMYa small, relatively healthy bank that we believe will serve as aplatform for rapid growth through <strong>the</strong> acquisition of <strong>the</strong> assetsand deposits of troubled banks <strong>in</strong> Florida.There will be big opportunities <strong>in</strong> <strong>the</strong> f<strong>in</strong>ancial services <strong>in</strong>dustrythat are a direct result of this crisis. In private equity, transactionswill not be done as a result of leverage or f<strong>in</strong>ancial eng<strong>in</strong>eer<strong>in</strong>g thistime around. Instead, you’ll see private equity focus<strong>in</strong>g more on costcontrols, growth opportunities, and operational improvements.Management leverage will replace f<strong>in</strong>ancial leverage.Investment LandscapeAs I said earlier, <strong>the</strong>re are at least three major areas <strong>in</strong> f<strong>in</strong>ancialservices that are important to <strong>the</strong> economy (and to bus<strong>in</strong>esses andconsumers)—all of which have gone through serious problems:banks, <strong>in</strong>surance companies, and asset managers.Banks, are <strong>the</strong> highest profile and clearly have been <strong>the</strong> majorfocus of <strong>the</strong> past and current adm<strong>in</strong>istrations. They will be directlyaffected <strong>the</strong> most by <strong>the</strong> regulatory changes that are be<strong>in</strong>g proposed.There are more than 8,000 banks <strong>in</strong> <strong>the</strong> United States, many moreper capita than <strong>in</strong> any country <strong>in</strong> <strong>the</strong> world. Most of <strong>the</strong>se banks are,<strong>in</strong> fact, healthy, but all of <strong>the</strong>m are impacted by recent events. Fromour po<strong>in</strong>t of view, all this <strong>in</strong>formation about <strong>the</strong> bank<strong>in</strong>g systempo<strong>in</strong>ted out one central thought—community and local banks nowserve an even more important purpose: mak<strong>in</strong>g loans to buy housesand mak<strong>in</strong>g loans to small bus<strong>in</strong>esses <strong>in</strong> <strong>the</strong>ir communities. In bothcases, funds for <strong>the</strong>se loans were drastically reduced; even today wehave no <strong>in</strong>dication that credit has loosened up enough to meet <strong>the</strong>demands that are necessary for consumers and bus<strong>in</strong>esses. There is abig opportunity to provide additional capital to <strong>the</strong>se banks to meet<strong>the</strong> demands to make good loans <strong>in</strong> both areas.The second area is <strong>in</strong>surance. As I said, AIG had a big impact on<strong>the</strong> <strong>in</strong>surance <strong>in</strong>dustry. The <strong>in</strong>surance model, particularly <strong>in</strong> <strong>the</strong>property and casualty bus<strong>in</strong>ess, is based on writ<strong>in</strong>g <strong>in</strong>surance <strong>in</strong> a
DONALD MARRON 173profitable way and successfully <strong>in</strong>vest<strong>in</strong>g <strong>the</strong> capital <strong>the</strong>y get <strong>from</strong><strong>the</strong> <strong>in</strong>surance premiums. Both of <strong>the</strong>se areas were hard hit <strong>in</strong> 2008.On <strong>the</strong> liability side, companies were hit by two devastat<strong>in</strong>ghurricanes: Ike and Gustav. And, of course, <strong>the</strong>ir portfolios experiencedsubstantial decl<strong>in</strong>es <strong>in</strong> <strong>the</strong> stock and fixed-<strong>in</strong>come markets.None<strong>the</strong>less, many of <strong>the</strong>se bus<strong>in</strong>esses (<strong>in</strong>clud<strong>in</strong>g ours) were strong,solid bus<strong>in</strong>esses that provide essential services. We see real opportunitieshere, partly because rates are start<strong>in</strong>g to go up due to <strong>the</strong>reduced available capital <strong>in</strong> <strong>the</strong> <strong>in</strong>dustry and partly because <strong>the</strong>re is<strong>in</strong>creased technology that is available to manage risk. We currentlyown parts of four <strong>in</strong>surance companies, and we may consideradditional opportunities.The third area is asset management. With <strong>the</strong> stock market downas much as 30 to 40 percent and fixed-<strong>in</strong>come markets <strong>in</strong> disarray,most asset managers have seen substantial decl<strong>in</strong>es <strong>in</strong> <strong>the</strong> value of<strong>the</strong>ir portfolios. After <strong>the</strong> events of 2008, clients rout<strong>in</strong>ely open <strong>the</strong>irstatements to f<strong>in</strong>d 30 to 50 percent reductions <strong>in</strong> <strong>the</strong>ir equityportfolios. College endowments and pensions saw decl<strong>in</strong>es of 25to 40 percent. This, of course, has had a big impact on <strong>the</strong> life of<strong>in</strong>dividuals and <strong>in</strong>stitutions. Colleges have had to cut back spend<strong>in</strong>gand had bond issues because of <strong>the</strong> lack of liquidity <strong>in</strong> <strong>the</strong> markets;pension plan managers have had concerns about how <strong>the</strong>y are go<strong>in</strong>gto meet <strong>the</strong>ir payments; and <strong>in</strong>dividuals have lost substantialamounts of money.Individuals <strong>in</strong> particular have felt this more than any prior crisis,because this has been <strong>the</strong> first 401(k) crisis. We live <strong>in</strong> a world of 50million self-adm<strong>in</strong>istered pension plan managers. So ra<strong>the</strong>r than justbe<strong>in</strong>g spectators or <strong>in</strong>directly affected, <strong>in</strong>dividuals have been directlyaffected and are postpon<strong>in</strong>g retirement, reth<strong>in</strong>k<strong>in</strong>g lifestyles, andcutt<strong>in</strong>g spend<strong>in</strong>g altoge<strong>the</strong>r. This means <strong>the</strong>re is an importantopportunity <strong>in</strong> asset management. The creditability of asset managersis at a new low, but <strong>the</strong> necessity for <strong>the</strong>ir services is, <strong>in</strong> manyways, at a new high. All f<strong>in</strong>ancial assets have to and are now go<strong>in</strong>g tobe managed <strong>in</strong> <strong>the</strong> context of this crash.
174 THRIVING IN THE NEW ECONOMYTransparency and Restructur<strong>in</strong>g PositivesObviously, this k<strong>in</strong>d of f<strong>in</strong>ancial crisis is go<strong>in</strong>g to stimulate newregulation. In fact, as of this writ<strong>in</strong>g, <strong>the</strong> president has proposed anextensive overhaul of how banks, <strong>in</strong>surance companies, and o<strong>the</strong>rf<strong>in</strong>ancial service companies and <strong>the</strong>ir products are currently regulated.I hope <strong>the</strong> three ma<strong>in</strong> pr<strong>in</strong>ciples are embodied <strong>in</strong> <strong>the</strong> debate.First, <strong>in</strong> terms of <strong>in</strong>vest<strong>in</strong>g, it is essential that we have transparency.If you know what you are buy<strong>in</strong>g and what you are sell<strong>in</strong>g, and youknow what you are manag<strong>in</strong>g, <strong>the</strong>n you can do well. This k<strong>in</strong>d oftransparency was miss<strong>in</strong>g, particularly <strong>in</strong> terms of securitization.Second, we need to somehow limit <strong>the</strong> degree of complexity ofsecuritized products and derivatives. Third, to ensure that <strong>in</strong>vestorsrega<strong>in</strong> confidence <strong>in</strong> <strong>the</strong>se <strong>in</strong>stitutions, we need to make sure that<strong>the</strong> issuers and <strong>the</strong> market makers of <strong>the</strong> securities are properlycapitalized to cover <strong>the</strong>ir positions and restra<strong>in</strong> <strong>the</strong>m <strong>from</strong> tak<strong>in</strong>gon excessive leverage. Specific proposals should <strong>the</strong>refore <strong>in</strong>cluderequirements that: (1) issuers of securitizations hold at least 5percent <strong>in</strong> <strong>the</strong>ir own account of each security <strong>the</strong>y package and sell;(2) market makers <strong>in</strong> derivatives have enough liquid capital (muchmore than today) to have a cushion <strong>from</strong> what <strong>the</strong>y are do<strong>in</strong>g; and(3) complex f<strong>in</strong>ancial products are standardized so that <strong>the</strong>y can belisted on exchanges.Lay of <strong>the</strong> Economic LandBeg<strong>in</strong>n<strong>in</strong>g at <strong>the</strong> end of <strong>the</strong> first quarter of 2009, <strong>the</strong> underly<strong>in</strong>geconomic environment was experienc<strong>in</strong>g improvements. A bigpart of <strong>the</strong> stock market recovery stems <strong>from</strong> <strong>the</strong> fact that we knowmore because we have more tools. A good example is <strong>the</strong> stress teston <strong>the</strong> banks. You can question whe<strong>the</strong>r <strong>the</strong>y were tough enough,but what is def<strong>in</strong>ite is that <strong>the</strong> world now knows a lot moreabout <strong>the</strong>se banks than <strong>the</strong>y ever knew before, and <strong>the</strong>re is realvalue <strong>in</strong> this. Transparency will give <strong>in</strong>vestors more confidence <strong>in</strong>
DONALD MARRON 175<strong>the</strong> system, even if it doesn’t give <strong>the</strong>m more <strong>in</strong>centive to <strong>in</strong>vestright now.The consumer drives <strong>the</strong> American economy, and <strong>the</strong> averageAmerican consumer is very smart. Hav<strong>in</strong>g run Pa<strong>in</strong>eWebber andsee<strong>in</strong>g consumers <strong>in</strong> action, I’m not sure <strong>the</strong>y’ve been given enoughcredit. At <strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g of this crisis <strong>in</strong> August and September, <strong>the</strong>consumers decided someth<strong>in</strong>g was wrong, stopped spend<strong>in</strong>g, andstarted sav<strong>in</strong>g. They cut spend<strong>in</strong>g by 20 to 25 percent, push<strong>in</strong>g <strong>the</strong>sav<strong>in</strong>gs rates <strong>from</strong> noth<strong>in</strong>g to 4 to 5 percent.Is that a fundamental change <strong>in</strong> <strong>the</strong> trend? Or is this just a savvyreaction to difficulties now supplanted by different worries such asunemployment and hous<strong>in</strong>g values, and <strong>the</strong>n down <strong>the</strong> road of <strong>the</strong>fear of <strong>in</strong>flation? I am an optimist, so I th<strong>in</strong>k we will work our wayout of this and return to a 3 to 4 percent growth rate. But it couldvery well be two or three years before that happens, and it is go<strong>in</strong>gto feel like a long two or three years. So much of <strong>the</strong> recoverydepends on <strong>the</strong> confidence of Americans, and <strong>the</strong> president has abig role to play <strong>in</strong> that.So what has changed? Investors, bus<strong>in</strong>esspeople, and consumershave gone <strong>from</strong> worry<strong>in</strong>g about disaster to assess<strong>in</strong>g <strong>the</strong> presentand <strong>the</strong> future. The analysis of <strong>the</strong> bank has gone <strong>from</strong>, ‘‘Will thisbank be <strong>in</strong> bus<strong>in</strong>ess next year?’’ to ‘‘How much can this bank earn<strong>in</strong> this climate?’’ Consumers and <strong>in</strong>vestors who were orig<strong>in</strong>allyfeel<strong>in</strong>g <strong>the</strong>y had to have all <strong>the</strong>ir money <strong>in</strong> cash or gold are nowonce aga<strong>in</strong> consider<strong>in</strong>g <strong>in</strong>vest<strong>in</strong>g, but very cautiously.You cannot solve a hous<strong>in</strong>g crisis until you get buyers, andwe don’t really have enough programs to stimulate buyers yet.Ultimately, we need credit. I believe we will start to see creditbecome available by <strong>the</strong> end of 2009.Bottom L<strong>in</strong>eWe need to address <strong>the</strong> three issues <strong>in</strong> order to solve this crisis. Thefirst is that although <strong>the</strong> government has saved <strong>the</strong> banks, it hasn’t
176 THRIVING IN THE NEW ECONOMYfixed <strong>the</strong>m yet. Second, <strong>the</strong> hous<strong>in</strong>g crisis got us <strong>in</strong>to this, andsolv<strong>in</strong>g it will get us out of it. Third, s<strong>in</strong>ce <strong>the</strong> consumer drives<strong>the</strong> American economy, <strong>the</strong>re has to be a constructive return ofconfidence and will<strong>in</strong>gness to commit.These issues need to be confronted simultaneously. More importantly,<strong>the</strong> president’s stimulus plan and <strong>the</strong> Federal Reserve’s fiscaland monetary policies have to be seen as actually affect<strong>in</strong>g <strong>in</strong>dividuals.We will see <strong>the</strong> effects actually work<strong>in</strong>g when <strong>the</strong> consumerssay, ‘‘Yes, that plan helped me to buy this house’’ (or get this jobor get a student loan for my kids). There is not a lot of that yet, butit is <strong>in</strong> its early days.This environment has created a whole new world of possibilities.The American spirit of optimism will prevail.
Part ThreeReal Estate
17RichardLeFrakThe boom and catastrophicbust of <strong>the</strong>real estate market willbe studied by bus<strong>in</strong>essm<strong>in</strong>ds for years to come.Now we are faced withano<strong>the</strong>r crisis: <strong>the</strong> lack offund<strong>in</strong>g for commercialloans. One of my favoritereal estate contactsthat’s <strong>in</strong> both residentialand commercial realestate is Richard LeFrak,chairman and CEO of <strong>the</strong> LeFrak Organization. Richard isfac<strong>in</strong>g headw<strong>in</strong>ds <strong>from</strong> two sides, and is able to navigatearound <strong>the</strong> challenges and see opportunities to growhis portfolio.(cont<strong>in</strong>ued)179
180 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)Richard LeFrak comes <strong>from</strong> a dynasty of entrepreneurs.His grandfa<strong>the</strong>r Harry orig<strong>in</strong>ally created glassworks forLouis Comfort Tiffany, and <strong>in</strong> <strong>the</strong> early 1900s, he begandevelop<strong>in</strong>g <strong>New</strong> York City real estate. Soon after WorldWar II, Richard’s fa<strong>the</strong>r, Sam, began develop<strong>in</strong>g <strong>the</strong> companyfur<strong>the</strong>r by build<strong>in</strong>g apartment houses throughout<strong>New</strong> York City and <strong>New</strong> Jersey. In 1959, he began develop<strong>in</strong>gLeFrak City <strong>in</strong> Queens, a vast complex of 5,000apartments <strong>in</strong> twenty 18-story build<strong>in</strong>gs on 42 acres ofland along <strong>the</strong> Long Island Expressway.In <strong>the</strong> 1970s, Richard jo<strong>in</strong>ed <strong>the</strong> family bus<strong>in</strong>ess. Soon,under his supervision, <strong>the</strong> company began develop<strong>in</strong>g <strong>the</strong>92-acre Manhattan landfill to be known as Battery Park Cityand build<strong>in</strong>g its first 1,700 luxury apartments. S<strong>in</strong>ce <strong>the</strong>mid-1980s, <strong>the</strong> LeFrak Organization has been develop<strong>in</strong>g<strong>New</strong>port, <strong>the</strong> largest and most successful waterfront community<strong>in</strong> <strong>the</strong> United States, on several hundred acres on<strong>the</strong> Jersey City bank of <strong>the</strong> Hudson River. To date, morethan 15 million square feet have been completed, alongwith apartments for approximately 5,000 families, officespace for more than 20,000 employees, shopp<strong>in</strong>g facilitiesfor more than 2 million annual visitors, two major hotels, amar<strong>in</strong>a, parks, schools, and even an ice-skat<strong>in</strong>g r<strong>in</strong>k.Richard is more than just a <strong>New</strong> York area developerand builder. The LeFrak portfolio <strong>in</strong>cludes a worldwiderange of f<strong>in</strong>ancial <strong>in</strong>vestments, real estate <strong>in</strong> Los Angelesand London, and <strong>in</strong>terests <strong>in</strong> oil and gas wells, as wellas w<strong>in</strong>d energy production. LeFrak made news <strong>in</strong> May2009, when <strong>the</strong> <strong>in</strong>vest<strong>in</strong>g group that he was a part ofbecame owners of <strong>the</strong> Florida bank BankUnited, whichwas seized by <strong>the</strong> Federal Deposit Insurance Corporation(FDIC). The group put up $900 million <strong>in</strong> new capital<strong>in</strong>to <strong>the</strong> failed bank, which got dragged down <strong>in</strong> <strong>the</strong>real estate undertow.
RICHARD LEFRAK 181Richard is a natural when it comes to <strong>in</strong>terviews, which isironic consider<strong>in</strong>g that he never really ‘‘did TV’’ until heappeared on my show. I knew <strong>from</strong> my first pre-<strong>in</strong>terviewthat he would be great, and to this day, he has neverdisappo<strong>in</strong>ted our viewers. He has <strong>the</strong> ability to connectwith people because he can break down a complex situation<strong>in</strong>to a story that people can relate to. His stories oftenare harb<strong>in</strong>gers of th<strong>in</strong>gs to come.My story of <strong>the</strong> market meltdown actually takes me back toAugust 2007 with an anecdote that, <strong>in</strong> h<strong>in</strong>dsight, shouldhave been <strong>the</strong> first <strong>in</strong>dication of what our <strong>in</strong>dustry and <strong>the</strong> nationmight be fac<strong>in</strong>g. It was a clue that was so obvious that I should haverealized what was about to happen, even if <strong>the</strong> reality would bedifficult to accept.I’m a member of a Long Island golf club where <strong>the</strong>re’s a caddiewho we’ll call ‘‘Jimmy’’ for <strong>the</strong> sake of anonymity. He’s <strong>in</strong> his early50s, has 14 or 15 children, and makes his liv<strong>in</strong>g full time as a caddie.I would help him out <strong>from</strong> time to time if he was hav<strong>in</strong>g moneyproblems. Sometime <strong>in</strong> late summer 2007, Jimmy came to me andsaid, ‘‘Mr. LeFrak, I have a great opportunity to buy a house.’’ Iasked him where <strong>the</strong> house was, and he said <strong>in</strong> <strong>the</strong> Bronx. He <strong>the</strong>nwanted me to consider lend<strong>in</strong>g him $5,000 for a down payment. Iasked Jimmy how much <strong>the</strong> house would cost. He said $800,000. Abit startled, I asked, ‘‘Where would you get <strong>the</strong> money to do that?’’Given his circumstances, it sounded like a large amount of moneyfor somebody who would not have <strong>the</strong> down payment or <strong>in</strong>comenecessary to purchase an $800,000 home. His answer was that <strong>the</strong>broker who was sell<strong>in</strong>g him <strong>the</strong> house reassured him that he couldget him a mortgage.This was a graphic example of <strong>the</strong> aggressive nature of <strong>the</strong>subprime mortgage market at that time, and I should have realizedthat it might be lead<strong>in</strong>g to a giant f<strong>in</strong>ancial downfall. I should
182 THRIVING IN THE NEW ECONOMYhave acted by sell<strong>in</strong>g everyth<strong>in</strong>g I owned, because it was a clear signalthat we had really gone over <strong>the</strong> edge <strong>in</strong> terms of how we wereallocat<strong>in</strong>g credit.The follow<strong>in</strong>g year, <strong>in</strong> 2008, <strong>the</strong>re were a number of very highlypriced transactions <strong>in</strong> <strong>the</strong> real estate bus<strong>in</strong>ess, <strong>in</strong>clud<strong>in</strong>g <strong>the</strong>purchase of Equity Office Properties and Stuyvesant Town.Both were multibillion dollar dealsaccomplishedwithanenormousamount of leverage. Aga<strong>in</strong>, <strong>the</strong>se were clear signals thatreality had escaped <strong>the</strong> credit markets. As long as you could comeup with any idea, <strong>the</strong>re was someone to lend you money to achieveit. After hav<strong>in</strong>g been <strong>in</strong> <strong>the</strong> bus<strong>in</strong>ess for so many years, I should<strong>in</strong>st<strong>in</strong>ctively have been aware of this mushroom<strong>in</strong>g dilemma. DidI act as I should have? No, I did not. We did sell a portfolio ofbuild<strong>in</strong>gs <strong>in</strong> 2007 and 2008, someth<strong>in</strong>g we rarely do. But, <strong>in</strong>h<strong>in</strong>dsight,IrealizeIdidn’tdoasmuchasIshouldhavetotakeadvantage of <strong>the</strong> leverage mania.Putt<strong>in</strong>g a Strategy Toge<strong>the</strong>r Post–Lehman Bro<strong>the</strong>rsIt’s also ironic that Lehman Bro<strong>the</strong>rs went under a few days after Iappeared on CNBC’s Squawk Box on September 11 with my dearfriend, and former head of Shearson Lehman, Peter Cohen. Thesubject of Lehman Bro<strong>the</strong>rs’ solvency was discussed on <strong>the</strong> air thatday, because everybody was concerned about <strong>the</strong> firm’s ability tosurvive. Unfortunately, Lehman Bro<strong>the</strong>rs didn’t make it. In retrospect,that too was probably <strong>the</strong> biggest mistake that <strong>the</strong> f<strong>in</strong>ancialregulators made—lett<strong>in</strong>g Lehman Bro<strong>the</strong>rs go under—because <strong>the</strong>credit markets obviously froze up; <strong>the</strong> panic set <strong>in</strong>, and we crepttoward <strong>the</strong> edge of <strong>the</strong> abyss of <strong>the</strong> f<strong>in</strong>ancial system as we had knownit. My reaction after that terrible event was to take stock of mycompany’s assets and to try to f<strong>in</strong>d out where all our cash was. Whowas hold<strong>in</strong>g it? What were our short-term <strong>in</strong>vestments? We tried toidentify, reorganize, and put our cash <strong>in</strong> extremely safe <strong>in</strong>struments.
RICHARD LEFRAK 183Everyone <strong>in</strong> my company’s f<strong>in</strong>ancial department—controller,treasurer, and chief <strong>in</strong>vestment officer—was told to catalog explicitlynot only how <strong>the</strong> money was <strong>in</strong>vested but who was hold<strong>in</strong>g it andhow it was be<strong>in</strong>g held; for example, <strong>in</strong> what street name or <strong>in</strong> whatcustody accounts? And where were <strong>the</strong>se custody accounts? Althoughwe didn’t panic, <strong>the</strong>re was a sense of urgency, and thatprocess took several weeks to complete.Manag<strong>in</strong>g Through <strong>the</strong> Credit CrisisWhen <strong>the</strong> credit crisis emerged, I thought that I would have toreserve my liquidity for my bus<strong>in</strong>ess to pay down loans as <strong>the</strong>ycame due. I did not believe that banks, with <strong>the</strong>ir restrictedbalance sheets, would be <strong>in</strong> a position to ref<strong>in</strong>ance exist<strong>in</strong>gamounts of many loans. I always keep a conservative loanbook; that’s one of <strong>the</strong> reasons why we’ve been able to stay <strong>in</strong>bus<strong>in</strong>ess as long as we have. We always believe that loans have toamortize. I don’t believe <strong>in</strong> stand<strong>in</strong>g loans that just pay <strong>in</strong>terest. Inever did any securitized f<strong>in</strong>anc<strong>in</strong>g. I always want to be able to lookmylender<strong>in</strong><strong>the</strong>eye,especiallyifIhaveanyproblems.Myloanswere made through <strong>in</strong>surance companies, banks, and pensionfunds. Still, we were very careful with schedul<strong>in</strong>g our liabilitiesto make sure that as loans came due (and fortunately, we didn’thave very much happen<strong>in</strong>g <strong>in</strong> 2009), we would have <strong>the</strong> liquidityto pay <strong>the</strong>m down to a level to keep banks happy. In real propertyf<strong>in</strong>ance, you have to differentiate between commercial and multifamilyresidential assets.The Commercial Apartment House F<strong>in</strong>anc<strong>in</strong>g market is <strong>the</strong>beneficiary of Fannie Mae and Freddie Mac government creditsupport. An active f<strong>in</strong>anc<strong>in</strong>g market is available <strong>in</strong> apartmenthouse product, as long as it fits with<strong>in</strong> <strong>the</strong>ir criteria, and mostof our residential properties fit with<strong>in</strong> that envelope. On <strong>the</strong> o<strong>the</strong>rhand,offices,retailspace,andhotelsdonothave<strong>the</strong>benefitof
184 THRIVING IN THE NEW ECONOMYFannie Mae or Freddie Mac. Those are situations where we mustdeal with traditional lenders or securitized loans. Securitized loans,for all <strong>in</strong>tents and purposes, ceased at <strong>the</strong> end of 2008, creat<strong>in</strong>g anacute need for capital. At this po<strong>in</strong>t, capital and <strong>the</strong> structure fordispers<strong>in</strong>g capital virtually do not exist.I always took loans that are highly conservative by <strong>the</strong> standards ofo<strong>the</strong>r real estate companies. That also meant that I was not asaggressive as o<strong>the</strong>r people who had been participat<strong>in</strong>g <strong>in</strong> <strong>the</strong> bubbleof leverage dur<strong>in</strong>g <strong>the</strong> past five years.Assess<strong>in</strong>g Liabilities and Creat<strong>in</strong>g OpportunitiesRightafter<strong>the</strong>bubbleburst,weimmediately reviewed <strong>the</strong> liabilityside of our balance sheet. We asked ourselves what obligations wefaced and how we would cover <strong>the</strong>m. Cash would have to beavailable <strong>in</strong> case we were challenged. Once we realized <strong>the</strong> problemwas pass<strong>in</strong>g—and we had sufficient work<strong>in</strong>g capital and cash <strong>in</strong> <strong>the</strong>bus<strong>in</strong>ess—we began focus<strong>in</strong>g on what we were prepared to do next<strong>in</strong> <strong>the</strong> market. I was particularly concerned because although we’vecoped with downturns <strong>in</strong> <strong>the</strong> past, none had ever been quite asformidable as this. We faced problems <strong>in</strong> 1973, 1974, <strong>in</strong> <strong>the</strong> early1980s and early 1990s, when <strong>the</strong> real estate bus<strong>in</strong>ess had beenseverely affected. There would be <strong>the</strong> <strong>in</strong>evitable impact on generalmarket demand; rent rolls and cash flow would suffer. I knew that Iwouldhavetomakeupforthat.So we <strong>in</strong>vested our free cash <strong>in</strong> a way that ensured that wewould have sufficient reserves to support <strong>the</strong> core bus<strong>in</strong>ess. I beganstudy<strong>in</strong>g opportunities that were becom<strong>in</strong>g available. For a while,high rates of return were available through reasonably safe debt<strong>in</strong>struments. Members of my staff were busy <strong>in</strong>vestigat<strong>in</strong>g <strong>the</strong> manyopportunities presented to <strong>the</strong>m. Then <strong>the</strong>y would meet with me ormy two sons, Harrison and Jamie, on a regular basis to discuss
RICHARD LEFRAK 185potential <strong>in</strong>vestments. Sometime <strong>in</strong> late October or early November,when yields on municipals had reached high levels, we decidedthat we would <strong>in</strong>vest <strong>in</strong> some long-term, high-quality bonds. We<strong>in</strong>vested several hundred millions of dollars <strong>in</strong> <strong>the</strong>se <strong>in</strong>struments,which we determ<strong>in</strong>ed to be substantially safe.The rationale for <strong>the</strong> <strong>in</strong>vestment was quite simple. Yields onsome tax-free <strong>in</strong>vestments had reached 7 to 8 percent per annum,which equaled 14 to 16 percent on comparable taxable bonds.Many of <strong>the</strong>se bonds were backed by <strong>the</strong> federal government, as<strong>the</strong>y were issued by <strong>the</strong> Federal National Mortgage Association(FNMA) or Freddie Mac, which by that time had been takenover by <strong>the</strong> federal government. O<strong>the</strong>r bonds were backed bysecure streams of <strong>in</strong>come with dedicated water, sewer, or sales taxrevenue. We believed that at that level of return, <strong>the</strong> limited riskwas justified.Optimist at HeartKeep <strong>in</strong> m<strong>in</strong>d that I’m a builder by trade; and a builder is alwaysby nature an optimist. This is <strong>the</strong> first time <strong>in</strong> 15 years that I don’thave a new build<strong>in</strong>g underway. But I have been expand<strong>in</strong>g mybus<strong>in</strong>ess <strong>in</strong> o<strong>the</strong>r very sound and conservative ways, such as myrecent <strong>in</strong>vestment <strong>in</strong> BankUnited.Historically, I always constructed only a few build<strong>in</strong>gs at atime. As I’d f<strong>in</strong>ish one and f<strong>in</strong>ance it conservatively, I wouldstart ano<strong>the</strong>r. S<strong>in</strong>ce April of 2009, I’ve completed a 430-roomWest<strong>in</strong> Hotel; 400 condom<strong>in</strong>ium units; an office build<strong>in</strong>g <strong>in</strong>Los Angeles; and a 360-unit luxury rental apartment tower <strong>in</strong><strong>New</strong>Jersey.It’snotthatI’moutofbus<strong>in</strong>ess.Butifyouaskedmewhat I might have on <strong>the</strong> agenda for 2010, <strong>the</strong> answer is that I’mus<strong>in</strong>g my capital to make <strong>in</strong>vestments <strong>in</strong> ei<strong>the</strong>r exist<strong>in</strong>g assets(f<strong>in</strong>ished real properties) or <strong>in</strong> o<strong>the</strong>r asset classes, such as Bank-United <strong>in</strong> Florida.
186 THRIVING IN THE NEW ECONOMY‘‘Bad Bank’’ OpportunityI recently participated <strong>in</strong> <strong>the</strong> <strong>in</strong>vestor group of a failed bank <strong>in</strong>Florida called BankUnited. This <strong>in</strong>stitution had significant assetstied up <strong>in</strong> subprime and exotic mortgage paper, associated with <strong>the</strong>big real estate bust <strong>in</strong> Florida. BankUnited had more than $8 billion<strong>in</strong> deposits and $10.5 billion <strong>in</strong> assets, many of which were <strong>in</strong> arrearsand not worth a mere fraction of <strong>the</strong>ir face value.We were <strong>in</strong>vited to bid on <strong>the</strong> fail<strong>in</strong>g bank with former NorthFork Bank CEO John Kanas and Wilbur Ross. John had greatsuccess with North Fork and had a terrific management teamthat was prepared to take on this challenge. Despite all <strong>the</strong> problems<strong>in</strong> Florida, I believe <strong>the</strong> state has a tremendous future because of<strong>the</strong> country’s demographics. Many of <strong>the</strong> post-war generation arestart<strong>in</strong>g to retire and will be attracted to Florida by <strong>the</strong> low taxenvironment and sunsh<strong>in</strong>e. A well-run bank <strong>in</strong> Florida shouldsucceed; and John Kanas and his team were <strong>the</strong> right people tolead it.We participated <strong>in</strong> a complex bidd<strong>in</strong>g process that required usto recapitalize <strong>the</strong> bank with more than $900 million and agreeon a loss shar<strong>in</strong>g formula with federal regulators. By buy<strong>in</strong>g <strong>the</strong>franchise, <strong>the</strong> branches, and deposits, and putt<strong>in</strong>g <strong>in</strong> <strong>the</strong> money tomake <strong>the</strong> bank an extremely well capitalized <strong>in</strong>stitution, John andhis team have a runn<strong>in</strong>g head start. I expect this <strong>in</strong>vestment tomake an outstand<strong>in</strong>g return. Moreover, this gives us a platform tobuy o<strong>the</strong>r fail<strong>in</strong>g <strong>in</strong>stitutions <strong>in</strong> our primary market and turn thisbank <strong>in</strong>to a much larger <strong>in</strong>stitution.Invest<strong>in</strong>g <strong>in</strong> ‘‘Toxic’’ AssetsThere are opportunities <strong>in</strong> real estate to <strong>in</strong>vest <strong>in</strong> loans that, althoughoften <strong>in</strong>accurately called toxic, are simply mispriced. In many<strong>in</strong>stances, <strong>the</strong>se assets are ‘‘toxic’’ only because <strong>the</strong> banks hold amark-to-market value on <strong>the</strong>ir books that is much higher than <strong>the</strong>
RICHARD LEFRAK 187assets’ true market value. Never<strong>the</strong>less, <strong>the</strong>y’re not without value;even a lemon has a price. But <strong>the</strong>se assets have to be bought at <strong>the</strong>right price and studied and evaluated with great precision. At <strong>the</strong>end, if <strong>in</strong>vestors are wise and meticulous and have done <strong>the</strong>irdue diligence, <strong>the</strong>re will be a reasonable rate of return—perhaps20 to 30 percent for <strong>the</strong> risk <strong>in</strong>volved—because those <strong>in</strong>vestors havedone <strong>the</strong>ir homework.There will be some excellent opportunities to <strong>in</strong>vest <strong>in</strong> real estate<strong>in</strong> <strong>the</strong> future. Both debt and equity markets have been fractured by<strong>the</strong> failure <strong>in</strong> capital markets. A severe recession, dur<strong>in</strong>g which rentsare fall<strong>in</strong>g while vacancy rates <strong>in</strong>crease, is compound<strong>in</strong>g <strong>the</strong> problemand leav<strong>in</strong>g cash flows uncerta<strong>in</strong>. Moreover, <strong>the</strong> mania that producedcap rates of 4 to 5 percent for properties has been replaced by afar more sober environment. A few properties that have traded haveseen price decl<strong>in</strong>es of as much as 60 percent. In some cases, sales havebeen accomplished only with seller f<strong>in</strong>anc<strong>in</strong>g. In <strong>the</strong> end, buy<strong>in</strong>gproperty below its replacement cost with conservative judgmentsabout rents will lead to very positive returns.The year 2010 will present many opportunities for those whohave <strong>the</strong> cash to take advantage of <strong>the</strong>m. For small <strong>in</strong>vestors, <strong>the</strong> realestate <strong>in</strong>vestment trusts (REITs) may prove to be a good space <strong>in</strong>which to <strong>in</strong>vest if <strong>the</strong> companies have good assets, strong balancesheets, and solid management, and <strong>the</strong>y operate <strong>in</strong> strong andgrow<strong>in</strong>g markets.The Black Swan event has taken place <strong>in</strong> real estate, and when <strong>the</strong>prices adjust, <strong>the</strong> future will be excellent. We are start<strong>in</strong>g to look<strong>in</strong> <strong>New</strong> York and Los Angeles—our primary markets of <strong>in</strong>terest—for properties that conform to <strong>the</strong>se standards.<strong>Thriv<strong>in</strong>g</strong> StrategiesTo thrive <strong>in</strong> this new economy, you must have a clear picture ofwhat to expect <strong>from</strong> people. You need to reassure <strong>the</strong>m that you
188 THRIVING IN THE NEW ECONOMYhave given enough forethought to what bad times can mean andthat your bus<strong>in</strong>ess will be able to survive <strong>in</strong> those bad times. Youmust be concerned about employees and <strong>the</strong>ir fears becausemany of <strong>the</strong>m are apprehensive about job security. You can’t benegative. If you’re a pessimist, don’t go <strong>in</strong>to bus<strong>in</strong>ess, becausesuccess won’t be <strong>in</strong> your future. In <strong>the</strong> end, bus<strong>in</strong>ess relies on twoth<strong>in</strong>gs: capital and human capital. And you must keep <strong>the</strong> humancapital motivated.
18Don PeeblesProm<strong>in</strong>ent real estatedeveloper Don Peebleshas been around hotelshis entire life and isoften referred to as <strong>the</strong>‘‘African American DonaldTrump.’’ Peebles’sgrandfa<strong>the</strong>r was a doormanfor 41 years at <strong>the</strong>Marriott Wardman Park Hotel <strong>in</strong> Wash<strong>in</strong>gton, DC, and hismo<strong>the</strong>r ran a successful real estate firm. Don himself runsone of <strong>the</strong> country’s largest m<strong>in</strong>ority-owned real estatedevelopment companies, with a net worth of $350 million.His portfolio <strong>in</strong>cludes The Royal Palm Hotel and The L<strong>in</strong>coln<strong>in</strong> Miami Beach, Florida, and Wash<strong>in</strong>gton’s Courtyard byMarriott Convention Center.Don’s ability to be flexible <strong>in</strong> turbulent market conditionsis one of his greatest assets. In 2007, he purchased 13 acres<strong>in</strong> Las Vegas for $65 million, with <strong>the</strong> <strong>in</strong>tention of develop<strong>in</strong>ga luxury resort hotel and condom<strong>in</strong>ium on <strong>the</strong> same lot(cont<strong>in</strong>ued)189
190 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)of an exist<strong>in</strong>g apartment build<strong>in</strong>g. But <strong>the</strong>n <strong>the</strong> real estatemarket collapsed <strong>in</strong> Vegas, and fund<strong>in</strong>g for projects wasnowhere to be found. Don <strong>in</strong>stead looked at <strong>the</strong> money thathis apartment tenants were br<strong>in</strong>g<strong>in</strong>g <strong>in</strong> as a way to generate<strong>in</strong>come dur<strong>in</strong>g <strong>the</strong> downturn, and he has decided to wait fornow to start his project. Don’s ability to be nimble is <strong>the</strong> keyto his success <strong>in</strong> thriv<strong>in</strong>g <strong>in</strong> <strong>the</strong> new economy.At that po<strong>in</strong>t <strong>in</strong> time (<strong>in</strong> September 2008), <strong>the</strong>re were banksand <strong>in</strong>stitutions that most people assumed would neverhave failed. But history can be a guide for <strong>the</strong> future. After all, <strong>in</strong> <strong>the</strong>early 1990s, large bank<strong>in</strong>g <strong>in</strong>stitutions that had been around fordecades were fail<strong>in</strong>g. So based on <strong>the</strong> events of September, 2008, wewere now go<strong>in</strong>g to see some significant distress <strong>in</strong> <strong>the</strong> market. Ithappened very quickly, probably more so than I would’ve expected.But it wasn’t a big surprise. We eventually saw credit freeze up,especially on <strong>the</strong> real estate side. History was beg<strong>in</strong>n<strong>in</strong>g to repeatitself—and I saw it as a potential opportunity. I knew what wasgo<strong>in</strong>g to happen; people were go<strong>in</strong>g to panic.In real estate or <strong>the</strong> stock market, <strong>the</strong> air has to <strong>in</strong>evitably be letout of <strong>the</strong> balloon for people to make money aga<strong>in</strong>, because at acerta<strong>in</strong> po<strong>in</strong>t, you can’t keep mak<strong>in</strong>g money <strong>in</strong> a cont<strong>in</strong>uously ris<strong>in</strong>gmarket—it becomes too competitive. In my bus<strong>in</strong>ess, <strong>the</strong>re are noreal opportunities to get value on <strong>the</strong> buy side when <strong>the</strong>re is a l<strong>in</strong>e ofpeople who are will<strong>in</strong>g to pay more than <strong>the</strong> next person. That is oneof <strong>the</strong> biggest challenges <strong>in</strong> <strong>the</strong> boom market.In some regards, I was surprised by what happened. But I was alsoexcited, because although it was sad that people were go<strong>in</strong>g to belos<strong>in</strong>g a lot of money, <strong>the</strong>re were now go<strong>in</strong>g to be opportunities thatwould come <strong>from</strong> it. I viewed it as though we were enter<strong>in</strong>g <strong>in</strong>to adifferent market cycle.
DON PEEBLES 191Tim<strong>in</strong>g Your OpportunityWhen I look at a market cycle, I use a clock as a gauge. That is,12 o’clock is <strong>the</strong> peak, and 6 o’clock is <strong>the</strong> dip. We went <strong>from</strong>12 o’clock to 4 o’clock exceptionally quickly. In September 2008,<strong>the</strong> credit freeze brought us to about 4 o’clock, but it didn’t br<strong>in</strong>g usto <strong>the</strong> worst yet. We are now over <strong>the</strong> peak, and we’re on our waydown to 6 o’clock.I have always regarded real estate as a cyclical bus<strong>in</strong>ess, and this is<strong>the</strong> time to beg<strong>in</strong> gear<strong>in</strong>g up to take advantage of <strong>the</strong> opportunities. Iconsider several aspects when I evaluate any real estate opportunity.No matter what, it’s always important to buy quality. In a rapidlyris<strong>in</strong>g market, quality is essentially unaffordable <strong>in</strong> terms of mak<strong>in</strong>ggood returns. So <strong>in</strong> order to buy quality, you have to settle for subparreturns. That makes it far more of an <strong>in</strong>stitutional environment asopposed to an entrepreneurial environment. However, dur<strong>in</strong>g arecession—and a dramatic downturn <strong>in</strong> <strong>the</strong> marketplace wherefundamentals are out of whack—quality becomes accessible andaffordable. We, <strong>the</strong>refore, look to buy quality and take advantage of<strong>the</strong> market dysfunction. I saw <strong>the</strong> value of quality assets go<strong>in</strong>g downquickly and significantly, which we perceived as a prospect.In addition to buy<strong>in</strong>g quality, we also look to deal directly with<strong>the</strong> parties. We’re not <strong>in</strong>terested <strong>in</strong> engag<strong>in</strong>g <strong>in</strong> a broad competition,bidd<strong>in</strong>g with thousands of o<strong>the</strong>r people for troubled bank assets, orgo<strong>in</strong>g out on a bidd<strong>in</strong>g contest. We’re look<strong>in</strong>g to f<strong>in</strong>d opportunitieswhere we can buy quality at significant discounts. And we’re alsolook<strong>in</strong>g at discounts where <strong>the</strong> values are at <strong>the</strong>ir peaks, somewherebetween $0.50 and $0.75 on <strong>the</strong> dollar. We want to buy assets <strong>from</strong>25 percent to approximately 40 percent of what <strong>the</strong>ir peak value was.That normally br<strong>in</strong>gs us back to a valuation that more closelyresembles <strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g of <strong>the</strong> rise <strong>in</strong> values after <strong>the</strong> mid-1990spullback. We seek to buy quality at depressed prices and forfundamental distress—which <strong>in</strong> <strong>the</strong> credit market, <strong>in</strong>volves moreowners’ distress.
192 THRIVING IN THE NEW ECONOMYLocation, Location, LocationWe are also, of course, look<strong>in</strong>g for geographic qualities. I alwaysconsider major markets that have a great deal of attraction, and <strong>the</strong>reare a handful of <strong>the</strong>se for which we have an appetite: <strong>the</strong> Wash<strong>in</strong>gton,DC, metropolitan area; <strong>the</strong> <strong>New</strong> York metropolitan area,ma<strong>in</strong>ly <strong>New</strong> York City; San Francisco; Los Angeles; Las Vegas;and to a lesser degree, South Florida and <strong>the</strong> Chicago area. Theselocations are world-class <strong>in</strong>ternational cities with strong underly<strong>in</strong>gfundamentals that have been hurt by <strong>the</strong> global meltdown. We are<strong>the</strong>n look<strong>in</strong>g for premier locations with<strong>in</strong> those premier cities.After we get <strong>the</strong> location, <strong>the</strong> third element we consider is—if it’san exist<strong>in</strong>g property—<strong>the</strong> level of quality <strong>in</strong> terms of design andphysical structure of <strong>the</strong> build<strong>in</strong>g. A great example of this was <strong>the</strong>development of my first hotel, The Royal Palm. I heard about it on avisit to Miami Beach, dur<strong>in</strong>g which I read a newspaper article about<strong>the</strong> city’s desire to redevelop The Royal Palm Hotel—and <strong>the</strong>opportunity <strong>in</strong>trigued me. Gett<strong>in</strong>g fully developed sites generallyrequires <strong>the</strong> assembl<strong>in</strong>g of properties, someth<strong>in</strong>g that was new topeople <strong>in</strong> Miami, but not to me. I went out and bought <strong>the</strong> hotelnext door to The Royal Palm Hotel—which I planned to use forexpansion—and <strong>the</strong>n bid for <strong>the</strong> city site, which was The RoyalPalm Hotel. I bid aga<strong>in</strong>st local developers and prom<strong>in</strong>ent families,and even hotel cha<strong>in</strong> giants like Ritz-Carlton and Hyatt. And I wasable to w<strong>in</strong> because I understood <strong>the</strong> value of site control of <strong>the</strong>neighbor<strong>in</strong>g property, which was a necessity to redevelop The RoyalPalm Hotel property. The idea is not to chase <strong>the</strong> market, and to try to buy value. Ofcourse, it’s a lot easier to buy value <strong>in</strong> a down market, and it is muchmore challeng<strong>in</strong>g to do <strong>in</strong> an up market. Most often, you’ll have toprocure value <strong>the</strong> way that I did with The Royal Palm—through apublic-private partnership. Author’s note: Site control is when you have <strong>the</strong> legal right to use a piece of land. Leases,deeds, and easements are examples of site control.
DON PEEBLES 193Ano<strong>the</strong>r method is <strong>the</strong> one that we used to secure <strong>the</strong> site that webuilt with <strong>the</strong> American Psychological Association. It was anamaz<strong>in</strong>g opportunity for us, because <strong>the</strong> price of that land wasset so low that we were able to pay off <strong>the</strong> o<strong>the</strong>r developer at cost. Itwas a w<strong>in</strong>-w<strong>in</strong> situation; <strong>the</strong>y got out of a failed project withoutlos<strong>in</strong>g any money, and we bought <strong>the</strong> land still significantly belowmarket and turned an amaz<strong>in</strong>g profit. We were able to do thisbecause, unlike <strong>the</strong> previous developer, we had a tenant for <strong>the</strong>build<strong>in</strong>g, and <strong>the</strong> tenant—<strong>the</strong> American Psychological Association—wasable to use tax-exempt status to obta<strong>in</strong> certificates ofparticipation (which was a precursor to <strong>the</strong> CMBS market y ).Not Abandon<strong>in</strong>g Old StrategiesIn <strong>the</strong> past, I used this strategy out of necessity; when I was build<strong>in</strong>gmy company, I couldn’t afford to have a big loss. Therefore, I had tobe very conservative and build brick by brick while simultaneouslyrely<strong>in</strong>g on high leverage and well-above-market returns. I started mybus<strong>in</strong>ess with no money. I had a couple of challenges that I needed toconfront. One of <strong>the</strong>se was that I wanted to create some significantwealth, and I wanted to do it <strong>in</strong> a short time period. Real estatetraditionally has a longer-term <strong>in</strong>vestment period of 5 to 10 years.One of <strong>the</strong> th<strong>in</strong>gs that I tried to do as I faced <strong>the</strong> obstacle ofbuild<strong>in</strong>g a bus<strong>in</strong>ess with no money was to use leverage, which is adifficult and risky th<strong>in</strong>g to do <strong>in</strong> a ris<strong>in</strong>g market. So <strong>the</strong> best time touse leverage is <strong>in</strong> a down market.Build<strong>in</strong>g <strong>from</strong> Noth<strong>in</strong>gWhen I first started my company <strong>in</strong> <strong>the</strong> mid-1980s, Wash<strong>in</strong>gton,DC politics were focused on rebuild<strong>in</strong>g neighborhoods—becausey Author’s note: A CMBS is a commercial backed mortgage security. These are securities thatare backed by commercial properties.
194 THRIVING IN THE NEW ECONOMYthat’s where <strong>the</strong> voters lived. I was able to capitalize on <strong>the</strong> desire for<strong>the</strong> city to create urban redevelopment and present a proposition: apublic-private partnership <strong>in</strong> develop<strong>in</strong>g a site where I would build<strong>in</strong> a decl<strong>in</strong><strong>in</strong>g area that would jump-start <strong>the</strong> revitaliz<strong>in</strong>g process.I learned a lot about <strong>the</strong> political process when I attended <strong>the</strong>Capitol Page School at <strong>the</strong> Library of Congress, where I was an<strong>in</strong>tern for two years and worked for Representatives Conyers andDellums. The relationships I forged dur<strong>in</strong>g that time helped menavigate my way through local DC politics. I eventually chairedDC’s tax appeals board. My knowledge of work<strong>in</strong>g my way around<strong>the</strong> political process was helpful <strong>in</strong> gett<strong>in</strong>g regulatory approval.I found a site <strong>in</strong> Anacostia on Mart<strong>in</strong> Lu<strong>the</strong>r K<strong>in</strong>g Avenue, anarea that had once been an economically thriv<strong>in</strong>g corridor but hadrecently decl<strong>in</strong>ed. S<strong>in</strong>ce <strong>the</strong>re was a desire to redevelop it, Iapproached <strong>the</strong> city to get <strong>the</strong>m to lease <strong>the</strong> office space on thatcorridor.Ihadanedge:First,Ifound<strong>the</strong>site.Second,Ihad<strong>the</strong>tenant,andIcouldpayverylittlefor<strong>the</strong>site.Thebuild<strong>in</strong>gIultimately built was a 100,000-square-foot build<strong>in</strong>g, which isconsidered a medium-sized office build<strong>in</strong>g <strong>in</strong> Wash<strong>in</strong>gton, DC.That land downtown would have cost me between $10 million and$15 million <strong>in</strong> that time <strong>in</strong> <strong>the</strong> marketplace. Instead, I was able tobuy it for $900,000. I <strong>the</strong>n went to <strong>in</strong>vestors and presented <strong>the</strong>mwith a proposition. They could own 50 percent of an officebuild<strong>in</strong>g fully leased to <strong>the</strong> government, and <strong>the</strong>y put up all <strong>the</strong>money. I delivered <strong>the</strong> government and <strong>the</strong> site. The risk ofdevelop<strong>in</strong>g an office build<strong>in</strong>g comes <strong>in</strong> <strong>the</strong> form of leas<strong>in</strong>g riskif you build it on spec.But s<strong>in</strong>ce I had a tenant <strong>in</strong> hand, that took risk out of <strong>the</strong>equation. The only question that was left was how to execute <strong>the</strong>construction. If it was done <strong>in</strong> a timely manner, <strong>the</strong>n <strong>the</strong> governmentwas obligated to take <strong>the</strong> space. They were a credit tenant, oneof <strong>the</strong> best <strong>in</strong> <strong>the</strong> area. As a result, I hired a general contractor to do adesign build, thus tak<strong>in</strong>g <strong>the</strong> risk of design and completion away<strong>from</strong> <strong>the</strong> developer and putt<strong>in</strong>g it <strong>in</strong> <strong>the</strong> design builder contractor’shands. We made an agreement that essentially said, ‘‘Here is a
DON PEEBLES 195build<strong>in</strong>g; you can deliver it to me with<strong>in</strong> _____ amount of time, at aguaranteed maximum price.’’ As a result, that was my first deal.Once that build<strong>in</strong>g was constructed, it provided me with an<strong>in</strong>come of $300,000 to $400,000 a year. It started with developmentfees once we broke ground, and <strong>the</strong>n went on to an <strong>in</strong>come stream. Istill own that build<strong>in</strong>g today, almost 20 years after I delivered it.And that is <strong>the</strong> strategy we still use today. We have never changedour underwrit<strong>in</strong>g purchas<strong>in</strong>g philosophy; this has put us <strong>in</strong> aposition where we can do well. In real estate, you make your moneywhen you buy; you realize your profit when you sell. But to makethat profit, you earn it when you buy.Unfortunately, a lot of people th<strong>in</strong>k <strong>the</strong>y understand how thatworks. People who buy never expect <strong>the</strong> hot market to end, especiallyon <strong>the</strong>ir watch. They figure that <strong>the</strong>y can play <strong>the</strong> game of musicalchairs, and when <strong>the</strong> music stops, <strong>the</strong>y’re go<strong>in</strong>g to have a seat. No oneexpects bad th<strong>in</strong>gs to happen to <strong>the</strong>m. The same is true of a tragic caraccident or a term<strong>in</strong>al disease, but <strong>the</strong>se th<strong>in</strong>gs do happen to somepeople. When money is <strong>the</strong> issue, we all ought to expect bad th<strong>in</strong>gsto happen. We must plan for <strong>the</strong>m. I can plan (somewhat) for <strong>the</strong>unexpected when I drive home by buckl<strong>in</strong>g my seat belt, driv<strong>in</strong>gcarefully, and not dr<strong>in</strong>k<strong>in</strong>g before I take <strong>the</strong> wheel. That’s <strong>the</strong> best Ican do. I can mitigate my risk <strong>in</strong> bus<strong>in</strong>ess by be<strong>in</strong>g discipl<strong>in</strong>ed withmy underwrit<strong>in</strong>g.So we look to discipl<strong>in</strong>e ourselves. We want to make <strong>the</strong> strongestreturn with a qualified risk, one that we are comfortable tak<strong>in</strong>g andone whose risk we believe we can mitigate. That makes it unique forus. We happen to be comfortable go<strong>in</strong>g through <strong>the</strong> politicalprocess, so we can take a land-use entitlement risk because weunderstand that risk.It’s All About Tim<strong>in</strong>gOne of <strong>the</strong> biggest misunderstand<strong>in</strong>gs among <strong>in</strong>vestors is <strong>the</strong>irassumption that <strong>the</strong>y have to wait to buy real estate at <strong>the</strong> ‘‘bottom.’’
196 THRIVING IN THE NEW ECONOMYAlthough tim<strong>in</strong>g is important, it’s important for <strong>in</strong>vestors torecognize that <strong>the</strong>y can’t buy at <strong>the</strong> absolute bottom, because what’sleft at that po<strong>in</strong>t are lesser-quality products. And when purchas<strong>in</strong>greal estate, you’ve got to f<strong>in</strong>d <strong>the</strong> best-quality assets at <strong>the</strong> bestopportunities. Let <strong>the</strong> opportunities dictate when you buy. Althoughwe may be at only 4:00 or 4:30 on our clock, perhaps <strong>the</strong> seller isdesperate and is actually sell<strong>in</strong>g <strong>the</strong> property at 6 o’clock prices out ofneed. Real estate must be evaluated on a case-by-case basis. Anybodywho says, ‘‘Now is not <strong>the</strong> time to buy,’’ is mak<strong>in</strong>g an overall sectordecision, as opposed to consider<strong>in</strong>g specific assets. We are anentrepreneurial company, so if a certa<strong>in</strong> benefit makes a goodbuy, <strong>the</strong>n we will buy it. Values on <strong>the</strong> whole may have a statisticalbasis to go down, but <strong>the</strong>re are some properties that are alreadydepressed sufficiently to buy. And <strong>the</strong>y’re not go<strong>in</strong>g to go downmuch lower, because somebody else is go<strong>in</strong>g to come and buy <strong>the</strong>m.Certa<strong>in</strong> factors will give you a sense of whe<strong>the</strong>r you’re buy<strong>in</strong>g ata good price. If you have an understand<strong>in</strong>g of <strong>the</strong> market and areable to see what k<strong>in</strong>d of immediate <strong>in</strong>come potential <strong>the</strong> propertyhas, <strong>the</strong>n that’s a good sign. Maybe it’s an undeveloped parcel ofland, so you ask yourself what a f<strong>in</strong>ished product would cost todayand how it’s utiliz<strong>in</strong>g that land price. What k<strong>in</strong>d of position wouldthat put you <strong>in</strong> as a f<strong>in</strong>ished product today? Where do you th<strong>in</strong>kth<strong>in</strong>gs are go<strong>in</strong>g to stabilize? How far back <strong>in</strong>to <strong>the</strong> market wouldthatpricebe(ifyou’rebuy<strong>in</strong>gsometh<strong>in</strong>gonavaluebasedon,say,1996 prices)? That tells you <strong>the</strong>re may be an opportunity to buy.If you go back much fur<strong>the</strong>r than that, <strong>the</strong> opportunity is notas favorable. It’s all risk. What’s <strong>the</strong> end game, and what is <strong>the</strong>end use for <strong>the</strong> property on <strong>the</strong> real estate side? What is your exitto profit?Challenges on <strong>the</strong> HorizonIn addition to depressed residential real estate prices, <strong>the</strong>re is ano<strong>the</strong>rchallenge unfold<strong>in</strong>g <strong>in</strong> my <strong>in</strong>dustry—and that’s <strong>the</strong> commercial
DON PEEBLES 197credit crisis. But aga<strong>in</strong>, with every crisis comes opportunities. Youhave to look at <strong>the</strong> whole picture. I am see<strong>in</strong>g great potential for mycompany, because when <strong>the</strong>re is less available capital and lessavailable f<strong>in</strong>anc<strong>in</strong>g, prices go down—it really is an all-cash buyer’smarket. For example, we’re now <strong>in</strong> <strong>the</strong> process of putt<strong>in</strong>g toge<strong>the</strong>r abillion dollar <strong>in</strong>vestment fund for real estate.This shortage of capital was someth<strong>in</strong>g I saw <strong>in</strong> <strong>the</strong> early 1990s,when <strong>the</strong> banks were clos<strong>in</strong>g and <strong>the</strong> regulators were press<strong>in</strong>g <strong>the</strong>lenders to divest <strong>the</strong>mselves of commercial real estate loans. Thelenders at that time were kick<strong>in</strong>g real estate loans off <strong>the</strong>ir books,fur<strong>the</strong>r depress<strong>in</strong>g prices and creat<strong>in</strong>g tremendous opportunities.That’s <strong>in</strong>itially what prompted <strong>the</strong> Wall Street private equity fundsto go <strong>in</strong>to real estate—<strong>the</strong>re was a void <strong>in</strong> <strong>the</strong> marketplace. Thetraditional real estate debt market had collapsed. What will ultimatelyhappen <strong>in</strong> this time period is that <strong>the</strong> markets are go<strong>in</strong>g tocome up with products that will alleviate this problem. So <strong>the</strong> moneyhas to be made prior to <strong>the</strong> early stages of a new approach <strong>in</strong>f<strong>in</strong>anc<strong>in</strong>g. Then, everyth<strong>in</strong>g will run up aga<strong>in</strong>. It might take 10 to 15years to peak aga<strong>in</strong>, but it will.Time CheckTh<strong>in</strong>gs should stabilize somewhat <strong>in</strong> 2010, hit <strong>the</strong> bottom, and <strong>the</strong>nhover <strong>the</strong>re for a while. The good news is that <strong>the</strong> places that <strong>in</strong>itiallyled <strong>the</strong> decl<strong>in</strong>e, such as Las Vegas, are bottom<strong>in</strong>g out. In fact, LasVegas is see<strong>in</strong>g huge <strong>in</strong>creases <strong>in</strong> sales volume, primarily because ofall <strong>the</strong> foreclosures and short sales. It’s so affordable that it’s almostirresistible for people not to buy <strong>the</strong>re now. As prices cont<strong>in</strong>ue to godown, velocity will pick up on <strong>the</strong> hous<strong>in</strong>g market.The real challenge is go<strong>in</strong>g to be <strong>in</strong> <strong>the</strong> job market; it’s go<strong>in</strong>g totake new <strong>in</strong>dustries time to create jobs. Look at <strong>the</strong> significant joblosses <strong>in</strong> <strong>the</strong> automobile <strong>in</strong>dustry; those are just <strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g.Manufactur<strong>in</strong>g across <strong>the</strong> board is down considerably. There are alsoextensive job losses—and more expected—<strong>in</strong> <strong>the</strong> f<strong>in</strong>ancial sector. It
198 THRIVING IN THE NEW ECONOMYwill take <strong>the</strong> economy some time to generate new jobs, someth<strong>in</strong>gthat will be a considerable part of <strong>the</strong> recovery.In any k<strong>in</strong>d of bus<strong>in</strong>ess—real estate, entrepreneurial—<strong>the</strong>re aretimes when <strong>the</strong> overall economy is good and times when it’s bad. Butremember that whatever bus<strong>in</strong>ess you’re <strong>in</strong>, you’re <strong>the</strong>re for <strong>the</strong> longterm. An entrepreneur needs to be able to make money <strong>in</strong> allenvironments. In my profession, when it’s a good time to sell, youwant to sell. When it’s a good time to buy, you want to buy. Whenit’s a good time to study and understand <strong>the</strong> fundamentals andprospects, <strong>the</strong>n you do that. You’re not just <strong>in</strong> bus<strong>in</strong>ess when it’s agood time to sell, or buy, or develop. The challenge is to operate well<strong>in</strong> every aspect, dur<strong>in</strong>g every part of <strong>the</strong> cycle. If you can do that,<strong>the</strong>n you will be successful—because you will be profitable wheno<strong>the</strong>rs aren’t.Ano<strong>the</strong>r element here is geographic and product-type diversification.In my approach to real estate, for example, that means differenttypes of uses of <strong>the</strong> property, such as hotel, residential, office, andretail properties. You need to consider geographic diversity as well,someth<strong>in</strong>g that also allows you to look at different sectors and pickproduct types that fit certa<strong>in</strong> markets. And if <strong>the</strong> market rebounds, itputs you <strong>in</strong> a position of strength, where <strong>the</strong> only th<strong>in</strong>g that willbr<strong>in</strong>g it down is a national or global recession. But even <strong>in</strong> such acase, you will have a softer land<strong>in</strong>g.
19Ron PeltierTo get a sense of what’s go<strong>in</strong>gon <strong>in</strong> <strong>the</strong> residential real estatemarket, I call on Ron Peltier,chairman and CEO of Home-Services of America, a BerkshireHathaway affiliate. HomeServicesof America, which is <strong>the</strong> second-largestU.S. residential realestate brokerage, expanded itsreal estate thumbpr<strong>in</strong>t <strong>in</strong> <strong>the</strong> fallof 2009 when it bought Koenig& Strey GMAC Real Estate foran undisclosed price <strong>from</strong> Brookfield Residential PropertyServices. The transaction added 900 additional agents toits sales fleet. Although HomeServices of America avoided<strong>the</strong> subprime market, that didn’t <strong>in</strong>sulate <strong>the</strong>m <strong>from</strong> <strong>the</strong> realestate dom<strong>in</strong>o effect. However, Ron’s new strategies havehelped his company survive <strong>the</strong> hous<strong>in</strong>g turmoil.199
200 THRIVING IN THE NEW ECONOMYWe saw <strong>the</strong> real estate market really beg<strong>in</strong> to boom right after<strong>the</strong> equities market collapsed, <strong>in</strong> mid-summer 2000, andit cont<strong>in</strong>ued to pick up momentum. It started <strong>in</strong> a few states, mostspecifically California, Arizona, Florida, and Nevada, and quicklyexpanded to o<strong>the</strong>r markets, but it did not hit every market at once,nor did it hit with <strong>the</strong> same sort of force.We clearly saw that <strong>the</strong> market was gett<strong>in</strong>g ahead of itself <strong>in</strong> termsof velocity and rapidly escalat<strong>in</strong>g home values. Long-establishedpractices of mortgage models and f<strong>in</strong>anc<strong>in</strong>g standards gave way tocreative low-risk f<strong>in</strong>anc<strong>in</strong>g. Speculators crept <strong>in</strong>to a mix of bus<strong>in</strong>essthat led <strong>the</strong>m to purchase a primary residence and shift it to an<strong>in</strong>vestment vehicle, with <strong>the</strong> sole motivation to quickly resell or flipproperties for profit. While we saw <strong>the</strong> force of this robust marketcont<strong>in</strong>ue to grow beyond normal real estate cycles, it was difficult toregulate this activity.Bus<strong>in</strong>ess operators attempted to ma<strong>in</strong>ta<strong>in</strong> our market shareand scalable bus<strong>in</strong>ess activity and balance that with good bus<strong>in</strong>esssense. One of <strong>the</strong> more compell<strong>in</strong>g challenges for us was manag<strong>in</strong>gan expansion that we knew <strong>in</strong> many ways was suspect. Dur<strong>in</strong>gthis period, we <strong>in</strong>creased our overhead, our employees, our programs,and our footpr<strong>in</strong>t with<strong>in</strong> our respective markets. Althoughwe believe we managed this process better than most, h<strong>in</strong>dsightwould tell us that it was not prudent to have expanded to such alarge degree.In retrospect, we would have been better off be<strong>in</strong>g satisfied as anorganization with slower growth of bus<strong>in</strong>ess activity that was moreconsistent with what we could reasonably support. Our bus<strong>in</strong>essrose by about 40 percent above <strong>the</strong> norm dur<strong>in</strong>g its peak.Interest<strong>in</strong>gly enough, because of <strong>the</strong> weight of <strong>the</strong> crash, it hascorrected back down and <strong>the</strong>n slightly more <strong>from</strong> its norm. Ourentire <strong>in</strong>dustry has paid <strong>the</strong> price of expansion and over<strong>in</strong>vestment<strong>in</strong> <strong>in</strong>frastructure. It was a lot more difficult to unw<strong>in</strong>d than it wasto build up.
RON PELTIER 201Buildup of SubprimeWe have a significant mortgage relationship with Wells Fargo.Although many creative mortgage products exist <strong>in</strong> <strong>the</strong> marketplace,Wells Fargo ma<strong>in</strong>ta<strong>in</strong>ed its discipl<strong>in</strong>ed mortgage processes andprograms and did not participate <strong>in</strong> this arena. Our sales associatesdid sell products and homes to customers who ultimately tookadvantage of <strong>the</strong>se creative products through alternative avenues.There was an abundance of lenders who were aggressively compet<strong>in</strong>gfor <strong>the</strong> subprime bus<strong>in</strong>ess and o<strong>the</strong>r creative mortgage products,which created a true feed<strong>in</strong>g frenzy.Unw<strong>in</strong>d<strong>in</strong>g of CreditThe unw<strong>in</strong>d<strong>in</strong>g of credit markets <strong>in</strong> August and September2008 was very challeng<strong>in</strong>g and pa<strong>in</strong>ful. The markets simply froze.The ultimate driver that allows <strong>the</strong> real estate transaction to go <strong>from</strong><strong>in</strong>itial contact to clos<strong>in</strong>g is <strong>the</strong> mortgage component. People at alleconomic levels want to own a home, but <strong>the</strong> cash side of <strong>the</strong>transaction is actually a very small piece; this means that hav<strong>in</strong>g amortgage product that matches <strong>the</strong> purchasers’ needs is critical.When Lehman Bro<strong>the</strong>rs collapsed and <strong>the</strong> f<strong>in</strong>ancial marketsseized up, we saw a 180-degree turn <strong>in</strong> <strong>the</strong> market <strong>from</strong> anenvironment where <strong>the</strong>re were virtually no credit standards andnorealpriceputonrisk<strong>in</strong><strong>the</strong>mortgagemarkets,toasituationwhere even <strong>the</strong> most creditworthy people were be<strong>in</strong>g shut out.That abrupt shift <strong>in</strong> our ability to do bus<strong>in</strong>ess was both unnerv<strong>in</strong>gand challeng<strong>in</strong>g. We experienced an environment where—for fiveor six years—traditional credit and mortgage underwrit<strong>in</strong>g standardscont<strong>in</strong>ued to erode to a po<strong>in</strong>t where <strong>the</strong> <strong>in</strong>dustry had nostandards at all. Now, <strong>the</strong> pendulum has swung too far <strong>in</strong> <strong>the</strong>opposite direction, and traditional mortgage lend<strong>in</strong>g practices havebecome more restrictive. It was a very frustrat<strong>in</strong>g market, one thatcaused tremendous pa<strong>in</strong> <strong>in</strong> <strong>the</strong> marketplace, not only for customers
202 THRIVING IN THE NEW ECONOMYand clients, but for our sales associates attempt<strong>in</strong>g to deliver anunparalleled level of service.Unw<strong>in</strong>d<strong>in</strong>g <strong>in</strong> Order to ThriveOur <strong>in</strong>dustry, which grew almost ‘‘unnaturally,’’ has shrunk just asdramatically. From our peak, we have closed approximately 100offices (about 25 percent), elim<strong>in</strong>ated most of <strong>the</strong> full-time employeeswho were hired dur<strong>in</strong>g <strong>the</strong> growth peak, and downsized our salesforce by just under 30 percent, and we are experienc<strong>in</strong>g revenuessimilar to those of <strong>the</strong> pre-boom days.The entire <strong>in</strong>dustry grew 40 percent dur<strong>in</strong>g <strong>the</strong> boom. This<strong>in</strong>cluded an <strong>in</strong>crease of sales associates, mortgage officers, titleofficers, and servicers of property casualty and <strong>in</strong>surance. It hasbeen a huge adjustment for <strong>the</strong>se <strong>in</strong>dividuals, as we all have had to domore with a lot less. When it is all said and done, we were try<strong>in</strong>g tocatch a ris<strong>in</strong>g star on its way up . . . and we expended a lot of ourresources try<strong>in</strong>g to catch it. As <strong>the</strong> market contracted, and it did soquicker and harder than anyone anticipated, <strong>the</strong> entire <strong>in</strong>dustry wasbloodied by <strong>the</strong> fall<strong>in</strong>g sword.The lesson we learned is that although it is difficult to workthrough downsiz<strong>in</strong>g, we are clearly positioned as an organization for<strong>the</strong> current market. We are confident that we can be a profitable,effective, and efficient organization <strong>in</strong> <strong>the</strong> current environment. Weknow that <strong>the</strong> markets will cont<strong>in</strong>ue to show more activity andstrength. We have a better view of <strong>the</strong> marketplace and <strong>the</strong> discipl<strong>in</strong>eto take more measured actions dur<strong>in</strong>g fluctuations.When you are <strong>in</strong> <strong>the</strong> real estate bus<strong>in</strong>ess, you establish a perspectiveabout standard <strong>in</strong>dustry metrics. The metrics that are associatedwith our bus<strong>in</strong>ess <strong>in</strong>clude growth <strong>in</strong> total home sales units and homeappreciation values. Typically, total home sales units were steady at3 to 4 percent over a 50- to 75-year historical period, and homesgenerally appreciate at 4 to 5 percent per year on a national basis.
RON PELTIER 203What we were see<strong>in</strong>g <strong>in</strong> this overheated market environment wasthat home sales activity grew <strong>from</strong> 5 million exist<strong>in</strong>g home sales toabout 7.2 million exist<strong>in</strong>g home sales <strong>from</strong> 2000 to 2005, up almost40 percent.Additionally, new construction <strong>in</strong>creased <strong>from</strong> about 800,000builds to just under 2 million builds per year. All of that speculationcreated a shortage of <strong>in</strong>ventory; demand outstripped <strong>the</strong> availablesupply for each and every build. At <strong>the</strong> same time, <strong>in</strong> many markets,home values were appreciat<strong>in</strong>g <strong>in</strong> double digits year after year.Instead of our normal growth of 3 to 5 percent <strong>in</strong> appreciation, wewere see<strong>in</strong>g home values go<strong>in</strong>g up to 12, 15, 18, and 20 percent yearover-year.Sales associates saw this as a huge opportunity to talk to<strong>the</strong>ir customers about <strong>the</strong> purchase transaction as an <strong>in</strong>vestmentopportunity, <strong>in</strong> addition to be<strong>in</strong>g a place to call home. As a result, wesaw people accelerat<strong>in</strong>g <strong>the</strong>ir natural schedule for buy<strong>in</strong>g a home andtrad<strong>in</strong>g up.In addition to trad<strong>in</strong>g homes more frequently, customer appetitefor homes was expand<strong>in</strong>g. Whereas people used to buy just onehome, now <strong>the</strong>y were buy<strong>in</strong>g <strong>in</strong> greater numbers than historicalaverages. About 25 percent of this activity was speculator-driven,mean<strong>in</strong>g that <strong>the</strong>ir primary motivation to purchase was to realize <strong>the</strong>property appreciation and <strong>the</strong>n to resell it at a significantly higherprice. It is fair to say that at some po<strong>in</strong>t, almost every person <strong>in</strong> <strong>the</strong>bus<strong>in</strong>ess believed that this was not susta<strong>in</strong>able. However, people feltthat <strong>the</strong>y were go<strong>in</strong>g to take advantage of every opportunity that wasout <strong>the</strong>re while it lasted.<strong>Thriv<strong>in</strong>g</strong> StrategiesNow it’s back to <strong>the</strong> basics. First, we believe that <strong>the</strong> underly<strong>in</strong>gpr<strong>in</strong>ciples are sound: that real estate, as a primary residence—a placeto call home—is desirable for both families and <strong>in</strong>dividuals. There isa tremendous desire to own a home, and over a period of time, it is
204 THRIVING IN THE NEW ECONOMYstill a solid long-term <strong>in</strong>vestment. What we are try<strong>in</strong>g to clearlycommunicate to our customers and clients is that home ownershipis not <strong>the</strong> type of <strong>in</strong>vestment that should be made for a short-termflip. Families and <strong>in</strong>dividuals purchas<strong>in</strong>g above <strong>the</strong>ir means—andthrough creative mortgage vehicles that will reset <strong>in</strong> two or threeyears and are not susta<strong>in</strong>able on <strong>the</strong>ir current <strong>in</strong>come—are <strong>in</strong>deedmak<strong>in</strong>g unwise decisions. It is critical when secur<strong>in</strong>g a mortgage <strong>in</strong>today’s environment that <strong>the</strong>y receive proper guidance <strong>from</strong> knowledgeableprofessionals.We are temper<strong>in</strong>g back <strong>the</strong> enthusiasm of our sales associates aswell as consumers about how quickly <strong>the</strong>y can build wealth throughreal estate. And although I’m one of <strong>the</strong> proponents of br<strong>in</strong>g<strong>in</strong>g atempered perspective to home ownership, that encouragement needsto be balanced with <strong>the</strong> idea that <strong>the</strong>re is underly<strong>in</strong>g value <strong>in</strong>residential real estate and that over time, purchas<strong>in</strong>g a home is agood <strong>in</strong>vestment.Ano<strong>the</strong>r th<strong>in</strong>g that we are cont<strong>in</strong>uously evaluat<strong>in</strong>g is <strong>the</strong> size of<strong>the</strong> market, which is currently off 40 percent <strong>from</strong> its peak. We areeducat<strong>in</strong>g all of our companies on what we believe is <strong>the</strong> new norm;<strong>in</strong> <strong>the</strong> future, ‘‘normal’’ will be less. I do not believe we will get backto our peak level of approximately 7.2 million exist<strong>in</strong>g home sales forano<strong>the</strong>r five to seven years.The postscript is that we have been see<strong>in</strong>g price destruction,particularly <strong>in</strong>fluenced or impacted by <strong>the</strong> real estate–owned (REO)bus<strong>in</strong>ess. This erosion of value will cont<strong>in</strong>ue at least through <strong>the</strong> endof 2009. I do believe we will see stabilization, but probably noappreciation, <strong>in</strong> home values before 2011.Silver L<strong>in</strong><strong>in</strong>gWe still have significant demand for homeownership <strong>in</strong> <strong>the</strong> future.The tax benefits that <strong>the</strong> Obama adm<strong>in</strong>istration has put <strong>in</strong> place(<strong>the</strong> $8,000 tax credit), <strong>in</strong> tandem with <strong>the</strong> historical low <strong>in</strong>terest
RON PELTIER 205rates, has led to tremendous pickup <strong>in</strong> sales activity for <strong>the</strong> lowerend-pricedhomes and for first-time home buyers. As a directresult, a tremendous buy<strong>in</strong>g opportunity now exists for potentialhomeowners. Buyers who thought <strong>the</strong>y’d never be <strong>in</strong> a position toown a home just a couple years ago now have ample selection andaffordability at record lows. There is a silver l<strong>in</strong><strong>in</strong>g here; but it iscom<strong>in</strong>g at a tremendous price consider<strong>in</strong>g <strong>the</strong> record number offoreclosures. We are currently envision<strong>in</strong>g approximately 2 millionforeclosures for <strong>the</strong> year com<strong>in</strong>g on <strong>the</strong> market, and that probablywill cont<strong>in</strong>ue <strong>in</strong>to early 2010.The impact of all <strong>the</strong>se foreclosures is that we have a bifurcatedreal estate marketplace. Currently, approximately 50 percent of allsales tak<strong>in</strong>g place nationally are distressed, or foreclosure-related.We also have <strong>the</strong> non-distressed homeowners, whose properties are,for <strong>the</strong> most part, with<strong>in</strong> 10 to 15 percent of <strong>the</strong> values atta<strong>in</strong>eddur<strong>in</strong>g <strong>the</strong> peak of <strong>the</strong> market; and those sales prices are be<strong>in</strong>g drivendown by <strong>the</strong> foreclosures.But if you are not a seller or <strong>in</strong> a highly distressed neighborhood,your home value is still relatively secure and solid, particularlylook<strong>in</strong>g five or six years <strong>in</strong>to <strong>the</strong> future. In fact, <strong>in</strong> most cases, yourhome value is still likely above your purchase price. In <strong>the</strong> end, it isimportant to understand that <strong>the</strong> pleasures we derived <strong>from</strong> <strong>the</strong> bullmarket were overshadowed by <strong>the</strong> pa<strong>in</strong> <strong>in</strong>flicted by <strong>the</strong> correction. Iwould like to believe that we all have learned that lesson.
Part FourAutos
20Mike JacksonThe relationship betweenreal estate andauto markets has alwaysbeen a strong one, and<strong>the</strong> direct effect that oneof <strong>the</strong>se areas can haveover <strong>the</strong> o<strong>the</strong>r has neverbeen more pronouncedthan it is now. Mike Jackson,chairman and CEO of AutoNation, understands <strong>the</strong>plight of <strong>the</strong> customer better than anyone else <strong>in</strong> <strong>the</strong>bus<strong>in</strong>ess. Mike predicted <strong>the</strong> demise of <strong>the</strong> consumer abouta year before it actually happened. As <strong>the</strong> largest autoretailer <strong>in</strong> <strong>the</strong> nation, one might assume that AutoNationwould be suffer<strong>in</strong>g <strong>in</strong> <strong>the</strong> new economy, but that’s not <strong>the</strong>case. Mike’s no-frills, CEO style has enabled <strong>the</strong> company towithstand a downturn, <strong>the</strong> likes of which hasn’t been seens<strong>in</strong>ce World War II. In <strong>the</strong> fourth quarter of 2008 and <strong>the</strong>first quarter of 2009, AutoNation blew by consensus and(cont<strong>in</strong>ued )209
210 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued )made his shareholders a strong profit, which reflected <strong>in</strong> <strong>the</strong>irstock rebound. Mike shares his <strong>in</strong>sights on how he has maneuveredaround <strong>the</strong> <strong>in</strong>dustry’s economic potholes.Abus<strong>in</strong>ess disaster strategy is a lot like flood <strong>in</strong>surance: Youcan try and do without it, but when <strong>the</strong> water startstopp<strong>in</strong>g <strong>the</strong> levee, you sure wish you had it.When I jo<strong>in</strong>ed AutoNation as chairman and CEO back <strong>in</strong> 1999,one of <strong>the</strong> first th<strong>in</strong>gs we did was develop a worst-case scenario—forthat very reason. We believed that <strong>the</strong> automotive <strong>in</strong>dustry rema<strong>in</strong>eda cyclical bus<strong>in</strong>ess with <strong>the</strong> potential for extreme peaks and valleys.Manag<strong>in</strong>g <strong>the</strong> peaks would be easy; <strong>the</strong> extreme valley, though, issometh<strong>in</strong>g else. In an <strong>in</strong>dustry that was about to average almost 17million units for <strong>the</strong> next seven years, we wondered how to stayprofitable and manage through a collapse to 10 million units. Mostof my colleagues thought I was crazy to even talk about it.The extreme of 10 million would be a major shakeout with clearlosers and w<strong>in</strong>ners. If you survived, you would be <strong>in</strong> a remarkableposition on <strong>the</strong> o<strong>the</strong>r side. In our judgment, a rational, discipl<strong>in</strong>ed,conservative strategy would be rewarded and irrational behaviorwould be wiped away. So we looked hard at our company <strong>in</strong> 1999and identified <strong>the</strong> follow<strong>in</strong>g vulnerabilities:1. An unfocused conglomerate2. Overdependence on domestics for 65 percent of profits3. Overdependence on direct lend<strong>in</strong>g to customers4. Decentralized command and control5. High fixed costs; little variability <strong>in</strong> o<strong>the</strong>r costs6. Over-leveraged balance sheetSo we actually began to implement our disaster plan <strong>in</strong> 2000—eight years before <strong>the</strong> actual crisis—by tak<strong>in</strong>g <strong>the</strong> follow<strong>in</strong>g steps:
MIKE JACKSON 2111. Narrowed focus, gett<strong>in</strong>g out of rental cars (Alamo/National),waste bus<strong>in</strong>ess, megastores, and o<strong>the</strong>rs.2. Diversified away <strong>from</strong> domestics <strong>in</strong>to import and premiumluxury.3. Moved <strong>from</strong> direct lend<strong>in</strong>g to an orig<strong>in</strong>ation fee model.4. Implemented common processes and technology (<strong>the</strong> operationalpractices—how we deal with customers, <strong>in</strong>ventory,f<strong>in</strong>ance and <strong>in</strong>surance, vehicle sales and service—and <strong>the</strong>technological platform <strong>in</strong> back office systems we use <strong>in</strong>both dealerships and corporate offices). Reduced fixed costs;established quick variability on costs.5. Built strong <strong>in</strong>vestment grade balance sheet.The moral is this: Without act<strong>in</strong>g on a strategic disaster plan years<strong>in</strong> advance, tactical responses when <strong>the</strong> storm hit would not havebeen enough.Harb<strong>in</strong>ger of Th<strong>in</strong>gs to ComeBus<strong>in</strong>ess was boom<strong>in</strong>g <strong>in</strong>to 2005 . . . and <strong>the</strong>n <strong>the</strong> hous<strong>in</strong>g marketstarted crack<strong>in</strong>g. This was because of autumn, and those of us whosebus<strong>in</strong>esses make us particularly sensitive to changes <strong>in</strong> <strong>the</strong> creditmarket took careful note. In fact, dur<strong>in</strong>g an appearance on SquawkBox, I mentioned how <strong>the</strong> situation—particularly <strong>in</strong> California—could be a harb<strong>in</strong>ger of much worse to come.I was more right than I realized. In 2006, California’s autoretail<strong>in</strong>g environment started to show signs of distress, and I couldtell that it was just a matter of time before <strong>the</strong> hous<strong>in</strong>g crisis spread,dragg<strong>in</strong>g auto vehicle sales along with it. By <strong>the</strong> end of <strong>the</strong> year,Florida was s<strong>in</strong>k<strong>in</strong>g, too, a difficult circumstance for <strong>the</strong> broadereconomy, of course, but also an especially troubl<strong>in</strong>g sign for ourcompany. We may have <strong>the</strong> largest network of dealerships <strong>in</strong> <strong>the</strong>United States, but <strong>the</strong>y’re most highly concentrated <strong>in</strong> <strong>the</strong> Sunbelt,and that’s where some of <strong>the</strong> biggest hous<strong>in</strong>g losses were occurr<strong>in</strong>g.
212 THRIVING IN THE NEW ECONOMYBy <strong>the</strong> time we announced our fourth quarter results <strong>in</strong> January2007, I noted dur<strong>in</strong>g our conference call with analysts that Arizonaand Nevada were <strong>the</strong> next <strong>in</strong> l<strong>in</strong>e. We forecast that our retail saleswere headed for double-digit decl<strong>in</strong>es, which meant implement<strong>in</strong>gour tactical disaster plan <strong>in</strong> addition to our strategic plan. Thatmeant cutt<strong>in</strong>g additional costs by $100 million annually, narrow<strong>in</strong>gour focus, and start<strong>in</strong>g to pay down debt.<strong>New</strong> <strong>Economy</strong> Rears Its Challeng<strong>in</strong>g HeadAs we entered 2008, it was clear that <strong>the</strong> floodwaters were ris<strong>in</strong>g.Therewas<strong>the</strong>legitimatepossibilitythatautomotivesalescouldbedriven down to half of what <strong>the</strong>y were just a couple of years before,which would be a decl<strong>in</strong>e of unprecedented proportions. What hadbegun as a hous<strong>in</strong>g collapse had turned <strong>in</strong>to someth<strong>in</strong>g muchworse. Every dealership group that carried large <strong>in</strong>ventories wassuddenly faced with hundreds and hundreds of unsalable cars,vehicles that cost <strong>the</strong>m money every month <strong>the</strong>y went withoutbuyers. What was even more amaz<strong>in</strong>g to us was that many of <strong>the</strong>segroups kept on buy<strong>in</strong>g more cars, <strong>in</strong> large part because manufacturerskept mak<strong>in</strong>g <strong>the</strong>m and putt<strong>in</strong>g <strong>the</strong>m <strong>in</strong> <strong>the</strong> pipel<strong>in</strong>e.The summer of 2008 was a struggle. In some areas around <strong>the</strong>United States, gasol<strong>in</strong>e spiked to $4.00 a gallon, which triggered<strong>the</strong> sharpest shift <strong>in</strong> consumer preference <strong>in</strong> <strong>the</strong> shortest amount oftime ever. Chang<strong>in</strong>g over <strong>in</strong>ventory was a nightmare.Then <strong>the</strong> Lehman Bro<strong>the</strong>rs’ bankruptcy hit. From one day to<strong>the</strong> next, a credit squeeze turned <strong>in</strong>to a full-scale credit panic. Loansfor our customers practically disappeared <strong>from</strong> one day to <strong>the</strong>next, for every brand, <strong>in</strong> every market; sales crashed an <strong>in</strong>cremental25 percent.We decided immediately on September 16, 2008, that this was<strong>the</strong> big one, and all <strong>in</strong>itiatives underway must double <strong>the</strong>ir targets <strong>in</strong>size and cut <strong>in</strong> half <strong>the</strong> timel<strong>in</strong>e. This is one of those moments oftruth. Is <strong>the</strong> steer<strong>in</strong>g wheel on <strong>the</strong> bridge truly connected?
MIKE JACKSON 213Figure 20.1Monthly SAARSAAR <strong>in</strong> Millions of Units1615141312111098LehmanBro<strong>the</strong>rsCollapsedJan Feb Mar Apr May Jun Jul Aug Sep Sep Oct Nov Dec Jan Feb Mar Apr1–15 16–302008 2009Source: Ward’s and AutoNation dataDisaster Plan Put to <strong>the</strong> TestNow <strong>the</strong> payoff of years of tedious work on processes and technologyand transparency, comb<strong>in</strong>ed with culture development, began. Thenext th<strong>in</strong>g to figure out was how to take out cost on a fast-track basison top of years of optimization without hurt<strong>in</strong>g <strong>the</strong> company’smuscle. Fortunately for us, <strong>the</strong> <strong>in</strong>vestment we made <strong>in</strong> data systemsreally paid off. Ours is an <strong>in</strong>dustry that’s still f<strong>in</strong>d<strong>in</strong>g its way withtechnology, but <strong>the</strong> massive scale on which we operate requires us to<strong>in</strong>vest heavily on cutt<strong>in</strong>g-edge technology. This turned out to give usa significant competitive advantage.Our data m<strong>in</strong><strong>in</strong>g capabilities provide immediate <strong>in</strong>sights thato<strong>the</strong>r dealer groups can’t see. They help us analyze trends at <strong>the</strong>irearliest stages, and <strong>the</strong>y allow us to create very accurate projectionsfor consumer behavior. And what we saw was that <strong>the</strong> new bottomfor <strong>the</strong> <strong>in</strong>dustry was go<strong>in</strong>g to be right where we predicted it.There would be no world-end<strong>in</strong>g crash, no apocalyptic meltdown.Moreover, we had accurately gauged <strong>the</strong> depth of <strong>the</strong>downturn and calibrated our bus<strong>in</strong>ess to accommodate it. Ofcourse, none of us were happy that we had to take such drasticmeasures. But it was a validation that our processes did what <strong>the</strong>y
214 THRIVING IN THE NEW ECONOMYwere supposed to: Our disaster plan accurately anticipated a longstr<strong>in</strong>g of f<strong>in</strong>ancial catastrophes, our top performers rolled up <strong>the</strong>irsleeves and performed at a level and with an <strong>in</strong>tensity that none ofus had seen before, and our technology gave us <strong>the</strong> <strong>in</strong>formation weneeded to take an appropriate level of aggressive action when it wasgenu<strong>in</strong>ely needed.We are optimistic about <strong>the</strong> future. Dur<strong>in</strong>g this period, irrationalbus<strong>in</strong>ess models were crushed and those focused on viability,susta<strong>in</strong>ability, and profitability made it to <strong>the</strong> o<strong>the</strong>r side of <strong>the</strong>abyss and will thrive. We are proud to lead <strong>the</strong> way.
21Jim LentzWhen Toyota took <strong>the</strong>checkered flag <strong>in</strong> quarterlyglobal auto sales away<strong>from</strong> General Motors <strong>in</strong>April 2007, it signaled <strong>the</strong>start of a new chapter for<strong>the</strong> auto <strong>in</strong>dustry. Nowexperts are anticipat<strong>in</strong>gthat <strong>the</strong> Japanese automakerwill knock GM outof <strong>the</strong> number one spot<strong>in</strong> <strong>the</strong> United States asearly as 2010. I <strong>the</strong>reforethought it would be <strong>in</strong>terest<strong>in</strong>gto sit down andspeak with <strong>the</strong> President of Toyota Motor Sales U.S.A.Jim Lentz to get his outlook on <strong>the</strong> challenges fac<strong>in</strong>g <strong>the</strong>auto <strong>in</strong>dustry and what <strong>the</strong> automaker is do<strong>in</strong>g to thrive <strong>in</strong>this new economy.When it comes to <strong>the</strong> nuts and bolts of <strong>the</strong> bus<strong>in</strong>ess,Lentz has seen it all. He started his career at Toyota as <strong>the</strong>(cont<strong>in</strong>ued )215
216 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued )merchandis<strong>in</strong>g manager for its Portland region back <strong>in</strong>1982, and he worked his way up, serv<strong>in</strong>g <strong>in</strong> various executivepositions, <strong>in</strong>clud<strong>in</strong>g distribution manager and trucksales team member. Jim is personable and a straightshooter. He looks back at how Toyota mobilized as twoenormous problems hit <strong>the</strong> <strong>in</strong>dustry way before <strong>the</strong> LehmanBro<strong>the</strong>rs hurricane made landfall.The auto <strong>in</strong>dustry was put <strong>in</strong> a very difficult position wellbefore <strong>the</strong> collapse of Lehman Bro<strong>the</strong>rs and <strong>the</strong> credit crisishit. A series of different factors unfolded, and it really was <strong>the</strong> perfectstorm. The comb<strong>in</strong>ation of <strong>the</strong> subprime hous<strong>in</strong>g crash with recordhigh fuel prices, rapidly followed by a 10-year low <strong>in</strong> fuel prices,totally changed <strong>the</strong> mix of what we had to sell. You had a spike <strong>in</strong>commodity prices, and if you recall, everyone was afraid of <strong>in</strong>flation,not deflation. Lehman Bro<strong>the</strong>rs declared bankruptcy, and <strong>the</strong> creditcrisis strikes. The stock market collapses, and for <strong>the</strong> most part, itjust totally shatters consumer confidence. All of that took place <strong>in</strong>about six months. Any one of those events alone could have hada fairly significant negative impact on <strong>the</strong> <strong>in</strong>dustry; toge<strong>the</strong>r, <strong>the</strong>ywere disastrous.Disaster PlanIt’s evident <strong>in</strong> analyz<strong>in</strong>g our <strong>in</strong>dustry’s scenario plans and bus<strong>in</strong>esscycles <strong>from</strong> each decade that, on average, <strong>the</strong> <strong>in</strong>dustry dropped <strong>from</strong>peak to valley about 23 percent—a fairly tight change. The biggestdrop was 25 percent, and <strong>the</strong> smallest was 21 percent. In 2000, when<strong>the</strong> <strong>in</strong>dustry cycle peaked at 17.4 million, one would’ve projectedthat when we saw a downturn <strong>in</strong> <strong>the</strong> economy we would have seen an<strong>in</strong>dustry drop to about 13.4 million. In fact, <strong>in</strong> 2008, <strong>the</strong> <strong>in</strong>dustry
JIM LENTZ 217ended up even lower, at about 13.2 million. This year, we’re go<strong>in</strong>g tobe down to about 10 million—more than a 40 percent decl<strong>in</strong>e <strong>from</strong>peak to valley. This is beyond anyone’s ability to forecast and reallyscenario plan around. That was <strong>the</strong> big crisis.We have made numerous changes and established priorities toadapt to this decl<strong>in</strong>e, and we have truly been operat<strong>in</strong>g on a step-bystepbasis. Our first priority was to look at restor<strong>in</strong>g profitability toour operations and gett<strong>in</strong>g our production aligned to this new<strong>in</strong>dustry at 10 million. It has been a comb<strong>in</strong>ation of reduc<strong>in</strong>g costsand preserv<strong>in</strong>g cash; monitor<strong>in</strong>g our supplier network to ensure that<strong>the</strong>y are strong when <strong>the</strong> cycle reverses; and all <strong>the</strong> while, guarantee<strong>in</strong>gthat our manufactur<strong>in</strong>g associates rema<strong>in</strong> tra<strong>in</strong>ed so that <strong>the</strong>ycan produce even better-quality, more efficient vehicles when wereturn to full production.The second area on which we’ve really concentrated is ma<strong>in</strong>ta<strong>in</strong><strong>in</strong>g<strong>the</strong> strength of our dealer network. We have worked very, veryhard to reduce dealer <strong>in</strong>ventory to get it <strong>in</strong> l<strong>in</strong>e with today’s salesenvironment. The <strong>in</strong>dustry average for days’ supply of <strong>in</strong>ventory is90 days. Our target, on <strong>the</strong> o<strong>the</strong>r hand, is 45 days; and we are ontarget. Our dealers are still profitable and <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> <strong>the</strong>ir facilities,<strong>the</strong>ir people, and <strong>the</strong>ir processes. So those two pieces of <strong>the</strong> puzzleare well <strong>in</strong>tact. We cont<strong>in</strong>ue to <strong>in</strong>vest <strong>in</strong> products for <strong>the</strong> future, like<strong>the</strong> all-new Venza, <strong>the</strong> third-generation Prius and Lexus RX, and<strong>the</strong> all-new Lexus dedicated hybrid, <strong>the</strong> HS.The last th<strong>in</strong>g that we have done is communicate, communicate,communicate; whe<strong>the</strong>r it is with <strong>the</strong> parent company back <strong>in</strong> Japan,<strong>the</strong> manufactur<strong>in</strong>g side, or our dealers and associates, we makesure that everyone understands what is happen<strong>in</strong>g. We will all getthrough this toge<strong>the</strong>r, but <strong>the</strong> most important th<strong>in</strong>g to us right nowis to always cont<strong>in</strong>ue to focus on our customer. Listen<strong>in</strong>g to andunderstand<strong>in</strong>g our customer’s needs and desires will allow us tobuild <strong>the</strong> right products and be able to wea<strong>the</strong>r <strong>the</strong> storm better thananybody else.
218 THRIVING IN THE NEW ECONOMYFuture of AutosYou have to start by look<strong>in</strong>g at macro trends, for which I’ll give you acouple of examples. We look at <strong>the</strong> midterm between, say, 2010 and2015. We understand that <strong>the</strong>re will be five generations purchas<strong>in</strong>gvehicles for <strong>the</strong> first time <strong>in</strong> our history when you look at ourcountry’s demographics. So whe<strong>the</strong>r it’s more traditional buyerswho are go<strong>in</strong>g to be purchas<strong>in</strong>g and driv<strong>in</strong>g cars <strong>in</strong>to <strong>the</strong>ir 90s,boomers mov<strong>in</strong>g <strong>in</strong>to <strong>the</strong> empty nest stage, or generations X, Y, andZ, each has a very unique desire for product. Some are go<strong>in</strong>g to wantto cont<strong>in</strong>ue to drive traditional large vehicles. As an example, I lookat myself and my parents. Basically, we bought cars by <strong>the</strong> pound.The bigger <strong>the</strong> car, <strong>the</strong> more we were will<strong>in</strong>g to spend. GenerationX, or especially generations Y and Z—my children—are verydifferent. They’re more likely go<strong>in</strong>g to purchase premium smallcars. They’re still go<strong>in</strong>g to want lea<strong>the</strong>r, along with <strong>the</strong> power andtechnology that we may expect <strong>in</strong> a more expensive car. If you go<strong>in</strong>to <strong>the</strong> future beyond 2015, we cont<strong>in</strong>ue to monitor trends that weth<strong>in</strong>k society is go<strong>in</strong>g to need for transportation.Energy efficiency and global warm<strong>in</strong>g are go<strong>in</strong>g to drive a lot of<strong>the</strong> decisions. For example, <strong>the</strong> re-urbanization of <strong>the</strong> Americancities is an important factor. Accord<strong>in</strong>g to <strong>the</strong> United Nations, <strong>in</strong>2007—for <strong>the</strong> first time s<strong>in</strong>ce <strong>the</strong>y have been track<strong>in</strong>g—morepeople are liv<strong>in</strong>g <strong>in</strong> urban centers than rural areas <strong>in</strong> <strong>the</strong> world.Cities across <strong>the</strong> country are see<strong>in</strong>g huge expansion <strong>in</strong> <strong>the</strong> urbanenvironment. Whe<strong>the</strong>r it is boomers retir<strong>in</strong>g or younger generationsbeg<strong>in</strong>n<strong>in</strong>g to live on <strong>the</strong>ir own, people want to get back to <strong>the</strong>vibrancy of city life. They may want to be closer to enterta<strong>in</strong>mentand sports centers, reduce <strong>the</strong>ir commute time, or perhaps saveenergy; whatever <strong>the</strong> reasons, this shift back <strong>in</strong>to <strong>the</strong> cities is go<strong>in</strong>g toimpact <strong>the</strong> type and size of vehicles people buy and <strong>the</strong> fuels <strong>the</strong>y’lluse to power <strong>the</strong>m. It may also affect how people are go<strong>in</strong>g to own<strong>the</strong>ir vehicles. We are really go<strong>in</strong>g to have to study ride-shar<strong>in</strong>g asopposed to personal ownership. Most people today consider only
JIM LENTZ 219two situations <strong>in</strong> terms of ‘‘gett<strong>in</strong>g places’’: public transportation orpersonal automobile ownership. However, <strong>the</strong> concept of rideshar<strong>in</strong>g<strong>in</strong> <strong>the</strong>se urban environments is go<strong>in</strong>g to become muchbetter and bigger <strong>in</strong> <strong>the</strong> future.Urbanization also drives <strong>the</strong> need to improve eng<strong>in</strong>e efficiency, so<strong>the</strong> type of eng<strong>in</strong>es we have <strong>in</strong> cars are go<strong>in</strong>g to change as well. In ourcase, Hybrid Synergy Drive is go<strong>in</strong>g to rema<strong>in</strong> our overall coretechnology, but we are also committed to develop<strong>in</strong>g advancedtechnologies. We cont<strong>in</strong>ue to <strong>in</strong>vest—even though it is a difficulttime <strong>in</strong> research and development—to accelerate advancements,whe<strong>the</strong>r it is conventional eng<strong>in</strong>es or advanced technologies, plug-<strong>in</strong>hybrids, battery electrics, compressed natural gas, clean diesels, andeventually, fuel cells. It is important for us to understand all <strong>the</strong>seneeds, because <strong>the</strong>re is no one-size-fits-all. The solution for a fullsizedtruck might be a clean diesel, whereas a smaller or urban vehiclemay need battery electric. So we really have to push all <strong>the</strong>setechnologies simultaneously <strong>in</strong> an attempt to understand whattransportation needs society and <strong>the</strong> consumer will have <strong>in</strong> <strong>the</strong>future. We have to see ourselves as a provider of transportation for<strong>the</strong> future, not just a manufacturer of cars and trucks.Game Plan Timel<strong>in</strong>eWe know that our current model l<strong>in</strong>eup is fairly firm through 2012.We are work<strong>in</strong>g on prelim<strong>in</strong>ary plans to 2015 and on long-termplans through 2020, when it is go<strong>in</strong>g to take big changes <strong>in</strong> ei<strong>the</strong>rvehicle platforms or power tra<strong>in</strong>s to achieve federal fuel economyand emissions standards. So you can look at short- and medium- andlong-term plans, but <strong>the</strong> driver for plans beyond 10 years is energyavailability—oil as we know it. One could argue that we’re go<strong>in</strong>g tohit <strong>the</strong> oil peak with<strong>in</strong> a few years, but it will likely be sometimetoward <strong>the</strong> end of <strong>the</strong> next decade. I do believe that <strong>the</strong> demand foroil will far exceed its supply sometime around 2018 or 2020. The
220 THRIVING IN THE NEW ECONOMYprice of gasol<strong>in</strong>e for cars will become so expensive that it willprobably not be realistic, so we have about 10 years to figure outwhat <strong>the</strong> next fuel source will be. Compressed natural gas, as anexample, will not reach its peak until probably 2040. So <strong>the</strong>re is atime period dur<strong>in</strong>g which compressed natural gas could play asignificant role. This is why we believe so strongly <strong>in</strong> our HybridSynergy Drive, which basically makes an eng<strong>in</strong>e with electric motorscapable of be<strong>in</strong>g fueled by a number of different types of eng<strong>in</strong>es.Today, it is <strong>in</strong>ternal combustion gas; <strong>in</strong> <strong>the</strong> future, it could becompressed natural gas or diesel, and eventually hydrogen fuel cellsif needed.What consumers today want is a stable price of fuel; and if that is$3.00 a gallon, so be it. If it is $4.00 per gallon, so be it. Whatconsumers have a difficult time adjust<strong>in</strong>g to is wide fluctuation,when one month it is $5.00, and six weeks later it’s $1.75. Giventhat situation, it is difficult for consumers to decide on what <strong>the</strong>y’rego<strong>in</strong>g to drive. Stability is necessary, and whe<strong>the</strong>r stability is createdby some type of gas tax or ano<strong>the</strong>r option, our policy makers need toresolve this situation.Wea<strong>the</strong>r<strong>in</strong>g <strong>the</strong> StormWe do not base our car production l<strong>in</strong>eup on <strong>the</strong> price of gasol<strong>in</strong>e;this is why we have been able to wea<strong>the</strong>r <strong>the</strong> storm better than most.We are a full-l<strong>in</strong>e manufacturer, and have always been. So when gasprices go up, we do not move all of our resources toward small cars.When gas prices go down, we do not move all of our resourcestoward full-size vehicles. It is important to offer a broad varietyof products to meet <strong>in</strong>dividual customer needs. A customer whohas a 47-mile commute will want a fuel-efficient vehicle, like a Prius;but ano<strong>the</strong>r—say, a contractor—will want someth<strong>in</strong>g larger, like aTundra. So we as a brand can offer what meets <strong>the</strong> needs of both of<strong>the</strong>se customers.
JIM LENTZ 221Circumvent<strong>in</strong>g <strong>the</strong> Credit CrunchWe have a captive f<strong>in</strong>ance company that has had adequate capitaland <strong>the</strong> right amount of cash to make loans to consumers. We’veseen a tighten<strong>in</strong>g of credit standards over time. If you look back threeor four years, it was easy to buy a car with no money down. If youhad a trade-<strong>in</strong> and you happened to owe more than your car wasworth, it was fairly simply to f<strong>in</strong>ance all of that <strong>in</strong>to <strong>the</strong> new purchaseand just have a bigger payment. But today, as a result of <strong>the</strong> creditcrisis, it is much, much more difficult to do.Plann<strong>in</strong>g AheadI cannot control what is go<strong>in</strong>g to happen to <strong>the</strong> economy; no onecan. I can only scenario plan and prepare for differ<strong>in</strong>g economicconditions. I can tell you that <strong>in</strong> <strong>the</strong> long run, this <strong>in</strong>dustry willrecover. American consumers still love cars and trucks, and <strong>the</strong>y love<strong>the</strong> freedom that own<strong>in</strong>g cars and trucks represent. The U.S.population is still grow<strong>in</strong>g. Members of generation Y are justreach<strong>in</strong>g <strong>the</strong>ir earn<strong>in</strong>g years, where <strong>the</strong>y are go<strong>in</strong>g to be buy<strong>in</strong>g<strong>the</strong>ir first—or, <strong>in</strong> some cases, <strong>the</strong>ir second—car. Generation Z is justgett<strong>in</strong>g <strong>the</strong>ir driver’s licenses, so we are look<strong>in</strong>g at 2.5 million newdrivers hitt<strong>in</strong>g <strong>the</strong> marketplace each and every year for <strong>the</strong> foreseeablefuture.The economy and auto <strong>in</strong>dustry show recovery rates <strong>from</strong> pastbus<strong>in</strong>ess cycles that br<strong>in</strong>g us to annual <strong>in</strong>dustry sales of 16 millionplus vehicles sometime <strong>in</strong> <strong>the</strong> next five or six years. The rate at whichwe will recover will be based on a number of th<strong>in</strong>gs—population,number of vehicles <strong>in</strong> <strong>the</strong> household—that won’t have a significanteffect over <strong>the</strong> short term. Pent-up demand will also have a positiveimpact. There are about 250 million vehicles <strong>in</strong> operation <strong>in</strong> today’smarket. Typically, <strong>in</strong> an average 15-million-vehicles sales year, weare also scrapp<strong>in</strong>g a similar number. In 2009, we will probably scrapabout 14 million vehicles, <strong>in</strong> a year when we will probably sell only
222 THRIVING IN THE NEW ECONOMYabout 10 million. That would be <strong>the</strong> first time that has happeneds<strong>in</strong>ce World War II. So <strong>the</strong>re are go<strong>in</strong>g to be more people andhouseholds, but fewer vehicles; and <strong>the</strong> median age of passenger carsis at an all-time high at 9.4 years. All of <strong>the</strong>se trends lead us back to<strong>the</strong> fact that <strong>the</strong>re is pent-up demand, which predicts better years tocome <strong>in</strong> <strong>the</strong> <strong>in</strong>dustry. But I do have one caveat with all that—andthat is what might happen with regulation.Caveat to Autos’ FutureThere is <strong>the</strong> potential that regulatory action is go<strong>in</strong>g to shape our—and everyone else <strong>in</strong> <strong>the</strong> <strong>in</strong>dustry’s—future product offer<strong>in</strong>gs. So<strong>the</strong> question is really go<strong>in</strong>g to be whe<strong>the</strong>r this aligns with whatconsumers want <strong>in</strong> <strong>the</strong> long run. We have to consider <strong>the</strong> cost ofcompliance with government regulation, which leads us to wonderif consumers will purchase <strong>the</strong>se new technologies <strong>in</strong> significantvolumes to make a difference to <strong>the</strong> environment and help reduceour dependence on foreign oil. That is go<strong>in</strong>g to be critical. Are wego<strong>in</strong>g to be able to susta<strong>in</strong> <strong>the</strong> development and production of <strong>the</strong>senew technologies that are profitable for automakers over time?The <strong>in</strong>dustry is suffer<strong>in</strong>g a little bit of a hangover <strong>from</strong> <strong>the</strong> huge<strong>in</strong>centives that started at <strong>the</strong> beg<strong>in</strong>n<strong>in</strong>g of this decade—and it hasput consumers <strong>in</strong> a very difficult position to trade <strong>in</strong> cars today.This has to change, because it’s not a susta<strong>in</strong>able model. After 9/11,<strong>the</strong> <strong>in</strong>dustry started boost<strong>in</strong>g <strong>in</strong>centives on vehicles to help getAmerica mov<strong>in</strong>g and keep <strong>the</strong> economy on track. Although itseemed like a pretty good idea at <strong>the</strong> time,<strong>the</strong><strong>in</strong>dustrycreatedavicious cycle. In order to fuel <strong>in</strong>centives,wehadtoraiseprices;andto cover <strong>the</strong> price <strong>in</strong>crease, more <strong>in</strong>centives were required. Thusbegan this cycle of higher price, higher <strong>in</strong>centive, which, <strong>in</strong> time,was not <strong>the</strong> consumer’s best friend. It didn’t really respect <strong>the</strong>consumer, because someone who buys a $40,000 vehicle with a$10,000 <strong>in</strong>centive doesn’t really know what <strong>the</strong>y’re gett<strong>in</strong>g <strong>in</strong>to orunderstand some of <strong>the</strong> hidden costs on <strong>the</strong> depreciation of <strong>the</strong>
JIM LENTZ 223vehicle. Our goal is to cont<strong>in</strong>ue to offer great products at a greatvalue for <strong>the</strong> consumer. In our m<strong>in</strong>d, good value is where <strong>the</strong>sticker price is very close to what <strong>the</strong> consumer is go<strong>in</strong>g to pay for<strong>the</strong>vehicle,so<strong>the</strong>rearenohiddencostsovertime,andwecanprotect <strong>the</strong> resale values.The Toyota WayWhat drives our company first and foremost—whe<strong>the</strong>r <strong>in</strong> goodtimes or <strong>in</strong> bad—are <strong>the</strong> pr<strong>in</strong>ciples of ‘‘The Toyota Way,’’ whichdictate that we cont<strong>in</strong>ue to have respect for customers. We challengeourselves and our dealers to provide <strong>the</strong> best products and ourdealers to offer <strong>the</strong> best service to customers; most importantly, wejust keep mov<strong>in</strong>g forward. We have this concept of kaizen, orcont<strong>in</strong>uous improvement, which allows us to rema<strong>in</strong> focused onsatisfy<strong>in</strong>g our consumers’ needs. So <strong>in</strong> response to <strong>the</strong> recentdownturn, we have taken significant companywide cost-cutt<strong>in</strong>gmeasures. We have curbed overtime and bonuses, reduced compensation,and curtailed travel. We have considerably reducedmarket<strong>in</strong>g costs, and cut out a lot of <strong>the</strong> motivational programsfor dealers. We’ve even cut out large-scale dealer meet<strong>in</strong>gs.Although we’ve managed to save some money over <strong>the</strong> short term,<strong>the</strong> reality is that you can’t save yourself <strong>in</strong>to profitability. Merelycutt<strong>in</strong>g costs is not enough. The most vital aspect for us is tounderstand what gets our customers excited about products andwhat it takes to get <strong>the</strong>m back <strong>in</strong>to <strong>the</strong> showroom. In our case, that isall about product cadence and new products. Ra<strong>the</strong>r than cutt<strong>in</strong>gback, we are cont<strong>in</strong>u<strong>in</strong>g to develop new and improved products; andour showrooms are a reflection of that. The Venza, <strong>the</strong> thirdgenerationPrius and <strong>the</strong> new generation of <strong>the</strong> Lexus RX, or anew vehicle for Lexus called <strong>the</strong> HS (which is <strong>the</strong> first dedicatedluxury hybrid) are examples of our dedication to thriv<strong>in</strong>g <strong>in</strong> <strong>the</strong> neweconomy. You realize that constantly br<strong>in</strong>g<strong>in</strong>g out new and fresh andexcit<strong>in</strong>g product will help us wea<strong>the</strong>r any storm.
224 THRIVING IN THE NEW ECONOMYIn reality, we are an extremely resilient company. If we reta<strong>in</strong> ourfocus on constant improvement, we are go<strong>in</strong>g to be pretty good. In<strong>the</strong> end, especially with everyth<strong>in</strong>g that is go<strong>in</strong>g on <strong>in</strong> <strong>the</strong> <strong>in</strong>dustryright now, stockholders or bondholders or those granted governmentsupport or new regulations are not who will determ<strong>in</strong>e <strong>the</strong>success of this <strong>in</strong>dustry. Ultimately, customers will be <strong>the</strong> oneswho <strong>in</strong>fluence success. Manufacturers who cont<strong>in</strong>ue to listen tocustomers—those who provide quality products that are durable,dependable, and reliable; products that add value; and productsthat are sold and serviced through profitable and trustworthy dealerswho provide an excellent experience—will be <strong>the</strong> w<strong>in</strong>ners.
22GeraldGreenwaldWhen it comes to allth<strong>in</strong>gs transportation,Jerry Greenwald is <strong>the</strong>expert to know. He hasmore than four decadesof experience <strong>in</strong> <strong>the</strong>transportation sectorand was chairman andCEO of UAL Corporation,parent of United Airl<strong>in</strong>es, for five years. He was hiredby auto legend Lee Iacocca to help lead Chrysler back <strong>from</strong><strong>the</strong> br<strong>in</strong>k <strong>in</strong> <strong>the</strong> 1980s. From 1979 through 1990, Greenwaldheld various executive positions with Chrysler. He served asvice chairman of <strong>the</strong> Board <strong>from</strong> 1989 to May 1990 and aschairman of Chrysler Motors <strong>from</strong> 1985 to 1988. He also heldtop executive positions at Ford, Dillon Read, and Olympia &York. Today, Jerry is a founder of Greenbriar Equity Group,(cont<strong>in</strong>ued )225
226 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued )which specializes <strong>in</strong> <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> <strong>the</strong> transportation sector. Heis also a member of <strong>the</strong> board of directors for Aetna.I met Jerry through ano<strong>the</strong>r one of my contacts, JerryYork, who was actually Greenwald’s protege back <strong>in</strong> <strong>the</strong>days of Chrysler. S<strong>in</strong>ce my <strong>in</strong>troduction to him, I have beencall<strong>in</strong>g on Greenwald for his <strong>in</strong>sight <strong>in</strong>to <strong>the</strong> market meltdownas well as <strong>the</strong> auto crisis. His honesty and candidnessare truly what lend to his credibility.Before <strong>the</strong> meltdown, I remember say<strong>in</strong>g, ‘‘You know, this isnot feel<strong>in</strong>g good. We better start develop<strong>in</strong>g some cont<strong>in</strong>gencyplans.’’ I went that far, but I did not go runn<strong>in</strong>g and jump<strong>in</strong>g.Credits started to tighten up. The markets began to drag. Avariety of economic <strong>in</strong>dicators began to show a slowdown. Ourclients are <strong>in</strong>vestors, who, although quite concerned, knew that wehad been careful and prudent and that we would be okay no matterwhat was go<strong>in</strong>g to transpire after September 2008.We went <strong>in</strong>to motion, and our first effort was to assume for <strong>the</strong>worst and hope for <strong>the</strong> best. That meant look<strong>in</strong>g at every one of ourportfolio companies and go<strong>in</strong>g through <strong>the</strong> what-ifs and economicmodel<strong>in</strong>g. In almost every case, we believed that it was prudent <strong>in</strong>some comb<strong>in</strong>ation to be sure that our credit l<strong>in</strong>es were sound andour operat<strong>in</strong>g costs were tight.OpportunitiesThere’s an expression: If you’re duck hunt<strong>in</strong>g, you don’t aim <strong>the</strong>shotgun at <strong>the</strong> duck as it’s fly<strong>in</strong>g; you aim <strong>in</strong> front of <strong>the</strong> duck.Likewise, our economic conditions are constantly <strong>in</strong> motion.We’ve been try<strong>in</strong>g to judge <strong>the</strong> right time to get more aggressiveand go <strong>in</strong>to a buy<strong>in</strong>g mode. We look at our own <strong>in</strong>dustries and welisten to economists, but we don’t do everyth<strong>in</strong>g <strong>the</strong>y say, because
GERALD GREENWALD 227<strong>the</strong>y recommend different th<strong>in</strong>gs. We compare notes with o<strong>the</strong>r<strong>in</strong>vestors, and we’re pretty close now. Will we be able to buy atbottom? I don’t th<strong>in</strong>k so; we’re not that good. But consider<strong>in</strong>gthat we are go<strong>in</strong>g to be buy<strong>in</strong>g and hold<strong>in</strong>g for three to seven years,we don’t have to buy at rock bottom, because we’re not sell<strong>in</strong>g nextweek anyway.In <strong>the</strong> meantime, we’ve been look<strong>in</strong>g at a number of opportunitiesthat are, <strong>in</strong> one form or ano<strong>the</strong>r, peculiar. What do I mean by that?Well, our biggest impediment to buy<strong>in</strong>g is credit availability. Thereis little credit out <strong>the</strong>re, so we look at some opportunities and th<strong>in</strong>k,‘‘Well, we don’t need a lot of credit to buy.’’ A particular opportunitymay be good enough that we will put <strong>in</strong> mostly equity and alittle bit of debt and wait for <strong>the</strong> markets to improve. Then we’ll dowhat we call recapitaliz<strong>in</strong>g, or borrow<strong>in</strong>g more money and tak<strong>in</strong>gsome of <strong>the</strong> equity out. Additionally, some really sound companiesare look<strong>in</strong>g for straight equity so that <strong>the</strong>y can renegotiate <strong>the</strong>ir creditl<strong>in</strong>es. There is a lot of Ch<strong>in</strong>ese and Middle Eastern money <strong>in</strong> <strong>the</strong>system, so we’re consider<strong>in</strong>g some opportunities <strong>in</strong> that ve<strong>in</strong>.Creat<strong>in</strong>g a StrategyWe aren’t very different <strong>in</strong> this sett<strong>in</strong>g <strong>from</strong> <strong>the</strong> day we started <strong>in</strong>bus<strong>in</strong>ess 10 years ago, although perhaps we’re a bit more cautious.What do I mean? We started with a strategy that we are more thanmoney. So many private equity firms and hedge funds take greatpride <strong>in</strong> ‘‘f<strong>in</strong>ancial eng<strong>in</strong>eer<strong>in</strong>g’’ and go<strong>in</strong>g anywhere money can bemade. The found<strong>in</strong>g partners were somewhat uneasy with this<strong>the</strong>me. I’m not say<strong>in</strong>g it doesn’t work, but we were uncomfortablebe<strong>in</strong>g opportunists and go<strong>in</strong>g where every opportunity would be.We felt that we would do better if we stayed with what we know best,which is transportation.From <strong>the</strong> day we started seek<strong>in</strong>g <strong>in</strong>vestors, we have wanted toprove <strong>the</strong> <strong>the</strong>sis that we are more than money. We have operationalexperience and knowledge about all transportation sectors. We
228 THRIVING IN THE NEW ECONOMYwanted to have a great mix of <strong>in</strong>vestment bankers, operationspeople, consultants, and people who grew up <strong>in</strong> <strong>the</strong> field of privateequity. And we have essentially stuck to that <strong>the</strong>me.The second belief we’ve stood by over <strong>the</strong> years is that it would bewrong to be overly concerned about ‘‘putt<strong>in</strong>g our money to work.’’Private equity firms typically function by creat<strong>in</strong>g a fund of <strong>in</strong>vestors,clos<strong>in</strong>g <strong>the</strong> fund, and <strong>the</strong>n tak<strong>in</strong>g about six years, sometimes alittle longer, to <strong>in</strong>vest that money. Our approach is to be highlyselective <strong>in</strong> <strong>in</strong>vest<strong>in</strong>g that money. We would ra<strong>the</strong>r pick our timescarefully, be patient, f<strong>in</strong>d <strong>the</strong> right opportunities, and <strong>the</strong>n makeour moves. In our 10 years, <strong>the</strong>re have been occasions when wewould not buy a company for a full year. We would <strong>in</strong>stead use<strong>the</strong> year to keep look<strong>in</strong>g and expand<strong>in</strong>g our network; we wouldn’tsweat our year without activity.Buy<strong>in</strong>g CriteriaIt is hard to describe a s<strong>in</strong>gle most important criterion <strong>in</strong> terms ofbuy<strong>in</strong>g. We look for companies that we believe represent seculargrowth. In o<strong>the</strong>r words, <strong>the</strong>y have a particular niche or particular<strong>in</strong>dustry with a great opportunity for ongo<strong>in</strong>g growth for <strong>the</strong> next10 years. We also look for companies with impressive brands.Hav<strong>in</strong>g said that, we have plenty of experience among us <strong>in</strong> areaslike crisis management and turnarounds. Therefore, we are not shyabout identify<strong>in</strong>g turnarounds that we th<strong>in</strong>k could add value. Butfor <strong>the</strong> most part, we are look<strong>in</strong>g for growth and first-rate managementteams with whom we want to partner.Here are two examples <strong>from</strong> our current portfolio. About a yearago, we bought a privately held company called AmSafe thatmanufactures seat belts for aircraft, commercial aircraft, generalaviation, and military. They have a dom<strong>in</strong>ant market share and anextremely smart, eng<strong>in</strong>eer<strong>in</strong>g-oriented management team. When webought <strong>the</strong>m, <strong>the</strong>y had just recently received certification <strong>from</strong> <strong>the</strong>Federal Aviation Adm<strong>in</strong>istration (FAA) for an air bag <strong>in</strong> <strong>the</strong> seat
GERALD GREENWALD 229belt. We believed that <strong>the</strong> air bag seat belts have a terrific growthpotential over <strong>the</strong> next several years. It is not an <strong>in</strong>vention that mighthappen; we’ve been at it now for a year or a year and a half, and<strong>the</strong>re’s someth<strong>in</strong>g like 30,000 seats <strong>in</strong> <strong>the</strong> air with <strong>the</strong>se air bags <strong>in</strong><strong>the</strong> seat belts. The next time you are on an airplane, turn yourseatbelt buckle upside down, and you’ll probably see AmSafe as <strong>the</strong>brand on that buckle.The o<strong>the</strong>r is a company called EMD, Electro-Motive Diesel.We bought this locomotive manufactur<strong>in</strong>g bus<strong>in</strong>ess <strong>from</strong> GeneralMotors, and we saw this company as a great brand. There are onlytwo companies <strong>in</strong> <strong>the</strong> world that manufacture <strong>the</strong>se heavy-dutylocomotives. GM was concentrat<strong>in</strong>g on cars and trucks and wantedto sell EMD.We saw this as a fantastic opportunity to work with a great brand,a well-eng<strong>in</strong>eered product, and a company that we thought we couldturn around and develop; <strong>the</strong>re was also a potential for seculargrowth <strong>in</strong> <strong>the</strong> market. It’s been four years, and <strong>the</strong> company has beenturned <strong>from</strong> losses to profits and has gone <strong>from</strong> hav<strong>in</strong>g sales of about$800 million to just under $2 billion <strong>in</strong> revenue (exclud<strong>in</strong>g thisdownturn). EMD has expanded <strong>from</strong> a North American to aworldwide bus<strong>in</strong>ess. We have been stress<strong>in</strong>g to our new managementteam at EMD that <strong>the</strong> customer really matters. They have turnedaround <strong>the</strong> company’s reputation. We are very pleased with howEMD is develop<strong>in</strong>g.Future of <strong>the</strong> Transportation IndustryOur transportation sector is comprehensive—air, ground, and seapr<strong>in</strong>cipal companies, services, and suppliers. The airl<strong>in</strong>e <strong>in</strong>dustry isa growth <strong>in</strong>dustry, but <strong>the</strong> problem for years—and it’s hardly ajoke—has been that it is one of <strong>the</strong> few growth <strong>in</strong>dustries that hasfigured out how to lose money. So we have tried to pick <strong>the</strong> placeswhere members of <strong>the</strong> <strong>in</strong>dustry make profits. For example, one of<strong>the</strong>firstcompanies<strong>in</strong>whichwe<strong>in</strong>vestediscalledHexcel.It’sa
230 THRIVING IN THE NEW ECONOMYpublic company that started about 50 years ago mak<strong>in</strong>g skis out ofcomposites. Today, <strong>the</strong>y manufacture a wide array of very lightweightproducts for commercial and military aircraft. Although wedon’t normally <strong>in</strong>vest <strong>in</strong> public companies, we felt very stronglyafter 9/11 that this growth <strong>in</strong>dustry was go<strong>in</strong>g to experience anupturn <strong>in</strong> manufactur<strong>in</strong>g of aircraft for commercial use after <strong>the</strong>ensu<strong>in</strong>g recession among Boe<strong>in</strong>g, Airbus, and o<strong>the</strong>rs. And oncethat happened, Hexcel (a supplier of parts) was go<strong>in</strong>g to see acorrespond<strong>in</strong>g upturn with <strong>the</strong> <strong>in</strong>dustry aga<strong>in</strong>.Ano<strong>the</strong>r appeal<strong>in</strong>g feature of this company was that it was one ofonly two or three suppliers who have learned to produce verylightweight components for aircraft—composites, not alum<strong>in</strong>umor o<strong>the</strong>r metals. We believe that as new platforms, such as <strong>the</strong> A380Airbus or 787 Boe<strong>in</strong>g are <strong>in</strong>troduced <strong>in</strong>to <strong>the</strong> market, <strong>the</strong>y wouldshift away <strong>from</strong> alum<strong>in</strong>um to <strong>the</strong>se k<strong>in</strong>ds of parts. F<strong>in</strong>ally, we loved<strong>the</strong> management team at Hexcel. They were dedicated, but <strong>the</strong>ygot caught <strong>in</strong> <strong>the</strong> enormous downturn <strong>in</strong> <strong>the</strong> <strong>in</strong>dustry, and <strong>the</strong>irbanks were lean<strong>in</strong>g on <strong>the</strong>m. We thought we could make an equity<strong>in</strong>vestment and use that <strong>in</strong>vestment as <strong>in</strong>centive for <strong>the</strong> Hexcel banksto renegotiate <strong>the</strong>ir terms and conditions. We also thought that wecould be of some help to <strong>the</strong> management. Because of our network,we knew <strong>the</strong> senior people who were <strong>the</strong>ir customers. But for <strong>the</strong>most part, we were just good board members. Three years later, wesold our shares.We jo<strong>in</strong> <strong>the</strong> boards for companies when we <strong>in</strong>vest. In <strong>the</strong> case ofHexcel, <strong>the</strong> management and o<strong>the</strong>r members of <strong>the</strong> board liked oneof our guys (my partner Joel Beckman) so much that even after wesold all our shares, <strong>the</strong>y asked him to stay on as a board member,which he has done.Airl<strong>in</strong>e TurbulenceNorth American Airl<strong>in</strong>es has struggled <strong>the</strong> most with<strong>in</strong> <strong>the</strong> airl<strong>in</strong>e<strong>in</strong>dustry, and <strong>the</strong> ma<strong>in</strong> reason for this is that <strong>the</strong> unions have
GERALD GREENWALD 231not been able to th<strong>in</strong>k long-term for <strong>the</strong>ir members. This meansthat too often, <strong>the</strong>se groups—particularly <strong>the</strong> pilots’ unions—havebeen quick to scoop up profits. The moment it looked like an airl<strong>in</strong>ewas start<strong>in</strong>g to make a profit, <strong>the</strong> unions would take <strong>the</strong> moneyoff <strong>the</strong> table for <strong>the</strong>ir members and threaten to shut <strong>the</strong> place downif refused.One answer to this situation might be a baseball-type arbitration,which would require congressional approval. It sounds k<strong>in</strong>dof off-<strong>the</strong>-wall, I know, but it might provide <strong>the</strong> right motivationif <strong>the</strong> two parties could not reach an agreement. The arbitratorwould decide on <strong>the</strong> next contract. Each side could submit a contract,but <strong>the</strong> arbitrator could not average. He would have to pickone or <strong>the</strong> o<strong>the</strong>r. As a result, both parties would submit moreresponsible proposals.Auto TransformationTo start with, I thank my lucky stars for not hav<strong>in</strong>g done properdue diligence when Lee Iacocca asked me to come to Chrysler back<strong>in</strong> 1979; if I had, I would have been scared to death and not gone<strong>the</strong>re. But I signed on and it was <strong>the</strong> experience of my life. There Iwas, essentially do<strong>in</strong>g f<strong>in</strong>e as a pitcher <strong>in</strong> <strong>the</strong> m<strong>in</strong>or leagues, andsome guy came <strong>in</strong> and said, ‘‘Hey, you want to pitch <strong>in</strong> <strong>the</strong> WorldSeries?’’ That’s how it all started for me.But when I had been <strong>the</strong>re for just four or five weeks (Iacocca hadarrived just months before), I realized it was a mess. It was just awful.The very first th<strong>in</strong>g we stopped do<strong>in</strong>g was build<strong>in</strong>g cars on speculation.Most car companies get orders <strong>from</strong> dealers, and <strong>the</strong> cars getbuilt. The moment <strong>the</strong> cars are ready, <strong>the</strong> dealers pay for <strong>the</strong>m atregular standard prices. If a car company builds cars on speculation, itis fudg<strong>in</strong>g <strong>the</strong> books. F<strong>in</strong>ancials may temporarily look good, but it is akiller, because <strong>the</strong> dealers soon catch on, and <strong>the</strong>y say, ‘‘No, I don’twant to buy <strong>the</strong> cars you have already built. I want to buy <strong>the</strong> carsthat you haven’t built yet.’’ And pretty soon <strong>the</strong> factory is forced to give
232 THRIVING IN THE NEW ECONOMYdiscounts to dealers to take <strong>the</strong> cars that were built on speculation, and<strong>the</strong>ir quality isn’t as good. They have been sitt<strong>in</strong>g <strong>in</strong> park<strong>in</strong>g lots allover <strong>the</strong> Midwest. Once started, this cycle is not so easy to stop. Wehad cars <strong>in</strong> park<strong>in</strong>g lots all over <strong>the</strong> place, and it took us a year to f<strong>in</strong>allysell <strong>the</strong> last of <strong>the</strong>m. The last were specialty trucks and <strong>the</strong>y were soldfor $0.35 on <strong>the</strong> dollar. But we cleaned it up, and we stopped.The people <strong>in</strong> <strong>the</strong> company had no clue about <strong>the</strong>ir warranty costsand <strong>the</strong> primary reasons for <strong>the</strong>m. Warranty costs essentially help acar company learn where <strong>the</strong> quality defects are by look<strong>in</strong>g throughwarranty claims. You can <strong>the</strong>n set assignments among eng<strong>in</strong>eers andmanufactur<strong>in</strong>g people, f<strong>in</strong>d <strong>the</strong> top 10 defects, and decide who isgo<strong>in</strong>g to be accountable for gett<strong>in</strong>g <strong>the</strong>m fixed. That was one of <strong>the</strong>early th<strong>in</strong>gs we started.This may sound too technical, but at that time, Chrysler did notunderstand car options—or what percent of <strong>the</strong>m were be<strong>in</strong>gordered for a particular automobile type. Options are more profitablethan <strong>the</strong> cars <strong>the</strong>mselves. If you can figure option rates andwhich are most profitable, you can f<strong>in</strong>d ways to dramatically <strong>in</strong>creaseprofitability per car by help<strong>in</strong>g to manage <strong>the</strong>m. But if you don’thave any way of know<strong>in</strong>g <strong>the</strong> quantity of options be<strong>in</strong>g bought andwhat <strong>the</strong> profits are on <strong>the</strong>m, you are bl<strong>in</strong>d. It took a few months,but we put <strong>in</strong> systems and managed options.Deja VuIn <strong>the</strong> end, we needed to build cars people wanted and that wecould make money sell<strong>in</strong>g. When we arrived, <strong>the</strong> cars were gasguzzlersand not of very good quality. This is deja vu,right?But<strong>the</strong>n we had a car that changed all that: <strong>the</strong> K-car. It was started byHal Sperlich, who had left Ford before Iacocca and I came toChrysler. The K-car was to be <strong>the</strong> most fuel-efficient six-passengercar <strong>in</strong> <strong>the</strong> world, with a four-cyl<strong>in</strong>der eng<strong>in</strong>e. That got us started;and we went back to Wash<strong>in</strong>gton and we made claims that wewould be able to f<strong>in</strong>d our way home f<strong>in</strong>ancially because of this car.
GERALD GREENWALD 233After that, some of <strong>the</strong> same guys with Iacocca—as well as Iacoccahimself—created <strong>the</strong> m<strong>in</strong>ivan. We did research on it, and <strong>the</strong>consumer said, ‘‘Why would you want to build that? Where’s<strong>the</strong> trunk? Where’s <strong>the</strong> hood? It looks like a breadbasket!’’ Andyet we were conv<strong>in</strong>ced that once we actually started sell<strong>in</strong>g <strong>the</strong>m,people would want <strong>the</strong>m. And we took our chances.Those were k<strong>in</strong>d of crazy days, but I remember it still as if it weretoday. Hal Sperlich, <strong>the</strong> guy who had been work<strong>in</strong>g on <strong>the</strong> m<strong>in</strong>ivan,and I were <strong>in</strong> <strong>the</strong> design center, and one of my f<strong>in</strong>ance guys came <strong>in</strong>with <strong>the</strong> news that it would cost us $700 million for tool<strong>in</strong>g <strong>the</strong>m<strong>in</strong>ivan. And although $700 million might not sound like muchtoday, it was for us back <strong>the</strong>n. I can recall tell<strong>in</strong>g him that we simplydidn’t have that k<strong>in</strong>d of money. But <strong>the</strong>n Hal and I looked at eacho<strong>the</strong>r and said, ‘‘Well, we don’t have any money, so what’s ano<strong>the</strong>r$700 million? Let’s get started, and we’ll figure out how to come upwith <strong>the</strong> money.’’ After <strong>the</strong> m<strong>in</strong>ivan, our next car was <strong>the</strong> JeepCherokee, which came after we bought American Motors.So what is my message here? The product, <strong>the</strong> product, <strong>the</strong>product! You cannot save your way out of a crisis. You cannot cutyour costs enough to become successful. If you are a servicecompany, you have got to have really good service—it’s that simple.If you are a product company, you have to have superb product, ornoth<strong>in</strong>g is go<strong>in</strong>g to save you. So we bet all our horses on newproduct, but it was pretty obvious we were runn<strong>in</strong>g out of cash.I was sent to Wash<strong>in</strong>gton, DC, to plead our case. One of <strong>the</strong>th<strong>in</strong>gs I learned <strong>in</strong> Wash<strong>in</strong>gton was <strong>from</strong> an old political warrior,Tip O’Neill, who said, ‘‘Listen, sonny; <strong>in</strong> Wash<strong>in</strong>gton, you can bedead right, but you can still be dead.’’ We were pitch<strong>in</strong>g anargument that <strong>the</strong> government—who was impos<strong>in</strong>g all <strong>the</strong>se fueleconomy <strong>in</strong>creases and emissions reductions—should give us a taxcredit because as <strong>the</strong> smallest of <strong>the</strong> ‘‘big three,’’ we were pay<strong>in</strong>gmore money per car than our competitors. Fixed costs were spreadover fewer cars. After about 30 days, Wash<strong>in</strong>gton was start<strong>in</strong>g tolaugh at us, but <strong>the</strong> argument was actually logical.
234 THRIVING IN THE NEW ECONOMYF<strong>in</strong>ally o<strong>the</strong>rs <strong>in</strong> <strong>the</strong> adm<strong>in</strong>istration came up with an idea that wemight be able to make a case for loan guarantees, and this is whatstarted us on <strong>the</strong> right path. I learned a lot about Wash<strong>in</strong>gton. Iliterally had an office <strong>in</strong> <strong>the</strong> basement of <strong>the</strong> Treasury department,because we were so <strong>in</strong>tertw<strong>in</strong>ed and <strong>in</strong>fluenced by what was go<strong>in</strong>g ondown <strong>the</strong>re. After all was said and done, we had a better product andcosts were down; we had 10 years to pay off those loans, but weneeded only four.Pay<strong>in</strong>g Uncle Sam BackChrysler and GM are go<strong>in</strong>g to need to do this <strong>the</strong> moment <strong>the</strong>ycome out of bankruptcy. We almost didn’t care about anyth<strong>in</strong>g elsef<strong>in</strong>ancially; we cared about gett<strong>in</strong>g to what we called ‘‘cash breakeven.’’ And we weren’t go<strong>in</strong>g to do it by stopp<strong>in</strong>g new product<strong>in</strong>vestment. We kept hammer<strong>in</strong>g at our costs and f<strong>in</strong>d<strong>in</strong>g new waysto generate cash.First, we changed <strong>the</strong> payment terms for dealers. They had to takecars literally <strong>the</strong> moment <strong>the</strong>y went over a yellow l<strong>in</strong>e <strong>in</strong> each assemblyplant; and if <strong>the</strong>y needed to borrow money, <strong>the</strong>y could borrow it <strong>from</strong>our f<strong>in</strong>ance company. We extended payment terms with our suppliersto 45 days, which for <strong>the</strong> most part, still exist 30 years later <strong>in</strong> <strong>the</strong><strong>in</strong>dustry. If you run <strong>the</strong> math on that, you create cash really fast whencar sales start go<strong>in</strong>g up. In fact, I always wanted to say to my guys,‘‘It’s not our cash permanently, because if sales ever turn down, allthat money is go<strong>in</strong>g to pour back out.’’ But our sales kept creep<strong>in</strong>gup, and that helped a lot to create <strong>the</strong> cash we needed to pay backUncle Sam.Fast-Forward to TodayWhat has happened to <strong>the</strong> Big Three has been quite a shock to me.I did not th<strong>in</strong>k that I had any emotional ties to <strong>the</strong> auto <strong>in</strong>dustryanymore. After all, <strong>the</strong> last time I worked at an auto company was <strong>in</strong>
GERALD GREENWALD 2351990, and that was 19 years ago. I couldn’t help <strong>from</strong> rem<strong>in</strong>isc<strong>in</strong>gwhen I worked for Ford at a time when <strong>the</strong> car companies were<strong>the</strong> k<strong>in</strong>g. I got sent out to build companies <strong>in</strong> o<strong>the</strong>r countries, and<strong>in</strong> <strong>the</strong> process, I would teach o<strong>the</strong>rs how to make cars. Now, <strong>the</strong>Big Three are at <strong>the</strong> bottom of <strong>the</strong> hill try<strong>in</strong>g to survive, whichis upsett<strong>in</strong>g.Optimistically, Ford will stay on its feet on its own. It willcont<strong>in</strong>ue to prosper or will start do<strong>in</strong>g so when <strong>the</strong> economy comesback. GM has downsized and has come out of bankruptcy with amuch better competitive cost structure and <strong>the</strong> opportunity tostart grow<strong>in</strong>g aga<strong>in</strong>. Chrysler has also emerged <strong>from</strong> bankruptcyand now with a partnership with Fiat has a new lease on life asChrysler Group.In any case, <strong>the</strong> auto <strong>in</strong>dustry, which I believe is about <strong>the</strong>toughest <strong>in</strong>dustry <strong>in</strong> <strong>the</strong> world <strong>in</strong> which to succeed, is go<strong>in</strong>g toget even tougher.Steps for Autos to ThriveYears ago, when I was <strong>in</strong> <strong>the</strong> auto bus<strong>in</strong>ess, <strong>the</strong>re would be momentswhen we were hav<strong>in</strong>g a dr<strong>in</strong>k or we would be between meet<strong>in</strong>gs andsomeone would say, ‘‘Wow, this is <strong>the</strong> toughest <strong>in</strong>dustry <strong>in</strong> <strong>the</strong>world.’’ And I would th<strong>in</strong>k, ‘‘Gee, isn’t that self-serv<strong>in</strong>g.’’ Now I’vebeen <strong>in</strong> five <strong>in</strong>dustries, and I can still claim that auto is <strong>the</strong> toughest<strong>in</strong>dustry <strong>in</strong> <strong>the</strong> world. It’s so difficult because you have to be braveenough to start on a billion-dollar project for one new car platformthree years <strong>in</strong> advance of sell<strong>in</strong>g it—and be smart enough to figureout how it can succeed. In addition, if it is a fair-sized car company,you have 10 of <strong>the</strong>se projects go<strong>in</strong>g on at any one time. You are alsotry<strong>in</strong>g to figure out what your competition is go<strong>in</strong>g to be do<strong>in</strong>g, soit’s tricky. Then, <strong>in</strong> order to succeed, you need to manufacture <strong>in</strong>several countries and deal with <strong>the</strong> political, <strong>in</strong>dustrial, and unionissues <strong>in</strong> all of <strong>the</strong>m, as well as <strong>the</strong> dealer organizations and anenormous world-wide supply base.
236 THRIVING IN THE NEW ECONOMYThe Nuts and Bolts of <strong>the</strong> Auto IndustryAsk yourself how many parts <strong>the</strong>re are <strong>in</strong> a car. If you count aneng<strong>in</strong>e as one, <strong>the</strong> answer would be 4,000 parts. But if you say,‘‘Well, wait a m<strong>in</strong>ute, <strong>the</strong> eng<strong>in</strong>e has x number of parts . . .’’ <strong>the</strong>reare 40,000 parts that go <strong>in</strong>to one car. And every one of those partshas to show up at a plant on time every day, and be on time and ofgood quality.Thereisalwaysexcessproductioncapacityaround<strong>the</strong>world.You hear people say that one of <strong>the</strong> problems of <strong>the</strong> auto <strong>in</strong>dustryis that <strong>the</strong>re is too much capacity; if GM and Chrysler downsize,that would be good. But that is not go<strong>in</strong>g to solve <strong>the</strong> problem ofextra capacity. The Ch<strong>in</strong>ese and Indians are add<strong>in</strong>g more capacity,and we haven’t heard <strong>from</strong> <strong>the</strong> Russians yet. So it’s an <strong>in</strong>dustrywith excess capacity all <strong>the</strong> time.Green PushI am oversimplify<strong>in</strong>g a little bit, but <strong>the</strong> only push <strong>in</strong> NorthAmerica for small cars that are high-tech and highly fuel efficientis com<strong>in</strong>g <strong>from</strong> Wash<strong>in</strong>gton and a few environmentalists. That’sit. Why? Because <strong>the</strong> price of gasol<strong>in</strong>e is down. The notion thatAmericansarego<strong>in</strong>gtorushtosmall,fuel-efficientcarsoutofasense of contribut<strong>in</strong>g to reduce global warm<strong>in</strong>g is someth<strong>in</strong>g Ireally doubt. We’ve seen it before. When <strong>the</strong> price of gasol<strong>in</strong>ewas $4.00, nobody wanted to buy pickups and SUVs; everybodywas rush<strong>in</strong>g to buy cars like <strong>the</strong> Prius. Right now, with gasol<strong>in</strong>ecosts around $2.00 to $3.00, small cars are not hot. And not justbecause <strong>the</strong> economy is soft. There used to be 16 million cars be<strong>in</strong>gpurchased per year; that number is now around 10 million. Thenumber one sell<strong>in</strong>g car is a V-8 pickup aga<strong>in</strong>, not a sedan.There is also an underly<strong>in</strong>g safety issue that we haven’t talkedabout. Many people believe that SUVs are safer than smaller cars,
GERALD GREENWALD 237because if you consider <strong>the</strong> statistics, you see that drivers of small carsget hurt more often than drivers of large cars. But <strong>the</strong> issue is reallyphysics. If a 2,000-pound object collides with a 4,000-pound object,<strong>the</strong> 4,000 pound object always w<strong>in</strong>s. SUVs are 4,000 or 5,000pounds, whereas smaller cars are 2,000 or 2,500 pounds. If all carson <strong>the</strong> roads are lightweight, <strong>the</strong>y will be safe; and at $4.00 pergallon, people are go<strong>in</strong>g to want small cars. Not true at $2.00. Theprice of oil is so volatile over a two- to five-year period, andcar companies are try<strong>in</strong>g to figure out which new cars to <strong>in</strong>vest<strong>in</strong> and <strong>in</strong>troduce to <strong>the</strong> market. That’s part of why this <strong>in</strong>dustry isso tough.Invest<strong>in</strong>g StrategiesIf you are a long-term <strong>in</strong>vestor, on <strong>the</strong> macro level, you need tobelieve <strong>the</strong> economy is go<strong>in</strong>g to get better. However, it seems to meit would be naïve to assume that it is ever go<strong>in</strong>g to get as frothy as itwas two years ago, when an <strong>in</strong>vestor could get all <strong>the</strong> credit he orshe needed to buy a company, an office build<strong>in</strong>g, a hotel, leverage totrade equities, or a house. That is not com<strong>in</strong>g back—at least notanytime soon. But our economy is go<strong>in</strong>g to streng<strong>the</strong>n aga<strong>in</strong>, andpeople like me are try<strong>in</strong>g to figure out when we hit bottom and haveconfidence that if we get close to a bottom and buy, we will be f<strong>in</strong>e.Then <strong>the</strong>re are those who say, historically, certa<strong>in</strong> sectors come backearly and some of <strong>the</strong>m come back late. You can k<strong>in</strong>d of count onthat sequenc<strong>in</strong>g as you <strong>in</strong>vest.<strong>Thriv<strong>in</strong>g</strong> IndicatorsI’ve always preached that <strong>the</strong> person responsible for o<strong>the</strong>rs <strong>in</strong> <strong>the</strong>workplace needs to rem<strong>in</strong>d himself or herself that we spend most ofour wak<strong>in</strong>g hours work<strong>in</strong>g, and <strong>the</strong>re’s got to be some element offun and enthusiasm <strong>in</strong> it or <strong>the</strong> boss isn’t do<strong>in</strong>g his job. So here we
238 THRIVING IN THE NEW ECONOMYare <strong>in</strong> a nasty recession and unemployment is ugly, but <strong>the</strong>re needsto be some measure of enjoyment and excitement <strong>in</strong> <strong>in</strong>vest<strong>in</strong>g.Someth<strong>in</strong>g Iacocca once said to me about build<strong>in</strong>g a managementteam—advice that I’ve been us<strong>in</strong>g to this day—is <strong>the</strong> follow<strong>in</strong>g: Ifyou are <strong>the</strong> leader, it is so much easier to slow down 10 stallions youhave than it is to get 10 mules to keep go<strong>in</strong>g.S<strong>in</strong>cewe<strong>in</strong>vest<strong>in</strong><strong>the</strong>wholesectoroftransportation,wehavew<strong>in</strong>dows <strong>in</strong>to a lot of <strong>the</strong> <strong>in</strong>dicators. When will our railroadsaga<strong>in</strong> start to order capital goods? That is one of <strong>the</strong> <strong>in</strong>dicators.When will truck fleets start to buy new equipment aga<strong>in</strong>? Thequantities of goods and passenger movement are strong <strong>in</strong>dicators.We watch all <strong>the</strong>se, and that helps give us confidence when it’s timeto come back <strong>in</strong>.
Part FiveRetail
23Steve SadoveIt’s hard enough deal<strong>in</strong>gwithanail<strong>in</strong>geconomy<strong>in</strong> <strong>the</strong> here andnow, but imag<strong>in</strong>e try<strong>in</strong>gto anticipate <strong>the</strong> confidenceand buy<strong>in</strong>gtrends of consumers atleast six months <strong>in</strong> advance.That’s what SaksCEO Steve Sadove hasto do. The Septemberfree fall hurt everyone,especially retailers. (SeeFigure 23.1.)Total retail sales weredown 10.6 percent <strong>in</strong>December, and <strong>in</strong>ventorieswere brimm<strong>in</strong>g after <strong>the</strong> consumer fell off a cliff.The statistics were even worse <strong>in</strong> <strong>the</strong> luxury sector. Steve(cont<strong>in</strong>ued )241
242 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued )Figure 23.1Total Retail Sales (Year-over-Year Percent Change)6.0%4.0%2.0%0.0%(2.0%)(4.0%)(6.0%)(8.0%)(10.0%)(12.0%)3.6%2.4%2.7% 2.9%1.8% 1.6% 1.7% 1.1%(1.5%)Jan 2008Feb 2008Mar 2008Apr 2008May 2008Source: Telsey Advisory GroupJun 2008July 2008Aug 2008(5.0%)(8.0%)(8.4%)(9.1%)(9.6%)(10.6%)(10.1%)hasbeenabletocutcostsandstrikeadelicatebalancebetween demand and <strong>in</strong>ventory. Along <strong>the</strong> way, he’s createda new corporate culture that he says will be Saks’ new norm.Sep 2008Oct 2008Nov 2008Dec 2008Jan 2009Feb 2009Mar 2009Apr 2009In 2007, Saks’ comparable store sales grew by double digits.Even <strong>in</strong> <strong>the</strong> fourth quarter of 2007, revenues <strong>in</strong>creased byapproximately 10 percent. In <strong>the</strong> luxury retail bus<strong>in</strong>ess, we must tryto accurately anticipate customer demand six to n<strong>in</strong>e months <strong>in</strong>advance, as that is when orders are placed for merchandise. As webegan to plan our fall 2008 bus<strong>in</strong>ess <strong>in</strong> late 2007, we believed wewere be<strong>in</strong>g conservative, assum<strong>in</strong>g that luxury sales would slowdown somewhat but that we would still achieve some modest yearover-yeargrowth. By early 2008, we had begun to experience someretrench<strong>in</strong>g of ‘‘aspirational’’ customers (that is, customers forwhom our items are <strong>in</strong>frequent, luxury purchases), but our core,higher-end customer was still hold<strong>in</strong>g up pretty well. We started to
STEVE SADOVE 243see a gradual slowdown <strong>in</strong> overall sales throughout <strong>the</strong> early partof 2008. Our comparable store sales grew <strong>in</strong> <strong>the</strong> 4 to 5 percent range<strong>in</strong> <strong>the</strong> first quarter, and we were flat <strong>in</strong> <strong>the</strong> second quarter. However,<strong>the</strong> higher-end customer with<strong>in</strong> our portfolio was still experienc<strong>in</strong>g adouble-digit growth rate through <strong>the</strong> middle of <strong>the</strong> year.Volatility and Consumer ConfidenceIn mid-2008, as <strong>the</strong> stock market became <strong>in</strong>creas<strong>in</strong>gly unstable andstarted experienc<strong>in</strong>g significant drops, we began to see more volatility<strong>in</strong> our bus<strong>in</strong>ess. With <strong>the</strong> September 2008 Lehman Bro<strong>the</strong>rs’bankruptcy, <strong>the</strong> stock market began what felt like a free fall, and ourcore consumers started freez<strong>in</strong>g <strong>in</strong> terms of <strong>the</strong>ir behavior. It was ashock to <strong>the</strong> system. The consumers at <strong>the</strong> high end, who had been<strong>the</strong> most stable and were hold<strong>in</strong>g up <strong>the</strong> best, suddenly turned <strong>in</strong>to<strong>the</strong> ones that were perform<strong>in</strong>g most poorly. Sales <strong>in</strong> <strong>the</strong> luxury sectorare closely correlated with <strong>the</strong> f<strong>in</strong>ancial markets. (See Figure 23.2.)Customers became <strong>in</strong>creas<strong>in</strong>gly reluctant to shop as <strong>the</strong>y watched<strong>the</strong>ir net worths plummet by 40 percent or more. Our double-digitgrowth quickly reversed to double-digit sales decl<strong>in</strong>es. The luxuryretailer was <strong>in</strong> some ways next to <strong>the</strong> f<strong>in</strong>ancial markets, probably <strong>in</strong><strong>the</strong> eye of <strong>the</strong> storm.The shopp<strong>in</strong>g spree that many people had been on for yearssuddenly came to a halt. So that’s <strong>the</strong> backdrop <strong>in</strong> terms of what wehad to th<strong>in</strong>k about and how we had to manage. We were nowoperat<strong>in</strong>g <strong>in</strong> a whole new world.Too Much InventoryIn light of <strong>the</strong> significant sales decl<strong>in</strong>es, we were sitt<strong>in</strong>g on a lotof <strong>in</strong>ventory, probably several hundred million dollars too much.The ‘‘system’’—mean<strong>in</strong>g Saks Fifth Avenue, <strong>the</strong> luxury vendors,and <strong>the</strong> o<strong>the</strong>r high-end competitors—had hundreds and hundreds
244 THRIVING IN THE NEW ECONOMYFigure 23.2Luxury Retail Sales versus Saks, Inc.Year-over-Year Change <strong>in</strong> Luxury Composite vs. Saks Inc. Stock PriceCorrelation = 0.72Year-over-Year % Change20.0%15.0%10.0%5.0%0.0%(5.0%)(10.0%)(15.0%)(20.0%)$25.00$20.00$15.00$10.00$5.00$0.00Clos<strong>in</strong>g PriceQ205Q305Q405Q106Q206Q306Q406Q107Q207Q307Q407Q108Q208Q308Q408Q109Year-over-Year Change <strong>in</strong> Luxury CompositeSaks Inc. Clos<strong>in</strong>g PriceYear-over-Year Change <strong>in</strong> Luxury Composite vs. S&P 500 Clos<strong>in</strong>g PriceCorrelation = 0.88Year-over-Year % Change20.0%15.0%10.0%5.0%0.0%(5.0%)(10.0%)(15.0%)(20.0%)1,8001,6001,4001,2001,0008006004002000Clos<strong>in</strong>g PriceQ205Q305Q405Q106Q206Q306Q406Q107Q207Q307Q407Q108Q208Q308Q408Q109Year-over-Year Change <strong>in</strong> Luxury CompositeS&P 500 Clos<strong>in</strong>g Price*1Q09 Year-over-year change excludes Hermes and LVMH because <strong>the</strong>y have not reported.Source: Telsey Advisory Groupof millions of dollars of too much product. So we were deal<strong>in</strong>g wi<strong>the</strong>xcess merchandise and a bus<strong>in</strong>ess and <strong>in</strong>dustry substantially smallerthan <strong>the</strong>y had been. The disconnect between supply and demandwas widen<strong>in</strong>g.Priority one was quickly clear<strong>in</strong>g excess <strong>in</strong>ventory. To do this, wehad to take some ra<strong>the</strong>r extraord<strong>in</strong>ary markdowns, and <strong>the</strong> pric<strong>in</strong>gactions we took resulted <strong>in</strong> <strong>the</strong> consumer gett<strong>in</strong>g some great deals.We were very proactive and aggressive about gett<strong>in</strong>g <strong>the</strong> two <strong>in</strong> l<strong>in</strong>eso that when we entered 2009, <strong>the</strong> company would have a more
STEVE SADOVE 245balanced <strong>in</strong>ventory position. It was difficult, because we took it on<strong>the</strong> ch<strong>in</strong> relative to our gross marg<strong>in</strong> rate, but we quickly cleared <strong>the</strong>products, which was <strong>the</strong> absolute right th<strong>in</strong>g to do. However, it waspa<strong>in</strong>ful <strong>from</strong> a f<strong>in</strong>ancial perspective, and we lost a lot of money <strong>in</strong> <strong>the</strong>fourth quarter of 2008.<strong>New</strong> <strong>Economy</strong> StrategyWith <strong>the</strong> recent downturn, we nimbly and quickly shifted <strong>the</strong> focusof our organization <strong>from</strong> operat<strong>in</strong>g a high-growth bus<strong>in</strong>ess tomanag<strong>in</strong>g a smaller sales base. A cultural evolution with<strong>in</strong> <strong>the</strong>organization was tak<strong>in</strong>g place. The past became a lot less relevant,and we started th<strong>in</strong>k<strong>in</strong>g differently about every aspect of ourbus<strong>in</strong>ess. There are three th<strong>in</strong>gs I would call out as be<strong>in</strong>g criticalto manage through and to w<strong>in</strong> <strong>in</strong> this new economy: controll<strong>in</strong>gwhat you can control; listen<strong>in</strong>g to your customers and mak<strong>in</strong>gneeded strategic shifts to <strong>the</strong> company’s bus<strong>in</strong>ess model to accommodate<strong>the</strong> chang<strong>in</strong>g environment and consumer desires; andcommunicat<strong>in</strong>g thoroughly, thoughtfully, and frequently.Controll<strong>in</strong>g What We Can ControlWith sales trend<strong>in</strong>g <strong>in</strong> excess of 20 percent below prior year levels,we began keenly focus<strong>in</strong>g on what we could control—our capitalspend<strong>in</strong>g, our <strong>in</strong>ventory purchases, and our expenses. We started toth<strong>in</strong>k about manag<strong>in</strong>g our bus<strong>in</strong>ess for cash and ensur<strong>in</strong>g that werema<strong>in</strong>ed f<strong>in</strong>ancially solid and that we emerged an even strongerbus<strong>in</strong>ess when <strong>the</strong> economic conditions improved.Although we cut our annual capital spend<strong>in</strong>g by nearly 60 percentand reduced <strong>in</strong>ventory purchases by 20 percent <strong>in</strong> 2009, I wasespecially pleased with how <strong>the</strong> organization approached andembraced right-siz<strong>in</strong>g <strong>the</strong> organization and cost structure for <strong>the</strong>lower sales base. Between <strong>the</strong> third fiscal quarter of 2008 and <strong>the</strong>second fiscal quarter of 2009, we reduced sell<strong>in</strong>g, general, and
246 THRIVING IN THE NEW ECONOMYadm<strong>in</strong>istrative expenses by over $125 million, which certa<strong>in</strong>lyexceeded our expectations and those of <strong>the</strong> <strong>in</strong>vestment community.These reductions reflected some hard decisions, such as reduc<strong>in</strong>g ourworkforce by approximately 17 percent and cutt<strong>in</strong>g managementsalaries, and <strong>in</strong>cluded reductions <strong>in</strong> essentially every area of <strong>the</strong>bus<strong>in</strong>ess, <strong>from</strong> travel to supplies to benefits to market<strong>in</strong>g to <strong>in</strong>formationtechnology. We left no stone unturned. We approachedevery area of <strong>the</strong> bus<strong>in</strong>ess ask<strong>in</strong>g, ‘‘How should we do it go<strong>in</strong>gforward?’’ not, ‘‘How did we do it <strong>in</strong> <strong>the</strong> past?’’ As a result, weidentified and began implement<strong>in</strong>g cost reductions beyond what weorig<strong>in</strong>ally anticipated. The cost reductions were significant; however,we were very cautious <strong>in</strong> areas where we <strong>in</strong>terface with <strong>the</strong>consumer as we cont<strong>in</strong>ue to place <strong>the</strong> utmost importance on fur<strong>the</strong>renhanc<strong>in</strong>g our service levels.I would be very surprised if this belt-tighten<strong>in</strong>g doesn’t become<strong>the</strong> new norm and stay with us. As <strong>the</strong>y say, ‘‘Don’t let a recession goto waste,’’ and we don’t <strong>in</strong>tend to. As <strong>the</strong> economy improves, <strong>the</strong>lessons learned of reduc<strong>in</strong>g costs, spend<strong>in</strong>g money more wisely, andmanag<strong>in</strong>g for cash are a part of our culture.Pulse of <strong>the</strong> ConsumerOur goal rema<strong>in</strong>ed constant: to w<strong>in</strong> with our merchandise, service,and market<strong>in</strong>g strategies. We had to ensure that <strong>the</strong>se strategies were<strong>the</strong> right ones to meet <strong>the</strong> desires of our customers and <strong>the</strong> chang<strong>in</strong>genvironment. In <strong>the</strong> spr<strong>in</strong>g of 2009, we conducted research withthousands of exist<strong>in</strong>g and potential customers. Although feel<strong>in</strong>g a lotless wealthy than <strong>in</strong> <strong>the</strong> past, <strong>the</strong> research confirmed that <strong>the</strong> luxuryconsumer still liked to shop, appreciated brands even more thanbefore, had developed a heightened service expectation, and wassearch<strong>in</strong>g for value more than ever—with value not just def<strong>in</strong>ed byprice but by quality, workmanship, and uniqueness as well.Although <strong>the</strong> research re<strong>in</strong>forced our belief that we were generallyon track with our strategies, we took <strong>the</strong> f<strong>in</strong>d<strong>in</strong>gs and made necessary
STEVE SADOVE 247adjustments to our <strong>in</strong>itiatives <strong>in</strong> order to ga<strong>in</strong> market share <strong>in</strong> <strong>the</strong>new environment. We collaborated closely with our vendor partnersto create merchandise that our customers would appreciate andvalue. Our customers love brands, and <strong>the</strong>y like th<strong>in</strong>gs that arespecial and exclusive—but <strong>the</strong>y want a fair value <strong>in</strong> what <strong>the</strong>y’rebuy<strong>in</strong>g. We worked to ensure that we offered <strong>the</strong> right balance of‘‘good,’’ ‘‘better,’’ and ‘‘best’’ luxury merchandise <strong>in</strong> each of ourstores. ‘‘Clientel<strong>in</strong>g,’’ build<strong>in</strong>g relationships, and provid<strong>in</strong>g exceptionalservice became more critical than ever. Every store developed alocal bus<strong>in</strong>ess plan and began tak<strong>in</strong>g ownership of expand<strong>in</strong>g <strong>the</strong>irmarket share by identify<strong>in</strong>g potential customers and how to improverelationships with <strong>the</strong>m.Communicat<strong>in</strong>gIntegral to reshap<strong>in</strong>g <strong>the</strong> organization’s culture and th<strong>in</strong>k<strong>in</strong>g wascommunicat<strong>in</strong>g to <strong>the</strong> associates and mak<strong>in</strong>g sure that <strong>the</strong>y understoodwhy we were do<strong>in</strong>g what we were do<strong>in</strong>g—<strong>from</strong> reduc<strong>in</strong>g coststo adjust<strong>in</strong>g our merchandis<strong>in</strong>g strategies. One of <strong>the</strong> most impactfulth<strong>in</strong>gs I did, beg<strong>in</strong>n<strong>in</strong>g <strong>in</strong> October 2008, was to create ‘‘StraightTalk with Steve.’’Every two weeks or so, I would spend five m<strong>in</strong>utes videorecord<strong>in</strong>g a message to all associates <strong>from</strong> my office <strong>in</strong> which Idescribed what we were do<strong>in</strong>g and why, basically shar<strong>in</strong>g whateverwas on my m<strong>in</strong>d. (See <strong>the</strong> photo on <strong>the</strong> follow<strong>in</strong>g page.) Then wewould send it out to our 12,000 employees. It became a way to keepeverybody apprised on a very frequent basis about what washappen<strong>in</strong>g <strong>in</strong> <strong>the</strong> organization. My direct reports were do<strong>in</strong>g similark<strong>in</strong>ds of th<strong>in</strong>gs. So I was lead<strong>in</strong>g <strong>the</strong> charge <strong>in</strong> communicat<strong>in</strong>g,gett<strong>in</strong>g everyone <strong>in</strong>volved, and mak<strong>in</strong>g everyone part of <strong>the</strong> process.In fact, ‘‘Straight Talk with Steve’’ cont<strong>in</strong>ues today.The remarkable th<strong>in</strong>g about this unprecedented period was that<strong>the</strong> morale throughout all levels of <strong>the</strong> company held up amaz<strong>in</strong>glywell. I believe that because we treated people with dignity and
248 THRIVING IN THE NEW ECONOMYFigure 23.3‘‘Straight Talk with Steve’’respect and communicated so frequently and so thoroughly, ourassociates understood that we weren’t alone <strong>in</strong> this—and that whatwe were do<strong>in</strong>g was necessary for <strong>the</strong> survival of <strong>the</strong> company.Be<strong>in</strong>g <strong>the</strong> CEO of a company <strong>in</strong>cludes be<strong>in</strong>g its chief cheerleader.In communicat<strong>in</strong>g, you have to be fact- and reality-based, but youmust also express optimism and confidence that we can not onlysurvive but w<strong>in</strong> <strong>in</strong> <strong>the</strong> long term.I am excited about <strong>the</strong> future of <strong>the</strong> country, <strong>the</strong> retail sector, andSaks. I have never seen <strong>the</strong> <strong>in</strong>dustry so energized about <strong>the</strong> changesthat are tak<strong>in</strong>g place. I see better days ahead. We are not lett<strong>in</strong>g arecession go to waste.
Part SixOpportunities
24Wilbur RossThe leaders <strong>in</strong> <strong>the</strong> neweconomy are <strong>the</strong> oneswho are pick<strong>in</strong>g through<strong>the</strong> carnage to uncoveropportunities at pricesthat may never be seenaga<strong>in</strong> <strong>in</strong> this generation.One <strong>in</strong>vestor who’sknown for hav<strong>in</strong>g <strong>the</strong> panacheto turn around‘‘bad’’ <strong>in</strong>vestments is Wilbur Ross. For more than four decades,Wilbur has become <strong>the</strong> undisputable k<strong>in</strong>g <strong>in</strong> spott<strong>in</strong>gtroubled companies and turn<strong>in</strong>g <strong>the</strong>m around. Althoughmany people characterize him as a ‘‘vulture’’ <strong>in</strong>vestor, Wilburreally is <strong>the</strong> discern<strong>in</strong>g judge of dy<strong>in</strong>g companies.Wilbur’s Wall Street fame began when he purchased <strong>the</strong>fail<strong>in</strong>g steel companies LTV and Bethlehem Steel and createdInternational Steel Group (ISG). In 2005, he sold ISG toArcelorMittal, <strong>the</strong> world’s largest steel company, for $4.5billion. His firm, WL Ross & Co., made $2.5 billion <strong>from</strong> thatdeal, and Ross himself took home a reported $300 million.(cont<strong>in</strong>ued)251
252 THRIVING IN THE NEW ECONOMY(cont<strong>in</strong>ued)After that, Wilbur created International Coal Group outof <strong>the</strong> bankrupt Horizon Natural Resources <strong>in</strong> 2004 and hass<strong>in</strong>ce set his sights on <strong>the</strong> new economy’s troubled assets:fail<strong>in</strong>g banks like BankUnited, struggl<strong>in</strong>g real estate f<strong>in</strong>ancecompanies such as Assured Guaranty and American HomeMortgage Servic<strong>in</strong>g, as well as <strong>the</strong> auto suppliers.Wilbur along with Richard LeFrak has comb<strong>in</strong>ed <strong>the</strong>ir realestate and f<strong>in</strong>ancial prowess <strong>in</strong> creat<strong>in</strong>g <strong>the</strong> jo<strong>in</strong>t ventureWLR LeFrak. In addition to <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> failed Floridabank BankUnited, <strong>the</strong> group was part of a consortiumthat announced <strong>in</strong> October of 2009 <strong>the</strong>y would acquire$4.5 billion <strong>in</strong> real estate assets <strong>from</strong> failed Chicago-basedbank Corus Bank Real. Valu<strong>in</strong>g around $2.77 billion, <strong>the</strong>transaction at <strong>the</strong> time was one of <strong>the</strong> largest acquisitions ofdistressed commercial real estate assets.For about n<strong>in</strong>e years, I have worked with Wilbur on <strong>the</strong>numerous corporate announcements he has made as wellas his guest co-host<strong>in</strong>g gigs on Squawk Box. His approachto a deal is very <strong>in</strong>terest<strong>in</strong>g; I enjoy hear<strong>in</strong>g about how hecan slice through what many <strong>in</strong>vestors may th<strong>in</strong>k is garbage.He is able to buy a company and transform it <strong>in</strong>to aprofitable bus<strong>in</strong>ess—and that is what makes him one of<strong>the</strong> best bus<strong>in</strong>essmen of his time.At 8:30 A.M. S<strong>in</strong>gapore time on Monday, September 15,2008, I was walk<strong>in</strong>g across Orchard Street <strong>from</strong> an <strong>in</strong>terviewon CNBC’s Asia Squawk Box to my meet<strong>in</strong>g with Madam Ho,CEO of Temasek and a major <strong>in</strong>vestment arm of <strong>the</strong> government.My BlackBerry rang with an excited call <strong>from</strong> our portfolio manager,David Storper: ‘‘Bank of America is acquir<strong>in</strong>g Merrill, andLehman will file bankruptcy tomorrow.’’I was stunned. Bank of America had been expected to acquireLehman Bro<strong>the</strong>rs, and <strong>the</strong>re was not even a whisper that Merrill
WILBUR ROSS 253Lynch needed to be taken over. In fact, CEO John Tha<strong>in</strong> hadraised billions of dollars of equity for Merrill Lynch—some of it<strong>from</strong> Temasek. David had checked on our exposures and reportedthatwehadasmallamountofdollar-yenswapwithLehmanBro<strong>the</strong>rs; Lehman Bro<strong>the</strong>rs was on <strong>the</strong> profitable side, and <strong>the</strong>reforewe had no credit risk. One of our portfolio companies,Montpelier Re<strong>in</strong>surance, also had some m<strong>in</strong>or direct hold<strong>in</strong>gs.That was good news, because recoveries would likely be pennies on<strong>the</strong>dollar.Butwhatdid<strong>the</strong>sesurprisesmean?Weconcludedthatboth Lehman Bro<strong>the</strong>rs and Merrill Lynch must have more severelytoxic assets than had been thought. That meant <strong>the</strong> same wouldhave to be true of o<strong>the</strong>r f<strong>in</strong>ancial <strong>in</strong>stitutions—and with <strong>the</strong>economy already teeter<strong>in</strong>g, that could lead to a credit crunchwith serious implications for all bus<strong>in</strong>esses. To protect ourselvesaga<strong>in</strong>st what could be a hostile credit environment, we promptlycontacted <strong>the</strong> CEOs of each of our portfolio companies with <strong>the</strong>follow<strong>in</strong>g suggestions:‘‘No one knows for sure how severe <strong>the</strong> problems of ourf<strong>in</strong>ancial system are, but we <strong>in</strong>terpret <strong>the</strong> events of this pastweekend as portend<strong>in</strong>g a new credit crunch on top of <strong>the</strong>economy’s exist<strong>in</strong>g weakness. Therefore, please assume that youwill likely f<strong>in</strong>d it challeng<strong>in</strong>g to achieve your budgets <strong>from</strong> nowthrough 2009. As a result, prudence dictates slow<strong>in</strong>g or elim<strong>in</strong>at<strong>in</strong>gcapital expenditures for growth, even tighter work<strong>in</strong>g capitalconstra<strong>in</strong>ts, expansion of committed bank l<strong>in</strong>es wherever possible,and draw<strong>in</strong>g down l<strong>in</strong>es well before you actually need <strong>the</strong> cash.S<strong>in</strong>ce <strong>the</strong>se moves will impact negatively our immediate earn<strong>in</strong>gs,it is appropriate to modify downward <strong>the</strong> earn<strong>in</strong>gs target of yourbonusformula.F<strong>in</strong>ally,wemustbeevenmoreconservativethanusual <strong>in</strong> <strong>the</strong> earn<strong>in</strong>gs and cash flow assumptions on which we baseacquisition bids.’’As <strong>the</strong> Temasek meet<strong>in</strong>g began, Madam Ho broke <strong>the</strong> ice byjok<strong>in</strong>g that s<strong>in</strong>ce Bear Stearns had failed on my prior visit andLehman Bro<strong>the</strong>rs and Merrill Lynch this time, that I should promise
254 THRIVING IN THE NEW ECONOMYnot to return to S<strong>in</strong>gapore soon because <strong>the</strong>y did not want ano<strong>the</strong>rcrisis. The rest of <strong>the</strong> meet<strong>in</strong>g went more or less normally.Over d<strong>in</strong>ner that night at <strong>the</strong> improbably named Palm BeachCrab House, my colleagues and I ma<strong>in</strong>ly discussed <strong>the</strong> implicationsaga<strong>in</strong>. The U.S. and Asian markets had tanked accord<strong>in</strong>g to <strong>the</strong>news, and <strong>the</strong> talk<strong>in</strong>g heads were shocked. Like <strong>the</strong> rest of <strong>the</strong><strong>in</strong>vestment community, and probably <strong>the</strong> broader public, our firstquestions were, ‘‘Who’s next?’’ and ‘‘How much of a dom<strong>in</strong>o effectwill <strong>the</strong>re be?’’It didn’t take long to f<strong>in</strong>d out. By <strong>the</strong> time we got to Tokyo forour major <strong>in</strong>vestor conference, a dom<strong>in</strong>o had fallen—and a majorone at that. AIG was taken over by <strong>the</strong> government because itsenormous exposure to derivatives—which had been problematiceven before Lehman Bro<strong>the</strong>rs collapsed—now became totally unmanageable.For as long as one could remember, AIG had been anunimpeachable AAA credit, and although it had gone through anaccount<strong>in</strong>g scandal a few years earlier, <strong>the</strong>re hadn’t been majorrumors of its <strong>in</strong>solvency. One could only wonder whe<strong>the</strong>r AIGmight not have failed if Lehman Bro<strong>the</strong>rs had been saved.Tome,AIG’sfailurewas<strong>the</strong>morefrighten<strong>in</strong>gof<strong>the</strong>two,because AIG was a problem not just for Wall Street but also forMa<strong>in</strong> Street. It was <strong>the</strong> largest U.S. <strong>in</strong>surance company and hadmillions of policy holders <strong>in</strong> <strong>the</strong> United States and Asia. Myforthcom<strong>in</strong>gspeechbecameevenmorebearishthan<strong>the</strong>earlierdraft. As far back as January 2007, I told attendees at a CreditSuisse Asset-Backed Securities Conference that <strong>the</strong> bubble wasburst<strong>in</strong>g. It had seemed clear even <strong>the</strong>n that <strong>the</strong> lack of <strong>in</strong>flationadjustedmedian <strong>in</strong>come growth <strong>from</strong> 2000 to 2006 had causedAmerican families to over-leverage <strong>the</strong>mselves, because that was<strong>the</strong> only way <strong>the</strong>y could live a little better each year. Ris<strong>in</strong>gresidential real estate prices and ever-more-generous mortgagesecuritizations cont<strong>in</strong>ually <strong>in</strong>flated each o<strong>the</strong>r’s bubbles andmade this leverag<strong>in</strong>g possible. Securitizations accounted for halfof all <strong>the</strong> consumer credit <strong>in</strong> <strong>the</strong> United States, and many of <strong>the</strong>
WILBUR ROSS 255credit derivative swaps (CDS) were issued to hedge <strong>the</strong> credit riskof securitizations. Thus, <strong>the</strong> CDS market disruption would createyet ano<strong>the</strong>r problem for securitizations to overcome. With lesscredit, <strong>the</strong> outlook for home and automobile sales would becomevery weak. For example, <strong>in</strong> 2007, 1 million cars were purchased byfamilies us<strong>in</strong>g proceeds <strong>from</strong> remortgag<strong>in</strong>g <strong>the</strong>ir homes. Compound<strong>in</strong>g<strong>the</strong> problem would be <strong>the</strong> loss of consumer confidenceas household name f<strong>in</strong>ancial <strong>in</strong>stitutions went up <strong>in</strong> smoke.For all <strong>the</strong>se reasons, we decided to temporarily suspend newcommitments <strong>in</strong> <strong>the</strong> WLR Recovery Fund IV, our most recent longonlyfund. It was about 25 percent committed, and because it cannotsell stocks short, <strong>the</strong> only way for it to be defensive was to stayun<strong>in</strong>vested. The commitments that it had made were generally <strong>in</strong>non-public companies, so <strong>the</strong>re was no realistic way to sell <strong>the</strong>m.We also decided to sharpen our focus and to put our major efforts<strong>in</strong>to f<strong>in</strong>ancial services. That was clearly <strong>the</strong> epicenter of <strong>the</strong> economicearthquake and most difficult to analyze, because it required one tomake judgments about how bad and for how long <strong>the</strong> economywould get and <strong>the</strong>n translate that <strong>in</strong>to credit judgments about <strong>the</strong>portfolios of <strong>in</strong>dividual <strong>in</strong>stitutions. That level of complexity andrisk tak<strong>in</strong>g would keep most <strong>in</strong>vestors out, especially given that <strong>the</strong>recent rounds of both private and public f<strong>in</strong>anc<strong>in</strong>gs <strong>in</strong> that sectorhad already produced terrible results. For example, Lehman Bro<strong>the</strong>rshad privately raised some $5.5 billion of private equity less thansix months before it folded and rendered <strong>the</strong>se <strong>in</strong>vestments worthless.We had participated that weekend <strong>in</strong> a whirlw<strong>in</strong>d round of duediligence but fortunately dropped out because we concluded thatmanagement was not sufficiently candid about <strong>the</strong>ir real estatehold<strong>in</strong>gs. As it turned out, real estate was <strong>the</strong> pr<strong>in</strong>cipal cause of<strong>the</strong>ir demise.We <strong>in</strong>itially settled on four sectors: mortgage servic<strong>in</strong>g, monol<strong>in</strong>e<strong>in</strong>surance, commercial banks, and thrifts. We already had<strong>in</strong>vested <strong>in</strong> American Home Mortgage Services. It had met orexceeded budget each month, so we were comfortable about
256 THRIVING IN THE NEW ECONOMYanalyz<strong>in</strong>g servic<strong>in</strong>g and achiev<strong>in</strong>g high rates of return <strong>from</strong> it. Theanalytical keys were: (1) to estimate <strong>the</strong> so-called roll rate—at whichborrowers who were pay<strong>in</strong>g on time would become progressivelymore del<strong>in</strong>quent; (2) to forecast how many of those would beforeclosed; (3) to determ<strong>in</strong>e how long it would take to foreclose andsell <strong>the</strong> property; and (4) to determ<strong>in</strong>e what percentage of <strong>the</strong> goodpayers would sell <strong>the</strong>ir homes voluntarily or ref<strong>in</strong>ance <strong>the</strong>m. Thesefactors would determ<strong>in</strong>e both how long we would reta<strong>in</strong> <strong>the</strong> streamof monthly servic<strong>in</strong>g fees and how much capital would be tied upmak<strong>in</strong>g advances on behalf of del<strong>in</strong>quent borrowers. The advanceswere creditworthy because <strong>the</strong>y rank senior to <strong>the</strong> mortgage andmust be paid first, but <strong>the</strong>y did consume capital at a low rate ofreturn. It turned out that we were able to buy a lot more servic<strong>in</strong>g ata high all-<strong>in</strong> rate of return. As of May 2009, eight months afterLehman Bro<strong>the</strong>rs fell—our company has become <strong>the</strong> largest <strong>in</strong>dependentservicer of non-prime mortgages at $106 billion and isearn<strong>in</strong>g at <strong>the</strong> rate of $130 million per year. In a different environment,it probably would have taken several years to achieve thatlevel of earn<strong>in</strong>gs.Monol<strong>in</strong>e <strong>in</strong>surance was our second target. There had orig<strong>in</strong>allybeen half a dozen of <strong>the</strong>se companies that had AAA rat<strong>in</strong>gs andprovided credit enhancement to municipal bonds, securitizations,and <strong>in</strong>frastructure project f<strong>in</strong>anc<strong>in</strong>gs. Most of <strong>the</strong>m were be<strong>in</strong>gdowngraded—<strong>in</strong> some cases, by several notches—because of poorrisk management. The municipal part of <strong>the</strong> bus<strong>in</strong>ess had a relativelylow-risk profile, but many of <strong>the</strong> securitizations, especially onesbacked by mortgages, proved to be quite toxic. Most of <strong>the</strong> monol<strong>in</strong>es,such as Ambac, committed a card<strong>in</strong>al s<strong>in</strong> of risk managementby own<strong>in</strong>g <strong>in</strong> <strong>the</strong>ir portfolios similar credit risks to what <strong>the</strong>y were<strong>in</strong>sur<strong>in</strong>g. This meant that if <strong>the</strong>ir default rate assumptions proved tobe too low, as <strong>the</strong>y did, <strong>the</strong>n <strong>the</strong> monol<strong>in</strong>e would be hit by <strong>the</strong>double whammy of <strong>in</strong>surance and portfolio losses. The <strong>in</strong>suranceexposure alone was many times <strong>the</strong> shareholders’ equity, so <strong>the</strong>specter of <strong>in</strong>solvency loomed large.
WILBUR ROSS 257But one company seemed different: Assured Guaranty. Its CEO,Dom<strong>in</strong>ic Frederico, had a home a few miles <strong>from</strong> my pr<strong>in</strong>cipalresidence <strong>in</strong> Palm Beach, so I asked ano<strong>the</strong>r Palm Beacher, BillBartholomay, <strong>the</strong> Vice Chairman of Willis Group Hold<strong>in</strong>gs (an<strong>in</strong>surance brokerage group), to make <strong>the</strong> <strong>in</strong>troduction. Dom<strong>in</strong>iccame to my home, and we hit it off personally; but more importantly,I was impressed by his command of details of both <strong>the</strong><strong>in</strong>surance and <strong>in</strong>vestment portfolios, and by <strong>the</strong>ir concepts of riskmanagement. The <strong>in</strong>vestments were, on average, AA rated andsubstantively different credits <strong>from</strong> <strong>the</strong> A and BAA issues <strong>the</strong>ytypically enhanced. After a few more meet<strong>in</strong>gs and field duediligence, it seemed clear that <strong>in</strong> an implod<strong>in</strong>g <strong>in</strong>dustry, AssuredGuaranty would be <strong>the</strong> last one left stand<strong>in</strong>g with high credit rat<strong>in</strong>gs.That meant it was <strong>in</strong> a position both to ga<strong>in</strong> market share organicallyand to ei<strong>the</strong>r re<strong>in</strong>sure or acquire exist<strong>in</strong>g <strong>in</strong>surance volumes <strong>from</strong>companies with capital problems. Assured Guaranty’s stock wasdown 30 percent <strong>from</strong> its high 12 months earlier. It also seemedstatistically cheap, because it was trad<strong>in</strong>g modestly below its bookvalue, but at only half <strong>the</strong> sum of its book value and <strong>the</strong> present valueof its future premiums (PVP).PVP is unique to <strong>the</strong> monol<strong>in</strong>e <strong>in</strong>surers. It arises <strong>from</strong> <strong>the</strong> factthat municipalities pay a s<strong>in</strong>gle premium at <strong>the</strong> time <strong>the</strong> coverageof <strong>the</strong> life of <strong>the</strong> bond issue is underwritten, sometimes as long as30 years. But <strong>the</strong> account<strong>in</strong>g rules require <strong>the</strong> premium to be taken<strong>in</strong>to <strong>in</strong>come proportionately over <strong>the</strong> life of <strong>the</strong> bond, <strong>the</strong>rebylock<strong>in</strong>g <strong>in</strong> many years of 100 percent predictable revenues. AssuredGuaranty had generated a non–balance sheet asset of PVP roughlyequal to its book value, which was grow<strong>in</strong>g daily; so at less than onehalf <strong>the</strong> sum of book value and equity, it seemed very attractive.We agreed to <strong>in</strong>vest $250 million at a discount <strong>from</strong> market andcommitted to <strong>in</strong>vest ano<strong>the</strong>r $750 million over <strong>the</strong> next year fordeals at a discount <strong>from</strong> <strong>the</strong> <strong>the</strong>n-market, subject to a floor and aceil<strong>in</strong>g price, and Assured Guaranty’s retention of its AAA stablerat<strong>in</strong>gs. This gave <strong>the</strong> company <strong>the</strong> war chest it needed for
258 THRIVING IN THE NEW ECONOMYacquisitions. A few months later, we helped <strong>the</strong>m negotiate <strong>the</strong>highly complex but also highly accretive acquisition of FSA <strong>from</strong>Dexia, a large European f<strong>in</strong>ancial services company. FSA’s <strong>in</strong>suranceand <strong>in</strong>vestment portfolios had manageable problems, but likeAIG, <strong>the</strong>y had written vast amounts of guaranteed <strong>in</strong>vestmentcontracts and o<strong>the</strong>r derivatives <strong>in</strong> <strong>the</strong>ir f<strong>in</strong>ancial products divisionthat were billions of dollars under water—and gett<strong>in</strong>g worseevery day. The trick was to pay for <strong>the</strong> <strong>in</strong>surance bus<strong>in</strong>ess <strong>in</strong>stock, a deal that would be highly accretive to Assured Guaranty,but to <strong>in</strong>sulate <strong>the</strong> merged company <strong>from</strong> <strong>the</strong> toxicity of <strong>the</strong>f<strong>in</strong>ancial products division. Ultimately, <strong>the</strong> French and Belgiangovernments, who had by now nationalized Dexia, providedAssured Guaranty with <strong>in</strong>demnification.Banks and thrifts were <strong>the</strong> o<strong>the</strong>r targets. We already had made ajo<strong>in</strong>t venture with John Kanas to f<strong>in</strong>d a regional bank, <strong>in</strong>fuse capital<strong>in</strong>to it, <strong>in</strong>stall John as <strong>the</strong> CEO, and <strong>the</strong>n roll up o<strong>the</strong>r depositary<strong>in</strong>stitutions <strong>in</strong> <strong>the</strong> same region, creat<strong>in</strong>g one large enough ei<strong>the</strong>r totrade actively on <strong>the</strong> <strong>New</strong> York Stock Exchange at a decent multipleor to be acquired by one of <strong>the</strong> major domestic or foreign hold<strong>in</strong>gcompanies. John, 62, had taken charge of North Fork Bank <strong>in</strong>Mattituck, Long Island, when it had $20 million of deposits andbuilt it up to $60 billion before sell<strong>in</strong>g it to Capital One at 3.5 timesits book value. He had made a couple of hundred million dollars forhimself out of <strong>the</strong> deal and had served out his non-competeagreement. He didn’t need a job, but he needed a big pocketbook;so we agreed to back him for up to $1 billion. Comb<strong>in</strong><strong>in</strong>g amean<strong>in</strong>gful capital base with John’s excellent reputation withbankers and regulators meant that we would get a look at essentiallyevery troubled bank.But <strong>the</strong>re were some difficult regulatory issues that needed to beresolved. S<strong>in</strong>ce we believed that our targets would be billions ofdollars <strong>in</strong>solvent, we would need <strong>the</strong> Federal Deposit InsuranceCorporation (FDIC) to seize <strong>the</strong> <strong>in</strong>stitution and fill a lot of <strong>the</strong>hole. O<strong>the</strong>rwise, more private capital would be required than
WILBUR ROSS 259could be justified by future earn<strong>in</strong>gs. The problem was that FDIC’spractice had been to conf<strong>in</strong>e <strong>the</strong> bidd<strong>in</strong>g for failed banks to o<strong>the</strong>rbanks and to seize <strong>the</strong> failed <strong>in</strong>stitution on a Friday even<strong>in</strong>g andreopen it as <strong>the</strong> acquir<strong>in</strong>g bank on Monday at 9:00 A.M. Butourfund was not a bank or a bank hold<strong>in</strong>g company—and did notwant to become one. Do<strong>in</strong>g so would have required us to divest ofour non-f<strong>in</strong>ancial assets and never acquire any <strong>in</strong> <strong>the</strong> future. Toavoid this problem, we could not own more than 24.9 percent of<strong>the</strong> hold<strong>in</strong>g company. That problem could be solved by jo<strong>in</strong><strong>in</strong>gwith o<strong>the</strong>r <strong>in</strong>vestors, as we soon did with Blackstone, Carlyle,Centerbridge, LeFrak Organization, and o<strong>the</strong>rs. But, how do youbecome qualified as a bank or a bank hold<strong>in</strong>g company withoutbe<strong>in</strong>g one so that you can be a bidder?Eventually, we reached an agreement with <strong>the</strong> regulators that <strong>the</strong>management team and <strong>in</strong>vestors would file a hold<strong>in</strong>g companyapplication that would be complete, except for <strong>the</strong> identity and dealterms of <strong>the</strong> target. The regulators <strong>the</strong>n would do <strong>the</strong>ir backgroundchecks, etc., and be ready to approve <strong>the</strong> application concurrentlywith FDIC approval of our bid.On Thursday, May 21, 2009, at 6:00 P.M., <strong>the</strong> FDIC announcedthat we had taken over BankUnited for an <strong>in</strong>vestment of $900million immediately after <strong>the</strong> FDIC had seized it. FDIC alsoannounced that <strong>the</strong>y estimated that <strong>the</strong> cost to <strong>the</strong>m would be$4.9 million. BankUnited is <strong>the</strong> largest <strong>in</strong>dependent depositary<strong>in</strong>stitution <strong>in</strong> Florida, with $12 billion of deposits and 85 branchesrunn<strong>in</strong>g north along <strong>the</strong> east coast of <strong>the</strong> state <strong>from</strong> Boca Raton. Ithas about 2 percent of all <strong>the</strong> deposits <strong>in</strong> Florida, even though <strong>the</strong>reare many important markets, like Tampa, Orlando, St. Petersburg,Palm Beach, and Jacksonville, where it is not yet represented. Inaddition to <strong>the</strong> potential of de novo branches, Florida has more than60 banks, which we believe are or soon will be <strong>in</strong>solvent and<strong>the</strong>refore distressed takeover targets. They, like BankUnited, arebe<strong>in</strong>g brought down by bad real estate <strong>in</strong>vestments, one of <strong>the</strong> ma<strong>in</strong>reasons why Lehman Bro<strong>the</strong>rs failed and Merrill Lynch had to be
260 THRIVING IN THE NEW ECONOMYtaken over <strong>in</strong> September 2008. The long-term objective would be tocreate a hold<strong>in</strong>g company that was mak<strong>in</strong>g a sufficiently high returnon capital that it would be worth two or more times a book valuehigher than today’s because of retention of earn<strong>in</strong>gs. Given <strong>the</strong>quality of management, <strong>the</strong> due diligence that was performed by a20-person team, and <strong>the</strong> loss shar<strong>in</strong>g arrangement with FDIC, <strong>the</strong>downside seems very limited. Therefore, <strong>the</strong> risk-adjusted rate ofreturn is very high.In general, we had correctly identified <strong>the</strong> opportunities that <strong>the</strong>f<strong>in</strong>ancial malaise would create for us; but we did underestimate <strong>the</strong>problems that would arise for <strong>the</strong> auto <strong>in</strong>dustry. Our pr<strong>in</strong>cipal<strong>in</strong>vestment <strong>in</strong> that arena was International Automotive Components(IAC), which we had begun creat<strong>in</strong>g <strong>in</strong> October 2005. We did so bybuy<strong>in</strong>g parts of <strong>the</strong> notorious bankruptcy of Coll<strong>in</strong>s & Aikman andsupplement<strong>in</strong>g <strong>the</strong>m with Lear Corporation’s Interior PlasticsDivision, by buy<strong>in</strong>g Mitsuboshi Belt<strong>in</strong>g Kaseih<strong>in</strong> <strong>in</strong> Japan andby restructur<strong>in</strong>g PLASCAR <strong>in</strong> Brazil. In 2007 and <strong>the</strong> early part of2008, all of <strong>the</strong>se units were operat<strong>in</strong>g <strong>in</strong> l<strong>in</strong>e with or better thanbudget, and we were on our way to about $5.5 billion of sales.But <strong>the</strong> American Axle strike <strong>in</strong> <strong>the</strong> second quarter shut downsome GM plants, creat<strong>in</strong>g a m<strong>in</strong>or problem. Our real problems <strong>in</strong>both <strong>the</strong> United States and Europe started with<strong>in</strong> weeks after <strong>the</strong>fateful phone conversation <strong>in</strong> S<strong>in</strong>gapore. People simply stoppedbuy<strong>in</strong>g cars. In retrospect, it should have been obvious that acredit crunch would be especially bad for autos, s<strong>in</strong>ce a car is mosthouseholds’ second largest purchase after a house. We now havehad to undergo four rounds of downsiz<strong>in</strong>g and salary cuts and havebeen forced to <strong>in</strong>fuse a bit more capital <strong>in</strong>to <strong>the</strong> company. Thegood news is that, like Assured Guaranty <strong>in</strong> monol<strong>in</strong>es, IAC will beamong <strong>the</strong> few entities left stand<strong>in</strong>g when <strong>the</strong> <strong>in</strong>dustry turnsaround.IAC,likemostofourportfolio companies, is relativelyunleveraged—because we believe that high levels of debt are<strong>in</strong>appropriate for companies that are highly cyclical and havecommoditypriceriskstoboot.OnceitbecameclearthatGM
WILBUR ROSS 261and Chrysler needed federal bailouts, we jo<strong>in</strong>ed with both of<strong>the</strong>m, <strong>the</strong> unions, and o<strong>the</strong>r suppliers to lobby for federal guarantyof <strong>the</strong> money owed to suppliers by GM and Chrysler; for o<strong>the</strong>rfederally assisted restructur<strong>in</strong>g of <strong>the</strong> two companies; and for <strong>the</strong>cash for clunkers program to encourage people to scrap old carsand buy new ones. This is green <strong>in</strong> both <strong>the</strong> environmental senseand <strong>in</strong> terms of <strong>the</strong> economy. With or without that program, IAChas been ga<strong>in</strong><strong>in</strong>g market share, with $300 million of currentbus<strong>in</strong>ess hav<strong>in</strong>g been transferred to it <strong>in</strong> <strong>the</strong> past 90 days <strong>from</strong>failed or fail<strong>in</strong>g competitors. While this is not nearly enough tomake up for <strong>the</strong> huge drop <strong>in</strong> unit production, it does conv<strong>in</strong>ceus that IAC will be f<strong>in</strong>e when volume returns to a more normallevel of 13 to 14 million cars per year <strong>in</strong> <strong>the</strong> United States. Ourcountry scraps between 12.5 and 13 million cars annually and<strong>the</strong>re is also population growth, so unless <strong>the</strong>re are fewer andfewer cars per capita, <strong>the</strong> annual average sales must be <strong>in</strong> <strong>the</strong>rangeof13to14million,versus<strong>the</strong>9millionorsothatwillbesold this year. We also acquired <strong>in</strong> Europe Stankiewicz a highquality s 150 million producer of automotive acoustical products.This will enhance our market share <strong>in</strong> that segment and br<strong>in</strong>g usadditional technology.We now are mov<strong>in</strong>g more aggressively to commit our portfolio,although I must admit, most importantly and most surpris<strong>in</strong>gly,to <strong>the</strong> new government-assisted programs. In <strong>the</strong> fall of 2008,when Treasury Secretary Paulson correctly announced a programto buy <strong>from</strong> <strong>the</strong> banks <strong>the</strong> k<strong>in</strong>ds of toxic assets that slew AIG,Bear Stearns, Citibank, Lehman Bro<strong>the</strong>rs, Merrill Lynch, and <strong>the</strong>Reserve Fund, <strong>the</strong> Bush adm<strong>in</strong>istration changed its emphasis todirect <strong>in</strong>vestment <strong>in</strong> hundreds of banks. I cont<strong>in</strong>ue to believe thatnei<strong>the</strong>r <strong>the</strong> f<strong>in</strong>ancial system nor <strong>the</strong> hous<strong>in</strong>g market will straightenout until <strong>the</strong>re is a clear<strong>in</strong>g event for <strong>the</strong> toxic assets. The TroubledAsset Relief Program (TARP) is a good way to fill <strong>the</strong> holes, butjust pump<strong>in</strong>g <strong>in</strong> more TARP money is treat<strong>in</strong>g <strong>the</strong> symptomsra<strong>the</strong>r than cur<strong>in</strong>g <strong>the</strong> disease. Banks will not lend with normal
262 THRIVING IN THE NEW ECONOMYaggressiveness until and unless <strong>the</strong>y believe that <strong>the</strong>ir exist<strong>in</strong>gportfolio will not blow up even worse. The only way to give<strong>the</strong>m that confidence will be <strong>the</strong> public-private <strong>in</strong>vestment portfolio(PPIP) proposed by Treasury Secretary Geithner, coupledwith <strong>the</strong> additional TARP money needed to replace <strong>the</strong> loss on <strong>the</strong>sale of toxic assets. We are seek<strong>in</strong>g to be big players <strong>in</strong> <strong>the</strong> PPIP,just as we were <strong>in</strong> <strong>the</strong> Term Asset-Backed Securities Loan Facility(TALF). We closed <strong>in</strong> September 2009 on close to a $1 billion <strong>in</strong>Public-Private Investment Funds (PPIFs), which were createdunder <strong>the</strong> Legacy Securities Public-Private Investment Program(PPIP). Invesco is among <strong>the</strong> firms <strong>the</strong> government has selected tohelp get toxic assets off <strong>the</strong> balance sheets of troubled banks. Ourequity will be matched 50/50 by TARP money.TALF has reopened <strong>the</strong> asset-backed commercial paper (ABCP)market, and if applied with aggressive encouragement of <strong>the</strong> banks tosell, PPIP will reopen <strong>the</strong> longer-term securitization market big time.That is what we need to get <strong>the</strong> economy go<strong>in</strong>g aga<strong>in</strong>, especially nowthat commercial real estate loans, <strong>in</strong> general, and commercialmortgage-backed securitizations, <strong>in</strong> particular, are about to blowup, with $750 billion due through 2011 and $1.5 trillion duethrough 2013.In <strong>the</strong> first TALF auction, we were a major buyer of Ford MotorCredit ABCP. The yield on it was 6.05 percent, and <strong>the</strong> governmentguaranteed a non-recourse loan for 90 percent of <strong>the</strong> purchase priceat 2.70 percent. The yield on <strong>the</strong> equity sliver was about 35 percent.Auto ABCP had been essentially unsalable for many months, so thismade fund<strong>in</strong>g available, albeit at a high price. Each subsequentauction developed <strong>in</strong>creas<strong>in</strong>gly lower asset yields, so we did notbuy any. In fact, <strong>in</strong> <strong>the</strong> fourth auction, we had American Home Author’s note: Term Asset-Backed Securities Loan Facility (TALF) was created by <strong>the</strong>Federal Reserve to add liquidity back <strong>in</strong>to <strong>the</strong> credit markets by meet<strong>in</strong>g <strong>the</strong> credit needs ofsmall bus<strong>in</strong>ess and consumers. The Fed would issue <strong>the</strong>m asset backed securities (ABS).
WILBUR ROSS 263Mortgage issue $600 million at about 3 percent to cut its costs off<strong>in</strong>anc<strong>in</strong>g advance.In September 2009, I had to make ano<strong>the</strong>r trip back to S<strong>in</strong>gaporeand I dreaded <strong>the</strong> idea that I would get ano<strong>the</strong>r urgent phone callabout ano<strong>the</strong>r major <strong>in</strong>stitution fail<strong>in</strong>g. If that was <strong>the</strong> case, I wouldbe banned <strong>from</strong> S<strong>in</strong>gapore forever. Thankfully, I was welcomedback to S<strong>in</strong>gapore without ano<strong>the</strong>r crisis.
EpilogueS<strong>in</strong>ce this book went to pr<strong>in</strong>t <strong>in</strong> late fall of 2009, <strong>the</strong> lack ofliquidity was still impact<strong>in</strong>g bus<strong>in</strong>ess, as well as <strong>the</strong> hous<strong>in</strong>gmarket, and economists and market strategists were debat<strong>in</strong>g onwhe<strong>the</strong>r we were <strong>in</strong> a ‘‘W’’ or ‘‘U’’ shaped recovery. The fear is out<strong>the</strong>re, but as you have read <strong>in</strong> all of my contacts’ stories, fear is notstopp<strong>in</strong>g <strong>the</strong>m <strong>from</strong> thriv<strong>in</strong>g. In fact, fear is actually driv<strong>in</strong>g <strong>the</strong>m tochallenge <strong>the</strong>mselves, <strong>in</strong>novate, to th<strong>in</strong>k outside <strong>the</strong> box, and lookfor opportunities where many would just see carnage.Whe<strong>the</strong>r acquir<strong>in</strong>g an <strong>in</strong>vestment boutique like Peter Cohen, totransform and expand his bus<strong>in</strong>ess <strong>in</strong> what he calls ‘‘go<strong>in</strong>g back to<strong>the</strong> future,’’ or plann<strong>in</strong>g years ahead for a disaster and streaml<strong>in</strong><strong>in</strong>g abus<strong>in</strong>ess like Mike Jackson, or by blaz<strong>in</strong>g a new trail and buy<strong>in</strong>g a‘‘sick bank’’ like Wilbur Ross and Richard LeFrak—good bus<strong>in</strong>essesthrive by th<strong>in</strong>k<strong>in</strong>g outside <strong>the</strong> box. The strategies highlighted <strong>in</strong> thisbook all have one common thread—<strong>the</strong>se <strong>in</strong>dividuals have criteria<strong>the</strong>y stick to, <strong>the</strong>y believe <strong>in</strong> <strong>the</strong>ir guts, and <strong>the</strong>y are not afraid tomake decisions some <strong>in</strong> <strong>the</strong> public may doubt.Innovation is one of <strong>the</strong> greatest tools of capitalism. Jerry Greenwald’swords on thriv<strong>in</strong>g are dead on: ‘‘. . . you can’t save your wayout of a crisis. You cannot cut your costs enough to becomesuccessful.’’ <strong>Thriv<strong>in</strong>g</strong> <strong>in</strong> this new economy means not to be bl<strong>in</strong>dedby a moment <strong>in</strong> a crisis. It means to seize that moment, embrace it,and turn it <strong>in</strong>to a moment of opportunity.265
AfterwordMayor Rudy GiulianiWhen I was a kid grow<strong>in</strong>g up <strong>in</strong> Dodgers-mad Brooklyn, Iliked to wear my Yankees uniform. I suspected it wouldget me <strong>in</strong>to trouble—and it certa<strong>in</strong>ly did—but <strong>the</strong>re was someth<strong>in</strong>gappeal<strong>in</strong>g about do<strong>in</strong>g <strong>the</strong> opposite of what everyone expects.Tak<strong>in</strong>g chances often leads to enormous opportunities, both <strong>in</strong>life and as an <strong>in</strong>vestor <strong>in</strong> our current crisis.I have worked with Lori Ann LaRocco at CNBC’s Squawk Box,and I’ve been impressed with her ear for <strong>in</strong>terest<strong>in</strong>g, useful <strong>in</strong>formationfor <strong>the</strong> <strong>in</strong>vestor. Her book is full of <strong>in</strong>sight and also reflects acontrarian, dar<strong>in</strong>g viewpo<strong>in</strong>t that can lead to excit<strong>in</strong>g prospects.In 2009, <strong>the</strong> f<strong>in</strong>ancial landscape is daunt<strong>in</strong>g, and many f<strong>in</strong>ancialexperts have conflict<strong>in</strong>g advice for <strong>the</strong> <strong>in</strong>vestor. American workersare be<strong>in</strong>g laid off at a dizzy<strong>in</strong>g pace, and our nation is <strong>in</strong>debted toCh<strong>in</strong>a for a sum approach<strong>in</strong>g $1 trillion. Whatever we th<strong>in</strong>k about<strong>the</strong> current adm<strong>in</strong>istration’s response to <strong>the</strong> f<strong>in</strong>ancial crisis, we haveto remember that <strong>the</strong> stock market rises and falls based not just on<strong>the</strong>ir decision, but on <strong>the</strong> judgments of millions of <strong>in</strong>dividual<strong>in</strong>vestors. Each <strong>in</strong>vestor has a chance to look for open<strong>in</strong>gs andways to thrive even <strong>in</strong> <strong>the</strong> bleakest landscape.When I first took office <strong>in</strong> 1994, <strong>New</strong> York City faced very seriouschallenges. <strong>New</strong> Yorkers saw mounta<strong>in</strong>s of trash on <strong>the</strong> streets,267
268 AFTERWORDpanhandlers accosted visitors, <strong>the</strong> murder rate was out of control,and sky-high taxes were chas<strong>in</strong>g <strong>the</strong> city’s bus<strong>in</strong>ess base out of town.A miserable bond rat<strong>in</strong>g reflected all of <strong>the</strong>se concerns and madeborrow<strong>in</strong>g that much more expensive.My team became contrarians. We decided to believe <strong>in</strong> a <strong>New</strong>York City that didn’t exist yet. We embraced a vision that called forchange many thought impossible, <strong>in</strong> a city that had long beendeemed ‘‘ungovernable.’’ By <strong>the</strong> time I left office, <strong>the</strong>re were nosqueegee men, trash was under control, crime rates had plummeted,and our bond rat<strong>in</strong>g had soared to a 30-year high. We had overcometerrible obstacles through will and a stubborn belief <strong>in</strong> what <strong>New</strong>York City could and should be.Today’s <strong>in</strong>vestors need to imag<strong>in</strong>e what <strong>the</strong> American economycan and will look like, ra<strong>the</strong>r than react<strong>in</strong>g solely to today’s reality.Many of <strong>the</strong> bus<strong>in</strong>ess legends <strong>in</strong>terviewed here share that perspectiveand Lori Ann LaRocco shares <strong>the</strong>ir <strong>in</strong>sights and adds to <strong>the</strong>m. Ourmarket will be powerful aga<strong>in</strong> if we cont<strong>in</strong>ue to appreciate how itbuilt our country and how we will build it aga<strong>in</strong>.Rudolph W. Giuliani is <strong>the</strong> chairman and CEO of <strong>the</strong> securityconsult<strong>in</strong>g bus<strong>in</strong>ess Giuliani Partners, LLC, which hefounded <strong>in</strong> January 2002. He was <strong>the</strong> mayor of <strong>New</strong> YorkCity <strong>from</strong> 1994 to 2001.When Giuliani first took office, poverty was someth<strong>in</strong>gmany <strong>New</strong> Yorkers knew, with one out of every seven<strong>New</strong> Yorkers collect<strong>in</strong>g welfare. By implement<strong>in</strong>g whatmany refer to as <strong>the</strong> largest and most successful welfareto-work<strong>in</strong>itiative <strong>in</strong> <strong>the</strong> nation, Giuliani cut welfare rolls <strong>in</strong>half, while help<strong>in</strong>g get 640,000 <strong>in</strong>dividuals off governmentassistance. Tax cuts were also a central part of his economicagenda, with a record of over $2.5 billion <strong>in</strong> taxreductions, <strong>in</strong>clud<strong>in</strong>g <strong>the</strong> personal <strong>in</strong>come tax, commercial
AFTERWORD 269rent tax, sales tax on cloth<strong>in</strong>g for purchases up to $110,and <strong>the</strong> hotel occupancy tax. These reforms transformed<strong>the</strong> $2.3 billion budget deficit Giuliani <strong>in</strong>herited <strong>in</strong>to amultibillion dollar surplus. In addition to his economicaccomplishments, Giuliani is most known for his leadershipdur<strong>in</strong>g <strong>the</strong> 9/11 terrorist attacks, when he garnered <strong>in</strong>ternationalattention and was called ‘‘America’s Mayor.’’
AcknowledgmentsIwould like to take this time to thank those who were<strong>in</strong>strumental <strong>in</strong> my accomplishment <strong>in</strong> writ<strong>in</strong>g <strong>Thriv<strong>in</strong>g</strong> <strong>in</strong><strong>the</strong> <strong>New</strong> <strong>Economy</strong>. Thank you, Richard, for encourag<strong>in</strong>g me to writea book. You planted <strong>the</strong> seeds months ago, and it got me th<strong>in</strong>k<strong>in</strong>g ofundertak<strong>in</strong>g such a project. I also want to thank Don for suggest<strong>in</strong>gWiley. It has been an amaz<strong>in</strong>g experience. I have loved every m<strong>in</strong>utework<strong>in</strong>g with Shannon, Beth, and Kate. Thank you!I also want to say thank you to all my contacts who participated <strong>in</strong>this book and shared <strong>the</strong>ir stories. They were thought provok<strong>in</strong>g and<strong>in</strong>spirational. And f<strong>in</strong>ally, I would like to say thank you to MarkHoffman, president of CNBC, for giv<strong>in</strong>g me <strong>the</strong> green light to writethis book.271
About The AuthorLori Ann LaRocco is <strong>the</strong> senior talent producer at CNBC andhas <strong>the</strong> ear of some of <strong>the</strong> world’s biggest bus<strong>in</strong>ess m<strong>in</strong>ds.Lori Ann has been work<strong>in</strong>g at <strong>the</strong> network s<strong>in</strong>ce 2000. She was firsthired as one of Maria Bartiromo’s producers on her even<strong>in</strong>g show,Market Week. Lori Ann produced and booked <strong>in</strong>terviews with someof <strong>the</strong> biggest and previously unatta<strong>in</strong>able names <strong>in</strong> bus<strong>in</strong>ess. In2005, Lori Ann was tapped to help with <strong>the</strong> relaunch of CNBC’sflagship morn<strong>in</strong>g show, Squawk Box.Lori Ann’s track record has garnered trust and respect <strong>from</strong> WallStreet ra<strong>in</strong>makers and Wash<strong>in</strong>gton leaders and <strong>in</strong>siders, who confide<strong>in</strong> Lori Ann first with <strong>the</strong>ir break<strong>in</strong>g billion dollar bus<strong>in</strong>ess dealsand policy announcements. Lori Ann cont<strong>in</strong>ues to add to herroster of contacts, as well as field produce million dollar showslike Squawk Box Across America at Gillette Stadium. Prior to CNBC,Lori Ann worked as an anchor, reporter, and assignment editor <strong>in</strong>local news around <strong>the</strong> country for seven years. Lori Ann is also aproud and busy hockey, baseball, soccer, karate, and dance mom ofthree children.273
IndexAAAA rat<strong>in</strong>g:for bonds, 77, 139for CDOs, 38ABCP (asset-backed commercial paper) market,262Account<strong>in</strong>g, <strong>in</strong>vestment criteria and, 64Adaptive strategies, Jim Lentz on, 217Advertis<strong>in</strong>g, strength and stability as focus of,137–138Aetna, 226Aggregate ga<strong>in</strong>s, 42AIG, see American International GroupAir bag seat belts, 229Aircraft manufactur<strong>in</strong>g, 230Airl<strong>in</strong>e <strong>in</strong>dustry, 230, 231Allocation of resources, 72Ambac (company), 256American Axle, 260American Century, 108American Home Mortgage Services, 256, 262–263American International Group (AIG):Ron Baron on, 81Peter Cohen on, 103Kelly K<strong>in</strong>g on, 128Larry L<strong>in</strong>dsey on, 9Donald Marron on, 168–169Wilbur Ross on, 254scruit<strong>in</strong>ization of, 26American Motors, 233American Psychological Association, 193AmSafe, 228–229Analytic leadership, 9, 17Analytic realists, 20Antares (company), 170Anto<strong>in</strong>ette, Marie, 152Arbitration, <strong>in</strong> airl<strong>in</strong>e <strong>in</strong>dustry, 231Arizona, real estate boom <strong>in</strong>, 199Asian Century, 108Asian markets, Lehmann Bro<strong>the</strong>rs failure and,254Aspirational customers, 242Assets, 63, 140. See also Toxic assetsAsset allocation, 75, 77Asset-backed commercial paper (ABCP) market,262Asset management, <strong>in</strong> current crisis, 173Asset prices, 8, 22Assured Guaranty, 257–258Auto <strong>in</strong>dustry, 67, 94, 95, 212asset-backed commercial paper <strong>in</strong>, 262challenges <strong>in</strong> <strong>the</strong> <strong>New</strong> <strong>Economy</strong> <strong>in</strong>, 212–213and consumer preferences, 212, 236–237and credit crisis, 255, 260disaster plans <strong>in</strong>, 210–211, 213–214,216–217drop-off <strong>in</strong> demand for, 120future of, 218–220, 234, 235and gas prices, 220Gerald Greenwald on, 231–232, 235–236and hous<strong>in</strong>g market, 212job losses <strong>in</strong>, 197Jim Lentz on, 216–218, 222–223Larry L<strong>in</strong>dsey on, 8–9production capacity <strong>in</strong>, 236and real estate <strong>in</strong>dustry, 209recovery of, 221–223regulatory action <strong>in</strong>, 222–223Wilbur Ross on, 260–261success <strong>in</strong>, 224, 235–236Jerry York on, 120AutoNation, 209Axelrod, David, 18BBailouts, 74, 125and <strong>the</strong> market, 128–129and protection of stockholders, 151–152Balance sheet(s):accountability for, 153debt on, 121Donald Powell on strong, 145Balance sheet liquidity, 105275
276 INDEXBanks, 96as cause of current crisis, 146<strong>in</strong>vest<strong>in</strong>g <strong>in</strong> failed, 186public perception of, 133–134regional, 125–126Wilbur Ross on <strong>in</strong>vest<strong>in</strong>g <strong>in</strong>, 258–260securitization and lend<strong>in</strong>g by, 169Bankers:meet<strong>in</strong>g of, with Barack Obama, 150m<strong>in</strong>dset of, 163–164Bank hold<strong>in</strong>g companies, 259Bank<strong>in</strong>g crisis, 53Bank<strong>in</strong>g <strong>in</strong>dustry:competition <strong>in</strong>, 139–140<strong>in</strong> current crisis, 172diversification <strong>in</strong>, 154<strong>in</strong>vestment opportunities <strong>in</strong>, 170–171and liquidity crisis, 130Donald Powell on, 144–145as protectors of national security, 142–143proven pr<strong>in</strong>ciples of, 160–161regulatory actions <strong>in</strong>, 172Bank of America, 142, 253Bankruptcy, 115of Chrysler, 94of General Motors, 94of Lehman Bro<strong>the</strong>rs, 33–34, 121, 243BankUnited, 180, 185, 186, 259–260Baron, Ron, 79–90on causes of current economic crisis, 81–82on <strong>in</strong>vest<strong>in</strong>g by Obama adm<strong>in</strong>istration,88–89on <strong>in</strong>vest<strong>in</strong>g criteria, 90on look<strong>in</strong>g for leadership, 83–86on new <strong>in</strong>vestment opportunities, 89–90on past mistakes, 82–83on realiz<strong>in</strong>g opportunities, 84–85on strategies for thriv<strong>in</strong>g, 86–88Baron Funds, 90Bartholomay, Bill, 257Base-build<strong>in</strong>g patterns, Bob Doll on, 51Basel<strong>in</strong>e prices, <strong>in</strong> commodities, 35Battery Park City (development), 180BB&T Corporation, 126–127acquisition of Colonial Bank by, 127conservative strategies of, 129–130and TARP, 132–133BB&T Lighthouse Project, 134–135Bear markets, 49–50, 53Bear Stearns:Peter Cohen on, 101–102Bob Doll on, 49failure of, 62Cam F<strong>in</strong>e on, 150, 158Steve Forbes on, 26Kelly K<strong>in</strong>g on, 127, 128Ken Lagone on, 92David Malpass on, 32Donald Marron on, 166–167Jerry York on, 118, 119, 125Berkshire Hathaway, 42Bernanke, Ben, 26, 128Bernste<strong>in</strong>, Peter, 45Bethlehem Steel, 252Bidd<strong>in</strong>g, <strong>in</strong> real estate, 191BlackRock, 47Black Sunday, Cam F<strong>in</strong>e on, 151–153Black Swan events, 187Bloomberg, Michael, 87Boards:of community banks, 162–163of <strong>in</strong>vestment companies, 230Bogle, Jack, 37–45on causes of current economic crisis, 38on economic resiliency, 41on emotional <strong>in</strong>vest<strong>in</strong>g, 42–45on Forbes.com, 29on liquidity puts, 38–39on rid<strong>in</strong>g out <strong>the</strong> risk, 45on rise of f<strong>in</strong>ancial system, 30–41on successful <strong>in</strong>vest<strong>in</strong>g, 41–42Bond, Christopher "Kit,’’ 149Bonds:AAA, 77, 139government, 12, 75–76higher- vs. lower-quality, 61municipal, 185, 257private sector, 76Boomers, car preferences of, 218Boom markets, mak<strong>in</strong>g money <strong>in</strong>, 190Borrow<strong>in</strong>g:excessive, 60, 96by federal government, 22BRIC nations, 66Broadpo<strong>in</strong>t Securities, 111Broken Hill, 112Budget deficits, 19–20, 52Buffett, Warren, 41, 45, 80, 82Build<strong>in</strong>g <strong>in</strong>dustry, <strong>in</strong> current economic crisis,185Build<strong>in</strong>g on speculation, at Chrysler, 231–232Bull market(s), 53–54<strong>in</strong> capitalism, 73<strong>in</strong> Treasuries, 76of 2007, 56Bush, George, W., and adm<strong>in</strong>istration, 19and creation of TARP, 132direct <strong>in</strong>vestment <strong>in</strong> banks by, 261election of, 15and public perception of TARP banks, 134treatment of community banks by, 157weak-dollar policy of, 26, 33Bus<strong>in</strong>ess cycles, <strong>in</strong>evitability of, 145–146Bus<strong>in</strong>ess growth, as shareholder expectation, 137Buybacks, 97Buy<strong>in</strong>g at <strong>the</strong> bottom (real estate), 195–196
INDEX 277CCalifornia, 199, 211Candor, Larry L<strong>in</strong>dsey on, 15–16Cap-and-trade, 20, 27Capital, 96<strong>from</strong> abroad, 20access to, 105<strong>in</strong> BB&T Corporation game plan, 135at community banks, 161cost of, 35and liquidity, 143as measure of banks’ health, 126protection of, 108<strong>in</strong> real estate market, 197and recovery <strong>from</strong> current crisis, 131<strong>in</strong> TARP plan, 132Capital constra<strong>in</strong>ed (term), 110Capitalism:<strong>in</strong> cumulative vot<strong>in</strong>g process, 72and economic recovery, 140rule of law <strong>in</strong>, 72–73Capitalization, of securities, 174Capital markets:and debt/equity markets, 187reduc<strong>in</strong>g exposure to, 82and securitization, 138, 139Capital One, 258Capital Purchase Plan (CPP), 133Capital spend<strong>in</strong>g, Steve Sadove on, 245–246Capitol Page School, 194Carbon energy, 88Carbon tax, 20Car dealers, 217, 234Car loans, 27Car options, 232Case Shiller Index, 6, 11Cash:and f<strong>in</strong>ancial strategy, 182–184people’s feel<strong>in</strong>gs about, 143preserv<strong>in</strong>g, 217Cash flow analyses, for assets, 140Cash flows, 105, 187Cash for Clunkers program, 261Casualty <strong>in</strong>surance, 172–173CDs (certificates of deposit), 139CDOs (collateralized debt obligations), 38CDS (credit derivative swaps), 255Certificates of deposit (CDs), 139Certificates of participation, 193‘‘Chapter 11,’’ 115Chas<strong>in</strong>g profits, 162Cheap credit, availability of, 39Ch<strong>in</strong>a, 66, 106, 227, 236Chrysler:Gerald Greenwald on, 225Wilbur Ross on, 261Steve Sadove on, 231–235Jerry York on, 115Chu, Steven, 69Citadel, 111Citibank, 261Citigroup, 39Clients:Abby Joseph Cohen on, 66–68Paul McCulley on, 77Donald Marron on, 167Climate change, 67Cl<strong>in</strong>ton, Bill, 18–19Cl<strong>in</strong>ton, Hillary, 18Cloutier, Rusty, 161CMBS (commercial backed mortgage securities),193n.CNBC, 30, 112Cohen, Abby Joseph, 59–70on causes of current economic crisis, 60–61on differentiated conclusions, 65on fac<strong>in</strong>g economic transitions, 69–70on manag<strong>in</strong>g clients’ expectations, 66–68on market-to-market account<strong>in</strong>g, 63–64on stay<strong>in</strong>g ahead of <strong>the</strong> curve, 61–62on stock market meltdown, 62–63on us<strong>in</strong>g crisis to your advantage, 68–69Cohen, Peter, 99–114, 182on causes of current economic crisis,100–102on characteristics of <strong>New</strong> <strong>Economy</strong>, 109on failure of Lehman Bro<strong>the</strong>rs, 102–103on future of bus<strong>in</strong>ess, 111on <strong>in</strong>vestment opportunities, 104–106,110–114on keep<strong>in</strong>g an open m<strong>in</strong>d, 111–114on lead<strong>in</strong>g by example, 108–109on strategies for <strong>New</strong> <strong>Economy</strong>, 106–110on systematic leverage, 104on wealth protection, 107–108Collateral, 102, 103Collateralized debt obligations (CDOs), 38Collateral risk, 93Colleges, for-profit, 84–85College endowments, 173Coll<strong>in</strong>s & Aikman, 260Colonial Bank, 126–127Commercial Apartment House F<strong>in</strong>anc<strong>in</strong>gmarket, 183–184Commercial backed mortgage securities(CMBS), 193n.Commercial banks and bank<strong>in</strong>g, 38, 144–145Commodities, 52, 216‘‘Common sense lender’’ campaign (ICBA), 158Communication:<strong>in</strong> auto <strong>in</strong>dustry, 217with clients, 167Cam F<strong>in</strong>e on open, 162–163Kelly K<strong>in</strong>g on, 134–136at Saks Fifth Avenue, 245, 247–248Steve Sadove on, 247–248
278 INDEXCommunity banks:and Bush adm<strong>in</strong>istration, 157core strategies of, 160–164Cam F<strong>in</strong>e on, 154–155and government <strong>in</strong>tervention, 153leadership at, 160loans by, 172and local markets, 154and Ma<strong>in</strong> Street America, 158–160and seizure of GSEs, 151–154and U.S. Treasury, 157–158Community service, 134–135Competition, <strong>in</strong> bank<strong>in</strong>g <strong>in</strong>dustry, 139–140Competitive advantage, 87Complexity, of f<strong>in</strong>ancial products, 174Concentration of resources, as cause of crises, 159Confidence, rebuild<strong>in</strong>g <strong>in</strong>vestor, 174–175Conform<strong>in</strong>g mortgages, 100Congress:ICBA’s campaign to educate, 155–157and TARP, 132, 134Congressional Budget Office, 19Consolidation, <strong>in</strong> f<strong>in</strong>ancial markets, 54Consumers, 54, 130Consumer choice, economic strength and, 159Consumer confidence:and auto <strong>in</strong>dustry, 216and credit crisis, 255Steve Sadove on, 243Consumer-driven economy, 106, 109, 175Consumption, 16, 75Convertible preferred stock, 112Conyers, John, Jr., 194Copenhagen discussions, 69Core bus<strong>in</strong>ess, <strong>in</strong>vest<strong>in</strong>g to support, 184Core values, <strong>in</strong> current crisis, 68, 109Corporate debt, 108Corporate earn<strong>in</strong>gs growth, 35Corporate pensions, 107Corporate profits, 39Corporate securities, 64, 105Corporate values, 44Corus Bank Real, 252Cost cutt<strong>in</strong>g:<strong>in</strong> auto <strong>in</strong>dustry, 210, 211, 213, 217, 223<strong>in</strong> crises, 233at Saks Fifth Avenue, 243–246Countercyclical spend<strong>in</strong>g programs, 68Counter party risk, 119Courtyard by Marriott Convention Center(Wash<strong>in</strong>gton, DC), 189Cowen Group, 99–100CPP (Capital Purchase Plan), 133Creative destruction, 68, 74Credit (credit availability):and buy<strong>in</strong>g, 227cheap credit, 39<strong>in</strong> current crisis, 100, 105and <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> equities, 120<strong>in</strong> recovery, 175securitizations as source of, 255Jerry York on, 120Credit card loans, 27Credit crisis, 48and auto <strong>in</strong>dustry, 212, 255, 260Richard LeFrak on, 183–184and lend<strong>in</strong>g, 221Larry L<strong>in</strong>dsey on, 12–13long term implications of, 65Don Peebles on, 196–197Ron Peltier on, 201Credit default swaps, 168–169Credit derivative swaps (CDS), 255Credit markets:anomalies <strong>in</strong>, 60and failure of Lehman Bro<strong>the</strong>rs, 182prices <strong>in</strong>, 76problems <strong>in</strong>, 104–105and rate cuts, 12Credit quality (mortgages), 38Credit rat<strong>in</strong>g(s), 61AAA, 38, 77, 139of securitizations, 169Credit research, 65Credit risk, 22Credit Suisse Asset-Backed SecuritiesConference, 254Crises, prepar<strong>in</strong>g for, 130Cultural evolution, at Saks Fifth Avenue, 245Currencies, <strong>in</strong> emerg<strong>in</strong>g markets, 76Current economic crisis, see Economic crisisCustomers:aspirational, 242generations of, 218listen<strong>in</strong>g to, 217respect for, 223at Saks Fifth Avenue, 242–243and success of auto <strong>in</strong>dustry, 224Customer research, <strong>in</strong> retail, 247–248Customer service, 247Cyclical bus<strong>in</strong>ess, auto <strong>in</strong>dustry as, 210, 216–217Cyclical downturns, 68Cyclicality, 48DDana Hold<strong>in</strong>gs Company, 118Data m<strong>in</strong><strong>in</strong>g, <strong>in</strong> auto <strong>in</strong>dustry, 213, 214Debt, 96conversion of, to equity, 111corporate, 108and GDP, 82long-term, 102maturity schedule for, 120–121and roll<strong>in</strong>g over, 35and stock selection, 121Debt-deflation risk, 73
INDEX 279Debt-f<strong>in</strong>anced consumption, 20Debt markets, capital markets and, 187Deflation, 51–52, 73, 106Deleverag<strong>in</strong>g, 16, 54Dellums, Ronald V., 194Demand, and recovery of auto <strong>in</strong>dustry, 221–222Democratic process, economy and, 72Deregulation, 73Derivatives, f<strong>in</strong>ancial, 41, 119Detroit Auto Show of 2006, 117Detroit Edison, 89Developed sites (real estate), 192, 193DeVry, 84Dexia, 258Differentiated conclusions, Abby Joseph Cohenon, 65Dim<strong>in</strong>ished environments, 35Disaster plans:Mike Jackson on, 210–211, 213–214Jim Lentz on, 216–217Discount w<strong>in</strong>dows, 101Dis<strong>in</strong>termediation, 138–139Diversification, 154, 198Dividends, 41, 43–44, 76, 97Doll, Bob, 47–59on base-build<strong>in</strong>g patterns, 51on bottom<strong>in</strong>g out of stock market, 54–56on causes of current economic crisis, 48–49on deflation vs. reflation, 51–52on flat stock market periods, 56–57on predictions for 2009, 52on waterfall decl<strong>in</strong>es, 49–51Domestic consumption, 75Down markets, real estate value <strong>in</strong>, 191, 192Downsiz<strong>in</strong>g, 202, 246Downturns, 34, 55cyclical, 68plann<strong>in</strong>g for, 146, 195EEarn<strong>in</strong>gs, 52estimates of, 64growth <strong>in</strong>, 41, 43–44maximization of, 86Earn<strong>in</strong>gs environment, 35Economic crisis, 30, 96Ron Baron on, 81–82Jack Bogle on, 38Abby Joseph Cohen on, 60–61, 65, 68–69Peter Cohen on, 100–102Bob Doll on, 48–49Cam F<strong>in</strong>e on, 150Steve Forbes on, 26Gerald Greenwald on, 226Mike Jackson on, 210–212Kelly K<strong>in</strong>g on, 127, 130–131Ken Langone on, 92–93Richard LeFrak on, 181–182Jim Lentz on, 216Larry L<strong>in</strong>dsey on, 4Paul McCulley on, 72David Malpass on, 32–33Donald Marron on, 166–167Don Peebles on, 190–191Ron Peltier on, 199–200Donald Powell on, 142–143Wilbur Ross on, 252–253Steve Sadove on, 242–243Jerry York on, 118Economic environment, f<strong>in</strong>ancial markets and,60–62Economic growth, 69, 74, 137Economic model<strong>in</strong>g, 226Economic recovery, 19Jack Bogle on, 41and capitalism, 140and credit availability, 175Federal Reserve <strong>in</strong>, 176<strong>in</strong> Florida, 186Rudolph W. Giuliani on, 266and job market, 197–198leadership <strong>in</strong>, 131and regulation, 174Wilbur Ross on, 261–263securities <strong>in</strong>, 174sequenc<strong>in</strong>g <strong>in</strong>, 237and stimulus plan, 176stock market <strong>in</strong>, 174The Economic Role of <strong>the</strong> Investment Company(Jack Bogle), 44Economic transitions, Abby Joseph Cohen on,69–70Edison, Thomas, 30Education, 68–69Electro-Motive Diesel (EMD), 229Emanuel, Rahm, 18, 68Emerg<strong>in</strong>g economies, 75–76Emission regulations, 234Emotional <strong>in</strong>vest<strong>in</strong>g, Jack Bogle on, 42–45Employees, communicat<strong>in</strong>g with, 134–136, 188,247–248Energy efficiency, 69, 88, 218Energy <strong>in</strong>dependence, 69, 70Eng<strong>in</strong>es, automobile, 219Environmental, social, and governancecitizenship (ESG citizenship), 67Equities, 105, 118–121. See also Stock(s)Equity markets, 48–49, 54, 62, 104, 187Equity Office Properties, 182Equity-oriented research, 65ESG citizenship (environmental, social, andgovernance citizenship), 67ETFs (exchange-traded funds), 34Europe Stankiewicz (company), 261Evans, Richard, 161
280 INDEXExchange-traded funds (ETFs), 34Executive teams, <strong>in</strong> crises, 130Exporters, 22FFAA (Federal Aviation Adm<strong>in</strong>istration), 229Fair Value Account<strong>in</strong>g, 8Faith, as basis of f<strong>in</strong>ancial system, 130Fannie Mae, 131and Commercial Apartment House F<strong>in</strong>anc<strong>in</strong>gmarket, 183–184and junk mortgage guarantees, 26leverage at, 8seizure of, 151–153FDIC, see Federal Deposit InsuranceCorporationFederal Aviation Adm<strong>in</strong>istration (FAA), 229Federal Deposit Insurance Corporation (FDIC):and <strong>in</strong>vestments <strong>in</strong> failed banks, 258–259Donald Powell on, 141–143seizure of banks by, 125, 180Federal Hous<strong>in</strong>g F<strong>in</strong>ance Agency (FHFA), 151,153Federal National Mortgage Association(FNMA), 185Federal Open Market Committee (FOMC), 13Federal Reserve, 101, 149and AIG, 103and bailout of Bear Stearns, 150<strong>in</strong> current crisis, 48–49funds rate of, 12on <strong>in</strong>terest rates, 35problems with, 102and recovery <strong>from</strong> current crisis, 176and seizure of Fannie Mae/Freddie Mac, 153support of liquidity by, 143FHFA, see Federal Hous<strong>in</strong>g F<strong>in</strong>ance AgencyFiat (company), 235Fiat-money system, 23–24F<strong>in</strong>ancial crisis, see Economic crisisF<strong>in</strong>ancial derivatives, 41, 119F<strong>in</strong>ancial eng<strong>in</strong>eer<strong>in</strong>g, 227F<strong>in</strong>ancial markets, economic environments and,60–62F<strong>in</strong>ancial services <strong>in</strong>dustry, 102bailout of, 125challenges faced by, 99earn<strong>in</strong>gs <strong>in</strong>, 39–40<strong>in</strong>termediation of, 23<strong>in</strong>vest<strong>in</strong>g <strong>in</strong>, 255job losses <strong>in</strong>, 197Donald Marron on, 169–170<strong>in</strong> <strong>New</strong> <strong>Economy</strong>, 109–110opportunities <strong>in</strong>, 172and sector valuations, 32–33as source of current crisis, 131F<strong>in</strong>ancial system:and deleverag<strong>in</strong>g, 54rise of, 30–41unsusta<strong>in</strong>able path of, 10F<strong>in</strong>anc<strong>in</strong>g phase, <strong>in</strong> economic crisis, 16F<strong>in</strong>e, Cam, 149–165on be<strong>in</strong>g a banker, 163–164on Black Sunday, 151–152on causes of current economic crisis, 150on community banks, 154–155on conservative bank<strong>in</strong>g, 162on Independent Community Bankers ofAmerica, 155–160on Ma<strong>in</strong> Street, 157–158on ma<strong>in</strong>ta<strong>in</strong><strong>in</strong>g a strong capital base, 161on market/product knowledge, 161on never chas<strong>in</strong>g profits, 162on open communication, 162–163on overleverag<strong>in</strong>g an organization, 163on policy maker attitudes, 152–154on risk, 161–162on us<strong>in</strong>g proven pr<strong>in</strong>ciples of bank<strong>in</strong>g, 160–161First National Bank of Amarillo, 142First Sou<strong>the</strong>rn, 165, 171First Union, 136First-wave adapters, of <strong>in</strong>novation, 162Fiscal policy, 20, 22Fiscal stimulus measures, 52Fixed <strong>in</strong>come markets, 62, 77Flat stock market periods, 56–57Flexibility, as asset, 189–190Flipp<strong>in</strong>g (real estate), 200Florida, 186, 199, 211FOMC (Federal Open Market Committee), 13Forbes, Steve, 25–30on causes of current economic crisis, 26on history as guide for <strong>the</strong> future, 28–29on look<strong>in</strong>g to <strong>the</strong> future, 30on magaz<strong>in</strong>e <strong>in</strong>dustry, 29on <strong>New</strong> <strong>Economy</strong>, 27Forbes.com, 28–29Forbes India, 28, 30Forbes magaz<strong>in</strong>e, 28–30Forbes Woman, 28Ford, Henry, 81Ford Motor Company, 235Ford Motor Credit, 262Forecasts (forecast<strong>in</strong>g), 66, 83Foreclosures, 205For-profit colleges, 84–85Fortress (company), 111401(k) plans, 173Freddie Mac, 130–131and Commercial Apartment House F<strong>in</strong>anc<strong>in</strong>gmarket, 183–184and junk mortgage guarantees, 26leverage at, 8seizure of, 151–153Frederico, Dom<strong>in</strong>ic, 257
INDEX 281Free enterprise system, bank<strong>in</strong>g <strong>in</strong>, 145Frost Bank, 160, 161, 163Frugality, 109FSA (company), 258Fuel economy restrictions, 234Fuld, Dick, 103, 167, 168Future, <strong>the</strong>:Mike Jackson on, 211–212Kelly K<strong>in</strong>g on, 135–136Future history approach, for <strong>in</strong>vest<strong>in</strong>g, 14GGAAP (Generally Accepted Account<strong>in</strong>gPr<strong>in</strong>ciples), 8Gasol<strong>in</strong>e prices, 212, 216, 220, 236–237GDP, see Gross Domestic ProductGeithner, Timothy, 262Generally Accepted Account<strong>in</strong>g Pr<strong>in</strong>ciples(GAAP), 8General Motors (GM):and American Axle strike, 260bailout of, 115, 261Gerald Greenwald on, 235locomotive manufactur<strong>in</strong>g at, 229rebuild<strong>in</strong>g of, 117–118sales at, 215and S&P 500, 84Jerry York on, 117Generation X, 218Generation Y, 218, 221Generation Z, 218, 221Gen-Probe, 89–90Geographic diversification, <strong>in</strong> real estate, 198Geopolitical issues, 108Giuliani, Rudolph W., 265–267Giuliani Partners, LLC, 266Gleacher Partners, 111Global economy (global market), 65leverage <strong>in</strong>, 100recession <strong>in</strong>, 143role of U.S. dollar <strong>in</strong>, 23–24stability of, 48structure of, 66Global Investment Research Division, 63Globalization, 73, 74Global warm<strong>in</strong>g, 67, 218, 236GM, see General MotorsGold, 105–106, 108Goldman Sachs, 63, 151Government:as cause of current crisis, 130hands-on, 22–23repayment of, 234–235role of, 53visible fist of, 72–73Government bonds, 12, 75–76Government f<strong>in</strong>anc<strong>in</strong>g:of AIG, 128of Bear Stearns, 119, 128Larry L<strong>in</strong>dsey on, 16–17Government <strong>in</strong>tervention, 73–74<strong>in</strong> bus<strong>in</strong>ess and markets, 106<strong>in</strong> community banks, 153<strong>in</strong> f<strong>in</strong>ancial <strong>in</strong>dustry, 140and <strong>in</strong>vestments, 35Government regulation, see Regulation(s)Government-sponsored enterprises (GSEs),151–154Graham, Benjam<strong>in</strong>, 45Grasso, Dick, 92Great Depression, 101anticipation of, 13BB&T Corporation <strong>in</strong>, 126, 129and lack of credit availability, 120lessons of, 93and negative stock returns, 55short sell<strong>in</strong>g of securities <strong>in</strong>, 26Great Moderation, 21Great Recession of 2009, 82–83Greenberg, “Ace”, 127Greenberg, Hank, 168Greenbriar Equity Group, 225–226buy<strong>in</strong>g criteria for, 228–229growth opportunities at, 232–234strategy creation at, 227–228Green push, 236–237Greenwald, Gerald, 225–238on causes of current economic crisis, 226on creat<strong>in</strong>g strategies, 227–228on future of transportation <strong>in</strong>dustry, 229–230on green push, 236–237on <strong>in</strong>dicators of thriv<strong>in</strong>g, 238on <strong>in</strong>vestment criteria, 228–229on mak<strong>in</strong>g <strong>the</strong> auto <strong>in</strong>dustry thrive, 235–236on opportunities for growth, 226–227, 232–234on production capacity <strong>in</strong> auto <strong>in</strong>dustry, 236on repay<strong>in</strong>g <strong>the</strong> government, 234–235on strategies for <strong>in</strong>vest<strong>in</strong>g, 237–238on transformation of auto <strong>in</strong>dustry, 231–232Gross Domestic Product (GDP), 35, 61, 68, 82Growth:earn<strong>in</strong>gs, 35, 41, 43–44economic, 69, 74, 137Gerald Greenwald on opportunities for, 226–227, 232–234Donald Marron on opportunities for, 170–176Don Peebles on opportunities for, 191–192,197–198as shareholder expectation, 137susta<strong>in</strong>able, 69GSEs, see Government-sponsored enterprisesHHands-on government, 22–23Harvard model (of portfolio construction), 77
282 INDEXHarw<strong>in</strong>ton Capital, 118Health care, 27, 67, 88, 89Hexcel, 230Higher One, 170History:economic transitions <strong>in</strong>, 69–70as guide for future, 28–29, 129–130<strong>in</strong>fluence of, on bus<strong>in</strong>ess, 42and objectivity, 12Holdren, John, 69Home Depot, 92Home ownership:government support for, 130–131as long-term <strong>in</strong>vestment, 203rates of, 23tax advantages of, 204–205Home sales, <strong>in</strong> real estate boom, 202, 203HomeServices of America, 199Horizon Natural Resources, 252Hospitality bus<strong>in</strong>ess, 86Household sav<strong>in</strong>g rates, 17Household sector, 60Hous<strong>in</strong>g and Economic Recovery Act of 2008,151Hous<strong>in</strong>g crisis, 6anticipation of, 10–11as cause of current economic crisis, 176Larry L<strong>in</strong>dsey on, 6–11recovery <strong>from</strong>, 175Hous<strong>in</strong>g <strong>in</strong>dustry, 6, 95Hous<strong>in</strong>g <strong>in</strong>ventory, 10–11Hous<strong>in</strong>g markets, 60, 62, 167, 211, 212Hous<strong>in</strong>g prices, 187Human capital, 188Human Genome Project, 113Human Genome Sciences, 113Hummer, 117Hurricane Gustav, 173Hurricane Ike, 173Hybrid Synergy Drive eng<strong>in</strong>e, 219, 220Hydrogen fuel cells, 220IIAC (International Automotive Components),260Iacocca, Lee, 225, 231, 233, 238IBM, 118ICBA, see Independent Community Bankers ofAmericaIlliquid <strong>in</strong>struments, 77Incentives, <strong>in</strong> auto <strong>in</strong>dustry, 222Income streams (real estate), 195Independent Community Bankers of America(ICBA), 149Cam F<strong>in</strong>e on, 155–160and seizure of GSEs, 153–154Independent leadership, 9–10Index funds, 45India, 66, 236Individual retail accounts, 108IndyMac Federal Bank, failure of, 129, 143,150Inflation, 34, 52Inflation-adjusted <strong>in</strong>come, 60Inflection po<strong>in</strong>ts:after Lehman Bro<strong>the</strong>rs collapse, 49of economy, 33David Malpass on, 33–34Infrastructure, 89Innovation, 162Institutional bus<strong>in</strong>esses, 108Institutional demands, 5Insurance:casualty, 172–173monol<strong>in</strong>e, 256–258property, 172–173Insurance <strong>in</strong>dustry:and AIG’s seizure, 168<strong>in</strong> current crisis, 172–173Intelligence Investor, 45Intelligent Invest<strong>in</strong>g (video feature), 29Interconnectedness, 167, 168Interest rates, 21, 130Intermediation, f<strong>in</strong>ancial, 23Internal controls, at community banks, 162Internal rate of return, 140International Automotive Components (IAC),260International Coal Group, 252International Steel Group (ISG), 252Internet, 29Intr<strong>in</strong>sic values, 44Inventory:<strong>in</strong> auto <strong>in</strong>dustry, 212reduc<strong>in</strong>g, 217Steve Sadove on, 243–244, 246Invesco, 262Investment (<strong>in</strong>vest<strong>in</strong>g), 105, 120<strong>in</strong> auto <strong>in</strong>dustry, 217, 219, 223, 260–261<strong>in</strong> banks and thrifts, 258–260Ron Baron on, 90Peter Cohen on, 104–106and decision mak<strong>in</strong>g, 64Bob Doll on, 51Gerald Greenwald on, 228–229, 237–238Ken Langone on, 97long-term, 30, 36, 44, 66, 86, 121Paul McCulley on, 75–76David Malpass on, 34–36Donald Marron on, 172–173<strong>in</strong> monol<strong>in</strong>e <strong>in</strong>surance, 256–257<strong>in</strong> mortgage servic<strong>in</strong>g, 255–256<strong>in</strong> new products, 233opportunities for, 83, 89, 97, 170–171<strong>in</strong> real estate, 187returns on, 44, 69, 78
INDEX 283Investment advisors, communicat<strong>in</strong>g with, 121Investment bank<strong>in</strong>g, 38, 100, 109, 145Investopedia, 30Iran, 108ISG (International Steel Group), 252ITC Hold<strong>in</strong>gs, 89JJackson, Mike, 209–214on causes of current economic crisis, 210–212on challenges <strong>in</strong> <strong>New</strong> <strong>Economy</strong>, 212–213on disaster plans, 210–211, 213–214on predict<strong>in</strong>g <strong>the</strong> future, 211–212Japan, 106, 120Jarrett, Valerie, 18Jobless claims, 35Job market, 197–198Job security, 188J.P. Morgan, 93, 101, 166–167JPMorgan Chase, 151Judgment, role of, 147Jumbo mortgages, 100KKaizen, 223Kanas, John, 186, 258K-cars, 233Kemper, Mar<strong>in</strong>er, 161Kerkorian, Kirk, 85, 117Keynes, John Maynard, 41, 44K<strong>in</strong>g, Kelly, 125–140on causes of current economic crisis, 127on causes of f<strong>in</strong>ancial meltdown, 130–131on crisis preparedness, 130on criteria for thriv<strong>in</strong>g, 140on failure of Lehman Bro<strong>the</strong>rs, 128–129on growth <strong>in</strong> <strong>New</strong> <strong>Economy</strong>, 138–140on history as guid<strong>in</strong>g pr<strong>in</strong>ciple, 129–130on l<strong>in</strong>es of communication, 134–135on plann<strong>in</strong>g for <strong>the</strong> future, 135–136on public backlash, 133–134on seiz<strong>in</strong>g opportunities, 136–138on tak<strong>in</strong>g TARP money, 132–133Korea, 106, 108Kost<strong>in</strong>, David, 60Kyoto Protocol, 69LLabor markets, 68Langone, Ken, 91–97on causes of current economic crisis, 92–93on economic reality, 94–96on <strong>in</strong>vest<strong>in</strong>g criteria, 97on strategies for <strong>the</strong> <strong>New</strong> <strong>Economy</strong>, 96–97Langone Program, 91Las Vegas, Nevada, real estate market <strong>in</strong>, 197Law of Un<strong>in</strong>tended Consequences, Larry L<strong>in</strong>dseyon, 13Leadership:analytic, 9, 17Ron Baron on look<strong>in</strong>g for, 83–86Peter Cohen on, 108–109at community banks, 160dur<strong>in</strong>g economic catastrophe, 5dur<strong>in</strong>g economic recovery, 131Lee Iacocca on, 238<strong>in</strong>dependent, 9–10at Lehman Bro<strong>the</strong>rs, 167–168Larry L<strong>in</strong>dsey on model of, 5–6<strong>in</strong> <strong>New</strong> <strong>Economy</strong>, 23objective, 11, 12, 14political, 18–22Donald Powell on, 144qualities of, 144rhetorical, 17, 19, 20Leadership model, 5Lear Corporation, 260LeFrak, Harry, 180LeFrak, Richard, 179–188, 252on an optimistic future, 185on assess<strong>in</strong>g liabilities, 184on BankUnited, 186on causes of current economic crisis, 181–182on creat<strong>in</strong>g opportunities, 184on credit crisis, 183–184on <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> toxic assets, 186–187on post-Lehman Bro<strong>the</strong>rs strategies,182–183on strategies for thriv<strong>in</strong>g, 187–188LeFrak, Sam, 180LeFrak City, 180LeFrak Organization, 180Lehman Bro<strong>the</strong>rs, 93, 259bankruptcy of, 33–34Ron Baron on, 81, 83Peter Cohen on, 102–103and credit markets, 35–36Bob Doll on, 49Steve Forbes on, 26Mike Jackson on, 212Kelly K<strong>in</strong>g on, 125, 128–129Richard LeFrak on, 182–183Larry L<strong>in</strong>dsey on, 7, 9Paul McCulley on, 72David Malpass on, 32Donald Marron on, 167–168Ron Peltier on, 201Wilbur Ross on, 253–254Jerry York on, 119Lend<strong>in</strong>g:<strong>in</strong> auto <strong>in</strong>dustry, 210, 211and politics, 133shift<strong>in</strong>g of practices <strong>in</strong>, 35standards for, 201tighten<strong>in</strong>g of, 119at Toyota, 221
284 INDEXLentz, Jim, 215–224on adaptive strategies, 217on auto <strong>in</strong>dustry <strong>in</strong>centives, 222–223on auto <strong>in</strong>dustry trends, 216–217on causes of current economic crisis, 216on future of auto <strong>in</strong>dustry, 217–218on game plan timel<strong>in</strong>es, 219–220on <strong>in</strong>fluence of regulatory actions, 222on plann<strong>in</strong>g ahead, 221–222on success <strong>in</strong> <strong>New</strong> <strong>Economy</strong>, 220on Toyota Way, 223–224Leverage (leverag<strong>in</strong>g), 6–7, 82, 89, 96, 104<strong>in</strong> auto <strong>in</strong>dustry, 210, 211of community banks, 163<strong>in</strong> current crisis, 130, 131of cyclical companies, 260<strong>in</strong> down markets, 193at Fannie Mae, 8<strong>in</strong> f<strong>in</strong>ancial services <strong>in</strong>dustry, 172at Freddie Mac, 8<strong>in</strong> global system, 100<strong>in</strong> hous<strong>in</strong>g boom, 254–255<strong>in</strong> hous<strong>in</strong>g crisis, 10layers of, 93and private risk tak<strong>in</strong>g, 21–22<strong>in</strong> real estate market, 182, 184Lewis, Ken, 142Lexus HS, 217, 223Lexus RX, 223Liabilities, Richard LeFrak on, 184Lightyear Capital, 165–166, 168The L<strong>in</strong>coln (Miami Beach, Florida), 189L<strong>in</strong>dsey, Larry, 3–24on auto market crisis, 8–9on believ<strong>in</strong>g <strong>in</strong> economic history, 13–14on candor, 15–16on credit spread crisis, 12–13on current economic crisis, 4on flawed model of leadership, 5–6on government f<strong>in</strong>anc<strong>in</strong>g, 16–17on hous<strong>in</strong>g market crisis, 6–11on Law of Un<strong>in</strong>tended Consequences, 13on leadership, 17–22on <strong>New</strong> <strong>Economy</strong>, 23–24The L<strong>in</strong>dsey Group, 17Liquidity, 27, 62balance sheet, 105bank<strong>in</strong>g <strong>in</strong>dustry and, 130BB&T Corporation and, 135and capital, 143<strong>in</strong> credit crises, 130, 183<strong>in</strong> current crisis, 93, 143, 169–170Lehman Bro<strong>the</strong>rs and, 102portfolio, 167Liquidity puts, Jack Bogle on, 38–39Loans:banks’ views of, 169by community and local banks, 172<strong>in</strong> credit crisis, 183, 184, 212Kelly K<strong>in</strong>g on, 140and real estate market, 179re<strong>in</strong>termediation and volume of, 139securitized, 138, 184and TARP, 132Loan guarantees, at Chrysler, 234Local banks, lend<strong>in</strong>g by, 172Location, Don Peebles on importance of, 192–193Lockhart, James B., 151, 152Locomotives, 229Long-term debt, 102Long-term <strong>in</strong>vest<strong>in</strong>g, 30, 36, 44, 66, 86, 121‘‘Lost decade,’’ 56Lower middle-<strong>in</strong>come households, 60Lower-quality <strong>in</strong>vestments, 54, 61LTV (company), 252Luxury retail sales, 241–244MMcCa<strong>in</strong>, John, 15, 18McCulley, Paul, 71–78on causes of current economic crisis, 72on client advisement, 77on emerg<strong>in</strong>g opportunities, 75on <strong>in</strong>vestment strategies, 75–76on need for capitalism, 72–73on <strong>New</strong> <strong>Economy</strong>, 73–74, 76Macro-trad<strong>in</strong>g, 106Madoff, Bernard, 104, 109Magaz<strong>in</strong>e <strong>in</strong>dustry, Steve Forbes on, 29Magna Copper, 112Ma<strong>in</strong>stream media, 20Ma<strong>in</strong> Street (Ma<strong>in</strong> Street America):and AIG failure, 254as brand, 159Cam F<strong>in</strong>e on, 153, 157–158Wall Street vs., 154, 157–158Malpass, David, 31–36on causes of current economic crisis, 32–33on <strong>in</strong>flection po<strong>in</strong>ts, 33–34on markets <strong>in</strong> post-Lehman Bro<strong>the</strong>rs era, 33on new <strong>in</strong>vestment strategies, 34–36Manufactur<strong>in</strong>g, 39, 230Market(s):history of, 56<strong>in</strong>visible hand of, 72–73short<strong>in</strong>g <strong>the</strong>, 119Market cycles, 191Market dislocations, 63Market downturn, 35Market <strong>in</strong>dices, 7Market knowledge, Cam F<strong>in</strong>e on, 161Market movements, 83Market players, 6Mark-to-market account<strong>in</strong>g, 26, 63–64Marron, Donald, 165–176
INDEX 285on AIG takeover, 168–169on causes of current economic crisis, 166–167on client advisement, 167on failure of Lehman Bro<strong>the</strong>rs, 168on f<strong>in</strong>ancial services <strong>in</strong>dustry crisis, 169–170on future economic environment, 174–175on <strong>in</strong>vestment trends, 172–173on opportunities for growth, 170–176on overcom<strong>in</strong>g <strong>the</strong> economic crisis, 175–176on restructur<strong>in</strong>g, 174on transparency, 174Maturities, debt, 120–121Media:and culture, 30ICBA’s campaign <strong>in</strong>, 157, 159Medicare, 67Mercantilist model, 75Merger(s):of First Union and Wachovia, 136–137reverse-, 99–100Merrill Lynch, 39, 111, 253, 259–260Merrill Lynch Investment Managers (MLIM), 47Metaldyne, 120Middle East, 227Middle-<strong>in</strong>come households, 60Middle-tier firms, 110MidSouth Bank, 160–163Midwest Independent Bank, 149M<strong>in</strong>ivans, 233Missouri, 149Mitsuboshi Belt<strong>in</strong>g Kaseih<strong>in</strong>, 260MLIM (Merrill Lynch Investment Managers), 47Monetary stimulus measures, 52Money, 95, 107Monol<strong>in</strong>e <strong>in</strong>surance, 256–258Montpelier Re<strong>in</strong>surance, 253Moody’s, 77Moran, Michael, 64Mortgages, 101<strong>in</strong> current economy, 203–204securitization of, 6, 169–170, 254–255and seizure of GSEs, 154Mortgage-backed securities, 27, 169Mortgage f<strong>in</strong>ance markets, 62Mortgage servic<strong>in</strong>g, <strong>in</strong>vest<strong>in</strong>g <strong>in</strong>, 255–256Multilateral f<strong>in</strong>ancial regulation, 66Municipal bonds (municipal securities), 118,120, 185, 257Mutual funds, 38, 139NNational Association of securities DealersAutomated Quotation (NASDAQ), 33Nationalism, 74National security, bank<strong>in</strong>g <strong>in</strong>dustry and, 142–143Natural gas, 220Net short positions, 34Network18 (CNBC affiliate), 30Nevada, real estate boom <strong>in</strong>, 199<strong>New</strong> Balance, 113<strong>New</strong> <strong>Economy</strong>:Peter Cohen on, 106–110Steve Forbes on, 27Mike Jackson on, 212–213Kelly K<strong>in</strong>g on, 138–140Ken Langone on, 96–97Jim Lentz on, 220Larry L<strong>in</strong>dsey on, 23–24Paul McCulley on, 73–74, 76Donald Powell on, 143Steve Sadove on, 245‘‘<strong>New</strong> normal,’’ 65, 76<strong>New</strong>port (waterfront community), 180<strong>New</strong> products, <strong>in</strong>vest<strong>in</strong>g <strong>in</strong>, 217, 219, 223<strong>New</strong> York City, 87, 265–267<strong>New</strong> York City teachers union, 87<strong>New</strong> York Reserve Bank, 101<strong>New</strong> York Stock Exchange (NYSE), 49–50Nike, 113Nimble, be<strong>in</strong>g, 63–64North American Airl<strong>in</strong>es, 231North Fork Bank, 258International Steel Group (ISG), 252NYSE, see <strong>New</strong> York Stock ExchangeOObama, Barack, and adm<strong>in</strong>istration, 18–19and economic confidence, 104election of, 15Steve Forbes on, 27and health care overhaul, 67and public perception of TARP money, 134and tax benefits, 204vision of, 88Objective leadership, 11, 14Office build<strong>in</strong>gs, develop<strong>in</strong>g, 194Oil, auto <strong>in</strong>dustry and demand for, 219–220Oil crisis of 1980s, 146O’Neill, Tip, 233Open communication, Cam F<strong>in</strong>e on, 162–163Opportunities:Ron Baron on, 84–85Peter Cohen on, 104–106, 110–114<strong>in</strong> current environment, 68<strong>in</strong> f<strong>in</strong>ancial services <strong>in</strong>dustry, 172Kelly K<strong>in</strong>g on, 136–138Richard LeFrak on creat<strong>in</strong>g, 184Ron Peltier on, 204–205<strong>in</strong> real estate, 187Optimism:Richard LeFrak on, 185Jerry York on, 121Options, car, 232Orig<strong>in</strong>ation fees, 211Over-leverag<strong>in</strong>g, 107, 163
286 INDEXOverseas debt, 22Overseas expansion, 30Overspend<strong>in</strong>g, 60PPa<strong>in</strong>eWebber Group, 165Panic, reduc<strong>in</strong>g employees’, 135Pascal wager, 45Past mistakes, Ron Baron on, 82–83Paulson, Henry, 26, 103, 128, 151, 152, 261PCA 3 (prostate cancer gene 3), 89Peebles, Don, 189–198on causes of current economic crisis, 190–191on <strong>the</strong> commercial credit crisis, 196–197on <strong>the</strong> importance of location, 192–193on <strong>the</strong> importance of tim<strong>in</strong>g, 195–196on old strategies, 193on opportunities for growth, 191–192, 197–198on real estate development, 193–195Peltier, Ron, 199–206on <strong>the</strong> causes of current economic crisis, 199–200on <strong>the</strong> credit crisis, 201on downsiz<strong>in</strong>g, 202on real estate <strong>in</strong>dustry trends, 202–203on real estate opportunities, 204–205on strategies for thriv<strong>in</strong>g, 203–204on subprime mortgages, 200–201Penny stocks, 97Pensions (pension plans):corporate, 64, 107<strong>in</strong> current crisis, 173public pension funds, 107Pent-up demand, and recovery of auto <strong>in</strong>dustry,221–222P/E ratio, see Price-to-earn<strong>in</strong>g ratioPerform<strong>in</strong>g well, dur<strong>in</strong>g a crisis, 76Perot, Ross, 92Personal sav<strong>in</strong>g rates, 17Perspective, and objective leadership, 12Peterson, Pete, 111PIMCO, 76–77Plann<strong>in</strong>g:<strong>in</strong> crises, 144for downturns, 146, 195Kelly K<strong>in</strong>g on, 135–136Jim Lentz on, 221–222at Toyota, 216, 218–220PLASCAR (company), 260Politics:and bank bailouts, 128<strong>in</strong>fluence of, 15<strong>in</strong> lend<strong>in</strong>g process, 133and real estate, 194Political changes, effects of, 65Political leadership, Larry L<strong>in</strong>dsey on, 18–22Political managers, 20Portfolios, 45, 77, 101assess<strong>in</strong>g, <strong>in</strong> crises, 167, 170current crisis and asset managers’, 173factors affect<strong>in</strong>g, 51of monol<strong>in</strong>e <strong>in</strong>surers, 256negative returns on, 119Powell, Donald, 126, 141–149on causes of current economic crisis, 142–143on FDIC, 143on future of bank<strong>in</strong>g, 144–145on keep<strong>in</strong>g banks strong, 145–147on plann<strong>in</strong>g ahead, 144on qualities of a leader, 144on succeed<strong>in</strong>g <strong>in</strong> <strong>the</strong> <strong>New</strong> <strong>Economy</strong>, 143PPIFs (Public-Private Investment Funds), 262PPIP (Public-Private Investment Program), 262Pragmatists, 20–21Preferred stock, 133, 151–152, 154Premiums (municipal bonds), 257Present value of future premiums (PVP), 257Prices:asset, 8, 22<strong>in</strong> auto <strong>in</strong>dustry, 222basel<strong>in</strong>e (commodities), 35distortion of, 35gasol<strong>in</strong>e, 212, 216, 220, 236–237hous<strong>in</strong>g, 187real estate, 196<strong>in</strong> recessions, 191<strong>in</strong> retail <strong>in</strong>dustry, 245stock, 36Price destruction, and REO bus<strong>in</strong>ess, 204Price momentum, 64Price-to-earn<strong>in</strong>g (P/E) ratio, 43Pride, employee, 134–135Primary data sources, 65Pr<strong>in</strong>ce, Chuck, 5, 21, 39Pritzker, Jay, 85Private domestic <strong>in</strong>vestment, 20Private equity, 108at Lehmann Bro<strong>the</strong>rs, 255TARP as alternative to, 171Private equity firms, <strong>in</strong>vestment strategies of, 228Private equity funds, <strong>in</strong>vestment <strong>in</strong> real estate by,197Private sector, leverage <strong>in</strong>, 16Private sector bonds, 76Proactive stimulus, 106Products, <strong>in</strong>vest<strong>in</strong>g <strong>in</strong> new, 217, 219, 223, 233Production capacity (auto <strong>in</strong>dustry), 236Productivity, ga<strong>in</strong>s <strong>in</strong>, 74Product knowledge, Cam F<strong>in</strong>e on, 161Profits (profitability), 86<strong>in</strong> auto <strong>in</strong>dustry, 210, 211, 217, 232and BB&T Corporation game plan, 135at community banks, 162and compliance with government regulations,222
INDEX 287and cost cutt<strong>in</strong>g, 223<strong>in</strong> real estate market, 195short-term, 86Property <strong>in</strong>surance, 172–173Property values, 187Prostate cancer gene 3 (PCA 3), 89Prostate-specific antigen (PSA) test, 89Protect<strong>in</strong>g wealth, 107–108Protectionism, 27PSA (prostate-specific antigen) test, 89Public backlash, Kelly K<strong>in</strong>g on, 133–134Public firms, 40Public markets, 100Public pension funds, underfund<strong>in</strong>g of, 107Public-Private Investment Funds (PPIFs), 262Public-Private Investment Program (PPIP), 262Public-private partnerships, <strong>in</strong> real estate sector,194Public sector, leverage <strong>in</strong>, 16Purchas<strong>in</strong>g power, 107‘‘Putt<strong>in</strong>g money to work,’’ 228PVP (present value of future premiums), 257QQuality assets, returns on, 191Quality of life, 107RReagan, Ronald, 80RealClearPolitics, 30Real estate, 108location of, 192–193Don Peebles on develop<strong>in</strong>g, 193–195purchas<strong>in</strong>g, 195–196Real estate <strong>in</strong>dustry:and auto <strong>in</strong>dustry, 209future of, 204–205growth and downsiz<strong>in</strong>g of, 202–203Ron Peltier on, 202–205Real estate <strong>in</strong>vestment trusts (REITs), 187Real estate market, 191, 192boom <strong>in</strong>, 199–200cash flows <strong>in</strong>, 187and commercial loans, 179and credit crisis, 197–198, 201–203and <strong>in</strong>solvency, 259<strong>in</strong>vestment opportunities <strong>in</strong>, 187leverage <strong>in</strong>, 182, 184profit <strong>in</strong>, 195<strong>in</strong> recessions, 187and strategies for construction, 194–195tim<strong>in</strong>g <strong>in</strong>, 191value <strong>in</strong>, 191, 192Real estate–owned (REO) bus<strong>in</strong>ess, 204Recapitaliz<strong>in</strong>g, 227Recession(s):economies <strong>in</strong>, 81effects of, 64, 68forecasts of, 61–62<strong>in</strong> global economy, 143Great Depression vs., 13quality assets <strong>in</strong>, 191real estate market <strong>in</strong>, 187recovery <strong>from</strong>, 54start of, 48–49Recovery, see Economic recoveryRe-equalization, 111Reflation, 51–52, 73Regional banks, 125–126Regulated economy, 75Regulation(s), 74<strong>in</strong> bank<strong>in</strong>g <strong>in</strong>dustry, 172on fuel economy and emissions, 234Jim Lentz on, 222and recovery <strong>from</strong> current crisis, 174self-, 11Regulatory community, as cause of current crisis,131Re<strong>in</strong>termediation, 138, 139REITs (real estate <strong>in</strong>vestment trusts), 187Renault-Nissan, 118Renewable energy sources, 69Rents, 187REO (real estate–owned) bus<strong>in</strong>ess, 204Reorganiz<strong>in</strong>g, 28Repayment, of government assistance, 133, 234Research, focus<strong>in</strong>g on, 84Research analysts, 65Research and development, 219Residential mortgage-backed securities (RMBS),100, 127Resources:allocation of, 72concentration of, 159Respect, for customers, 223Restructur<strong>in</strong>g, 110, 174Retail <strong>in</strong>dustry:after Lehman Bro<strong>the</strong>rs bankruptcy, 243Steve Sadove on trends <strong>in</strong>, 246–247Retail sales, <strong>in</strong> current crisis, 241–243Retirement plans, 67Retra<strong>in</strong><strong>in</strong>g, 68Returns, stock, 57Re-urbanization, and auto <strong>in</strong>dustry, 218, 219Reu<strong>the</strong>r, Walter, 81Reverse-mergers, 99–100Rhetorical leadership, 17, 19, 20Rhetorical management, 17Ride-shar<strong>in</strong>g, 218–219Risk(s):Jack Bogle on rid<strong>in</strong>g out, 45collateral, 93counter party, 119credit, 22debt-deflation, 73<strong>in</strong> develop<strong>in</strong>g office build<strong>in</strong>gs, 194
288 INDEXRisk(s) (cont<strong>in</strong>ued )of f<strong>in</strong>ancial derivatives, 41Cam F<strong>in</strong>e on, 161–162leverage and tak<strong>in</strong>g, 21–22management of, by monol<strong>in</strong>e <strong>in</strong>surers, 256,257systematic, 102tail, 78Risk premiums, 22, 61Risk strategies, of community banks, 161–162RMBS, see Residential mortgage-backedsecuritiesRohatyn, Felix, 111Roll rate, 256Ross, Wilbur, 186, 251–264on AIG, 254on American Home Mortgage Services, 256on Assured Guaranty, 257–258on automobile crisis, 260–261on Bank of America, 253on banks, 258–259on BankUnited, 259on causes of current economic crisis, 252–253on Ford Motor Credit ABCP, 262–263on future opportunities <strong>in</strong> <strong>New</strong> <strong>Economy</strong>, 260on Monol<strong>in</strong>e Insurance, 256–257on PPIP, 262on securitizations, 255on TALF, 262on TARP, 261–262Royal Palm Hotel (Miami Beach, Florida), 189,192Rub<strong>in</strong>, Robert, 39Russia, as BRIC nation, 66SSaab division (of General Motors), 117Sadove, Steve, 241–248on capital spend<strong>in</strong>g, 245–246on causes of current economic crisis, 242–243on communicat<strong>in</strong>g, 247–248on consumer confidence, 243on <strong>in</strong>ventory, 243–244on <strong>New</strong> <strong>Economy</strong> strategies, 245on retail <strong>in</strong>dustry trends, 246–247‘‘Safe and stable’’ campaign (ICBA), 158Safety concerns, automobile preference and, 237Saks Fifth Avenue:communication at, 247–248cultural evolution at, 245<strong>in</strong>ventory at, 243, 245, 246sales <strong>in</strong> current crisis at, 241–243spend<strong>in</strong>g controls at, 245–246Sav<strong>in</strong>g, rates of, 16–17Schumpeter, Joseph, 68Seat belts, air bag, 229SEC, see Securities and Exchange CommissionSecond quarter bounce, 13–14Sector valuations, 32–33Secular growth, 228Securities and Exchange Commission (SEC), 26,38Securities firms, 101Securitization(s):and commercial loans, 138–139and monol<strong>in</strong>e <strong>in</strong>surance, 256of mortgages, 169–170Wilbur Ross on, 255as source of credit, 255Securitization market, reopen<strong>in</strong>g of, 262Securitized loans, 184Security, of municipal bonds, 185Self-regulation, 11September 11, 2001 terrorist attacks, 28–30,142, 230, 267September 2008 meltdown, 100Sequenc<strong>in</strong>g, <strong>in</strong> economic recovery, 237Shadow bank<strong>in</strong>g system, 77Shakespeare, William, 45Shareholder activists, 6Shareholder values, 6Short<strong>in</strong>g <strong>the</strong> market, 119Short-term conditions, 28Silberman, Rob, 84Sites, secur<strong>in</strong>g real-estate, 192–193Site control, 192n.Small bus<strong>in</strong>esses, community banks and, 159Small cap companies, 92Smok<strong>in</strong>g, 87–88Snow, John, 8Social Security, 67SourceForge, 97S&P 500, see Standard & Poor’s 500 Stock IndexSpecie-based currencies, 24Speculation:<strong>in</strong> real estate market, 200, 203<strong>in</strong> stock market, 42, 44Spend<strong>in</strong>g:consumer, 60, 175controls on, at Saks Fifth Avenue,245–246Sperlich, Hal, 233Spitzer, Eliot, 92Squawk Box (television show), 8, 126, 182, 211,252Stability:and FDIC, 143as focus of advertis<strong>in</strong>g, 137–138<strong>in</strong> gasol<strong>in</strong>e prices, 220of U.S. dollar, 27Stagflation, 95Standard & Poor’s (S&P) 500 Stock Index,39–40, 50–51, 53–55, 77, 84Standards of liv<strong>in</strong>g, 75Stand<strong>in</strong>g loans, 183Ste<strong>in</strong>, Herb, 7
INDEX 289Stimulus plan:development of, 19need for, 21and politicization of lend<strong>in</strong>g, 133and recovery <strong>from</strong> current crisis, 176Stock(s), 108prices of, 36purchas<strong>in</strong>g of, 121returns on, 41, 44valuation of, 42Stockholders, bailouts and protection of, 151–152Stock market(s), 41as cause of f<strong>in</strong>ancial crises, 169Abby Joseph Cohen on meltdown of, 62–63cumulative returns on, 43ga<strong>in</strong>s <strong>in</strong>, 52and Lehman Bro<strong>the</strong>rs bankruptcy, 121and mutual funds, 139recovery <strong>in</strong>, 174‘‘Straight Talk with Steve’’ program, 247–248Strategy(-ies):adaptive, 217adjustment of, 73for build<strong>in</strong>g construction, 194–195creat<strong>in</strong>g, 227–228<strong>in</strong>vestment, 34–36, 75–76liquidity fund<strong>in</strong>g, 102long-term, 30for <strong>the</strong> <strong>New</strong> <strong>Economy</strong>, 96–97, 106–110, 245for thriv<strong>in</strong>g, 86–88, 187–188, 203–204Strayer Education, 84Strength:economic, 159as focus of advertis<strong>in</strong>g, 137–138Stress tests (for banks):BB&T Corporation, 126and September 2008 meltdown, 62and stock market recovery, 174Stroper, David, 253Structured f<strong>in</strong>ance <strong>in</strong>dustry, 77Stuyvesant Town, 182Subprime mortgages (subprime mortgagemarket), 7, 11, 100aggressive nature of, 181–182and auto <strong>in</strong>dustry, 216and BB&T Corporation, 127and CDOs, 38implosion of, 51problems <strong>in</strong>, 48and Wells Fargo, 201Successful <strong>in</strong>vest<strong>in</strong>g, Jack Bogle on, 41–42Supplier network, for auto <strong>in</strong>dustry, 217Susta<strong>in</strong>able dividends, 76Susta<strong>in</strong>able growth, 69Susta<strong>in</strong>ed recovery, 14SUVs, safety of, 237Swapp<strong>in</strong>g stocks, 40Systematic leverage, Peter Cohen on, 104Systematic risk, 102TT. Rowe Price, 40Tail risks, 78TALF, see Term Asset-Backed Securities LoanFacilityTARP, see Troubled Asset Relief ProgramTaxes and taxation:on carbonated dr<strong>in</strong>ks, 88and GSE stock, 154and home ownership, 204–205<strong>in</strong>creases <strong>in</strong>, 27, 106Taylor, Ron, 84Tech bubble, 56Technology, 32, 219Temasek, 252–254Term Asset-Backed Securities Loan Facility(TALF), 94, 262Term structure risk premiums, 22Terrorism, f<strong>in</strong>anc<strong>in</strong>g of, 142Test scores, 87Textile <strong>in</strong>dustry, 97Tha<strong>in</strong>, John, 253Thrifts, <strong>in</strong>vest<strong>in</strong>g <strong>in</strong>, 258–260<strong>Thriv<strong>in</strong>g</strong>, Ron Baron on strategies for, 86–88Tiffany, Louis Comfort, 180Tim<strong>in</strong>g, Don Peebles on, 195–196‘‘Too big to fail’’ :expansion of, 128Donald Powell on, 142‘‘Too small to save,’’ Cam F<strong>in</strong>e on, 151Toxic assets:government buy<strong>in</strong>g of, 261<strong>in</strong>vest<strong>in</strong>g <strong>in</strong>, 186–187at Lehmann Bro<strong>the</strong>rs and Merrill Lynch, 253Toyota, 215–216disaster plann<strong>in</strong>g at, 216as full-l<strong>in</strong>e manufacturer, 220lend<strong>in</strong>g at, 221plann<strong>in</strong>g for <strong>the</strong> future at, 218–220recovery at, 221–223Toyota Prius, 223Toyota Venza, 223Toyota Way, Jim Lentz on, 223–224Trac<strong>in</strong>da Investment Company, 117Trade agreements, 27Trad<strong>in</strong>g desks, 110Trad<strong>in</strong>g up (<strong>in</strong> real estate), 203Tranches, 38Transparency, Donald Marron on, 174Transportation <strong>in</strong>dustry, future of, 229–230Troubled Asset Relief Program (TARP), 9, 88,93–95, 103as alternative to private equity, 171and BB&T Corporation, 126Kelly K<strong>in</strong>g on, 132–133
290 INDEXTroubled Asset Relief Program (cont<strong>in</strong>ued )public perception of, 134Wilbur Ross on, 261–262Wall Street-centrism of, 158Trust, <strong>in</strong> bus<strong>in</strong>ess partners, 23Turnarounds, <strong>in</strong>vest<strong>in</strong>g <strong>in</strong>, 228Tyco International Ltd., 118UUAL Corporation, 225UBS AG, 165UMB (bank), 160–163Underemployment, 68Underwrit<strong>in</strong>g, 110, 195Unemployment, 68. See also downsiz<strong>in</strong>gand household sav<strong>in</strong>gs, 16–17peak of, 13rise of, 107UnifiedBank, 97Unions, 87, 231United Airl<strong>in</strong>es, 225U.S. dollar:and global economy, 23–24Obama adm<strong>in</strong>istration and stability of, 27and weak-dollar policy of Bushadm<strong>in</strong>istration, 26, 33U.S. Treasury, 52Public-Private Investment Program of, 53, 103and seizure of Fannie Mae/Freddie Mac, 151–153treatment of community banks by, 157–158United Way, 134Up markets, real estate value <strong>in</strong>, 191, 192Uptick rule, 26Urban redevelopment (Wash<strong>in</strong>gton, DC), 193–194VVA L<strong>in</strong>ux, 97Valuation(s), 36sector, 32–33stock, 42tools for, 61Value(s) (economic):<strong>in</strong> auto <strong>in</strong>dustry, 223and luxury consumers, 247real estate, 187, 191, 192, 202–204shareholder, 6of toxic assets, 186–187Values (ethical):at community banks, 160core, <strong>in</strong> current crisis, 68, 109corporate, 44<strong>in</strong>tr<strong>in</strong>sic, 44Value-based <strong>in</strong>vest<strong>in</strong>g, 36Value-oriented purchase discipl<strong>in</strong>e, 79Vanguard, 38, 45Vassallo, Mark, 165Venture capitalists, 67Vision, 265–266Visteon Corporation, 120Volatility:high levels of, 63<strong>in</strong>crease of, 102of <strong>in</strong>vest<strong>in</strong>g, 43<strong>in</strong> stock market, 50–52Volcker-Reagan nexus, 34Volunteer<strong>in</strong>g, 134–135Vulture <strong>in</strong>vestors, 251WWachovia, 125, 136–137Wages, decl<strong>in</strong><strong>in</strong>g, 107Wall Street:and Lehman Bro<strong>the</strong>rs, 10Ma<strong>in</strong> Street vs., 154, 157–158and new products, 38Warranty costs, at Chrysler, 232Wash<strong>in</strong>gton, DC, urban redevelopment <strong>in</strong>,193–194Wash<strong>in</strong>gton Mutual, 125Waterfall decl<strong>in</strong>es, 49–51Weak-dollar policy, 26Wealth destruction (wealth reduction), 16,107Wealth-to-<strong>in</strong>come ratios, 12Welfare-to-work <strong>in</strong>itiative, 267Wells Fargo, 200Willis Group Hold<strong>in</strong>gs, 257W<strong>in</strong>d power, 88–89WLR LeFrak, 252WL Ross & Co., 252, 255–261Work environment, 87World War II, 209, 222Wynn, Steve, 85–86Wynn Resorts, 85YYale model (of portfolio construction), 77Yemenidjian, Alex, 85York, Jerry, 117–121, 226on analyz<strong>in</strong>g <strong>the</strong> situation, 119on availability of credit, 120on causes of current economic crisis, 118on downfall of Lehman Bro<strong>the</strong>rs, 119on future of auto market, 120on <strong>in</strong>vest<strong>in</strong>g criteria, 120–121YouTube, 155
“<strong>Thriv<strong>in</strong>g</strong> <strong>in</strong> <strong>the</strong> <strong>New</strong> <strong>Economy</strong> is a must-read for anyone who wantsto th<strong>in</strong>k big. Leaders are people who can look at a crisis and actaccord<strong>in</strong>gly. This book has strategies <strong>from</strong> bus<strong>in</strong>ess leaders who do justthat. Lori Ann LaRocco sits down with some of <strong>the</strong> biggest and brightestm<strong>in</strong>ds on Wall Street and has <strong>the</strong>m open up and tell <strong>the</strong>ir stories <strong>in</strong> acompell<strong>in</strong>g, page-turn<strong>in</strong>g book.”—DONALD TRUMP, Chairman and President, The Trump Organization“Lori Ann’s book is a fast read and gives some <strong>in</strong>terest<strong>in</strong>g perspectiveson <strong>the</strong> disaster that we’re currently com<strong>in</strong>g out of and some predictionsfor <strong>the</strong> calamity that we are now fac<strong>in</strong>g.”—BERNIE MARCUS, cofounder of Home Depot and Chairman, Marcus Foundation“A fasc<strong>in</strong>at<strong>in</strong>g analysis of <strong>the</strong> recent American f<strong>in</strong>ancial markets directly<strong>from</strong> <strong>the</strong> mouths of major participants, all of whom are unusuallyarticulate and able to convert complex issues <strong>in</strong>to easily understoodconcepts. A must-read for both <strong>the</strong> novice and <strong>the</strong> professional,yet <strong>in</strong> a style that makes for easy and enjoyable read<strong>in</strong>g.”—LEONARD STERN, Chairman and CEO, Hartz Group“Lori Ann LaRocco has edited and written a compendium <strong>from</strong>a group of successful <strong>in</strong>novators and <strong>in</strong>vestors . . .it is a very worthwhile read. Our thanks to her for do<strong>in</strong>g this.”—JOHN GUTFREUND, former CEO, Salomon Bro<strong>the</strong>rsand President, Gutfreund & Company