Historical Research: The Canal Builder

How DeWitt Clinton's Erie Canal changed the financial landscape.

Research Magazine
December 1, 2009 | By Kenneth Silber
DeWitt Clinton (1769-1828) was an early American politician who transformed the country in far-reaching ways -- physically, economically and financially. He was the driving force in building the Erie Canal, a massive engineering achievement that helped make Wall Street into a major financial center and the United States into an economically dynamic nation where investors would want to put their money.
Clinton served at various times as governor of New York state, mayor of New York City, U.S. senator and member of the Erie Canal commission. … He was an intellectual with interests ranging from rattlesnake biology to the history of Native Americans. He also was imperious and abrasive. …
Among Clinton's accomplishments were improvements in public education, sanitation and city planning, reforms of criminal laws and helping found and promote cultural institutions such as the New York Historical Society. But his lasting place in history comes primarily from his role in spearheading development of the Erie Canal, notwithstanding the skeptics who called it "Clinton's folly" or "Clinton's ditch."
Large-Scale Project
In 1810, Clinton, who had served intermittently as mayor, was picked by the State Legislature to be one of the first members of the Commission to Explore a Route for a Canal to Lake Erie and Report, which would go through various unwieldy names and become known as the Erie Canal commission.

Image via WikipediaThe idea of opening America's interior through a canal linking upstate New York to the Great Lakes region had been floating around for decades. … A more ambitious plan would be to connect Lake Erie to the Hudson River.

That, however, would mean crossing hundreds of miles of often difficult terrain, passing through swamplands and cutting through rock ridges. …
Clinton spent the next few years campaigning for an Erie Canal, arguing that New York state should build the thing without federal help if necessary. In 1817, a veto by President Madison showed that this was indeed necessary. But that same year, the State Legislature passed a Canal Act, and Clinton, his career increasingly connected to the issue, became governor. Overturning some soil with a shovel, he promised that the huge undertaking would be done in 10 years. It ended up taking just eight.
Buy Canal Bonds
The canal's projected cost was $7 million, a stupendous sum. New York state issued bonds on an unprecedented scale, while also taxing land, salt and other items in the canal area so as to have ready cash to service the debt. Relatively small investors provided a substantial portion of the initial capital. An 1818 bond issue attracted 69 subscribers, with 51 investing less than $2,000 and 27 investing less than $1,000. The Bank for Savings, an institution set up with Clinton's encouragement to serve small depositors, became a major buyer of canal bonds as well.
With construction moving fast and the canal demonstrating itself to be a reliable generator of interest payments, wealthier individuals and institutions increasingly got in on the action. By the end of 1822, John Jacob Astor owned $213,000 of canal bonds. Foreign interest grew as well, as Barings and other British firms became big buyers of canal paper. The London Times opined that the canal would turn New York City into the "London of the New World."
That would prove accurate. Once the 363-mile-long canal was completed in 1825, New York was essentially guaranteed preeminence as the nation's top commercial and financial city. … Moreover, the city's banks and investors had gained sophistication in dealing with financial instruments such as canal bonds. This would serve them well in future decades, as railroad bonds and other securities came to the fore.
At the same time, the whole country stood to benefit. Shipping times and costs were slashed. People could move west with relative ease, and substantial cities such as Chicago, Cleveland and Milwaukee would grow along the Great Lakes. And the United States, barely a decade after the 1814 burning of public buildings in Washington, D.C. by occupying British troops, was now a magnet for British and other foreign investment. In the parlance of a later age, the U.S. had become a very promising "emerging market."
Political Twists
Clinton's political fortunes took a hit while the canal was still under construction. He was dumped from the governorship in 1822, after a state constitutional convention changed the term of office from three years to two and canceled his final months. … Clinton was losing a political contest with a faction headed by Martin Van Buren, who would be president years later.
Then his opponents overreached, orchestrating a vote in the State Legislature to remove Clinton from his post as head of the Erie Canal commission. "There is such a thing in politics as killing a man too dead," Van Buren fretted, and he was right. A wave of popular indignation at Clinton's dismissal got him reelected as governor in 1825.
Thus, Clinton was in office in time for the canal's official opening ceremonies. On Oct. 26, 1825 he set off from Buffalo in the boat Seneca Chief, heading a flotilla of vessels that would go through the new canal and then down the Hudson. On Nov. 4, the celebrants passed lower Manhattan and moved onto Sandy Hook, N.J. There, Clinton poured a cask of Lake Erie water into the Atlantic.
Note: The author's interest in this subject is personal as well as professional. His wife C. Brooke Silber, n?e Carter, is DeWitt Clinton's great-great-great-great granddaughter.
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DeWitt Clinton Facts

• Image via WikipediaDeWitt Clinton was born in Little Britain, N.Y. to a family that was increasingly politically prominent. His father James Clinton was a Revolutionary War general, and his uncle George Clinton would become governor of New York and later vice president.
• Image via WikipediaDeWitt graduated on April 11, 1786 from what is now Columbia University, giving a commencement speech in Latin with the U.S. Congress in attendance.
• Clinton was married twice, first to Martha Franklin in 1796 and then to Catharine Jones in 1819. DeWitt and Martha had 10 children, seven of which were alive at the time of her death in 1818.
• Worried about a buildup of federal power, Clinton opposed ratification of the Constitution and later argued for narrow interpretation of its provisions. …
• He served in the State Legislature during 1798-1802 and 1806-1811. … He was mayor of New York during the three separate periods, and was governor of New York twice.
• In July 1802, Clinton fought a duel with John Swartwout, a friend of Aaron Burr, over allegations that Clinton was trying to ruin Burr's political career through smears. Five shots were exchanged, one grazing Clinton's jacket. After shooting his opponent's leg, Clinton walked off in disgust, saying he did not wish to hurt Swartwout and that he wished "the principal" (Burr) were present as his opponent.
• Clinton was initially a member of the Democratic-Republican Party that was led in the early 1800s by Thomas Jefferson. However, he ran for president in 1812 as a candidate of the rival Federalists, having broken with his party over the issue of war with Britain. … Clinton won 47.6 percent of the popular vote, to Madison's 50.4 percent.
• Image via WikipediaClinton was contemplating another run for the presidency in the 1828 election.
  He died in Albany, N.Y. on February 11, 1828 at age 58, while serving as governor. …
• A DeWitt Clinton steam locomotive began operating in 1831. DeWitt Clinton High School in the Bronx is one of a number of educational institutions given his name. Various towns and counties in states across America are named Clinton or DeWitt in his honor. A portrait of DeWitt Clinton appeared on a $1,000 bill issued in 1880.

Image via WikipediaAbout the Author

Kenneth Silber
Senior Editor, Research Magazine
Kenneth Silber is a senior editor at Research magazine. His work on science, economics and history has appeared in a variety of publications, including The Wall Street Journal and The New York Post. He appears on a monthly radio show on the Business Talk Radio Network.

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Tech Professionals Say Venture Capital Model Has Changed Forever

Portfolio.com - a bizjournals property

A slower market for initial public offerings is likely the new norm, and venture capitalists are likely to make smaller bets on smaller companies and make their returns from mergers and acquisitions of their portfolio companies.
That, at least, is what tech honchos surveyed by DLA Piper expect. That’s a major change for one of the most glamorous corners of the innovation business.
It may well mark the end of the big, bold, VC plays, said Peter Astiz, global co-head of the DLA Piper Technology Sector Practice.

Image via Wikipedia“This is a profound, game-changing development," Astiz said Tuesday in a statement. "If there is a long-term expectation that the IPO market will not rebound, that means a reduction in the number of dramatic ‘home runs’ for venture capital investors and lower overall returns. Fewer IPOs also means fewer small and medium-size public technology companies, which traditionally have been the acquirers for venture-backed company exits.”

Astiz went on to say that tech companies would continue to move forward and investors would still be active, but that the venture model is changing. "For startup tech companies, the bar is being raised, capital will be harder to come by, and pressure to perform will increase.”
Those expectations are reflected in the third-quarter report on venture exits by the National Venture Capital Association’s report in conjunction with Thomson Reuters. (Download a PDF of the report by clicking here.)

Image via CrunchBaseThe market for public offerings of venture-backed companies is recovering from the disastrous 2009 period. But it’s nowhere near the levels seen in the boom times of the late 1990s, and there haven’t been any blockbuster IPOs like that of Google.

Instead, venture capitalists have made their money through the sale of their portfolio companies to other firms. In the third quarter, there were 27 deals with disclosed values worth $3.8 billion, up from 22 deals worth $2.9 billion. As for IPOs, there were 14, worth $1.2 billion, in the third quarter. …
The technology professionals surveyed by DLA Piper agree. Nearly 60 percent say the venture model has been permanently altered. But that’s not all bad news, because with technologies like cloud-based computing available, it’s cheaper now to build a company. So VCs may be able to make smaller bets across more companies and get high rates of returns on those small bets.
In other topics, tech leaders told DLA Piper they expect:

• The economy will continue to grow, albeit slowly, with 85 percent of those surveyed expecting at least a couple of percentage points of growth in the coming year.
• Seventy-two percent expect sales increases in the coming year.
• Forty-three percent expect to keep staffing levels flat.

“While some economists and headlines question whether the U.S. economy is headed for a double-dip recession, technology leaders seem confident of a sustained recovery,” Astiz said. “Tech leaders are forecasting stronger sales and earnings across the board, yet they are not planning to invest in hiring nor R&D. This suggests that we may be in for a prolonged period of guarded investment and slow growth.”

Related articles

• IPO Plunge Has Many VC Firms 'Walking Dead' (businessweek.com)
• As Bush-Era Tax Cuts Expire, VCs Nearly Split On Impact [Voices] (voices.allthingsd.com)
• Venture capital investments decline 7% (usatoday.com)

Employees Value More Employers that Offer Voluntary Benefits

Image via Wikipedia October 6, 2010 (PLANSPONSOR.com) - According to a survey conducted for insurer WellPoint, Inc., most employees (83%) think more highly of employers that offer voluntary insurance benefits than those that don't.

In addition, nearly 90% of respondents report that when it comes to accepting a new job, it is important that companies offer a full range of health benefits, including voluntary. More than half (56%) said it is "very important." 

Image via Wikipedia

According to a press release, eight in ten employees whose company offers voluntary benefits (82%) are satisfied with their benefits offerings, compared to 30% of those whose companies do not offer such benefits.

The top reasons employees cited for enrolling in voluntary benefits include cost savings (54%), greater protection for their families (50%), and ease of mind (44%).

Additional survey results include:

• Two thirds of employees (67%) say their company currently offers voluntary insurance.
• Specific groups of employed Americans are more likely to report their company offers voluntary insurance, including men (71%), those located in the Northeast region of the United States (74%), workers at large companies (81%), and those with an average household income of $50,000 or more (74%).
• Only half of workers (56%) say they are knowledgeable about the voluntary insurance products offered at their companies.
• The majority of workers agree (67%) that having their employer provide voluntary benefits would increase their productivity at work.

The survey was conducted online among a national sample of 2,500 Americans ages 18+ in August 2010.

Rebecca Moore
editors@plansponsor.com

Protection from the Storm

PLANSPONSOR.com

Thinking about investment-management outsourcing? Here are seven of the biggest myths and realities
“If it is raining, you are looking for the best umbrella,” says Joshua Dietch, Managing Director at Waltham, Massachusetts-based Chatham Partners, a market research and consulting company. Some employers—who sponsor underfunded defined benefit (DB) plans that need better risk management or defined contribution (DC) plans that need less-costly, more-customized investment options, for example—have looked to the expertise of investment-management outsourcers as that protection from the current storm.

However, this complex field is ripe for confusion among employers considering it. Sources talked about several of the most common investment-outsourcing myths:

1. It is just for mid-size sponsors. “The real sweet spot for outsourcing is mid-size companies,” says Seth Masters, CIO of AllianceBernstein Blend Strategies and Defined Contribution, and most of the first wave of deals did, in fact, happen with these plans. These employers often do not have the in-house resources to do all the work effectively, but have enough in assets to make deals scalable for an outsourcer.

Image via WikipediaWhile the mid-size market remains active, “we also see much more of a trend at the larger end,” says Joseph Gelly, Russell Investments Investment Outsourcing Practice Leader. “It is less around ‘I do not have buying power’ or ‘I do not have the resources or the technical competence’ and more around ‘I need to focus on running my company,’” he says, adding that many of those larger employers have frozen DB plans and want to devote their time and resources to core parts of their business rather than legacy benefits.

2. It is just about managing managers. Many sponsors traditionally see outsourcing in terms of investment oversight, says Clint Cary, Senior Vice President at Aon Investment Consulting. “It is not just managing assets; it is managing the funded status,” he says. Sponsors of active DB plans “are migrating to a risk-management approach, where they are trying to improve the funded status of the plan and de-risking the plan as they get better funded,” he says, “and they do not have the risk managers internally.”…

Image via Wikipedia3. Only defined benefit plans get outsourced. These plans have used outsourcing the most, but defined contribution (DC) sponsors increasingly consider it, says Jennifer Tretheway, a Senior Vice President and Managing Director at Northern Trust Global Advisors. “The most common thing we see from DC plans is an interest in having some type of oversight done, anything from overseeing the mutual fund options on a recordkeeper’s platform to something more proactive, in terms of having discretion on which investment-management firms to utilize,” she says.

DC plans may need outsourcers’ expertise even more than DB plans, Masters says. “Historically, DC plans did a kind of outsourcing by hiring recordkeepers that provided a bunch of options, mostly in mutual fund form and often, frankly, at a fairly high cost,” he says. However, DC plans have become most Americans’ primary retirement-savings vehicle, leading employers to want to limit the cost to participants as much as reasonably possible.
“The single biggest thing that people will get help with is customizing target-date funds,” Masters predicts. “In the next 10 years, virtually all growth in DC assets will be in target-date assets. So, as that unfolds, it becomes increasingly important for plan sponsors to get the target-date decision right.” Designing and implementing a customized target-date structure so that it comes as close to the cost of a DB plan as possible “is a fairly specialized task,” he says, and many employers lack that in-house expertise.
4. It costs a lot, or saves a lot. “Another primary misconception is that outsourcing is more expensive than doing it in-house,” Tretheway says. “The majority of our clients do recognize some savings, in the form of hard-dollar expenses for investment management, custody, and performance measurement. On average, clients might recognize a savings of around 10%.”…
“[Sponsors] do not go in thinking the overall fees are lower; they go in thinking they will get a more comprehensive service set,” Cary says. “They see it as a cost-neutral solution. Cost is not a main driver, and is also not a hindrance.”
Remember that the cost of administration for a DB plan pales compared with the cost of funding the plan, Dietch says. The argument for outsourcing a pension plan is “you reduce your cost of funding if you generate higher returns and less volatility, and reduce tracking error,” he explains.
5. Sponsors can offload their fiduciary responsibility. Dietch wonders if most employers realize that they retain significant fiduciary obligations if they outsource. Even if they think they can transfer that responsibility legally, Masters says, “I think you cannot morally: The reputational risks are too great.”
Yet, the desire to forgo as much fiduciary responsibility as possible “is a big motivator” to outsource, Dietch says. “It is certainly being aggressively marketed.” However, an ERISA plan sponsor remains a fiduciary, he adds, and has to operate with that standard in selecting and monitoring an outsourcer.
“That fiduciary role does not go away,” Gelly says. “The responsibility shifts from day-to-day to more strategic. Their involvement is extremely critical, but it is more at the strategic level,” such as approving the investment policy. The employer also still needs to evaluate the investment outsourcer’s performance regularly, Tretheway says, and most clients look at quarterly committee meetings as a good time to cover that.
6. It means giving up all control. “One thing I hear a lot is that people feel like, ‘Oh, I am giving up control,’” Gelly says of employers thinking about outsourcing. In reality, Tretheway says, clients’ ongoing involvement level really ranges. For instance, some clients delegate to Northern Trust the authority to hire and fire investment managers but, in other cases, it does not have complete discretion. For those with less day-to-day involvement, she believes, they ultimately have more control because they can track progress more closely to meet their goals.
There is no one right answer on how involved in day-to-day workings a sponsor should stay after outsourcing, Masters says. …
7. Outsourcers only sell pre-packaged solutions. “There is a little bit of a myth out there around, ‘This is a black box,’” Gelly says. “Unfortunately, some people think that everybody is treated the same.” Sometimes yes and sometimes no. For instance, Gelly says that Russell highly customizes the weighting among plan clients’ asset classes based on factors such as a plan’s liabilities.
Outsourcing has a lot of different permutations in the marketplace, Dietch says, but to do this business profitably, outsourcers have to create something scalable. As for customizing to specific clients, he says, “a lot of it comes down to what the contractual terms say.” Some outsourcing providers take a more-standard approach: “They have one fund, and everybody goes into that fund,” Tretheway says, “but all of our clients have a unique asset allocation, and a unique investment policy statement. We really have a hard time believing that any two organizations have identical needs.”
Judy Ward
editors@plansponsor.com

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Tips for Documenting the Selection and Monitoring of Your Advisers

Reish & Reicher

By Jason Roberts (July 2010)

…[While] most [plan sponsors] go to great lengths to establish procedures to select and monitor plan investment options, many do not have adequate processes or documentation regarding the selection and monitoring of consultants or advisers that often assist the plan fiduciaries in investment-related matters.
Fiduciaries of employee benefit plans are charged with carrying out their duties prudently and solely in the interest of participants and beneficiaries of the plan and are subject to personal liability to, among other things, make good any losses to the plan resulting from a breach of their fiduciary duties. In selecting service providers, the responsible plan fiduciary must engage in an objective process designed to elicit information necessary to assess the qualifications of the service provider, the quality of the work product, and the reasonableness of the fees charged in light of the services provided. In addition, this process should be designed to avoid self-dealing, conflicts of interest or other improper influence. The following steps are designed to assist fiduciaries in evaluating the adviser and the services to be provided.
Step 1: Evaluate the credentials of the adviser and his or her experience with servicing employee benefit plans, the services to be provided and the fees to be charged.

• You should also consider obtaining competing bids from other providers offering equivalent services and document the basis upon which you have selected your adviser, including any relevant industry experience and/or retirement-specific designation(s).

Step 2: Evaluate any potential conflicts of interest and the adviser’s policies and procedures designed to address those conflicts.

• The SEC has warned that “business alliances” among pension consultants and money managers can give rise to serious potential conflicts of interest under the Advisers Act that need to be monitored and disclosed to plan fiduciaries.

Step 3: Periodically review the performance of your service providers to ensure that they are providing the services in a manner and at a cost consistent with the agreements.
Step 4: Review plan participant comments or any complaints about the services and periodically ask whether there have been any changes in the information you received from the service provider prior to hiring (e.g. does the provider continue to maintain any required state or federal licenses).
Step 5: Prepare a written record of the process you followed in reviewing potential service providers and the reasons for your selection of a particular provider.

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Any U.S. federal income tax advice contained in this communication (including any attachments) is neither intended nor written to be used, and cannot be used, to avoid penalties under the Internal Revenue Code or to promote, market or recommend to anyone a transaction or matter addressed herein.

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© 2010 Reish & Reicher, A Professional Corporation. All rights reserved. The REPORT TO PLAN SPONSORS is published as a general informational source. Articles are general in nature and are not intended to constitute legal advice in any particular matter. Transmission of this report does not create an attorney-client relationship. Reish & Reicher does not warrant and is not responsible for errors or omissions in the content of this report.

Goldman Sachs, Buffett to help small businesses

Goldman Sachs teams with Warren Buffett on $500 million effort to help small businesses
Yahoo! Finance

• On 10:57 pm EST, Tuesday November 17, 2009

NEW YORK (AP) -- Goldman Sachs Group Inc. is teaming with billionaire investor Warren Buffett to invest $500 million to provide thousands of small business owners across America with college scholarships and boost their access to capital.
AP - FILE - In this March 27, 2009, file photo, Goldman Sachs Chief Executive Officer Lloyd Blankfein ...
The move comes as the company has been criticized for setting aside billions for employee paychecks despite the continuing weak economy.
Goldman's philanthropic effort, called "10,000 Small Businesses," includes a $200 million contribution to community colleges, universities and other institutions to give grants to small business owners to further their education.
The New York-based bank also will invest $300 million through a combination of lending and charitable support. Goldman said the money will be funneled through community development financial institutions to boost lending and technical assistance available to small businesses in underserved communities.
In addition, Goldman Sachs executives, in partnership with national and local business organizations, will aid small businesses with advice, technical assistance and professional networking opportunities.
An advisory council co-chaired by Goldman Sachs CEO Lloyd Blankfein will oversee the program. Legendary investor and Goldman's largest shareholder, Warren Buffett, and Harvard Business School Professor Michael Porter will serve as co-chairs as well. …
10,000 Small Businesses, which has been in development for nearly a year, is a five-year program modeled on the Goldman Sachs 10,000 Women initiative, which creates partnerships between academic institutions and non-profits to provide business and management education to women around the world.
Other Council members include George Boggs, president and CEO of the American Association of Community Colleges, Glenn Hubbard, dean of Columbia Business School and Marc H. Morial, president and CEO of the National Urban League, among others.
The first community college to participate will be LaGuardia Community College in New York City's Queens borough, which houses a Small Business Development Center. The first community development financial institution to receive financing from Goldman Sachs will be New York-based Seedco Financial Services Inc., with loans to underserved businesses in the New York area expected to begin early next year.

Advice restrictions expected

Rejection of Bush-era rule signals tougher regs ahead

Pensions & Investments

By Jeff Nash September 21, 2009, 12:01 AM ET

Industry experts expect a more restrictive investment advice proposal later this year now that the Labor Department has killed a Bush administration regulation on advice to DC plan participants.

The rule, floated in the last days of the Bush administration, would have allowed employees of financial firms that sell investments to provide direct advice to defined contribution plan participants. …

While it's unclear what the new investment advice proposal will say, many experts agree that the Labor Department will work with Congress to find a way for plan participants to receive objective investment advice. As part of that process, Phyllis Borzi, assistant secretary of the Labor Department and head of the Employee Benefits Security Administration, will likely solicit wide-ranging opinions to re-examine three core topics:

• Should the “fee leveling,” condition — which would permit an employee of a financial services firm to offer investment advice directly to DC plan participants if his compensation doesn't vary based on the investment recommendation — be extended to that adviser's employer, as well as any affiliate of that employer? This effectively would prevent money managers from offering advice if they recommend their own products.

• Should new legislation support or invalidate the Department of Labor's 2001 SunAmerica advisory opinion, which allows a DC plan's service provider to offer advice to plan participants through an affiliated adviser using an independently developed computer model?

• Should “off-model” advice be permitted? In other words, can a mutual fund or investment management company design its own computer software to deliver advice, as long as the model is certified as unbiased by an independent third party.

… The EBSA is expected to release new proposals on Nov. 18 — the date the Bush investment advice rules would have taken effect after two delays. …

Pro-participant

“I think Phyllis wanted a tabula rasa, and the only thing for certain is that the new rules will be pro-participant,” said Marcia Wagner, an ERISA attorney with Wagner Law Group PC, Boston. “She may well come up with something never thought of, something completely different. Remember this is the woman who basically created COBRA; she's extremely creative.” …

[Rep. Robert Andrews (D-N.J.), chairman of the House Education and Labor Committee's pensions subcommittee],explained the 2006 Pension Protection Act would have to be changed in order for the DOL to issue the kind of investment advice rules Congress would support. “It will take statutory and regulatory change to create the goal of qualified-independent-investment advice affordable to every investor,” he said.

One major area to be considered is what is meant by “fee leveling.” …

… Many experts expect the new proposals also will address the SunAmerica opinion.

“We need to see some clarification and formalizing of this rule, which really avoids conflicts of interest for advisers and ensures some independence,” said Robyn Credico, director of the plan management group practice, North America, at Watson Wyatt Worldwide Inc., Arlington, Va.

But if the Labor Department reverses the opinion, that could force employees to use independent advisers. “Not everyone can use truly independent advisers because they're expensive,” Ms. Credico said.

Questions of scope

Jason Bortz, an ERISA attorney with the law firm Davis & Harman LLP, Washington, said “some people have raised questions about the scope of the SunAmerica opinion — for example, whether a model should take into account non-proprietary funds.”

In July, the House Education and Labor Committee approved the 401(k) Fair Disclosure and Pension Security Act of 2009, which was sponsored by Messrs. Miller and Andrews. The legislation would prohibit employees of financial services firms from offering investment advice if their compensation varies depending on the investment advice they give. …

Another option the Department of Labor might consider is allowing mutual funds and other investment companies to offer advice through their own computer model that has been certified as unbiased by a third party — an idea originally floated in a bill introduced by Mr. Andrews back in May.

Contact Jeff Nash at jnash@pionline.com

What’s next for US banks

Two different kinds of accounting—fair value and hold to maturity—have created two different kinds of crises. One is almost over. The other is only beginning.

McKinsey Quarterly

JUNE 2009 • Lowell Bryan and Toos Daruvala

Source: Financial Services Practice

… How close are we to the restoration of a strong and profitable banking and securities industry that is capable of providing the US economy with the credit it needs to grow?

The good news is that we have probably turned a corner in the credit securities crisis … But the contours of a broader resolution of the crisis will remain fuzzy for some time to come. That’s because what many have been regarding as a single credit crisis is in reality the tale of two closely related but different crises, each with its own pace, duration, and demands on banks to rediscover operational discipline in a harsh economic and regulatory environment.

Twin crises

The first credit crisis was centered in the securities markets and initially manifested itself in the subprime and mortgage-backed securities markets. Because of the fair-value accounting that broker–dealers and investment companies use to mark assets to current market expectations, these firms began to suffer deep losses on mortgage-backed securities long before large volumes of loans started to default. …

The good news is that we appear to be seeing the end of this credit securities crisis. That is in part due to the clarity provided by the stress test exercise and the ongoing commitment on the part of government not to allow a large-scale bank failure. The other credit crisis is a commercial-bank lending crisis. …[It] involves a broader array of lending, including commercial real-estate loans, credit card loans, auto loans, and leveraged/high-yield loans, all of which are now going bad because of the economic downturn. The bulk of these loans are subject to hold-to-maturity accounting, which, in contrast to fair-market accounting, typically does not recognize losses until the loans default. The bad news is that this crisis is still in its early stages and may take two years or more to work through the credit losses from these loans.…

It might seem odd that accounting methodologies can make such a big difference. At the end of the day, what counts is the net present value of the cash flows from each asset, but those are unknowable until after a debt is repaid. Fair-value accounting, based on mark-to-market principles, immediately discounts assets when the expectation of a default arises and ability to trade the assets declines. Fair-value therefore makes the holder of the assets look worse, sooner. Hold-to-maturity accounting works in reverse and makes the holder look better for a longer time.

First-quarter 2009 earnings

Many of the largest banks reported a return to profitability in the first quarter of 2009. The comfort this provided to markets is not necessarily misplaced. …

An analysis of these results shows that quarterly noninterest revenue for corporate- and investment-banking activities (that is, largely broker–dealer operations) increased by a surprisingly large $26.3 billion from the prior year …. Fair-value accounting losses depressed 2008 results but in 2009 were replaced by fair-value gains. Large additional trading profits were made possible by arbitrage and other trading opportunities that became available as market conditions improved.

While the worst may be over for the broker–dealer sector, first-quarter 2009 results tell a different story for commercial-banking activities at the same major banks. These banks took $38 billion in loan-loss provisions in the first quarter, $16 billion more than in the 2008 period. Most of this increase—$12 billion—was from retail-banking and credit card credits. …

This merits concern because loan provisioning under hold-to-maturity accounting is a lagging indicator of future loan losses. … When loan-loss provisions start rising rapidly, it is likely that more losses lie ahead.

Loan losses to come

While 2008 was the year for taking losses on broker–dealers, this year and next will be the years for taking losses on assets subject to hold-to-maturity accounting. These are the losses that show up in stress tests, in which regulators make assumptions about how the economy will perform and calculate the resulting loan losses under various economic outcomes. …

McKinsey research estimates that total credit losses on US-originated debt from mid-2007 through the end of 2010 will probably be in the range of $2.5 trillion to $3 trillion, given the severity of the current recession … Some $1 trillion of these losses has already been realized. Since US banks hold about half of US-originated debt, the US banking and securities industry will incur about $750 billion to $1 trillion … of projected losses on this debt, which includes residential mortgages, commercial mortgages, credit card losses, and high-yield/leveraged debt. …

Since the middle of 2007, the US banking and securities industry has absorbed some $490 billion of losses, or $80 billion per quarter … If the industry incurs additional losses of $1 trillion in 2009 and 2010, the losses will be about $125 billion a quarter. … Importantly, many of these losses will be concentrated in the banks that the stress tests revealed to be undercapitalized….

Grading the stress tests

Stress testing may have set the stage for restoring the health of individual institutions because it has provided the financial markets with information on the quality of each individual institution’s loan portfolio. …

The tests also marked a turning point because they provided much greater clarity regarding how the US government will handle troubled institutions in the future. … The government is clearly prepared to use whatever combination of funding support, guarantees, and capital injections are required to ensure that any future resolution of troubled financial institutions will be orderly.

Restoring earnings strength

While the stress tests have focused on capital adequacy, the only real way for an institution to become strong enough to stand on its own feet is through its ability to earn profits. …

The challenge for many adequately capitalized banks is that they will find it difficult to generate enough income to cover loan-loss provisions over the next two years. …

To meet this earnings challenge, well-capitalized and adequately capitalized banks must play both defense and offense. In terms of defense, investing in building collection and workout skills is essential. …

It is also essential for banks and securities firms to begin reducing operating expenses more programmatically. …[The] 19 stress-tested institutions have actually increased annual operating expenses by 32 percent since 2006…. Many banks need to target reductions in noninterest expenses of 20 percent or more from 2008 levels.

Banks with broker–dealers should have an abundance of opportunities as the markets continue to thaw. The pent-up demand for credit securities issuance, acquisitions, and spin-offs is considerable. Moreover, trading opportunities should be numerous for strong counterparties.

Challenges ahead

… Not only has the economic shock thrown financial markets and industry structures into flux, but the process of saving the banking and securities industry has transformed the nation’s social contract with the industry. The entire industry is now dependent on government support of all kinds, ranging from low-cost funding (courtesy of the Federal Reserve), to debt guarantees, asset guarantees, and capital injections.

There is no clear path to restoring the industry to independence from the US government. Major changes in regulation are coming, and the industry is going to be subject to more government involvement and oversight than it would like for a long, long time. Against that backdrop, stress testing has removed much of the generalized fear that painted all institutions with the same brush. It has also removed the uncertainty related to how the US government is going to treat individual institutions. But it will remain for the industry’s leaders to put in place the operational efficiencies and discipline that may determine when—and how—the credit crisis is finally resolved.

About the Authors

Lowell Bryan and Toos Daruvala are directors in McKinsey’s New York office.

The authors would like to acknowledge the contributions of Kevin Buehler, Chris Mazingo, Kazuhiro Ninomiya, and Hamid Samandari to this article.