Banking on the Theory of the Firm.

The other day, the undercover economist Tim Harford passed along Michael Munger’s lucid essay on the theory of the firm.

Then one day, in one firm, one manager, perhaps on a whim, outsources the computer services or janitorial services or the legal advice. Not to India or Ireland but simply to another company across town or across country. The boss signs a contract, after taking bids from several companies that provide similar services. These companies are forced by the scolding winds of market competition to provide excellent service at low cost. By looking at the different prices in the bids offered in this competition, the boss learns something. He learns how much the service costs to provide. And he learns how much money he saves by laying off the employees who used to provide the service in-house.

It’s hard to fire employees, particularly since most employees are smart enough to work hard enough to get acceptable performance reviews. The boss also has a hard time motivating the in-house staff, because watching each employee is expensive and tiresome. But it’s easy to fire contracted employees, because you just sign a new contract with a competitor. Why not let the market system do your motivation work? Let’s suppose that our outsourcing boss sees the company’s profits rise dramatically, and the stock price goes up 18% in six months. Life is good, for the boss.

Munger continues on to explain his thoughts on why too-little outsourcing will burden a firm with detrimental production costs and why too-much outsourcing will burden a firm with transactional costs that surpass cost savings from market pricing. In the Banking industry, any process that we outsource to an external service provider must fit into the firm’s operational risk framework because of the strict data privacy regulations that our firms face. An oversight by the risk management department’s auditing of the service provider, poses regulatory, legal, and reputation risks for the firm. This risk can be mitigated by paying a premium for service providers that are known for handling sensitive data and have a favorable working relationship with other risk management departments. But, it’s ultimately up to the firm’s policy makers to decide how much of that risk they are willing to take.

.info: economist

Microsoft and Facebook to Strengthen Strategic Alliance

As a progressively conservative businessman, I take an objective approach in my analysis of pending transactions, looking for value and risk that others may not see. One of the stories to hit the newspapers and blogs last week was the $10 billion to $15 billion valuation that Facebook is seeking from Microsoft. In an article at AllThingsD, Kara Swisher discusses her conservative view on the expenditures coming out of Silicon Valley and how they relate to Facebook.

Today, The Wall Street Journal follows up on my story by adding more interesting details, including the fact that Microsoft is seriously considering an investment offer that would value the company at $10 billion.

(Google might be in there too, according to the story, but I think it is just there to annoy Microsoft.)

In any case, this was the ludicrous price once floated by Founders Fund’s Peter Thiel, Facebook’s first investor, which was widely derided at the time he uttered it.

More laughable still is that Facebook, according to the Journal story, might be holding out for a $15 billion valuation.

Why? Because I believe Silicon Valley can now be considered to be at Delusional Level Red. Or green, given all the cash that is being shoved in Facebook’s direction now.
(Full article here)

In the shadow of the sub prime real estate crisis, I understand the fear about overvaluation and how it further stretches this bubble. The difference between this deal and to a certain extent the outright purchase of 3COM, is the amount of debt that is assumed by the investors. From what I understand about Microsoft’s investment, they are injecting their own cash which bypasses the leverage risk associated with most private equity investments.

A typical PE deal involves buying a company for 4-5x cash flow or EBITDA (earnings before interest, taxes, depreciation, and amortization) and injecting 20-30% of its own equity. The remaining equity would be borrowed from the banks and the debt would become part of the acquired company. This allowed investors to make small improvements to the acquired companies to improve performance and recuperate their investment.

However, over the past few years low interest rates made borrowing funds cheaper for the PE investors, and they began to overpay for companies. Prior to the subprime crisis, investors were paying upwards of 15x EBITDA for companies and did not have a viable plan to create value out of their investments. These overpayments increased the debt needed to complete the transaction, and while rates were low, interest payments were too high for companies to sustain themselves.
(http://www.techcrunch.com/2007/09/28/private-equity-eats-avaya-for-82-billion-and-3com-for-22b-burp/trackback/)

David Kirkpatrick, a Senior Editor at Fortune weighs in on the transaction, discussing the disruptive advertising effect that Facebook will have on Google and the Internet as a whole.

This matters in business terms because the Internet is rapidly moving toward a world in which advertisers are able to target their messages to those most likely to be responsive.

While this is often painted as an invasion of privacy, in fact it is a service. If these future systems work the way the ad industry expects them to, the ads we see will quite often be ads that convey information we want. If software algorithms can help marketers identify what sorts of goods and services we are most likely to buy, it is a benefit, not an intrusion.

Facebook may be the best place yet for marketers to experiment with these new techniques. Unlike its bigger rival MySpace, Facebook’s individual profile information is intended to represent a real person precisely and accurately. So by investing in Facebook, Microsoft - or Google or another intrepid company -may be buying access to a tremendously valuable testbed for the future of web advertising.
(Full article here)

Google’s approach to advertise the global internet landscape has caused them to lose focus on how to stay within their niche. Instead of focusing on being a top-tier search engine, they are trying to take Microsoft and Facebook head on by offering competing productivity software and social networks respectively — which are already saturated with competition. The problem is that they are following an acquisitive growth model and aren’t allowing their portfolio to take root with the company. This has in my humble opinion created an overvaluation of the company in the global capital market.

In comparison, Microsoft is valued at 1/20th of the price, pays a 1.50% dividend, has no debt, and a boatload of cash. They have tangible products in their software and consumer electronics divisions and have been planning their investments carefully. While I agree that Facebook’s valuation may be high, Microsoft is spending $500MM to buy a 5% equity stake in a web platform with 40MM+ users.

What I don’t understand is why the technology community keeps focusing on Facebook as just another “social networking website” that provides cute gimmicks to bubbly students. In my humble opinion, members of this community do not see the true value of Facebook’s growth because they joined the site three years after its start when the doors were opened to the public.

I first joined Facebook in September 2004 when it became available to my University. I was told about the site — which at the time was located at http://thefacebook.com, by my friend Sara who had used the site at WashU. Facebook’s strategy was to follow an organic growth model, building its user base by slowly expanding across college campuses. This created two effects: College students had an easy way to connect with each other and maintain relationships post graduation, and an opportunity to reconnect with people from their past.

Facebook was created to focus first on people we knew, not people we thought looked cute a-la Myspace. This is why the growth that Facebook sees now is sustainable until they mature, and why Myspace is increasingly losing its market share. A prime example of someone using Facebook against its intended use is Robert Scoble, who is proud that he hit Facebook’s limitation in connections. This attitude, which I find to be prominent in the technology sector, is that the internet is a popularity contest and they dilute the value of their friends / followers / connections / etc. Most sites on the Web maintain this attitude because it is their belief that the more eyeballs they have, the more money they can make through AdSense revenue. Eventually, we are going to reach a point where Google becomes too saturated with advertising partners that it will no longer be a strong source of revenue generation — a model that many new technology startups use.

Furthermore, the community is focused on Microsoft’s past ills and they forget the sheer amount of philanthropy generated by the Bill & Melinda Gates Foundation. Microsoft’s investment in Facebook gives Bill Gates an opportunity to act as an advisor to a young visionary, helping him avoid the mistakes that he made in the past with Microsoft. Together, Facebook and Microsoft can build an online business and entertainment platform that will revolutionize how the online landscape is monetized.

School: commerce, drexel

Banking in the United States - Why Regulation Works

I found this article through Netvibes and it ties in well to my series on Banking in the United States.

Online bank NetBank closed by U.S. regulators
FDIC to oversee customers’ access to insured funds
By Robert Schroeder, MarketWatch
Last Update: 6:11 PM ET Sep 28, 2007
WASHINGTON (MarketWatch) — U.S. banking regulators shut down a Georgia-based online bank on Friday due to high levels of mortgage-related losses.

The Office of Thrift Supervision closed down NetBank Inc. (NTBK) , a thrift with $2.5 billion in assets, and appointed the Federal Deposit Insurance Corp. as receiver.

The OTS said the bank experienced significant losses beginning in 2006 due to defaults on loans sold, weak underwriting, poor documentation, a lack of proper controls and failed business strategies.

It was only the second bank failure in the past three years.

It reminds me that we shouldn’t let new technology fuel our arrogance to reinvent the wheel. While the Banking system in the United States has flaws, the leadership in this country went through one humbling experience after another to get it right.

When the United States was still a colony, the financial system here was a complete mess. Unregulated, both the colonies and private institutions could issue paper money at will. Since there was absolutely no regulation, there was a likely chance that the institution would fail making your money worthless. Caught in the Revolutionary War without a way to finance it, the Continental Congress began printing its own currency. However, they saturated the market causing inflation; when too much money follows too few goods, making the money worth 1/100th of its face value.
Banking in the United States - Colonization to the Civil War

After the Civil War, it took nearly fifty years to create the Federal Reserve System — which is the dual control central Banking system that we have today. The National Banking Act was a step in the right direction, but it had its problems.

The National Banking Act was the seed that created the Federal Reserve System we have today, but the road was rocky. After The Civil War and up to World War I, 100 years of financial insolvency had severed the trust that that citizens had with their banks. This period of growth was tough because banks were still failing, the stock market was down, currency was disappearing, and people were panicking. The fear that financial institutions would fail became a self-fulfilling prophecy and for every step forward the country took two steps back.
Banking in the United States - The Civil War

The moral of the story is that before we consider sites such as Prosper and Lending Club as the saviour to central Banking, we need remember why we have this system in the first place. I read here that Lending Club is going to take on the United States banking system.

Lending Club also aims to be to the lenders rescue, positioning itself as offering investors “the ability to gain higher returns than those offered by CDs and savings accounts” while “benefiting from an asset class whose performance is more predicable than stocks and is not correlated to the stock market”

Without deposits, you lose stability and create a financial institution that has a greater chance of failing. The United States banking system has a deposit reserve in place that ensures its customers that if there is a widespread financial crisis, they won’t lose all of their money. While FDIC insurance only insures deposits up to $100,000, it is a start to rebuild your wealth.

The Banks will evolve and become net-friendlier, but will never be replaced by P2P lending.

School: commerce, drexel, economist

Banking in the United States - The Civil War

In the midst of the Civil War, banking in the United States was chaotic and unruly. With no central regulation by the states there were thousands of financial institutions and no confidence by Americans because they didn’t know if their Bank would be open the next day. In today’s financial market, it was the equivalent of banking with venture capitalists. In 1863, the National Banking Act privatized all national banks and created the Office of Comptroller of the Currency (OCC) for regulation. This created a check and balance system between private industry and the government to make the country’s money more secure. All the bank notes issued by these financial institutions were backed by an interest in the U.S. Treasury which created a transparent picture of the money supply in the country. Although State chartered banks remained, they were not a part of the U.S. Treasury and were more likely to fail than the national banks.

The National Banking Act was the seed that created the Federal Reserve System we have today, but the road was rocky. After The Civil War and up to World War I, 100 years of financial insolvency had severed the trust that that citizens had with their banks. This period of growth was tough because banks were still failing, the stock market was down, currency was disappearing, and people were panicking. The fear that financial institutions would fail became a self-fulfilling prophecy and for every step forward the country took two steps back.

School: commerce, drexel

Banking in the United States - Colonization to the Civil War

When the United States was still a colony, the financial system here was a complete mess. Unregulated, both the colonies and private institutions could issue paper money at will. Since there was absolutely no regulation, there was a likely chance that the institution would fail making your money worthless. Caught in the Revolutionary War without a way to finance it, the Continental Congress began printing its own currency. However, they saturated the market causing inflation; when too much money follows too few goods, making the money worth 1/100th of its face value.

To cure inflation, the First Central Bank of the United States was started in 1791 and was fully backed by the United States government. Any bank notes printed by the First Central Bank were redeemable in coin, which has tangible value. The bank was politically controversial and its charter (or authorization) was not renewed in 1811. Without a central bank, the states returned to authorizing their own bank notes and over-saturated the market again. With inflation running rampant, the Second Bank of the United States was started in 1816 to help finance the war of 1812. It faced the same political pressures as the First Central Bank and its charter wasn’t renewed when Andrew Jackson was elected president in 1832.

Through the civil war, the financial institutions in the united states were in a chaotic state. These banks were chartered and supervised by the states and were not heavily regulated. This created an opportunity for any institution that wanted to to print its own currency. At the peak, the United States had over 10,000+ variations of paper money making counterfeiting simple and hard to trace. As the Banks started to fail and consumer confidence dropped, the government needed a central system that worked.

School: drexel, commerce

Template: Excel Construction Cash Flow

Previously I discussed my sample of a construction cash flow and have received requests for an excel file to use as a template. Attached below is the workbook that I used to create the construction cash flow, and includes a permanent cash flow with sensitivity analysis.

As always, if you have any questions, please feel free to contact me.

Links:
Construction Cash Flow Template

Tags: Real Estate

Quick Tip: UCA Cash Flow Analysis

It is important to watch accounts receivable growth, because any increases to A/R from year to year are an immediate reduction to cash.

Links:
Cash’s effect on the balance sheet.
Traditional Cash Flow versus UCA Cash Flow

Cash’s effect on the balance sheet.

Here is a chart on how cash is affected by changes to the balance sheet.

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A detail that is commonly overlooked on financial statement analysis, is that A/R growth is a use of cash. Consecutive periods of A/R Growth, is an indicator that a company is becoming insolvent. In the UCA Cash Flow, these changes are reflected in net cash after operations (ncao) and are not available for debt service. A sign of further insolvency is a company has several layers of debt, with escalating balances outstanding and interest rates.

To mitigate this situation, growth must be limited.

ma.gnolia: CNN

Community Banks

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Increased inventories from the sub-prime mortgage crunch are affecting loans to prime borrowers that have borrowed against excess equity in their properties. These borrowers have over extended themselves, primarily funding undersold, speculative construction projects.Signs of a distressed community bank include:

• rapid growth - increases to loans receivable outpace receivables collection, which reduces cash.
• homogeneous portfolio - high risk if primary asset class becomes distressed.
• credit quality - sudden and sharp increases to bad debt allowance and non-amortizing loans are an indicator of distressed assets.
• cost of funds - the legal lending limit is directly tied to deposits and some community banks pay a premium to increase deposits. This is demonstrated through high-yield savings, money market, and three-month C/Ds. The higher the yield, the narrower the interest rate margin which leaves little flexibility for rate reductions.

For more information, please read the text.

Tags: Money

Market Depreciation

An excellent article, Why the private equity bubble is bursting, by Shawn Tully.

Tags: CNN