James Saft

By James Saft

(Reuters) – The Facebook IPO, which started as a global search for a greater fool, developed on Monday into a circular firing squad.

Facebook’s newly minted stock tumbled well below its issue price on Monday, falling as much as 12 percent, as it struggled in its first day trading without the full support of its investment banking syndicate.

The problem, of course, is that too many buyers were playing the same game, looking to lay off their exposure quickly to some other patsy. As they say in Silicon Valley, this isn’t a bug, it’s a feature.

We are now 15 years into what may someday be thought of as the great speculative era of financial history, during which a series of bubbles was caused to come into existence and then duly explode. The easy lesson has been to get in early and then get out. As such the Facebook IPO isn’t just the third-biggest such offering in U.S. history, it is one of the largest ever exercises in collective cynicism.

After all, what “long-term investor” buys into a public offering and then changes her mind, bailing out simply because that satisfying initial pop we’ve been conditioned to expect fails to materialize? On the evidence, there were precious few Facebook buyers who really did want a long-term option on the company’s vertiginous growth. They were instead game-players, some of whom always planned on getting out immediately and some of whom probably wanted to wait a short while but, having little actual conviction about the company’s valuation and prospects, panicked when trading went sideways on Friday.

What the players failed to recognize is perhaps the central feature of the bubble series which started in Southeast Asia in the 1990s and spread in turn to dotcom shares, real estate and now social media: growing frequency and severity. The bubbles are inflating faster each time, growing more disproportionate to underlying value and bursting faster. There is no arguing that the social media bubble is bigger or more damaging than housing, but you can make a case that it has, at its worst, gotten more out of proportion. It also took less time to inflate, and is showing every sign of bursting more quickly.

Human beings are good at pattern recognition, but not perhaps quite so good at working out that so are their fellow men. Everyone saw clearly what the game was, but failed to account for what would happen when everyone plays.

FINE LINE BETWEEN BEST AND WORST

As such, it is hard to judge if the Morgan Stanley-led deal is one of the best or the worst navigated major IPOs in recent history. If you believe that social media is a bubble and one with severe risks of rapid deflation, then this was a work of genius. This does, on the other hand, make future social media IPOs much more difficult. No one likes being played for a fool, at least not on the first date.

It is worth noting that existing holders provided an unusually high percentage of the shares sold, never a good indication in a business with a long road to justifying current valuations.

None of this is to say that Facebook isn’t a great franchise and won’t continue to be very successful. Facebook is profitable and a great success story. It is just horribly over-priced. Even at its current price 10 percent or so below the offering, it is trading at about 70 times prospective 2012 earnings, making it almost five times as expensive as Google shares. Sure, Facebook is only in the early days of extracting revenue from its massive user base, but even if you credit it with the ability to generate 50 percent earnings growth over an extended period – five years or so – it still ends up as a terrifically expensive stock.

That leaves very little margin of safety. Sure, Facebook has changed the world but it would be silly to expect those changes to remain fixed. Based on the evidence of the past decade the world, especially that province inhabited by Facebook, is changing extremely rapidly. It is all too easy to imagine Facebook’s network being undermined by new technologies.

Facebook looks great right now, but so did Ohio farmland in 1825 when the Erie Canal opened a cheap route to European markets. The problem, of course, was that railroads and other canals would shortly open up supply from the two-thirds of a continent to Ohio’s west.

Facebook investors are banking on its undoubted ability to innovate and create revenue while being unwilling, and probably unable, to account for that ability among literally millions of potential competitors, using technologies which may not have even been invented yet. (Editing by James Dalgleish) (At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – Like all massive risks, holding large amounts of stock in your employer is a way to make an investment home run, but an even better way to strike out.

The sad tale of Chesapeake Energy employees is a reminder of a series of oft taught but seldom learned lessons, namely that when you hold too much of your employer’s stock you imperil your retirement, impair your ability to manage risk and set yourself up for expensive, emotionally driven investment decisions.

A massive 38 percent of Chesapeake’s main 401(k) retirement plan’s assets were in company stock, despite only 5 percent of those assets still being tied up in a vesting period.

It is no wonder that employees jumped at a generous offer to match, dollar-for-dollar, the first 15 percent of their salary with shares of stock. What makes a heck of a lot less sense is why they held on to them after they were free to diversify.

While this has been a bit of a disaster for employees, as Chesapeake shares have fallen by nearly half, I’d argue holding more than 5 percent of your financial assets in your employer’s stock is bad policy whatever the returns and no matter how well run the company.

Considering that 9 percent of total 401(k) assets were still invested in company shares in 2009, according to the Employee Benefit Research Institute – and many accounts hold no company shares, thus implying greater concentration among those who do – this clearly is a message some people just don’t want to hear.

TAKE THE MONEY AND RUN

This is not to say that you shouldn’t avail yourself of matching funds if the cost of doing so is holding shares in your employer. Do, but cut back your holding as soon as you are allowed, no matter how tasty the Kool-Aid about your company’s bright future may be.

As an employee you already are hugely exposed to your company’s future, so holding lots of company stock represents an unacceptable risk.

Companies whose stocks fall sharply have a distressing tendency to lay people off – and vice versa. You could easily see your retirement or other assets dwindle just as your income falls off a cliff. As well, many people who get laid off find their career capital is worth much less on the open market than it was within an organization, meaning that when they do become re-employed it is at a lower salary.

Of course, some people get rich by holding nothing but shares in their employers, but there are also many, probably many more, who work for Lehman Brothers or Enron and see their portfolios turn to dust.

Diversification is basically the single best tool any investor has: it is reliable, it is cheap, and it unquestionably improves outcomes. Use it.

TAKE YOUR LOSSES

The other great lesson out of this is that grown-up investors take losses. If you have been foolish and held lots of your company’s stock and now it is tumbling, for heaven’s sake, don’t just stand there wishing it back up again. Sell some and cut risk.

All investors have a tendency to become psychologically attached to the top market value of their shares, and many confuse the plans and fantasies they hatch based on those values for promises. The universe does not care what your 401(k) used to be worth. Don’t wait for the rebound.

PERSPECTIVE MATTERS

Another reason to avoid holding too much of your employer’s stock is our natural tendency to let our emotional connection to a company get in the way of rational decision-making. No one can fairly evaluate their own children or the company to which they devote most of their waking hours.

This is a version of the endowment effect, a phenomenon described by James Montier of investment management firm GMO. People tend to demand more in payment for something they own than they would be willing to pay for it themselves, endowing it with a special value simply because it is associated with them. This is a classic mistake in the housing market, where people expect to get top dollar for a tired house simply because they raised a family there.

So it often is with employers. People simply don’t have the perspective they need to make good judgments. That’s a really useful attitude to have in forming a community or making a company successful, but check your endowment at the door when you visit your wealth manager.

When we know there is a good chance we are laboring under a behavioral fallacy, the best thing to do is impose a rule on yourself and follow it.

Simply put, don’t hold more than 5 percent of your financial assets in any security, especially if you happen to work for the company which issued it. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

(Editing by Walden Siew and James Dalgleish)

By James Saft

(Reuters) – A spreading bank run could hasten Greece’s exit from the euro zone but it certainly doesn’t have to end that way.

It is far less clear what the impact would be should the wave of withdrawals accelerate in other peripheral states such as Spain or Portugal, which are further from outright revolt over German-led austerity, and which, due to their sheer size, will enjoy a vastly improved negotiating position.

Greeks have been withdrawing hundreds of millions of euros of deposits from their banks in recent days, driven by a rational but dangerously self-reinforcing fear that a Greek exit from the euro will leave them holding far less valuable new drachma.

That fear, though, is predicated on a shaky notion: that the players in the drama will do what they have said they would.

Greek depositors are worried that their politicians will repudiate the terms of the bailout and that the ECB and European authorities will, ultimately, cut them off, either directly or by refusing to accept dubious collateral in exchange for fresh euros.

That would bring down the Greek banking system, or most of it, and force Greek authorities to impose capital controls. Cue Spanish, Italian and Portuguese depositors, who might follow suit and start to withdraw their own deposits, putting massive amounts of collateral into the hands of the ECB and their own central banks.

The betting on this one comes down to whether you think European officials will stick with their principles or act in their own best interests, always a legitimate and uncertain question. The ECB could, at any point it chooses, pull the plug on the Greek banking system by refusing to accept the sort of bad collateral now being offered. A prudent act, utterly within their rights and a highly destructive one.

Greek depositors only have as much power as the ECB chooses to give them. The simple answer is to take more bad collateral and keep negotiating. Even if the troika elects to punish Greece by stopping payments to it there is nothing that would stop the ECB from carrying on providing liquidity to the Greek banking system. Remember too that the amount of money involved is not huge, especially in proportion to the potential damage caused by a bank-run-caused exit of Greece from the euro.

CONTAGION RISK?

That said, if things get worse in Greece, as they are almost certain to, depositors elsewhere in the euro zone may follow suit and withdraw money from banks in weaker countries. Deposits in Italian and Portuguese banks have dropped, relatively gently, though Italian deposits are still near earlier peaks.

More withdrawals will be no surprise, whatever you think of the game of chicken between Greece and the rest of Europe. The opportunity cost of moving money is low, and even if the money is not deposited elsewhere, very low interest rates impose little penalty on cautious savers stuffing bank notes into mattresses.

The logic is even less strong for a bank run in Spain, for example, forcing a disorganized euro exit. So long as Spain, or Portugal, is making minimal progress on reforms – and they are doing better than that now – there is even less incentive for the ECB to become spooked by a rush of questionable collateral onto its books.

And if Spanish bank funds flee, the math will be the same for the ECB but the scale will be far different and argues further for forbearance rather than retribution. Something on the lines of a third of Greek deposits, or a bit more than 70 billion euros, have left its system. Extrapolate that to the Spanish system and you are looking at more than 500 billion euros.

That could spook Germany and the ECB, but more likely it brings Europe into a sort of de facto fiscal union, in which the affairs, credits and debits of the players are so intertwined as to utterly resist detangling. The ECB will not end the euro on its own authority, and in the event of a huge bank run it will probably prove impossible for politicians to make the decision to pull the plug quickly. That will leave the south owing the north even more, but the north having less ability to collect or dodge. Some sort of common bond issuance or fiscal union might actually be hastened by a bank run, ironically enough.

If you owe the bank a million, the bank owns you; if it is a half a trillion euros, the situation is somewhat reversed.

None of this is to say that the ECB or euro zone authorities won’t become so exasperated with Greece that they pull the plug. It may come to that, and it’s fair to say that the odds have narrowed, but we are not quite there yet.

(Editing by James Dalgleish)

(James Saft is a Reuters columnist. The opinions expressed are his own)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – JP Morgan Chase’s loss is the perhaps inevitable result of the interaction of two policies: too big to fail and zero interest rates.

JP Morgan lost $2 billion when trades put on by its chief investment office blew up, prompting a sell-off in its stock, an investigation by regulators and new calls to limit speculative activities by banks.

Too big to fail, the de facto insurance provided by the U.S. to financial institutions so big their failure would be disastrous, provides JP Morgan and its peers with a material advantage in funding and as counterparties. Depositors see it as an advantage, as do bondholders and other lenders. That leaves TBTF banks flush with cash.

At the same time, ultra-low interest rates make the traditional business of banks less attractive, naturally leading to a push to make money elsewhere. With interest rates virtually nothing at the short end but not terribly higher three, five or even 10 years out, net interest margins, once the lifeblood of large money center banks, are disappointingly thin. Given that investors are rightly dubious about the quality of bank earnings, and thus unwilling to attach large equity market multiples to them, this puts even more pressure on managers to look elsewhere for profits.

Investors believe, rightly, that the largest banks won’t be allowed to fail; what they also appear to believe is that they very well may not be able to prosper and that to the extent they do shareholders won’t fairly participate.

What would you do if you had a built-in funding advantage but little demand for your services as a traditional lender, i.e., one which borrows short and lends long? If you are anything like JP Morgan Chase appears to be you will put some of that lovely liquidity to work in financial markets, hoping to turn a built-in advantage into revenue.

JP Morgan stoutly maintains that the purpose of the trades was to hedge exposure elsewhere, as opposed to being proprietary trading intended to generate profits. That’s contradicted by a report from Bloomberg citing current and former employees of the chief executive office, including its former head of credit trading. here

The Volcker Rule, now being shaped, is intended to stop such speculative trades, though in practice debating what is a hedge and what isn’t is a sort of angels-dancing-on-the-heads-of-pins argument which makes effective regulation almost impossible.

PROBABLE CAUSE

The keys are motive, opportunity and ability. Profits – and the investment office is reported to have made considerable ones in the past – provide a more believable motive than simple hedging. Opportunity is afforded by the combination of a privileged funding cost combined with poor alternative places to put money to work elsewhere in the banking business. While there may be some active borrowers, and TBTF banks enjoy an unfair advantage in serving their needs, the trans-Atlantic balance-sheet recession means households and businesses are showing a preference for paying back loans rather than taking them out.

Bruce Lee, chief credit officer of Fifth Third Bancorp, which isn’t TBTF, was frank about this recently, saying that the value of deposit funding was now at its lowest in his career.

Finally there is ability, and like common sense all bankers believe they have the ability to trade successfully despite the wealth of historical evidence to the contrary.

While events show clearly that JP Morgan wasn’t able to adequately manage its own business, an attack on it engaging in speculation doesn’t actually hinge on that.

There is clearly a public policy outrage here because should JP Morgan find itself in difficulties due to speculation the taxpayer will end up paying the freight. That’s probably not even the worst of it. All of the profits that TBTF banks make through speculation have been subsidized and enabled by the taxpayer. It is obvious that managers and employees have an incentive to take risks because, after all, TBTF may not be forever but they will capture 35 or 40 percent of the inflated takings so long as it lasts. Even if JP Morgan never blew up speculative trades, we should still oppose them so long as they are made possible and profitable by government policy.

Raising interest rates in order to remove an incentive to speculation probably wouldn’t work; low rates are the result of too much debt as well as a palliative for that disease.

The Volcker Rule won’t be effective; it is impossible to distinguish hedges from speculation and either can blow up banks.

The better alternative is to end the policy of too big to fail, preferably while at the same time forcing all banks out of the business of market speculation through a revival of the kind of Glass-Steagall-like policy which encouraged a small and useful financial sector for decades, forcing those that want government insurance to act like utilities, taking deposits, processing payments and making simple loans.

Let the investment banks take their risks, take their chances and suffer their losses – as separate entities.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – Venture capital investors put their money down with dreams of backing the next Facebook, but the reality involves high fees and much disappointment.

A new study by the Kauffman Foundation, an entrepreneurship charity and a heavy and long-time backer of venture capital, makes disturbing reading oo.gl/eAp9E, detailing 20 years of disappointment, a failure by venture capital firms to deliver and of the foundation itself to take the needed steps to protect its own interests.

Kauffman, which has $249 million in venture capital, is providing insights which, because of tight disclosure agreements, are almost impossible to obtain elsewhere.

The message is that most of the foundations, pension plans and high net worth investors who back venture capital would be better off trying their luck in public equity markets, which may make investors feel a bit less hip but the returns of which venture capital struggles to beat.

Over its 20-year experience, just 20 of Kauffman’s 100 venture funds beat a public market benchmark by more than 3 percent annually, a generally accepted target for VCs, and most of those are funds which started before 1995. Well over half – 62 of 100 – actually failed to beat public markets after fees.

As well, returns are concentrated in a very few top performing funds, but those did not tend to be among the largest funds.

Venture capital operates on the famous 2/20 system, under which investors pay the venture capital manager 2 percent annually on the value of the funds plus 20 percent of the takings when investments are ultimately sold. This protocol, which in an industry dedicated to innovation hasn’t actually changed in decades, actually gives VC managers perverse incentives.

For example, Kauffman’s funds are showing very positive returns much earlier in their life cycle than they in theory should, given that they are supposed to make long-term investments that pay off well down the road. Peak returns tend to come sometime in a given fund’s second year, rather than five or six years down the road. It is not at all surprising, however, when you factor in that funds usually do second round capital raises in their second year, often for much more than the initial commitment. It’s very handy for a VC to have a good record just as you are going out marketing, but perhaps it is a bit harder to find a good home for all those new funds raised.

Like other businesses, VC firms enjoy economies of scale and therefore it’s in their interest to rack up funds, all of which guarantee them at least a 2 percent annual fee. Kauffman rightly advocates negotiating a cost-based fee based on operating expenses.

NOT JUST KAUFFMAN

It is, of course, possible that Kauffman is simply not very good at its job as an investor in venture capital funds. That’s not supported by industry-wide data from Cambridge Associates, which found that between 1997 and 2009 there have only been five years in which funds raised that year generated enough of a return to actually return investor capital, much less beat public markets by 3 to 5 percent a year.

So why are returns so poor, and why has the trend been so dismal over the past decade and more?

In part, it is because the industry has grown more quickly than has the supply of good investments and capable managers. There was a lot more low-hanging fruit in the fabled early days of venture capital than there is today.

“When you get an above-average return in any class of assets, money floods in until it drives returns down to normal, and that’s what I think happened,” legendary venture investor Bill Hambricht said at a February event at Kauffman.

Whereas $500 million a year flowed to venture capital between 1985 and 1995, over the last 15 years the industry has had to find a place to park about $20 billion a year. That puts enormous pressure of managers to find investments, a pressure that seems to be driving poor returns.

All in it has to be counted a market failure. The law of supply and demand seems to apply to investments but not to the fees managers charge. Kauffman is right to lay the blame for this on investors, who have not done a good job fighting their own quarter.

That’s because, like wedding dress shops, the venture capital industry is selling hope. No one likes to buy cut-rate hope, even though that is what so many get in return for their full-price money.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)

May 10 (Reuters) – Venture capital investors put their money
down with dreams of backing the next Facebook, but the reality
involves high fees and much disappointment.

A new study by the Kauffman Foundation, an entrepreneurship
charity and a heavy and long-time backer of venture capital,
makes disturbing reading oo.gl/eAp9E, detailing 20 years of
disappointment, a failure by venture capital firms to deliver
and of the foundation itself to take the needed steps to protect
its own interests.

Kauffman, which has $249 million in venture capital, is
providing insights which, because of tight disclosure
agreements, are almost impossible to obtain elsewhere.

The message is that most of the foundations, pension plans
and high net worth investors who back venture capital would be
better off trying their luck in public equity markets, which may
make investors feel a bit less hip but the returns of which
venture capital struggles to beat.

Over its 20-year experience, just 20 of Kauffman’s 100
venture funds beat a public market benchmark by more than 3
percent annually, a generally accepted target for VCs, and most
of those are funds which started before 1995. Well over half -
62 of 100 – actually failed to beat public markets after fees.

As well, returns are concentrated in a very few top
performing funds, but those did not tend to be among the largest
funds.

Venture capital operates on the famous 2/20 system, under
which investors pay the venture capital manager 2 percent
annually on the value of the funds plus 20 percent of the
takings when investments are ultimately sold. This protocol,
which in an industry dedicated to innovation hasn’t actually
changed in decades, actually gives VC managers perverse
incentives.

For example, Kauffman’s funds are showing very positive
returns much earlier in their life cycle than they in theory
should, given that they are supposed to make long-term
investments that pay off well down the road. Peak returns tend
to come sometime in a given fund’s second year, rather than five
or six years down the road. It is not at all surprising,
however, when you factor in that funds usually do second round
capital raises in their second year, often for much more than
the initial commitment. It’s very handy for a VC to have a good
record just as you are going out marketing, but perhaps it is a
bit harder to find a good home for all those new funds raised.

Like other businesses, VC firms enjoy economies of scale and
therefore it’s in their interest to rack up funds, all of which
guarantee them at least a 2 percent annual fee. Kauffman rightly
advocates negotiating a cost-based fee based on operating
expenses.

NOT JUST KAUFFMAN

It is, of course, possible that Kauffman is simply not very
good at its job as an investor in venture capital funds. That’s
not supported by industry-wide data from Cambridge Associates,
which found that between 1997 and 2009 there have only been five
years in which funds raised that year generated enough of a
return to actually return investor capital, much less beat
public markets by 3 to 5 percent a year.

So why are returns so poor, and why has the trend been so
dismal over the past decade and more?

In part, it is because the industry has grown more quickly
than has the supply of good investments and capable managers.
There was a lot more low-hanging fruit in the fabled early days
of venture capital than there is today.

“When you get an above-average return in any class of
assets, money floods in until it drives returns down to normal,
and that’s what I think happened,” legendary venture investor
Bill Hambricht said at a February event at Kauffman.

Whereas $500 million a year flowed to venture capital
between 1985 and 1995, over the last 15 years the industry has
had to find a place to park about $20 billion a year. That puts
enormous pressure of managers to find investments, a pressure
that seems to be driving poor returns.

All in it has to be counted a market failure. The law of
supply and demand seems to apply to investments but not to the
fees managers charge. Kauffman is right to lay the blame for
this on investors, who have not done a good job fighting their
own quarter.

That’s because, like wedding dress shops, the venture
capital industry is selling hope. No one likes to buy cut-rate
hope, even though that is what so many get in return for their
full-price money.

By James Saft

(Reuters) – Received wisdom on Europe’s electoral results is that the throw-the-bums-out events in France and Greece represent a vote against austerity.

Here’s another possibility: it is an anti-reality vote.

That’s not to say that policies of austerity are helpful; they are not, especially when they are, as in the euro zone, taken as a futile means to support unsustainable debts in the financial system.

Rather, the elections illustrate a truth which will vex whatever policies are enacted next in all of the economies which are struggling with high amounts of total debt, be it corporate, banking, government or household. No one, no electorate, reacts well to the policies put in place during times when living standards are grinding slowly lower. Voters, just like investors, endow the things they can control, like who is in office and what they are doing, with far more power and ability to turn the course of events than they probably possess.

France voted in Socialist Francois Hollande over the weekend, opting for his ‘pro-growth’ stance over Nicolas Sarkozy. In Greece all of the parties which supported the current bailout, which features a program of deep austerity for Greece, were soundly thrashed, and the electorate made its will known by voting in such a way as to make any kind of coalition difficult to form and even harder to sustain.

The latest U.S. polls provide further evidence of the difficulty of governing in tough times; no sooner do the Republicans stop making a spectacle of themselves in primaries and the polls for the presidential election tighten to a dead heat. While President Obama is not advocating the kind of austerity now getting the thumbs down in Europe, he is presiding over an economy which is, as economies do when they carry too much debt, failing to thrive and to create jobs.

Local elections in Britain, in which coalition partners the Conservatives and Liberal Democrats did poorly, provide further evidence.

Austerity has made things in Europe worse, but that’s almost not the point. People don’t like to be governed during times when standards of living for the majority are declining. They react by voting against the prevailing policy, even though the prevailing policy is at best having an effect on the margins. That will prove to be as true for so-called policies of growth, if indeed they can be achieved, as it will be for policies of austerity.

In short, it is very tough to govern during times like these. The process of debt destruction is going to take years and during that time it’s best to expect, if not political paralysis, then a series of policy lurches interspaced with periods, however short, of high uncertainty.

GOOD LUCK, INVESTORS

Practically, all of this puts investors and businesses in a particularly difficult position. How do you plan for investment, be it in plant and equipment or in stocks and bonds, when it is very difficult to see where policy will be beyond the next scheduled election?

Not that markets are now reacting as if that is true. While Greek shares plummeted and the price of insurance against euro zone sovereign default rose after the elections, the most interesting reaction was from developed stock markets, which were relatively calm. That’s partly because there is still in stock markets a stubborn belief that central banks will ride to the rescue if risk assets falter in a serious way. It is also, probably, because it simply takes a very long time for investors to get to grips with regime change, and the idea that there may not be for a while any sustainable regimes is a big and new idea.

Even if, as some argue, higher levels of growth-oriented government spending are the right policy, it may well be that they won’t be given a sufficient chance to take effect before impatient and suffering electorates force a change of course.

This is not too different from the experience of Japan in the 1990s, which did after all give reflationary policy a pretty fair chance. After years, not months, of this Japan lost its nerve in 1998 and took its foot off the gas, a decision which was followed shortly by a relapse.

In the meantime, the euro zone will face a series of tests. Germany’s Angela Merkel has greeted the news from Greece and France with a prescription of more of the same. She’s called on Greece to stick to its commitments, something which may prove impossible. Citibank now puts the chances of Greece falling out of the euro at between 50 and 75 percent over the near term.

Even Merkel, perhaps, should be hearing footsteps; weekend elections handed her Christian Democratic Union its worst showing in Schleswig-Holstein since 1950.

Investors will be best served by making plans which are less dependent on stability, a forecast which argues for stepping back from risk.

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on SAFT)

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

(Reuters) – As Chesapeake Energy Corp shows, fat executive compensation all too often comes twinned with lousy investor returns.

Shares of Chesapeake have tumbled in the last two weeks after revelations by Reuters of unusual and disturbing pay and other arrangements between the company and its CEO and founder Aubrey McClendon. McClendon borrowed up to $1.1 billion to fund private investments he was allowed to make in company oil and gas wells under its “Founder Well Participation Program,” a hilarious euphemism if ever there was one.

He also was, at least from 2004 to 2008, actively helping to manage a $200 million hedge fund that speculated in commodities his company produced.

McClendon is to relinquish his role as chairman, the SEC has launched in informal investigation and rating agency S&P has downgraded the company on corporate governance concerns. Meanwhile, since 2008 – the year McClendon was America’s top paid executive – Chesapeake shares are down more than 50 percent and have underperformed the S&P 500 by about 5,000 basis points.

Don’t say you weren’t warned. In 2008 the company awarded McClendon a one-time $75 million “Well Cost Incentive Award” (which I guess raised his already high incentive to be Aubrey McClendon) and agreed to buy his map collection – yes, his map collection – for $12 million. McClendon has since agreed to buy back the maps, with interest.

You could argue that McClendon isn’t at fault for the plunge in natural gas prices, which rocked his company. But by that logic you’d have been rewarding him in the first place for a natural gas price driven higher by Middle East instability and loose monetary policy, neither of which can be credited to the founder, whatever incentives he may enjoy.

Or consider Herbalife, a direct marketer, whose chief executive, Michael Johnson, was the top-paid U.S. executive in 2011, with total pay of $89.4 million. Its shares fell more than 30 percent since famed short-seller David Einhorn asked pointed questions on its conference calls, queries that cast doubt on the sustainability of its growth and business model.

A LOOK AT THE DATA

Of course Herbalife and Chesapeake are just examples, so rather than argue from anecdote, let’s take a look at the data.

A comprehensive 2009 study by Michael Cooper of the University of Utah and Huseyin Gulen and Raghavendra Rau of Purdue found that CEO pay is actually negatively related to future shareholder gains for periods of up to five years. To read the study, please click link.reuters.com/hum97s

Companies whose CEO pay is in the top 10 percent actually underperform peers by about 13 percent over five years, according to the study.

The absolute worst indicator is the value of options granted and long-term incentive payouts, upending the idea that fixing executive pay can be done simply by trying to tie executives’ long-term fortunes to those of the company.

“Our results seem most consistent with the hypothesis that over-confident managers accept large amounts of incentive pay and with the hypothesis that investors over-react to these pay grants and are subsequently disappointed,” the authors wrote.

I’d argue that high pay often comes to executives in industries and in companies that enjoy outsized success, most often due to factors beyond the CEO’s control.

They are then duly over-paid and, the law of reversion to mean being what it is, often go on to lead their companies into periods of value destruction.

Another 2009 study by Lucian Bebchuk of Harvard, Martijn Cremers of Yale and Urs Peyer of French business school Insead, found lower stock market returns tend to go hand-in-hand with periods when companies are reporting an increase in the share of overall compensation going to top executives. link.reuters.com/jum97s

The authors also found an association between higher pay and lower accounting profitability, less-upbeat market reaction to company acquisitions, more “opportunistic timing” of CEO option grants and lower CEO turnover even if you control for performance and length of tenure.

The bottom line is that there is a market-failure in executive pay and shareholder relations that allows for abuse by insiders.

While this abuse is made possible by lax regulations and laws, how often it happens is as much a social as a legal phenomenon, which is why it doesn’t happen in every company within a sector.

At the same time, executives who are bent on unfair self-enrichment will be more likely to make foolish or self-serving decisions about how to manage the business.

That explains Bebchuk’s high pay companies where takeovers are badly received by the market; they are often perceived as empire building or nest-feathering rather than value creating.

Other than exercising their inadequate rights of control, shareholders ought simply to vote with their feet. It pays and it will ultimately lead to reform.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Walden Siew and Dan Grebler)

By James Saft

(Reuters) – Pity poor Britain: their own currency to depreciate, their own central bank to print and buy government debt, and yet here we have the second recession in three years.

Not only did GDP shrink by 0.2 percent in the first quarter – the second consecutive contraction, but a sickly manufacturing survey and a drop in exports both indicate that there is a risk of something more sustained and deeper.

And it’s not as if labor hasn’t been sharing the burden; unemployment is high and wage earners are taking home less in inflation-adjusted terms than they were in 2005. That leaves many British households struggling with debts which haven’t really shrunk and must be repaid while earning, effectively, less. Inflation is high, leaving even less for consumption, and households continue to show a preference for paying back money rather than borrowing.

Britain’s stab at austerity has been a genuine drag – public sector investment has shrunk markedly and austerity measures shaved about 0.7 percent off of GDP last year.

Economist Richard Duncan, author of The New Depression, sees Britain as being near the end of its rope; an economy which has depended on ever-increasing amounts of debt to generate growth.

“If their debt contracts, the economy collapses,” Duncan, a former World Bank official, said.

“The government is claiming that they are instituting austerity but they’ve really just touched the tip of the iceberg. If they have a real dose of austerity the economy won’t just go into recession but depression.”

And in truth, Britain’s anemic showing – its economy has shrunk in four of the last six quarters – has happened even as total debt in the economy has expanded. Total debt in the British economy sky-rocketed from 2000-2008, growing 177 percent, but carried on growing since, rising another 20 percent through the first half of last year, according to data from the McKinsey Global Institute. here

During that time households and non-financial corporations paid down debt but financial institutions and the government more than made up the slack. Those facts aren’t, in themselves, a policy prescription, but they illustrate very clearly one thing: if Britain has grown weakly while the growth of debt slows, it will very likely contract savagely when debt contracts across the economy.

FREEDOM TO PRINT

And remember, too, this has all happened while the Bank of England has been very busy doing its part; buying up roughly a third of all outstanding gilts in an attempt to reflate the economy. That has only been of limited use. The BOE has been swimming against a tide where households and businesses would rather hold safe assets or pay down their debts than consume or invest.

That those debts are not shrinking in comparison to earnings only gives that cycle of thrift and austerity more impetus.

“There has been inflation in the UK. The real price of labor has not been sticky. The real burden of debt has fallen, sure, but real wages and incomes have fallen even farther, leaving people less able than ever to satisfy debts they’ve contracted and so purchase financial security,” economist Steve Randy Waldman writes in his blog. here#comments

“There is a lesson here. If we mean to pursue reflationary policy, the goal should not be to reduce real wages, but to reduce the real value of debt relative to incomes.”

That, by the way, may well work, but it is not even close to being on the cards for Britain, not politically and not in terms of how monetary policy is likely to be pursued.

The important point to note here – and this extends beyond Britain to the U.S. and Europe – is that debt is an extremely cumbersome and inflexible mechanism. It takes a long time for creditors and borrowers to re-set debt values and terms after a shock like 2008. Bankruptcy takes time and causes all sorts of negative external developments which may have little to do with the underlying viability of the business or household playing bluff with their creditors.

This all applies equally to the U.S. housing market, which may take a decade to fully clear, as it does to Britain.

Britain does have a bit of an excuse; its economy is closely tied with the euro zone so the emerging recession there, which is out of its control, is deeply its problem.

That said, an economy which reaches the giddy heights of carrying total debt five times larger than annual output is one which is largely the author of its own problems.

Cries against austerity are all well and good, but the alternative, more government spending, seems unlikely politically. Britain did well out of debt, financial intermediation and globalization; as those three partly unwind it will continue to do considerably less well.

(James Saft is a Reuters columnist. The opinions expressed are his own) (At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

By James Saft

(Reuters) – Europe looks to be entering a credit crunch, with loans harder to get and those that are made coming on tougher terms.

Strikingly, banks are being tight despite falling demand for credit, pointing to a nasty interaction between the economy, its banking system and the choices of wary and indebted households and companies.

That this is all happening despite the massive efforts of the European Central Bank, which twice recently has made extraordinary amounts of nearly free money available to the banks, tells the grimmest tale of all.

As for the future, European banks still have hundreds of billions of capital to raise, implying that even when demand for credit returns, the unbalanced recession in the euro zone might be extended by continued tough loan market conditions.

Bank lending to euro-area companies in the real economy fell again in March, declining by 5 billion euros, an increase on February’s 2-billion-euro contraction, according to data released by the ECB on Monday. Banks instead took some of the inexpensive 3-year money they accessed from the ECB and increased their loans to governments by 29 billion.

That’s a decent, if painfully slow, way to allow banks to rebuild capital and nations to stay afloat, but it won’t work very well if economies contract in the meantime, as Spain’s dwindling GDP demonstrates.

If the bank loan drought was happening in the U.S., with its highly developed capital markets and ample cash sloshing around, this would be poor news; that it is happening in Europe, which remains highly dependent on bank funding for job growth and capital investment, is all the more concerning.

Interestingly this is not simply a story about timid banks which need to rebuild capital levels; there seems to be a bit of a turning away from credit by borrowers, doubtless because they see weak growth for their goods and services.

An April survey of bank lending conditions by the ECB showed falling demand for loans even as banks made them harder to get and sometimes more expensive.

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More small and medium-sized companies are being turned down and loan conditions, while not as bad as in the aftermath of the failure of Lehman Brothers, have tightened.

This doesn’t make the ECB’s LTRO a failure, but it does show how little of the more than 1 trillion euros in three-year loans the ECB doled out is actually hitting the real economy. One easy conclusion: we’ve not seen the last extraordinary attempt to hose out the banking stables. It might be another LTRO, or it might be another “bad bank” to eat the sins of the “good” banks, but the current trajectory really can’t be allowed to continue.

At least on the credit supply side, none of this is going to improve any time soon. An April report from the Bank for International Settlements gave a broad and sobering indication of roughly how much capital banks globally need to raise. www.bis.org/press/p120412a.htm

Large, internationally active banks, about one fifth of which are European, would need to raise almost a half a trillion dollars to meet recommended new capital targets under the Basel III plan. That’s nearly one and a half times their annual profits, so no easy task. While the study did not break down the results by country, it’s reasonable to assume many euro zone banks are among those with big capital needs.

As it will be very difficult to raise the required amount of capital, especially in the midst of a slow-moving but profound crisis, banks are likely to try to dispose of assets. That will put even more pressure on credit availability.

It is unclear what will break the self-reinforcing cycle between Europe’s credit crunch and its recession.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)