Celebrate Mediocrity

This is an old archive article in the 1920s reflecting perhaps, the mindset of a typical brick and mortar business owner. The author is a grocery chain businessman who accounts his experience working with brilliant men, who despite their genius often have common flaws that make them less practical than the average joe plodding diligently. A rather thought provoking one, considering how hiring of the best management externally seems to be the cornerstone of HR policies everywhere in our current time.

Why I Never Hire Brilliant Men

SITTING in my office last week, facing the man whom I had just fired, I thought of the contrast between that interview and our first one, nearly two years ago! Then he did almost all the talking, while I listened with eager interest. Last week it was I who talked, while he sulked like a petulant child.

"Your contract has sixteen months to run," I said. "My proposition is that we cancel it at once, and that I hand you this check for ten thousand dollars."

With a show of bravado he waved the check aside. He would hold me to the letter of the contract if it were the last thing he ever did.

I told him he had that privilege, but I was sure he would see the futility of exercising it.

"Let me review the situation for a moment," I continued: "You came to us as general sales manager on January 1st, 1922, at a salary of twenty-five thousand dollars. It was by far the largest salary we had ever paid in any executive position; but your record seemed to justify it.

"The letters you brought spoke in the highest terms of your sales genius. The only question which they did not answer to my satisfaction was why companies which had valued you so highly should ever have allowed you to get away! When I voiced this, you stated that they merely had been outbid by their competitors -- and I accepted your statement. It wasn't until you had been here a year that I learned the truth. You are a quick starter, but a poor finisher -- no finisher at all, in fact."

"Who told you that?" he demanded.

"Nobody needed to tell me. I found it out from your effect on our own organization."

"Organization!" he sneered. "You haven't got an organization."

"So you have remarked to me frequently," I answered; "and you may be right. Our folks have mostly grown up in our own business; they know comparatively little of the way in which things are done in other lines. That's what we wanted you to teach us, and you were very sure that you could . . . We were all receptive."

"Yes, you were!" he exclaimed scornfully. "Your folks were jealous from the day I arrived. They sat back and dared me to show results. I told you that six months ago."

"I remember you did," I replied, "and my answer is just what it was then. You claim to be a brilliant salesman, and yey you failed in the first essential. You never sold yourself to the people with whom and through whom you had to work. You say they were jealous, but a man of your intelligence ought to know that the answer to jealousy is modesty, hard work -- and results. The would have jumped on your band wagon fast enough if you had made them see the advantage of it. But after waiting around for the band wagon to start, they concluded that it wasn't going to start, and it never has.

"You brought your own assistants, and we paid them high salaries," I went on. "You moved our offices away from the plant and took these expensive quarters in the center of town. You were given a sales and advertising budget more than twice as large as any we have ever had before. Every request you made I granted as whole-heartedly as I knew how, because I believed that your fresh ideas were what this business needed. But twenty months have passed, and the sales simply have not grown.

"That's the stubborn fact which can't be blinked; and now it's come to a point where I must choose between you and my good old wheel horses who, in spite of their mediocrity, have somehow managed to build a very profitable business.

"You can stay here until your contract expires, but you will have no further responsibilites. The news will get around that you are merely hanging on; and when the end comes you will step out, discredited, to look for another job. Or you can leave now with ten thousand dollars, which is the additional penalty I am willing to pay for my mistake in judgment. If you go in the proper spirit, you are still young enough to profit by your failure."

HE MADE a little further show of protest, but he took the check.

I wonder what old-line company will next be dazzled by his sales talk; and what I ought to say when the president writes to ask me why we were willing to let him go. If I tell the entire truth it may end his business career. And there is always the hope that, next time, he may enter modestly upon his opportunity and produce real results. For he has the talent; there is no doubt about that. He is undeniably a very brilliant man.

When I was a small boy my father bought me two pairs of shoes; one at two and one-half dollars and the other at five dollars.

"My son," he said, "I want you to wear these two pairs of shoes on alternate days, and watch them carefully. Later on I will ask you to tell me about them."

Without understanding at all what he had in mind I wore the two-and-one-half-dollar pair on Monday, the five-dollar pair on Tuesday, and continued to give them equal service for about six months. At the end of that period I reported that the cheaper shoes were worn out.

"How about the other pair?" he asked.

"Here they are," I answered; "I've had them half-soled and they are as good as new."

He nodded his head, as if he had expected this information.

"I bought those shoes for a special purpose," he told me; "and I want them to be a lifelong lesson to you. There are just two grades of commodities in the world: the best -- and the others. My experience is that it pays to buy the best; and what applies to things applies equally to men. Pick out the best men for employers; and when you get along in life pick out the best men for employees. never mind what the price mark may be; the question is, what service will they deliver, and how long will they wear?"

I NEVER forgot that homely incident; but not until years later did I understand its full significance. The five-dollar shoe has a lot more wear in it because there was a lot more work in it. Even fine material, carelessly put together, will not make a fine shoe; but if material which is of just average quality is fashioned with special care and attention, it will result in a quite superior article.

What my father was trying to teach me was this: God Almighty, in fashioning his most useful men, often works slowly with quite common stuff. Now and then He turns out a quick job of superfine materials -- a genius who really delivers the goods. But most of His better grade line is ordinary in everything except the extra effort, and dogged determination, which have given it a finer texture and finish.

This knowledge, as I say, came much later. When I set out in life, it was with the idea that if I could attach myself to exceptional men, and exceptional men to me, my advancement would be assured.

In my sophomore year in college my father died. One of his insurance policies of twenty thousand dollars was paid to me; the balance of his estate went to my mother. It would have been far wiser if I had completed my college course; but I was ambitious to make an immediate record.

As it happened, I had come under the influence of the first of my costly collection of brilliant men. I will call him Carroll. He was five years older than I was and a member of my college fraternity. But he had dropped out at the end of his freshman year and was supposed to be making a great record with a wholesale grocery house in New York. We undergraduates were dazzled by the splendor of his visits. He wore fine clothes, smoked the best cigars, and talked with the assurance of a successful man of the world.

One night, following the initiation ceremonies at the fraternity house, he drew me into a corner and asked me about my plans. I had no plan, I answered, except to finish my course and to take the best job that came along.

"You'll just be wasting two years," he said decidedly. "You've got everything that college can give you, except a diploma. Look at me. I'm just as much a college man as though I had hung around here four years; and compared with my classmates I've got a three-years start in business. I've been watching you ever since you entered, and I think you have the stuff.

"I'll make you a proposition," he went on confidentially. "The big future in the grocery business is in chain stores." (In which he was right, as has subsequently been proved.) "I know the business; you have twenty thousand dollars. I know a city where we can buy two good little stores for that amount in cash, and pay off the balance out of the profits. When we get those two going right, we'll buy another, and another, until we have a big chain. It's a sure-fire fortune. You think it over for a few days, and if you want to hook up with me, let me know."

I was flattered by his interest, so I thought it over. That is, I indulged in what young men frequently mistake for thought. In imagination, I saw my name over the door and myself in a fine glass office looking out and watching clerks taking in money. I had, in anticipation, the thrill of buying one store after another and going from town to town on tours of inspection. I tickled my fancy with the idea of coming back to college and letting the boys consult me as an experienced man of affairs. And having finished this process of "thinking" I wired Carroll that I was ready to join him.

WE BOUGHT our two stores; there was no trouble about that. We hung out the signs which my imagination had pictured, washed the windows, rearranged the goods, painted the delivery wagons a bright red and worked like Trojans. We made progress -- quite encouraging progress. One of the fine traits in human nature is the desire which almost every decent man has to help young men do well. The second month we broke even. The third month we began to show a small profit.

Everything might have gone well for us if it hadn't been for Carroll's brilliance. He walked into the office one night and sat down with an air of immense satisfaction.

"We're on our way, Jimmy!" he exclaimed. "I've just been over to Booneville and got an option on the best store there."

"How are we going to finance it?" I gasped. "We're short of working capital as it is, and I don't see how we can spread out our time any thinner."

"Leave that to your Uncle Dudley," he cried, with a wave of his hand. "I've been over to the bank, and they're willing to take a chance on us. It will be a tight squeeze for a few months; but we'll make it. And as for spreading ourselves too thin, don't you ever make the mistake of tying yourself down to this desk. Nobody gets anywhere by doing all the work himself. We'll take Ferguson" (referring to one of our clerks) "and make him manager here, while we step over to Booneville and breathe the breath of life into that dear old town."

His enthusiasm was contagious. We sat up half the night figuring and planning, and by one o'clock we had already moved on, in imagination, from Booneville to the two adjoining towns.

For another six months the sun seemed to be shining in at all our windows. We put on more delivery wagons, took an option on more stores, laid in lines of goods which had never been carried before, and reveled in the joys of big business.

Then the thing happened which was inevitable; we came smash up against inventory time and found that we had been insolvent for weeks without knowing it. Plenty of money was passing through our hands; but not enough stuck.

We made an assignment, turned over every cent we had in the world and trailed sadly back to New York, where I found a job as a clerk for one of the jobbers from whom we had bought goods.

Carroll, crushed to earth, rose brilliantly again. I heard of him next as one of the promoters of a new process for treating rubber. It lasted a few months, and exploded. Various enterprises followed, and my latest information about him is that he is practicing the profession of "Industrial Management." I should think it might be a good profession for Carroll. He is a bad employer for himself, but he could put a lot of ginger into somebody else's business, if the other man knew the trick of handling and properly discounting brilliant men.

Well, I went to work behind a high desk copying orders. After a while I was given a chance to sell; and ten years later, at the age of thirty-five, I was general sales manager. At this time the owner of the business died and was succeeded by his son, a man about my own age. I will call him Adams. He announced immediately that I was to be vice president and general manager, and made a private arrangement with me by which I was able to purchase some of the stock.

"I don't want to be tied down by details," he explained. "You know that end of things. I want to be free to work on big deals and think out plans for the future of the business. Father was a darned good man in his day, but he got pretty conservative toward the end. You and I together will do big things."

I OUGHT to have been warned; for while the voice was the voice of my new boss, the words were the words of my old partner, Carroll. Indeed, the two men were curiously alike -- both handsome, magnetic chaps with a facility for making quick friendships.

I was still young in experience, however, and I entered into the new arrangement whole-heartedly. But disillusionment came swiftly. Our principal customer walked into the office one afternoon and asked for Mr. Adams.

"He hasn't been in today," I said. "He may come later."

"May come," repeated the big fellow with unpleasant emphasis. "He had a definite appointment with me, and I've traveled a hundred miles to keep it."

I lied as nimbly as I could: Mr. Adams had been called away unexpectedly, I said. He told me about the appointment and would make every effort to get back. Probably he would come within the next half-hour.

But the customer refused to be mollified. He waited in Adams's office for exactly thirty minutes; then he stalked out.

At five-thirty that evening Adams burst in and began to unfold some new and splendid plan. It was dramatic -- a stroke of genius. But for two men in our circumstances it was impossible. When he had finished I poured the bad news of the Big Customer's call over him like a bucket of cold water. At once, all his enthusiasm died out; he was so contrite that I couldn't possibly be angry with him.

"That's a rotten shame," he exclaimed. "I forgot all about it. I'll write the old bear a letter and lay myself humbly in the dust."

And write a letter he did -- a masterpiece -- with delicate reference to the Big Customer's years of dealings with his father, and a profound apology. Better than that, he took a train and arrived in the Customer's office a half-hour after the letter, coming back with the best order we had ever shipped out.

He was brilliant, there was no denying it, and so lovable that I value his friendship to-day more than that of almost any other man in the world. But I couldn't stand him in the business; I decided that within the first year, and we had a showdown.

"One of us should go," I said in the course of the hardest interview of my life. "Either I'll sell my interest, or you sell me yours."

"I don't see why," he answered; and he had the look of a favorite puppy who has been scolded. "I thought you liked me."

"Like isn't a strong enough word," I said. "I love you, and you're brilliant. But I'm a commonplace plodder, and so are all our employees. Moreover, this is a plodding kind of business, where the money is made by pinching pennies. You're about as much at home in it as J. P. Morgan would be running a barber shop.

"You conceive a big idea, get the whole organization on tiptoes to carry it out, and then you lose interest and go off on a new tangent. You think everybody else's mind ought to function as swiftly as your own, so you are alternately overenthusiastic and over-depressed. One day you carry some poor devil up into a high mountain and make him think he has a chance to become general manager. The next day you blow him up for not doing something which you think you told him, but which you actually forgot. You are always living, in imagination, about six jumps ahead.

WITH Adams out of our business, it gradually settled down. That is a terrible phrase, I know, but it describes our situation. We no longer had the brilliant emotional moments which he had inspired; we didn't attempt any very daring exploits; but at the end of every year we had more money in the bank than we had while he ran things.

After that, I never hired a brilliant man from one of our competitors, nor listened to the siren-tones of "experts" who promised to double our volume -- until I encountered the twenty-five-thousand-dollar beauty I have mentioned at the start of this story. Every year I picked up a half-dozen live young fellows who seemed to have a capacity for hard work, and shoved them in at the bottom of the pile, letting them make their way up to the better air and sunlight at the top -- if they had it in them to do it.

For a time I tried picking these youngsters out of the colleges. But my experience with college men was not fortunate. If I selected good students, I found too often that their leadership had been won by doing very well what their teachers had laid out for them. They had developed a fine capacity for taking orders, but not much initiative. If I hired athletes, too many of them seemed to feel that their life work was done; that the world owed them a living in exchange for what they had achieved for the grand old school. Also, there is not much social distinction in the grocery business. Young ladies -- and their mothers -- are much more thrilled by bonds than by butter and eggs.

So I took most of my raw material from our delivery wagons, or other places right at hand. Out of this hard-muscled, hard-headed stuff I have built a business that has made me rich according to the standards of our locality, and has built modest fortunes for at least twenty other men. More important than that, it has stood for clean dealing and a faithful adherence to the best business ethics. Even our hottest competitors, I think, are willing to grant us that.

READING back over what I have written I am quite conscious that it is an indictment of myself, as well as of the brilliant men with whom I have been associated. Any reader might fairly say, "He was too mediocre to appreciate anything better than mediocrity."

That criticism may be justifiable, fo I am mediocre. But the point I have in mind is this: Business and life are built upon successful mediocrity; and victory comes to companies, not through the employment of brilliant men, but through knowing how to get the most out of ordinary folks.

I was talking not long ago with the president of one of the big insurance companies.

"There is not a single brilliant man in our organization," he said. "I am not brilliant myself. I am just an average chap who started in peddling policies, and -- knowing my own limitations -- felt that I must put in a couple of hours' extra work every day in order to hold my own against my competitors."

In one of our largest cities is a newspaper which is said to earn nearly a million dollars a year. It was on the verge of bankruptcy when the present owner purchased it. He has made it practically a daily necessity to the business men of his city -- complete, accurate, dependable.

One day a very talented journalist joined the staff in a position of considerable responsibility. He had been editor of a smaller newspaper noted for the brightness of its style; and in the first editorial counsel he volunteered a suggestion.

"You have made a marvelous success of this property," he said to the proprietor. "Nobody would think of suggesting any change in the news policies. But won't you let me hire two or three really brilliant editorial writers whom I have in mind? Even you must admit that there is room for improvement on your editorial page."

"What's the matter with the editorial page?" the proprietor demanded.

"Why, it's so -- so commonplace."

The proprietor was silent for a moment. Then he said:

"My dear sir, the average business man is commonplace."

There is a great deal of encouragement to me in that statement, and I find the same sort of encouragement in reading biography. Who have been the doers of important deeds? . . . Geniuses? . . . Yes, some of them. But not a majority, by any means.

No man contributed more to the winning of the World War than Lord Kitchener, who was one of the dullest boys that ever entered a school. All studies were hard for him, with one exception: he was remarkably good in arithmetic. Capitalizing that one point of strength, he learned to handle men in large numbers and to make accurate estimates of the strength of his own forces and those opposed to him. When brilliant men were talking about a six-months war, he bluntly prophesied a three-years war, and forced the Allies to prepare for it.

Charles Darwin, who revolutionized scientific thought, was so unpromising as a boy that his father predicted he would be a disgrace to the family. James Russell Lowell was suspended by Harvard for "continued neglect of his college duties." Neither of them showed any youthful brilliance; they matured gradually into eminence by the slow process of diligent effort.

SIR ISSAC NEWTON sat one night at dinner beside a very attractive and voluble young lady.

"My dear Sir Isaac," she exclaimed, "how did you ever happen to discover the law of graviation?"

"By constantly thinking about it, madam," her "dear Sir Isaac" muttered.

In that blunt answer lies the substance of my experience, and what I believe to be the real secret of business achievement.

So sure am I of the soundness of this philosophy that I have five very simple rules for hiring men, which are the outgrowth of it!

• Has he good health? Some months ago a newspaper collected from a hundred young men a list of the qualifications they would seek in the girls they hoped to marry. The list differed widely, as may be imagined. But at the top of almost every one was written the asset which I put first in men -- good health. Without it the best man in the world is likely to become pessimistic in his outlook, and to break when he is needed most. With it, even mediocrity can force itself by unusual effort into something fine and useful. Generally speaking, I would rather have a man who was born frail, and has overcome his frailty by careful living, than take one whose natural strength has never known its limits. The athlete, like the genius, frequently disappoints; while the man who has had to fight for his health knows how to value and preserve it.
• Has he saved some money? I don't care how much, or how little, but he must have saved something. At times, this demand may seem harsh. A man will say, "I have had parents to look after," or "I have had bad luck with an investment," or, "I trusted a friend who failed me." To all such excuses I am sympathetic, but I do not relent. I answer, "That is too bad, but think what it means. You have lived twenty-five or thirty years without making a profit on your life; how can I expect that you will be a profit-maker for me?"
• Does he talk and write effectively? This may seem a strange requirement, but it has been a very useful one. If we could unscrew the top of men's heads and look in, many of our problems would be eliminated, for we could see what sort of thinking goes on there. Lacking that privilege however, we have to judge by what comes out of the mind through the tongue and fingers. If a man writes and speaks "neatly" it is because his thinking is orderly; if his expression is forceful, the thought back of it must be forceful. But if he blunders for words, and uses phrases which express his meaning clumsily, I believe his mind is cluttered and ill-disciplined.
• Does he finish what he starts? Geniuses almost never do. I look very critically into little things respecting the men I hire; the details of their dress, their handwriting, their record of tying up a job and leaving no loose ends. The biggest men of my acquaintance in business are "detail men" to an amazing degree. Often the president of a company is the only man in it who knows the little things about every department.
• Finally, of course, I look for courage. General Grant was a rather slow-witted man, and a failure in middle life. But he won the Civil War; and the principle on which he proceeded was that the enemy was probably just as much scared as he was. Napoleon's motto was "When in doubt, attack." I like to throw something rather hard at a young man, and see how squarely he meets it. For with courage and the habit of going forward he can travel a long way. He will pass many men more brilliant than he is. Their active minds can always see two sides to every question; and they stand still while the debate goes on inside.

THESE are quite simple rules. They eliminate the genius quite as surely as they eliminate the unfit. No Edison could ever qualify; no Lincoln, either, with his soiled linen duster and his habit of interrupting important business with funny stories. I am sorry to forego the companionship of such men in my rather dingy building here in the wholesale grocery district. But I comfort myself with the thought that Cromwell built the finest army in Europe out of dull but enthusiastic yeomen; and that the greatest organization in human history was twelve humble men, picked up along the shores of an inland lake.

Dollar Trades Lower on expectation of lower funds rate

Dollar Trades Near Record Low Versus Euro Before Fed's Meeting
By Stanley White and David McIntyre

Oct. 30 (Bloomberg) -- The dollar traded close to a record low versus the euro before U.S. reports that economists forecast will show declines in housing prices and consumer confidence.

Signs of economic weakness may bolster speculation the Federal Reserve will cut borrowing costs this week by more than a quarter-percentage point to prevent the biggest housing slump in 16 years from triggering a recession. The dollar is trading near an all-time low against a basket of six currencies.

``The dollar's downtrend seems entrenched for now,'' said John Horner, a currency strategist at Deutsche Bank AG in Sydney. ``The U.S. economy continues to slow and the Fed is likely to cut rates.''

The dollar traded at $1.4415 per euro at 9:18 a.m. in Tokyo from $1.4425 late in New York yesterday, when it reached $1.4438, the lowest since the European currency's debut in January 1999.

It traded at $1.0484 per Canadian dollar after touching $1.0509 yesterday, the weakest since 1960, and was at 92.27 cents per Australian dollar, after yesterday sinking to 92.72 cents, the lowest since April 1984. The U.S. currency was at 114.68 yen from 114.66.

The U.S. Dollar Index traded on ICE Futures U.S. in New York was at 76.88 after falling to 76.78 yesterday, the lowest since its inception in 1973. The index tracks the dollar against six major currencies including the euro and the yen.

Home prices in 20 U.S. metropolitan areas probably fell 4.2 percent in the 12 months through August, the most on record, according to the median forecast in a Bloomberg News survey. The S&P/Case-Shiller home-price index is scheduled for release at 9 a.m. in New York.

Consumer Confidence

The Conference Board may say today that its index of consumer confidence declined to 99 this month, the lowest since November 2005, from 99.8 a month earlier, according to a separate Bloomberg News survey.

The Fed cut its target rate for overnight bank loans by a half-percentage point Sept. 18 to 4.75 percent, the first reduction since 2003, after losses from subprime mortgage investments roiled credit markets.

Interest-rate futures traded on the Chicago Board of Trade show a 98 percent chance the Fed will lower the rate by a quarter-percentage point to 4.50 percent tomorrow. On Oct. 26, traders saw a 92 percent chance of a quarter-point cut this month and an 8 percent probability of a half-point reduction.

``A housing slump, exemplified by falling housing prices, will keep dragging down the U.S. economy and the dollar,'' said Kenichiro Fujita, manager of Aozora Bank Ltd.'s derivatives marketing group in Tokyo. ``This situation may continue for two or three years.''

The U.S. currency may fall to 113.70 yen today, Fujita said.

Gross on Fed

Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co., wrote in a report published on the firm's Web site yesterday that he expects the Fed to lower benchmark interest rates to 3.5 percent to avoid a recession.

Gross, who manages the $106.5 billion Pimco Total Return Fund in Newport Beach, California, has predicted for more than a year that the Fed will lower rates in 2007.

A government report this week may show job growth is slowing. The U.S. economy may have added 80,000 non-farm jobs this month after an addition of 110,000 in September, according to the median estimate of economists surveyed by Bloomberg. The government reports the data on Nov. 2.

The European Central Bank will keep its key rate at 4 percent at a Nov. 8 meeting, according to the median forecast in a Bloomberg News survey.

Yen Gains Limited

Gains in the yen against the dollar may be limited by speculation the Bank of Japan will lower its economic forecasts in a semiannual report tomorrow after keeping rates unchanged.

The BOJ will keep its benchmark rate at 0.5 percent, the lowest among major economies, according to all 45 economists surveyed by Bloomberg News. The yen has slid against 14 of the 16 most-active currencies in the past year as speculators borrowed it to purchase higher-yielding assets in carry trades.

Yen Carry Trades

``Investors will continue to earn money on the yen carry trade,'' said Tsutomu Soma, a bond and currency dealer at Okasan Securities Co. in Tokyo. ``The BOJ may downgrade its economic outlook. There's no reason to buy yen.''

The central bank's semiannual outlook report, to be published at 3:30 p.m. in Tokyo tomorrow, will show the nine board members' forecasts for the economy and prices for the current fiscal year and the next.

Consumer prices excluding fresh food will be unchanged in the year ending March and rise 0.3 percent next year, according to the median estimate of 15 economists surveyed by Bloomberg News. The economy will expand 1.7 percent this year and 2.1 percent in the next, the survey shows. All estimates except for next year's growth are lower than the BOJ's April prediction.

The yen traded at 165.39 against the euro from 165.38. It may weaken to 165.70 and 115 against the dollar today, Soma said.

In a carry trade, investors get funds in a country with low borrowing costs and invest in one with higher interest rates, earning the spread between the borrowing and lending rate. The risk is that currency market moves erase those profits.

Expectations of lowering fed funds rates

Pimco's Gross Expects Fed to Cut Rates to 3.5 Percent (Update1)
By Deborah Finestone

Oct. 29 (Bloomberg) -- Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co., expects the Federal Reserve to lower benchmark interest rates to 3.5 percent to avoid a recession.

More conservative lending practices stemming from investors' reduced willingness to fund risky loans will induce a ``noticeable slowdown'' in credit growth, though not an outright contraction, Gross wrote in a report published on the firm's Web site today.

The Fed's target for overnight loans between banks will have to fall enough that interest rates will be about 1 percent above inflation, he said.

``An increasingly recessionary looking U.S. economy will likely require 1 percent real short rates and 3 1/2 percent fed funds in order to stabilize a potential growth contraction in lending not witnessed since the early 1970s,'' Gross said.

Earlier this month, he said the central bank will likely cut borrowing costs to 3.75 percent in the next six to nine months.

Gross, who manages the $106.5 billion Pimco Total Return Fund, has predicted for more than a year that the Fed will lower rates in 2007. The central bank reduced rates in September for the first time in three years.

Futures traded on the Chicago Board of Trade suggest a 98 percent chance the Fed will lower rates to 4.50 percent at its Oct. 30-31 meeting. The odds on rates declining to 4.25 percent by the Dec. 11 meeting are 69 percent.

A tribute to Alfred Chandler

Lessons from a Great Thinker

by Margaret Heffernan

(Fast Company) A master at recognizing patterns and avoiding reductive career structures, Alfred Chandler ensured his business success by recognizing that you can’t understand a business by simplifying it -- you have to master its complexity.

Last month, a great man died: Alfred Chandler. Aged 89, his passing didn't cause much of a stir, but it should have. Because like all great thinkers, Chandler set himself a huge question and devoted himself to exploring it. For Chandler, the question of our age was: how do businesses work? What are the relationships between the times, the technologies and the people that make corporations dynamic and self-sustaining?

A former professor of business history at Harvard Business School, Chandler tended to study the titans of the American economy -- General Motors, Dupont, Standard Oil and Sears -- but the lessons he extracted from those studies could be, and were, applied to businesses around the world. One business leader compared The Visible Hand to The Decline and Fall of the Roman Empire. Chandler's book had shown him everything about how organizations succeed or fail.

I met Chandler socially on a number of occasions and was always struck by two things. First was his immense youthfulness. His most recent book came out in 2005, at the age of 87, and he died in the midst of the next. He must have been eighty when we first met and yet he was the liveliest, best informed, most provocative conversationalist I can remember. Installing himself in a comfy seat, hubbub always formed around him; parties went into full swing when Chandler was there. And that was because of his second quality: curiosity. He wanted to know about everything from everyone. The people gathered around him weren't just business people; he befriended writers, musicians, artists, scientists, anyone with a lively mind. He understood that, at a certain level, you can't understand business by simplifying it. You have to master its complexity. It was no accident that he was married to an artist.

Chandler did what great thinkers do -- which, it turns out, is what great business leaders do too. When studies of thousands of top executives at companies around the world were analyzed, only one cognitive ability alone distinguished star performers. It wasn't technical expertise, schooling or IQ. It was pattern recognition, the big picture thinking that allowed leaders to pick out meaningful trends and to think far into the future.

Chandler was an ace pattern recognizer -- starting with his time in the Navy during World War II, when his job was analyzing aerial photographs of Japanese and German territory before and after bombing raids. He did as a young man what he would do for the rest of his life, and what, I would argue, all business leaders must do: survey the terrain, identify significant changes and figure out what they mean.

This is the most important thing that CEOs do and is almost always what spurs entrepreneurs into action. Business success is all about identifying patterns -- in product development, consumer tastes and social trends. To perform pattern recognition at a high level, you need to be curious, and you need to know a very wide range of people who are curious too. You can't know everything yourself, so you have to know a lot of people who know a lot. You have to place yourself in the midst of the hubbub.

Business failures occur when that pattern recognition stops, when business leaders fall for their own publicity or when the business itself becomes too narcissistic -- more concerned with internal politics and processes than with markets and customers. Many of our reductive career structures contribute to these failures. We start as generalists, and then get increasingly specialized until all we know is our area of expertise, and other people in it. We hang out with people just like ourselves who work in our industry, drive cars like ours, live in houses like ours, speak and think like us. The higher we get in the corporation, the more skills we need -- and yet our careers narrow our horizons at each step along the way. This reductivism is just the opposite of what we, and our companies, need.

One trend in leadership development seems to recognize this problem. More and more of the executive leadership conferences at which I speak feature experts and thought leaders from vastly different walks of life. Filmmakers talk about leading teams that must disband the minute work is complete. Religious thinkers discuss the spiritual dimensions of leadership. Scientists explain how to identify, from a sea of problems, those that you are capable of solving today. This is the opposite of old-style reductive thinking. It embraces the complexity of the business world and seeks to develop the talents to master it, not deny it. It stimulates the curiosity and enrichment true business leaders crave.

So what does that mean for individual careers? I think it means that the best employee, like the best leader, must at once be both narrow and deep. There's no substitute for knowing your business inside and out. But context is crucial and your ability to read the world around you is no longer an optional extra. This may feel like work has become harder than ever. It has. It's no longer enough to know just your job, to live it and breathe it eighteen hours a day. Now you need to have a life too.

The Center for Creative Leadership found a correlation between excellence at work and commitment to activities outside of work. This often comes as a surprise to corporate executives who think excellence and reductivism come together. But it comes as no surprise to women who've always had to combine a career with outside commitments. It serves as a significant wake up call to men who are just beginning to see fatherhood as a career asset. But Chandler, I suspect, would not have been surprised at all.

How to identify weak managers

Ten Habits of Incompetent Managers

by Margaret Heffernan

(Fast Company) How do you identify the members of your team that could sink it? Get an expert's tips on the signs you should look for.

Three years ago, I joined the board of a company whose management, I soon recognized, was incompetent. I said so, but I was a new board member and the management had a lot of old friends and allies on the board. I was listened to respectfully but nothing much happened.

Three years on, the board has recognized that the management is incompetent. The consequences of leaving them alone for three years now threaten to sink the company. We’ve fired one manager and hope to stay afloat long enough to replace the other. A few generous board members, with good memories, have acknowledged that we would not be in this pickle had I been listened to in the first place. But how did I know these managers were incompetent? I’m not a seer and, trust me, I’m not gloating. But I knew they were incompetent because I’ve hired and fired so many incompetent people myself. Every experienced manager has; you probably remember yours. So what hallmarks of incompetence have I learned to identify?

Bias against action:There are always plenty of reasons not to take a decision, reasons to wait for more information, more options, more opinions. But real leaders display a consistent bias for action. People who don’t make mistakes generally don’t make anything. Legendary ad man David Ogilvy argued that a good decision today is worth far more than a perfect decision next month. Beware prevaricators.

Secrecy: "We can’t tell the staff," is something I hear managers say repeatedly. They defend this position with the argument that staff will be distracted, confused or simply unable to comprehend what is happening in the business. If you treat employees like children, they will behave that way -- which means trouble. If you treat them like adults, they may just respond likewise. Very few matters in business must remain confidential and good managers can identify those easily. The lover of secrecy has trouble being honest and is afraid of letting peers have the information they need to challenge him. He would rather defend his position than advance the mission. Secrets make companies political, anxious and full of distrust.

Over-sensitivity: "I know she’s always late, but if I raise the subject, she’ll be hurt." An inability to be direct and honest with staff is a critical warning sign. Can your manager see a problem, address it headlong and move on? If not, problems won’t get resolved, they’ll grow. When managers say staff is too sensitive, they are usually describing themselves. Wilting violets don’t make great leaders. Weed them out. Interestingly, secrecy and over-sensitivity almost always travel together. They are a bias against honesty.

Love of procedure: Managers who cleave to the rule book, to points of order and who refer to colleagues by their titles have forgotten that rules and processes exist to expedite business, not ritualize it. Love of procedure often masks a fatal inability to prioritize -- a tendency to polish the silver while the house is burning.

Preference for weak candidates: We interviewed three job candidates for a new position. One was clearly too junior, the other rubbed everyone up the wrong way and the third stood head and shoulders above the rest. Who did our manager want to hire? The junior. She felt threatened by the super-competent manager and hadn’t the confidence to know that you must always hire people smarter than yourself.

Focus on small tasks: Another senior salesperson I hired always produced the most perfect charts, forecasts and spreadsheets. She was always on time, her data completely up-to-date. She would always volunteer for projects in which she had no core expertise -- marketing plans, financial forecasts, meetings with bank managers, the office move. It was all displacement activity to hide the fact that she could not do her real job.

Allergy to deadlines: A deadline is a commitment. The manager who cannot set, and stick to deadlines, cannot honor commitments. A failure to set and meet deadlines also means that no one can ever feel a true sense of achievement. You can’t celebrate milestones if there aren’t any.

Inability to hire former employees: I hired a head of sales once with (apparently) a luminous reputation. But, as we staffed up, he never attracted any candidates from his old company. He’d worked in sales for twenty years -- hadn’t he mentored anyone who’d want to work with him again? Every good manager has alumni, eager to join the team again; if they don’t, smell a rat.

Addiction to consultants: A common -- but expensive -- way to put off making decisions is to hire consultants who can recommend several alternatives. While they’re figuring these out, managers don’t have to do anything. And when the consultant’s choices are presented, the ensuing debates can often absorb hours, days, months. Meanwhile, your organization is poorer but it isn’t any smarter. When the consultant leaves, he takes your money and his increased expertise out the door with him.

Long hours: In my experience, bad managers work very long hours. They think this is a brand of heroism but it is probably the single biggest hallmark of incompetence. To work effectively, you must prioritize and you must pace yourself. The manager who boasts of late nights, early mornings and no time off cannot manage himself so you’d better not let him manage anyone else.

Any one of these behaviours should sound a warning bell. More than two -- sound the alarm!

Comment on IFRS

What's So Global about IFRS?

(CFO Magazine) As global accounting regulators aim to move to a single set of principles-based standards, international financial reporting standards, a set of rules crafted by the International Accounting Standards Board (IASB), have been frequently cited as a possible model. But allowing companies to file under IFRS poses some problems.

"One of the things that will be a challenge is that there have been modifications made as those standards have been implemented locally," says John Archambault, managing partner of professional standards at Grant Thornton. Instead of a single set of international standards, there are now several variations of the rules the IASB initially drafted. Most modifications are minor thus far, says Ray Beier, head of strategic policy and analysis at PricewaterhouseCoopers, but some countries could refuse to adopt significant new standards in the future.

There are also concerns about the quality of audits conducted under IFRS. "Accountants all over the world are applying IFRS. Do we really know how well they're applying it and what their audit standards are?" asks David Sherman, an accounting professor at Northeastern University. As the Securities and Exchange Commission moves to allow foreign issuers to file in the United States under IFRS, "that is going to ignore the potential audit issues, which could blow up," says Sherman. "U.S. GAAP may be rule-based, but it's also extremely well scrutinized and tested. You know what you're getting." — Kate O'Sullivan

Time to hit the books again

Rewriting the Rules
Everything you thought you knew about accounting is about to change. Is there any reason to smile?
Michelle Leder, CFO Magazine
October 01, 2007

Now the hard part begins. Five years after the Sarbanes-Oxley Act was passed, its raison d'être — to improve corporate transparency and thus boost investor confidence — has been realized, at least to a degree. Debates still rage about how much credit the act can claim for Wall Street's (pre-subprime) rebound, and, more fiercely, about the cost/benefit equation, but companies have largely made their peace with the act's major requirements, and many agree that its impact has been positive.

But any hope for a respite is misplaced. Most publicly traded companies may now be in compliance with Sarbox, but the push for transparency that it set in motion is rippling out in all directions, and there is scarcely any aspect of corporate accounting — from overarching principles to specific standards — that isn't ripe for reconsideration. "I've been a student of financial reporting for 25 years," says Greg Jonas, managing director of Moody's Investors Service, "and I've never seen a time when so many big-ticket financial-reporting issues were in play."

Those issues cover enormous ground, from the macro (Will generally accepted accounting principles still be accepted?) to the micro (specific changes to lease, pension, securitization, and other accounting standards that could have a major impact on companies' reported results). In between those extremes are issues such as the move to fair-value accounting, which could affect everything from hedging strategies to emissions credits, and a push to overhaul financial statements to make them better reflect corporate performance (see "Work Zone Ahead" at the end of this article).

Enter the "Complexity Committee" Adding a further wrinkle to these interesting times is the fact that no single organization or entity has complete dominion over all aspects of corporate reporting. Nor do investors, companies, and lawmakers always agree on how to proceed or even what the destination should be. While it is true that the Securities and Exchange Commission has asserted itself more vigorously in the wake of Sarbox (see Part 2 of this series, "The SEC Rules," August), the broad scope and complexity of financial reporting demands some level of collaboration among a wide range of parties.

That was made clear in July, when the SEC established the Advisory Committee on Improvements to Financial Reporting. Known as CIFR or, more colloquially, the "Complexity Committee," it comprises 17 experts from academia, banking, law, Wall Street, and Corporate America. The group has been asked to make recommendations on everything from the relative merits of rules-based versus principles-based accounting systems to "current systems" for delivering financial information to the manner in which accounting and reporting standards are set and whether any current standards could be deemed unnecessarily complex or costly — or unnecessary altogether.
"Financial statements should do a good job for both preparers and users," says Robert Pozen, chairman of MFS Investment Management and also the chairman of CIFR. "There are a lot of people who are trying to get it right, and yet [the high incidence of misstatements indicates that] something isn't working here." In fact, Pozen says, "most individual investors are probably throwing them [financial statements] in the trash, and sophisticated investors want a lot more information in different formats," so no one is happy.

That fact has not been lost on the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), which have been collaborating on the so-called presentation project since 2005. Whether CIFR's work dovetails or conflicts with the FASB/IASB effort is unclear, but it is reasonable to assume that such wholesale changes to financial statements will increase complexity for users and preparers, at least initially. One early set of revised financials that was distributed during a meeting of the Financial Accounting Standards Advisory Council (FASAC, a cross-section of businesspeople who advise FASB in much the same way that CIFR will advise the SEC) this past spring provided a side-by-side comparison of how financial statements might look at some point. The familiar income statement would be replaced by a statement that, in theory at least, would provide greater detail on the different types of income generated, so that investors could see core earnings versus earnings related to financing or investing activities.

"There's a wholesale commitment to this," says Leonard Griehs, vice president of investor relations for Campbell's Soup Co. and a FASAC member. "But I hope that they [FASB and the IASB] do it in a way that doesn't put companies through a lot of work that doesn't do all that much for investors."

If efforts to revamp financial statements appear duplicative, that's just the start. In the broader effort to rethink various aspects of financial reporting, work is under way at three (and possibly more) FASB committees, a new Treasury Department advisory committee, the Public Company Accounting Oversight Board (PCAOB), and the House Financial Services Committee.

"There are definitely too many cooks in the kitchen," says Marc A. Siegel, director of research for the Center for Financial Research and Analysis and a member of FASB's Investors Technical Advisory Committee, which was formed earlier this year. "There's way too much lobbying going on in Washington in an effort to influence accounting rules. I'm afraid this is turning into a turf war." That can sometimes be exacerbated by a combination of current events and politics, as when the recent crisis in the subprime market prompted the House Financial Services Committee to explore proposed changes to securitization accounting.

The People with the Power Those with long memories may be tempted to shrug off concerns that this spate of activity will produce chaos en route to profound change. After all, the staid world of accounting has been known to erupt periodically in a burst of reformism. The 1970s had the Cohen Commission; the 1980s the Treadway Commission; while in the early 1990s the Jenkins Committee, created by the American Institute of Certified Public Accountants to provide a new blueprint for financial statements, even managed to give detailed examples. Yet few today can recall those early efforts, or what fruit they may have produced.

But Pozen vows that CIFR will have a lasting impact, one that perhaps defies comparison to mere accounting groups of days gone by. "First of all, this group has the strong support of Chris Cox, Bob Herz, and Mark Olson," he says, referring to the heads of the SEC, FASB, and the PCAOB, respectively, "so we have a good chance of getting something done." Asked to compare CIFR to another recent high-profile group with a different focus, Pozen says simply, "With the 9/11 Commission, the political backing was unclear."

One advantage that CIFR has over other groups, he explains, is that it is composed of "the people who have the power to change the rules. They're helping to find the issues and examine them, so at the end, the report goes to the decision-maker. The analogy would be if the 9/11 Commission had been staffed with members of the National Security Agency."

Despite Pozen's metaphorical comparison to a spy agency in describing the work of a committee devoted to corporate transparency, his point about the alignment of interested parties and the will to make changes is well taken. There is broad interest in creating one set of accounting rules that would work whether a company is based in Dayton, Dusseldorf, or Dar es Salaam. Although FASB and the IASB have been taking baby steps in that direction ever since the 2002 Norwalk agreement, the move seems to be on a much faster track following the SEC's concept release on August 7. In 42 pages, the SEC spelled out 35 questions, including these two shockers: Is there a scenario under which it would be appropriate for the commission to call for all remaining U.S. issuers to move their financial reporting to IFRS? And, would it be appropriate for U.S. issuers that move to IFRS to be allowed to switch back to U.S. GAAP?

That the SEC has even voiced these questions has caused a huge stir. Jack Ciesielski, publisher of the Analyst's Accounting Observer newsletter, commented that, "This is an idea that's ahead of its time. Not a bad idea — just ahead of its time."

Others have been less restrained. George Washington University Law School professor Lawrence A. Cunningham quickly fired off a six-page letter to the SEC, arguing that "pursuing the concept would amount to a leap of faith, rich with paradox and irony. One paradox is how moving to a single set of global standards means the U.S. would have a double set of internal standards. One irony is how the Concept Release acknowledges, twice, that the whole notion is complex, while the Commission simultaneously says it is fighting against complexity in financial reporting!"

Is Simplicity Too Complicated? The counterargument is that long-term simplification will be worth short-term complexity, and that, in fact, a historical resistance to major change is at the root of today's complexity. "We need to create a financial-reporting system that will serve us for the next generation. Otherwise, it's just another patchwork job," says Neri Bukspan, chief accountant at rating agency Standard & Poor's. Still, Bukspan is the first to admit that creating something that appeals to every constituency that uses financial statements is going to be a lot harder than it sounds. "The goal of financial statements for everyone is a utopian ideal, much like creating a universal language that everyone can understand. We all know what happened with Esperanto."

Some standards do prove worth the pain. Bukspan points to the euro, which evolved from an accounting standard to a physical currency to a dominant currency, with plenty of resistance and griping along the way. Might a move toward global standards for reporting follow suit? Bukspan's colleague, Ron Joas, an accounting specialist at S&P, is doubtful. "Over the years, there's been constant talk about the need to simplify," he says. "But once you get down to the things that really need to be considered, and the fundamental question of what financial reporting is supposed to be, it's not easy to meet the needs of every constituency in a single document."

Pozen acknowledges that "we need to deal with the tension that's there and understand it," but is confident that can be achieved. Others worry not so much about outright failure as partial success: What if various constituencies agree that GAAP no longer suffices but can't agree on how to change it? Would that lead to a sort of accounting free-for-all? Griehs of Campbell's says that is a legitimate concern. "There's definitely a need to change — everyone knows that," he says. "But let's make certain that everyone is moving in the right direction."

Certainty, once a quality that many people assumed was the bedrock of accounting, isn't what it used to be. Whether CIFR, FASB, and the SEC can change that — and how quickly — will become clear in the next two years.

Michelle Leder is the founder of footnoted.org, a blog that looks at what companies bury in their SEC filings.

Financing's New Language

Financing's New Language

(CFO Magazine) Dealmaking language is changing, signaling less freedom for issuers and more protection for investors and banks. Gone are dividend recaps, refinancing, covenant-light deals, second-lien loans, and payment-in-kind (PIK). Back in the lexicon are market clauses, covenants, earnouts, and sellers' notes.

The return of vigilance is evident in the commitment letters banks give buyers to finance acquisitions. During the buyout frenzy, private-equity buyers often committed to purchasing companies without financing contingencies (like buying a house without the assurance you will be approved for a mortgage). In turn, private-equity firms pressed banks for firm financing commitments. Banks issued commitment letters without strong escape clauses and, as a result, were stuck with billions in debt they were unable to unload. Banks are now inserting tighter terms, including market clauses, which give them an out if market conditions worsen.

Covenants, once a staple, were removed in the frenzy, hence covenant-light deals. Omitting these agreements, which protect investors, enabled issuers to sell debt without obligating them to meet performance benchmarks. Covenant-light deals are now gone and traditional covenants are back. Also gone are PIK clauses. These toggle-like features enabled issuers to pay investors in bonds instead of cash at their choosing.

Financial buyers will also have to do without dividend recaps, which allowed buyers to reap a windfall long before exiting an investment by loading companies with extra debt. (Think Hertz and the $1 billion in additional debt that Clayton, Dubilier & Rice Inc., Merrill Lynch, and The Carlyle Group paid themselves just six months after acquiring the company in September 2005.) Ditto for refinancing. With debt tighter, companies on the edge may not be able to refinance with new cheap debt and instead may have to be sold. Gone too is unsecured debt such as second-lien loans.

With banks retrenching, buyers and sellers in M&A deals can expect more negotiations about bridging financing gaps. Helping close such gaps are earnouts and sellers' notes. Earnouts are benchmarks a company has to meet after it is sold, while sellers' notes mean a seller agrees to hold part of the debt. For example, to complete the sale of its wholesale unit in August, Home Depot had to agree to finance $1 billion of the deal price.

Prudence prevails as risk-rewards are reassessed

Only the Strong Shall Thrive
Financially sound companies find gold in credit mayhem even as weaker players fear the game is up.
Avital Louria Hahn, CFO Magazine
October 01, 2007

As the financial markets squealed in pain last August and frozen leveraged-buyout deals had bankers pulling their hair out, health-care distributor Henry Schein was in a different frame of mind. It was extending a $57 million offer to acquire the shares of New Zealand–based Software of Excellence, a developer of practice management systems for dentists.

Not that Henry Schein's executives didn't worry about the spreading subprime-debt fiasco. A credit crunch, billions in stuck deals, and an eerily uncertain situation provided plenty of cause for concern. But fear was not the overriding theme at Henry Schein's Melville, New York, headquarters. In fact, if one clear message emerged, it was that this was a good time for the $5 billion company to step up its acquisitions.

"For companies like ours that are in a strong cash position and have financing in place, this [credit crunch] is an advantage," says Steven Paladino, CFO of Henry Schein, which has $200 million in cash as well as an untapped line of credit. "We can do transactions without a financing contingency."

Not all companies are as fortunate as Henry Schein. A five-year stretch of plentiful and cheap borrowing is over, the subprime-mortgage meltdown having ushered in a new reality. Banks have tightened lending, borrowing costs have risen, and tolerance for risk has fallen off a cliff. Besides putting a number of mortgage lenders out of business and virtually shutting down the LBO pipeline, the crunch is altering the financing landscape for all companies going forward.

In many ways, the turmoil is self-inflicted — overissuance of leveraged paper to feed the LBO machine combined with overissuance of subprime mortgages to feed Wall Street's securitization engines. Record underwriting in both categories the past few years resulted in looser lending standards and removal of covenants. The system hummed until June, when investors balked and demanded higher payment for risk.

Assuming no further deterioration in the economy, the effects should be painful but not catastrophic, limited to what Wall Street calls the elimination of froth and the return of reason. But if economic conditions deteriorate, then everything from moderate pain to a full-blown recession is on the table. "The biggest risk is the economy," says Mike Jackson, segment leader of the corporate banking group at KeyBanc Capital Markets. "If the economy turns and you start to see true defaults, that will cause a natural tightening to the credit cycle."
For now, it is companies with leveraged-up balance sheets that are feeling the squeeze. For them, debt has become pricier and more scarce. And those planning a payday through a sale to private-equity players may not see that day anytime soon. But solid credits with strong banking relationships should be able to finance without a problem, Jackson says. In fact, some can find opportunities in crisis, in the form of cheaper acquisitions and weakened competitors.

The Return of Risk
The sharpening difference between stronger and weaker credits has to do with the way investors view risk. Before the credit turmoil, a combination of low interest rates, plentiful liquidity, a strong economy, and a hot real estate market took the edge off risk, making funding easily available to issuers, including speculative-grade companies. Leveraged loans, which weaker companies use to raise capital, exploded, hitting a record $427 billion in the first half of 2007, a 42 percent increase over 2006, according to Fitch Ratings.
Credit spreads narrowed on lower-grade securities as credit eased, meaning that investors were willing to accept little reward for taking extra risk. For example, spreads on high-yield corporate bonds, which were 818 basis points in March 2003, narrowed to 282 basis points in early 2007, according to the Securities Industry and Financial Markets Association. During the same period, spreads on subprime mortgages also shrank. As long as real estate prices kept rising, all was well.

But as real estate prices began to fall and subprime-mortgage defaults rose in late 2006 and early 2007, securitized bonds containing subprime mortgages collapsed, shaking investor confidence. By summer, investors were rejecting low-yielding, risky debt that carried lax issuance standards, including around $350 billion in leveraged financing, mostly for LBOs, basically shutting down the deal machine. As the market struggles to regain its footing, yields for lower-grade investments are climbing as investors demand more pay for risk. That trend is expected to continue. "As much as we thought it was different this time, it was not — there will be a reassessment of risk," says Art Hogan, director of global equity product at Jefferies & Co.

Rising interest on high-yield debt endangers highly leveraged firms. Businesses with lower credit ratings tapping the high-yield bond market are paying an average of 2 percent more than they did in early summer, according to Fitch. Spreads have widened to 456 basis points over 10-year Treasury notes as of early September, versus 240 basis points in early June.

Higher interest rates make it more difficult for speculative-grade corporations to refinance by issuing new debt. This could well kick off a wave of defaults and bankruptcies. Edward Altman, director of the credit-and-debt-markets program at New York University's Salomon Center, Stern School of Business, says high-yield debt issuers typically begin defaulting in the second year after issuance, and nonperformance accelerates in the third and fourth years. That scenario doesn't take into account outside conditions such as the economy and liquidity, he says. High liquidity, for example, can keep such companies propped up, as it did during the credit bubble, but with credit tighter, more bankruptcies are likely, Altman says.

Moody's predicts that the speculative-grade corporate default rate will rise from about 1.5 percent to 4.1 percent in the coming year. And the number could climb to 5.1 percent by August 2009.

Bankruptcy rates are rising, too. The American Bankruptcy Institute reports a 45 percent surge in business bankruptcies in the first half of 2007 from the same time in 2006. But the 12,985 business filings of the first half are still historically low, about 30 percent down from the comparable period in 2004.

Waiting for Distress
Distressed-debt and other investors are ready. "We have been waiting for this," says Philip Von Burg, principal of New York–based Monomoy Capital Partners, which invests in financially underperforming firms. Von Burg expects marginally higher financing costs, but because his firm has a conservative approach to debt, he believes bank funding will still be obtainable.
So far, the companies most hurt by banks' tightening have been those connected to housing, like Irvine, California-based Standard Pacific Corp., a home builder that also provides mortgage financing. In late August, the company took steps to avoid defaulting on a tangible net worth covenant it had with its lenders. It entered negotiations with its banks to reduce its credit facilities and renegotiate its leverage ratio. In a Securities and Exchange Commission filing, the company said it planned to reduce a revolver to $900 million, from $1.1 billion, and cut a term loan to $225 million from $250 million.

Renegotiation may have its limits in this market. "We expect Standard Pacific will violate its tangible net worth covenant (it must stay above $1.37 billion) in the second half of 2007," wrote Banc of America Securities analyst Daniel Oppenheim. "We believe lenders remain flexible on renegotiating covenants for now, but see risk as conditions deteriorate further." Smelling opportunity, hedge fund Citadel LP acquired a 4.9 percent stake in Standard Pacific in August.

Not everyone is convinced the roof is about to cave in. Brian Ranson, managing director of credit strategies at Moody's K.M.V., which tracks corporate default risk, says that aside from the real estate sector, many companies remain in good shape. "We measure the default risk of tens of thousands of companies," he said in late August. "What we observe is that the strength of Corporate America is not affected by subprime [issues]."

Cash Is King — Again
Indeed, while credit costs are rising and leverage ratios are tightening for speculative-grade issuers, other companies are in pristine condition. "We spent the past few years preparing ourselves for just this type of market," says David Johnson, CFO of The Hartford Financial Group. "The time you want to have liquidity and capital is when other people don't." The Hartford has increased its credit facility to $2 billion from $1.6 billion and extended its maturity. Luckily, it began negotiating with its banks in the spring and managed to close the amended facility on August 9.

To build another layer of protection, The Hartford also entered into a funded $500 million contingent capital facility that can be tapped "on a rainy day" in the future. While he would like to believe his firm could get the same terms even in the middle of the credit crisis, Johnson is not certain.

Like The Hartford, many companies have been accumulating cash. A survey last May by the Association for Financial Professionals found that 36 percent of companies responding held more cash and short-term equivalents than 6 months earlier. (Eighteen percent decreased balances; the rest saw no change.) Moreover, 27 percent expected to add to their cash balances in the ensuing 12 months. Most stashed funds in money-market funds, bank deposits, and commercial paper.

What is The Hartford doing with its excess cash? Johnson says current conditions may well present a stock-buyback opportunity. The firm's share price was only 5 percent above its 52-week low in early September. It has a $2 billion authorization, of which it has already purchased $250 million worth of shares. Indeed, S&P 500 companies spent a record $158 billion in the second quarter on stock buybacks, the seventh consecutive quarter of more than $100 billion in such spending.

Companies have been hoarding those repurchased shares in Treasuries without retiring them, says Howard Silverblatt, senior index analyst at Standard & Poor's. One way to use them, he says, would be for acquisitions.

For strategic buyers, this is a good time to shop. M&A volumes are already down from the record $2.65 trillion of the first half of 2007 and premiums are lower. In the days of extreme liquidity, private-equity buyers drove up prices, often snatching deals from strategic buyers. "Private-equity buyers were able to raise their bids because they were able to borrow so much — seven times cash flow plus 25 percent in equity," says Steve Bernard, director of M&A market analysis at R.W. Baird & Co. "It has probably come down to four or five times cash flow."

There is plenty of strength in small and midsize deals, one reason being that the middle market tends to finance more conservatively and is not as reliant on high-yield issuance.

Deals typically consist of 25 to 35 percent equity with the balance made up of senior secured debt and, in recent years, a layer of partially secured junior debt. The use of junior debt will diminish as it becomes more expensive due to investors demanding a higher rate of return, says Monomoy's Von Burg.

But midmarket deals have not been immune to market conditions already, as banks often renegotiate the terms before closing. "Fifteen months ago people would be lined up to help you," says Dan Reid, head of transaction advisory services at Grant Thornton. To bridge the gap, buyers and sellers will have to negotiate a lot more, he says. Solutions may include buyers putting in more equity or sellers holding part of the debt.

For the overall financing and M&A pipelines to flow again, and for the leveraged finance market to open up, deals will have to be renegotiated for the new risk reality. As of early September, appetite for high-yield securities in their bubble format was nonexistent. Banks have been busy trying to renegotiate terms with private-equity buyers and make the securities more appetizing to investors — raising yields and adding covenants to bolster investor protection. Unless restructured, these deals would fetch below-par pricing, making it uneconomical for banks to underwrite them in their present form.

That is a big departure from the height of the bubble, when banks "were able to sell these [leveraged loans used for acquisitions] after the deals closed for more than 100 cents on the dollar," says Gary Rosenbaum, head of the finance group at DLA Piper. Home Depot, for example, had to slash $2 billion from the price of its wholesale unit in August (to $8.3 billion) in order to make the deal possible. Rosenbaum expects a lot more of that.

"There will be a lot of preparation and adjustment to financings to make them palatable," says Mark Howard, co-head of research at Barclays Capital.

Absent an economic slowdown, which could tighten debt even more, market participants expect a return to reason rather than to a restrictive market. They also foresee a lower profile for private equity and a higher profile for strategic buyers. "Investment-grade companies will have a good and normalized access to capital in the corporate bond, commercial-paper, and loan markets," says Howard. "Higher-yielding companies will also have access, but at a wider spread and slightly more nervous covenants."

Save the SIVs

SIV Situation:Will Rescuers Arrive in Time?

Banks' Plan Comes As Fund Woes Mount; Not a Silver Bullet

By CARRICK MOLLENKAMP, IAN MCDONALD AND VALERIE BAUERLEIN
October 24, 2007

(WSJ) As three of the world's biggest banks try to finalize a rescue plan for some shaky investment funds, the funds themselves face mounting problems.

The outlines of a new superfund -- an effort led by Citigroup Inc., Bank of America Corp. and J.P. Morgan Chase & Co. that may include at least seven other banks -- are still being hashed out, according to a person familiar with the situation. The three banks could present a formal structure to potential bank partners and funds as soon as next week.

Meanwhile, the funds at the heart of the situation -- known as structured investment vehicles, or SIVs -- need to find investors for $100 billion in debt coming due in the next six to nine months, even as ratings firms continue to come out with reports that lower the ratings of securities in moves that could further depress the value of SIV holdings.

SIVs sell short-term debt and then use the proceeds to buy longer-term, higher-yielding securities. But SIVs have had trouble in recent months selling debt, and some of their roughly $350 billion in assets are backed by U.S. mortgages -- a market that has seized up amid the housing slump and subprime-lending shakeout. Typically, money-market funds, municipalities and other risk-averse investors buy SIV debt.

The bank consortium would provide much-needed cash to the funds by setting up a superfund to buy highly rated securities from them. The superfund plan would aim to buy assets from the SIVs to prevent them from selling those assets en masse at today's depressed prices, something the banks and some regulators say could roil markets and the economy.

The plan, which the banks aim to finalize by month's end, could still fail or arrive too late to be of help. Besides tapping the superfund, SIVs are likely to restructure their debt, wind down or, in a worst-case scenario, become a dead SIV that can't pay debt investors.

Still, as the superfund negotiations continue, problems for SIV operators have worsened. Some SIV operators, such as Citigroup and Rabobank of the Netherlands, have been selling assets. In the United Kingdom, the Whistlejacket Capital Ltd. fund operated by Standard Chartered PLC is considering alternative funding plans, a Standard Chartered spokesman said.

Meanwhile, the types of assets held by some SIVs continue to come into question. Moody's Investors Service Inc. recently downgraded $33.4 billion of securities issued in 2006 and backed by subprime mortgages in moves that could make it more difficult for SIVs to unload assets.

Holders of SIV capital notes are bearing the brunt of the SIV fallout. Investors in capital notes typically supply an SIV with as much as 5% of its money. In return, these noteholders -- often European banks and insurers -- receive a share of the SIV's profits or losses. They are ranked lower than the other debtholders and thus could be the first to bear losses if SIVs sell assets to the banks' rescue fund.

Capital-notes holders face two options: risk losing money if the SIV sells assets to the banks' fund at a loss, or try to keep the SIV going by buying more of its debt. In recent days, SIVs have been trying to persuade capital-notes holders to buy medium-term notes to fund the SIVs and protect their investments, people familiar with the matter say. Some capital-notes holders -- and SIVs -- say they are skeptical about the banks' plan, because selling assets at today's prices will require the SIV and the notes holders to recognize a loss on those investments.

Capital-notes holders "profit if the SIV does well, but they lose their investment if there is a shortfall," says Geoff Fuller, an attorney at London firm Allen & Overy LLP, who advises clients including Citigroup on SIVs and other securitization projects.

U.K. mortgage lender Nationwide Building Society, for instance, recently invested a fraction of its assets in capital notes of several older, bank-sponsored SIVs, and says its holdings haven't been downgraded by ratings firms. Indeed, holders of notes in the shakier SIVs launched over the past two to three years, not those in older SIVs, are taking the worst lumps.

"We saw it as a potentially attractive risk-reward proposition," says Mark Hedges, Nationwide's head of structured finance. "We are monitoring the situation because it needs to be monitored, but we have a very modest portfolio."

Mr. Hedges, like other notes holders, says he is concerned the rescue fund could dilute the value of his investment. He adds he doesn't have enough information to make up his mind on the fund.

The lead banks have provided little public guidance on their plans for the fund, leaving themselves open to criticism. Executives working on the fund see it not as a silver bullet but as one of several options open to SIV operators, according to a person familiar with the effort.

The plan would benefit a lead participant, Citigroup, because it is a large operator of SIVs. The SIV industry has become a key part of the U.S. economy, because the funds buy securities backed by mortgage loans to U.S. home buyers. The industry, at its peak earlier this year, totaled about 30 funds with $400 billion in assets.

The three banks have many issues to work out, according to people familiar with the situation. They need to figure out how participating banks would divide any profits or shoulder losses when the rescue fund is wound down, according to people familiar with the plan. They need to decide if participating banks will be ranked based on how much funding they provide, just as banks take lead and supporting roles in stock offerings.

In recent days, the group has tried to bring in other banks. Wachovia Corp. plans to participate -- at a level likely below the three lead banks -- pending approval of a governance plan for the fund, said a person familiar with the situation. Germany's Dresdner Kleinwort, a unit of Allianz SE and operator of the K2 Corp. SIV, and Britain's HSBC Holdings PLC, the affiliate of the Cullinan Finance Ltd. SIV, are considering joining. Both are large SIV operators.

Wealth is probably not correlated to happiness

You're Not Super Rich? You Lucked Out.
By JONATHAN CLEMENTS
(WSJ) Great wealth is overrated.

Whenever my kids swoon over a palatial home or a passing Ferrari, it always bugs the heck out of me. Before long, I am on my soapbox, insisting that they shouldn't be awed by such symbols of wealth.

This might sound odd coming from a personal-finance columnist. But the fact is, while it is comforting to be financially secure, money is no measure of self-worth, no guarantee of happiness -- and no reason to be impressed.

Forget Respect

We all tend to sit up and take notice when we come across people with fancy titles, hefty incomes and immense riches. Yet these aren't signs of genius or virtue. Want proof? All it takes is two words: Paris Hilton.

Wealth may be inherited, which means the beneficiaries' struggle for riches didn't extend beyond the delivery room. Legendary investor Warren Buffett, the billionaire chairman of Berkshire Hathaway, has described "the idea that you win the lottery the moment you're born" as "outrageous."

What about the self-made rich? Shouldn't we be more impressed by them? While their hard work and perseverance are often admirable, I wouldn't be too quick to deify.

Today, if you are adept at judging the chances that a corporate takeover will go through, you can make good money running an investment fund devoted to merger arbitrage. Such a skill, however, wasn't nearly so valuable in thirteenth century England -- or, for that matter, twenty-first century Afghanistan.

In other words, in a different society or at a different time, your peculiar set of skills might ensure fabulous financial success. But in today's America, you are just another working stiff.

Losing Money

Displays of wealth can also be misleading. Folks can appear wealthy -- but the mansion may be fully mortgaged, the cars might be leased and the landscaper may still be awaiting payment.

Even if you come across somebody who can easily afford the trappings of wealth, the trappings themselves are not a sign of wealth, but of wealth that has been spent. The money lavished on the cars, homes and jewelry is now gone.

True, these purchases could always be sold. But there's no guarantee they will fetch the price that was paid -- and, in the meantime, they may require hefty maintenance costs.

Don't get me wrong: There is nothing wrong with spending. The whole reason for saving and investing now is so we can have money to spend later. That said, I can't imagine why I should find this spending impressive -- and I am not sure it is making the spenders happy.

Feeling Tense

As the old adage goes, money doesn't buy happiness. Yes, those with high incomes and more wealth often say they are happier.

This may, however, be a so-called focusing illusion. When the well-heeled are asked how satisfied they are with their lives, they contemplate their position in society -- and they realize they're pretty fortunate.

But research has found that, when high-income earners are asked about their emotions on a periodic basis throughout the workday, they don't report being any happier -- but they are more likely to say they are anxious or angry.

No Satisfaction

All this might have you scratching your head. It seems obvious that your life would be better if you had a gardener to maintain the yard, a chef to prepare your meals and a private jet to whisk you off to exotic locations.

And if you were suddenly handed all these things, life would indeed be grand -- until you got used to them. Unfortunately, after a while, you would become accustomed to the great food and the no-hassle travel, and you would be hankering for something even better.

Problem is, once you are used to life's finest, that hankering can be hard to satisfy. Suppose you go to the best restaurant in town with your wealthy friends. To you, the food is unimaginably good. To your friends, it is just another meal -- and yet there's no place better they can eat.

Finding Purpose

As you might gather, I think it is important to realize that there is nothing that special about the wealthy or the life they lead. But my goal isn't to discourage folks from striving to be rich. That brings me back to my children.

Not everybody will grow up to be president of the United States -- or, for that matter, president of a major corporation. Still, I hate the idea that my kids might be so awed by such people that they consider these lofty positions out of reach.

Maybe, of course, my kids will decide that they aren't interested in spending their lives in pursuit of fame and fortune, and that would be fine. But I don't want them to be so awestruck by anybody -- whether wealthy, talented or powerful -- that they rule out such possibilities.

Having enough money is important, but having heaps of it doesn't guarantee happiness. Instead, what matters is doing something that you enjoy and that gives you a sense of purpose -- and I don't want my children to be deterred from doing just that.