In a recent post (see Are Better-than-Expected Earnings Illusory?) I suggested that first quarter earnings came in better than expected largely because corporations undertook larger-than-expected cost cuts.

In response to economic malaise, it’s fairly typical for firms to try to reduce costs in an effort to stave off the deleterious consequences of decreased demand. There are several ways that a firm can do so: through layoffs, by rationalizing product lines, by trimming fat from operations, and/or by squeezing suppliers for lower input costs.

Nike provides a classic example of the illusory earnings effect that I described in that post. Take, for example, the following nonsensical headline from CNBC: Nike Posts Surprise Profit Increase, Tops Estimates. At first glance, one might think, “Wow, great news, Nike (a consumer products giant) did well. Maybe there are some green shoots in this economy after all.” But after digging a bit deeper, reality sets in:

The maker of athletic shoes and apparel said after markets closed Wednesday that it earned 99 cents a share in its fiscal fourth quarter, excluding one-time items. Nike reported revenue of $4.71 billion during the period. On a comparable basis a year ago, Nike turned a profit of 98 cents a share on a topline of $5.088 billion.

During the quarter, Nike reduced several layers of management and cut more than 1,750 jobs worldwide, or 5 percent of its global work force. About 500 of the jobs lost were at Nike’s world headquarters in Beaverton, Ore.The cuts come on top of other measures that the company has taken—including a hiring freeze and tight inventory controls—to improve its bottom line as the economic meltdown took a toll on its sales.

So, let’s take stock. Nike’s revenues were down 8% from last year. The reason it reported profits that beat estimates was because of layoffs and its success in squeezing its suppliers.

As I wrote in my previous post:

…cost cutting has systemic implications…Many analysts are overlooking the higher order effects of layoffs and capital expenditure reductions on the broader economy. This manifests as the dreaded negative feedback loop – fewer jobs leads to reduced consumer spending which then reduces demand for firms’ products resulting in decreased corporate profits leading to fewer jobs (wash, rinse, repeat).

Squeezing suppliers generates the same effect. It reverberates up the supply chain by reducing supplier revenues leading to fewer jobs leading to reduced consumer spending which then reduces demand for firms’ products resulting in decreased corporate profits leading to fewer jobs. Again, wash, rinse, repeat.

I concluded that post by suggesting:

The key then to the future of corporate profitability lies in whether you believe corporate earnings have bottomed out and will now begin to increase from a lower base, or whether you believe that there is still substantial downside risk that increasing unemployment and decreased consumer spending will continue to put a crimp in profitability. Given the nearly 40% rally in equity markets over the past several months, market participants clearly believe the former. I fear that the latter might be more representative.

I concede that the economy is more stable now versus when Lehman collapsed and AIG nearly collapsed. We successfully averted the financial armageddon scenario. However, I believe that economic growth and corporate earnings are farther off than most think. Nike is fairly representative of the broad corporate earnings effect that I described in that prior post, and writ large, anemic corporate earnings coupled with cost cutting are likely to keep economic growth muted for quite some time.

So I ask: Where are those green shoots?

I am officially confused.

Much has been written about how managers respond rationally to pay incentives, and how their supposedly “rational” behavior manifests as excessive risk taking with other people’s money. Many have even detailed how excessive risk taking brought about by distorted pay incentives was central to the financial crisis.

I agree that excessive risk taking played a role in the financial crisis. This has been well documented. Moreover, I am willing to concede that in some cases the behavior observed may have seemed rational. At the very least, the managerial behavior was a response to some form of incentive. And after all, we know incentives work, …even distorted ones.

Indeed, I have even written a bit about executive compensation and managerial excess on this blog (see Op Ed on Executive Pay, The Credit Crunch and Executive Pay, New Approach to Executive Compensation, and Revisiting Executive Pay). But for me, the issue of executive pay is a systemic, economy-wide problem, not simply limited to the financial sector.

That said, there is one thing that has always bothered me about the explanation that somehow managers acted rationally, and that this “rational” behavior to an existing incentive structure caused the financial crisis. That is, it implies that someone else, somewhere, acted irrationally.

For example, Calculated Risk, discussing Martin Wolf’s column (see Financial Reform and Incentives or Reform of Regulation), writes:

[Martin] Wolf discusses how it is rational for management…to gamble when the risks are asymmetrical (huge potential winnings, limited losses).

But this begs the question: Why was a system that provides managers the incentive to make stupid bets like that constructed in the first place? That seems pretty irrational to me.

If the person/people who built such a system were rational, they would have anticipated the deleterious consequences of the system that they were about to enact, and they would have refrained from so doing.

So then who are all these irrational people running around building silly executive compensation systems? Aren’t they, after all, current and former managers – boards of directors, compensation consultants, and the like?

So then remind me again, how can managers be the rational ones??

No real news on GM today. The market largely anticipated the event, as it had been wholly telegraphed by the Obama administration (see Finally a Sensible Approach).

Moreover, as I stated on several occasions, if handled properly, there would be no reason to fear a GM bankruptcy (see Could GM Survive Bankruptcy?). Back then I concluded:

YES, GM could survive bankruptcy, and we needn’t be frightened by the prospects, …no matter how much GM tries to convince us that it would spell the apocalypse.

So here we are post bankruptcy, and as far as I can tell, the world has neither come to an end nor has the economy ground to a halt.

In a broader sense, the market’s lack of response to GM’s bankruptcy sends a signal that the economic future of the United States is no longer dependent on, or inextricably tied to, firms like GM. This is not to say that manufacturing is not important to the prosperity of the United States; rather, simply that the manufacturing future of the U.S. is not about the manufacture/assembly of automobiles. But that’s another story for a different day.

For now then, I’ll simply share GM’s official bankruptcy press release. It was sent to me from our new employees – the kind folks from the new GM, the firm in which you, me, and the rest of the American taxpayers will become majority shareholders. Click below to view the full release.

GM Bankruptcy Press Release

Now back to the fascinating part of the bankruptcy – the impending battle between GM bondholders and the U.S. Government. I would not be surprised to see this battle play out in much the same fashion as the battle between creditors and the U.S. Government in the Chrysler case (see Chrysler Bankruptcy: Anything but Surgical, Legal Issues Affecting Chrysler, and Lessons for GM for background). Nevertheless, as I suggested in my post Lessons for GM:

Although the debt restructuring problems they both face are the same in theory, in the case of Chrysler, it was much easier for the federal government to get Chrysler’s lenders to accept a haircut because the majority of its first lien debt sat with banks that accepted TARP money (e.g., Citigroup and JP Morgan). The government could therefore exert tremendous influence over these lenders.

Not so in the case of GM. GM’s bondholders are a much more diffuse bunch with disparate interests. Moreover, the government has much less of a direct influence over GM’s bondholders.

Although GM was able to reach an agreement, in principle, with many bondholders (see US Strikes Deal with Bondholders), it will be interesting to watch how those who remain opposed to the deal ultimately play their hand.

Now that we are largely out of Q1 earnings season, it might be helpful to take stock of the health of the corporate sector. By many accounts, Q1 earnings were better than expected. The better-than-expected earnings has led some to suggest that economic recovery might be right around the corner – you know, “green shoots” and all (see First Quarter Shows Hint of Recovery). A deeper look at those earnings, however, reveals that they are not all that they are cracked up to be.

It is true that many firms reported earnings that were better than analyst expectations. However, this stylized fact is not necessarily indicative of a recovery in corporate earnings, for the following reasons:

1. Analyst expectations were unrealistically low. Many companies hedged when giving guidance, preparing analysts for the absolute worst. Some companies even refused to give guidance, leaving analysts to founder with their projections.
2. Earnings were down 30% or so from a year-ago level, and nearly 90% over the past two years (see S&P Earnings Decline). No sugar coating it. This was a horrible quarter.
3. Corporations were able to report better-than-expected earnings in large part because they engaged in greater-than-expected cost cutting (see Is Cost Cutting Throat Slitting, ht Anuja). Although cost cutting through layoffs and slashing expenditures can increase earnings in the near term, they can be deleterious in the long run. For example, reducing R&D budgets today can result in a compromised product pipeline down the road. Although cutting costs is the natural (and rational) response to economic malaise, the question remains whether companies cut costs by too much. And it’s not just the firm-specific consequences, cost cutting has systemic implications as well. Many analysts are overlooking the higher order effects of layoffs and capital expenditure reductions on the broader economy. This manifests as the dreaded negative feedback loop – fewer jobs leads to reduced consumer spending which then reduces demand for firms’ products resulting in decreased corporate profits leading to fewer jobs (wash, rinse, repeat).

The key then to the future of corporate profitability lies in whether you believe corporate earnings have bottomed out and will now begin to increase from a lower base, or whether you believe that there is still substantial downside risk that increasing unemployment and decreased consumer spending will continue to put a crimp in profitability. Given the nearly 40% rally in equity markets over the past several months, market participants clearly believe the former. I fear that the latter might be more representative.

All this makes me wonder whether the current rally has legs…

The Geithner Treasury team finally unveiled the details of its Stress Test methodology today (see Supervisory Capital Assessment Program). We will have to wait a few more weeks for the results. Based on early returns, the results are all but a foregone conclusion – most banks will likely pass with flying colors.

So in the absence of meaningful outcomes from the Stress Test, we might be better served by deconstructing the process itself. In this way we can better determine what it might mean for a bank to pass or fail, better assess the results to sensitivity in the data, and ultimately, determine whether the test itself even made any sense.

So what can be made of the process?

It has recently been argued that the “more adverse” scenario should actually have been the baseline (see Stress Test Scenarios or Stress Testing the Stress Test). I agree wholeheartedly. It has been clear for awhile now that the Treasury’s scenarios did not adequately reflect economic reality. There is even some evidence that the economy has already deteriorated to a point where it is currently worse off than the “more adverse” scenario.

That notwithstanding, there were two other details about the methodology (among others) that raise some concern.

First, from p. 4 of the official Stress Test document:

The BHCs [bank holding companies] were asked to estimate their potential losses on loans, securities, and trading positions, as well as pre‐provision net revenue (PPNR) and the resources available from the allowance for loan and lease losses (ALLL) under two alternative macroeconomic scenarios.

My comment: So if I understand this correctly, the Treasury is relying on banks to provide them with an assessment of their current troubles. This is like asking an alcoholic if he thinks he has a problem.

Second, on p. 3 of the document, the Treasury points out:

The economic value of loans in the accrual book is reduced through the loan loss reserving process when repayment becomes doubtful, but is not reduced for fluctuations in market prices, which may be driven by market liquidity considerations…As a result…the results of this exercise are not comparable with those that would evaluate such assets on a mark‐to‐market basis.

My comment: So here we are again in a mark-to-fantasy kind of world, where banks (which possess asymmetric information about the true quality of their underlying asset portfolio vis-a-vis the Treasury) might be able to favorably adjust the value of their assets. In my opinion, the best assessment of the underlying value of the assets on the books is what the market is willing to pay for those assets. The Treasury’s approach, in my opinion, leaves too much room for banks to claim, “It’s a liquidity problem.”

All this begs the question: While most banks will pass, does the Stress Test fail?

Advertising Age recently asked me to write a short Op-Ed summarizing my reaction to the Obama administration’s stance toward GM and Chrysler. You can find the full piece on the Advertising Age website, or by clicking on the accompanying link (The Obama Administration Got it Right).

For those of you who have followed this blog, my opinion should not come as a surprise. I have expressed sentiment consistent with the Auto Task Force’s decision for the last half-year or more (see GM and Chrysler: Finally a Sensible Approach, Pre-Packaged Bankruptcy, Preventing Moral Hazard, and Aid for Chrysler? Just say No! for background).

Given that the decisions made by the Obama administration were largely consistent what I had been advocating, I am sanguine.

From the vault of the sublime, a friend recently e-mailed me a story (hat tip Joel) about how the Topps Company plans to release a set of trading cards depicting the “world’s biggest hoaxes, hoodwinks and bamboozles” (see Topps to Issue Cards with Swindlers). According to Fortune:

This year’s product will…nod to Madoff’s financial chicanery as part of a group of cards featuring the “world’s biggest hoaxes, hoodwinks and bamboozles.” Among the other do-badders in the subset are Charles Ponzi, The Runaway Bride, and Enron.

“These cards feature 20 perpetrators of some of the most notorious pranks, dubious claims, and outright frauds of the last 2 centuries,” boasts a Topps sell-sheet for the collection.

Apparently the “gimmicky” cards depicting the deplorable will be inserted into packs of baseball cards.

Upon hearing the news, I confess I chuckled at first. I’m always game for a good laugh. But then reality set in: The cards would be much funnier, and certainly less crass, had the victims of these “hoaxes, hoodwinks and bamboozles” not lost so much money.

In January I predicted (see Notable Bankruptcies of 2008) that “major” bankruptcies in 2009 would challenge the 383 mark set in 2001 (the high-water mark after the dotcom bubble). I even suggested that it was possible that we could exceed 400 “major” bankruptcies in 2009.

According to Bankruptcydata.com, there have been 90 “major” filings thus far in 2009. Assuming that bankruptcies are equally distributed throughout the year, this puts us on pace for 360 bankruptcies. I fully expect the filing pace to quicken as the year goes on, and as the economy continues to deteriorate.

Below you can find an updated list of what I see as the “noteworthy” bankruptcies of 2009, as reported by Bankrupctydata.com (please note that this is not an exhaustive list):

• Bearingpoint, Inc. (Consulting)
• BI-LO, LLC (Supermarkets)
• Charter Communications, Inc. (Telecom)
• Chemtura Corporation (Chemicals)
• Fleetwood Enterprises, Inc. (Recreational Vehicles)
• Fortunoff Holdings, LLC (Retail)
• Goody’s LLC (Retail)
• Herbst Gaming, Inc. (Gambling)
• Idearc (Publishing)
• Journal Register Companies (Newspapers)
• Lyondell Chemical Company (Chemicals)
• Magna Entertainment (Gambling)
• Masonite Corporation (Real Estate Manufacturing)
• Midway Games, Inc. (Entertainment Software)
• Monaco Coach Corporation (Recreational Vehicles)
• Nortel Networks, Inc. (Telecom)
• Pacific Energy (Oil & Gas)
• Philadelphia Newspapers, LLC (Newspapers)
• Ritz Camera Centers, Inc. (Retail)
• Shane Company (Jewelry)
• Silicon Graphics, Inc. (IT/Computing)
• Silver State Bancorp (Banking)
• Smurfit-Stone Container Corporation (Paper Manufacturing)
• Spectrum Brands (Consumer Products)
• Star Tribune Companies (Newspapers)
• Sun-Times Media Group, Inc. (Newspapers)
• Tarragon Corporation (Real Estate)
• Trump Entertainment (Gambling)
• WL Homes, LLC (Real Estate)
• Young Broadcasting, Inc. (Television)

In addition to “major” bankruptcies (e.g., those firms with assets greater than $50M) tracked by Bankruptcydata, the U.S. government tracks all bankruptcy filings by type (e.g., Chapter 7, Chapter 11, Chapter 13). You can find detailed bankruptcy statistics at the U.S. Courts website. Business bankruptcies for 2008 came in at 43,546, slightly shy of my 45,000 prediction; however, that still represents a 54% increase over 2007, and the greatest number of business bankruptcies since 1997.

The chart above presents annual (calendar year) business bankruptcy filings from 1990-2008 (click on the picture for a larger image). Interestingly, the number of filings had been trending steadily downward from 1990 through 2006. In 2007 the numbers started to reverse course. I expect that trend to continue in 2009, with total business bankruptcies reaching 55,000.

The big story today is the Obama administration’s decisions regarding GM and Chrysler aid (see US Lays Down Terms for Bailout). I won’t spend time re-hashing the specifics; instead, I will provide commentary on the plan as it has been advanced, assuming you already know the specifics.

Overall, I think this plan represents a sensible approach. It recognizes that there is substantial heterogeneity across GM and Chrysler. Their importance to the broader economy differs. GM is obviously the more systemically important firm of the two. Moreover, the two are not on equal footing with respect to future prospects. GM’s product portfolio moving forward is far superior. For these reasons, I have been an advocate of treating GM and Chrysler differently (see Pre-Packaged Bankruptcy, Preventing Moral Hazard, and Aid for Chrysler? Just say No! for details).

Kudos to the auto task force for recognizing this and responding accordingly. As a result, the Obama administration has committed to seeing GM through this crisis. Chrysler, by contrast, is on its own.

The Obama administration will provide additional aid for GM, and has committed to an out-of-court restructuring, provided GM receives substantial concessions from its creditors and its union. In the absence of a meaningful agreement with the UAW and bondholders, at the very least, the US government has pre-committed to act as GM’s DIP financier in bankruptcy, and guarantee its existence through the restructuring process (see Could GM Survive Bankruptcy?). The threat of bankruptcy for GM (hopefully a credible one) should be enough to elicit cooperation from the bondholders and the UAW.

With respect to Chrysler, this is the beginning of the end. The administration has told Chrysler that it has 30 days to strike a deal with Fiat or else it will not receive any additional public funds. This creates a dilemma for Chrysler. It needs Fiat to survive, but Fiat needs the US government to commit a significant amount of capital before it agrees to any deal. After all, Fiat does not intend to inject capital into Chrysler (see Fiasco for Fiat and Chrysler and Fiat Revisited). What is clear is that Chrysler would require significantly more to survive than the $6 Billion that the government has promised in the event that they strike a deal with Fiat (see GM, Chrysler Need More Aid than Requested). Fiat knows that. Moreover, the likelihood that the US government will continue to throw money at Chrysler (in excess of the $6 Billion promised), even if they strike a deal with Fiat, is remote. Fiat knows that too.

So the writing is on the wall. Chrysler is likely finished.

What is unclear to me from the plan as it has thus far been outlined, is whether the US government acts as the DIP financier when Chrysler goes bankrupt, or whether it allows Chrysler to be liquidated. Obama seems to be hinting (as I listen in real time) that the government will act as DIP financier to Chrysler, …but I am skeptical.

Irrespective of whether the US government acts as Chrysler’s DIP financier, Chrysler will serve as a lesson to GM, its creditors, and its bondholders union. Allowing Chrysler to go bankrupt should be enough to wake up GM’s creditors and bondholders union to the reality that US taxpayers will not support them indefinitely.

As a first shot over the bow, the Obama administration began by ousting Rick Wagoner.

UPDATE @ 11:30am

One last point, some have been asking why not just impose bankruptcy now (at the very least for Chrysler) if that will be the endgame anyway. I think the answer to this question lies in the shock that would have reverberated throughout the market. A sudden bankruptcy would have caused panic among stakeholders of all sorts. At this point, bankruptcy for Chrysler is all but assured. Bankruptcy for GM is a real possibility (perhaps 50/50). So the point of today’s action (stopping just short of imposing bankruptcy) is to forewarn market participants. Given this information, it would be prudent for those who have a stake in this outcome to get their affairs in order.

Several months ago, Fiat announced an alliance with Chrysler in which it would take a 35% ownership stake in Chrysler. In a post entitled Fiasco for Fiat, I discussed the alliance’s prospects for success, and what the deal meant for Chrysler and its creditors. With respect to Chrysler’s outstanding debt, I wrote:

As a Chrysler creditor (a U.S. taxpayer), anything that increases the likelihood, even infinitesimally, of receiving a return on my investment makes me happy. The U.S. taxpayer (and by corollary, the U.S. government) should therefore be positively predisposed toward this deal, taking comfort in the fact that, at the very least, in exchange for a 35% ownership stake in Chrysler, Fiat should be commensurately responsible for 35% of the liabilities. This should come as welcome news, assuming Fiat can keep Chrysler viable long enough to repay the U.S. government.

I then expressed incredulity at Fiat’s willingness to sign itself up for 35% of Chrysler’s liabilities:

Personally, I can’t believe that signing up for 35% of the liabilities of Chrysler would not be enough to scare off Fiat, …or any other potential investor for that matter.

But who am I to object. Caveat Emptor.

Well guess what?? Surprise, surprise. Fiat is not willing to assume 35% of the liabilities. According to recent reports (see Fiat Not to Take Debt), Fiat, while interested in owning 35% of Chrysler’s upside, is not interested in inheriting 35% of Chrysler’s problems. It’s like Geithner’s Public Private Investment Partnership – Fiat wants to be able to benefit from the upside while Chrysler’s current shareholders/creditors bear the downside risk (heads I win, tails you lose). According to the AP article:

A public tiff between Italian automaker Fiat SpA and Chrysler LLC apparently ended Friday when Chrysler rescinded a statement on its Web site that Fiat would be responsible for part of Chrysler’s debt if the two companies join forces.

Chrysler, in a Web video on Thursday explaining why an alliance for the two companies would be good for Chrysler and the country, said Fiat would be responsible for 35 percent of what Chrysler owed to the U.S. government.

But Fiat on Friday denied that it would be responsible for any of Chrysler’s debt.

…Chrysler, in a statement issued Friday, reversed the claim it made on the Web and said Fiat would become an equity holder.

“To clarify, this does not mean Fiat would assume responsibility for any of Chrysler LLC’s debt,” the statement said.

Fiat Group said in a statement Friday said it “intends to make absolutely clear that the proposed alliance will not entail the assumption of any current or future indebtedness to Chrysler.”

I have to admit, from a transactional perspective, I am not sure exactly how such an arrangement could be structured – i.e., how a firm can acquire 35% of the residual claims to a firm but not also be liable for 35% of the outstanding claims on the firm. Call me crazy, but that’s what I thought “ownership” meant. But that’s something for the lawyers to figure out.

What most interests me is what Fiat’s lack of commitment to Chrysler might mean for Chrysler’s prospects of receiving additional government aid. Answer: It cannot bode well for Chrysler.

Personally, I do not believe Chrysler deserves additional government loans with or without Fiat (see The GM and Chrysler Plans, Aid for Chrysler? Just say No! and Is the End Nigh for Chrysler? for details). That notwithstanding, the latest Fiat developments cannot help.