“Do you do this?” my correspondent asked. “Any comment?”

And I replied that the only person I would trust to comment was someone whom I had admired for many years but had never met.

That person is Lewis H. (“Harry”) Spence, a Harvard-trained lawyer who has taken a number of high-profile municipal and government turnaround assignments. He was receiver of the Boston Housing Authority in the 1980s, receiver of the city of Chelsea, Mass., in the ‘90s, and then deputy chancellor for operations of the notoriously bureaucratic New York Board of Education.

I had always been interested in the Chelsea assignment because of its relative rarity and unqualified success, but it was during the New York assignment that I tore an article about him out of The New York Times. Mr. Spence said something to the effect that he took on the lowly Board assignment after some spectacular success elsewhere, because his own spiritual journey taught him that it did not matter who got the credit.

This was clearly not your usual Brooklyn bureaucrat.

Harry then went on to become commissioner of the Massachusetts Department of Social Services (DSS) after that organization had a spate of tragic child abuse scandals.

He now teaches at Harvard, where I caught up with him by phone.

Q: Tell me about your assignment at Chelsea.

I initially thought it a pure financial assignment – that the city was poorly managed. But within a few days, I sought the advice of a mayor of a town nearby, and I asked him what he would do. He advised getting rid of what he called the gambling machines …. And I said, “What gambling machines?” It turns out that for many years, the town had been mob-run. It was the poorest city in the state, but it was one of those places that had a lot of social clubs. The machines would subsidize the club, and the mob would grease the palms at all levels, including the mayor, in order to protect the franchise.

By formal agreement, the vice squad reported to the mayor, instead of the chief of police. This made it easier for mayors to directly control the gambling payoffs.

Q: So what did you do?

I called in the police chief, and told him that within a couple of weeks, I wanted a signed affidavit that there were no illegal gambling machines left in town.

Q: But were the machines the root cause of the problem?

Mob rule was the root cause. They decided to kill the golden goose – probably because they saw the city going down faster than they could control, so they accelerated the payoffs and corruption, especially in the real estate development process.

They never believed anyone would intervene on behalf of the city. But once they saw the machines gotten rid of, they realized change was for real. Although a funny side show occurred when one mobster tried to arrange to have the high school cheerleaders demonstrate to return the one-armed bandits.

At the same time, the U.S. attorney’s office came in. Once the prosecutions started, the bad guys started to turn on each other. This gave us breathing room on the practical side.

The people knew something was wrong, because corruption at the street level caused the city to go broke when the rest of the region was booming.

The real financial turnaround occurred when we raised city fees at all levels, contracted out parking meter collection, closed a fire station, stuff like that.

Q: What about development?

The development process was so corrupt that every responsible developer stayed away. The development process didn’t just fail … it was stolen at gunpoint.

Q: So is there a broader lesson to be learned here? For, say, Benton Harbor?

The mob likes cities in desperate decline. So a question for a Camden, N.J., or Benton Harbor is, if you see substantial increases in drug dealing or so-called adult industries (i.e., sex trade) you should be aware that you have now got another level of problem on your hands, because these industries are mob-controlled.

As a matter of fact, in Chelsea, the only time we heard publicly from the mob figures was when we published our economic development plan. They came out in vehement opposition. They did not want to see a vibrant city emerge.

Q: What about cities that are going broke now?

Chelsea was only the second city in U.S. history to go bankrupt since the Second World War. It was a shocking thing at the time, but in the last three years we have seen a substantial number of municipal crises arising out of economic conditions generally. So it is a more mixed story today – both economics and mismanagement are causes.

Q: What would you do now?

I would spend the first six months doing two key things. First, develop a serious team by both recruiting new people and developing the existing staff. Conduct intensive meetings so the staff knows that they can act independently in service delivery. And that they should interview other staff in the middle and lower reaches on the town structure to continue that message, and also learn firsthand what the roadblocks are.

You also want to hear the history of the place – find out what has worked in the past. So that gives a positive message for people and something to aspire to. Because there will be a great deal of anxiety left over from years of damage to the organization.

You also want to make the workings of the government more open and transparent. There is what I call a first law of fundamental dysfunction, and that is make everything as secret as possible. You have to break that law to get people to come around.

Lastly, you need to find the possibility of economic development. Otherwise you are only in a position to cut services and reduce costs, and that becomes a vicious cycle.

So an overarching question is always, what is a realistic development plan? For many places in the U.S., I imagine this part is much harder now than it was for us in the ‘90s.

Q: On reflection, what common features do you find in your assignments?

All of the organizations suffered because the constituency was impoverished. Poor people generally don’t know how to get accountability from the system. This was especially true of DSS, where the constituency was abused children.

In many of these situations, the political accountability mechanisms have failed. So the key task is to remind the larger organization that they need to broaden their concerns beyond bureaucratic survival.

Q: And what are you doing now?

I am teaching management and leadership at Harvard. I am interested in the concept of the “passionate organization.” We are asking why is it that many organizations literally drive the passion away? Is it possible to reignite that passion?

The answer is that it is possible, but uncommon.

One reason is that staff and management have a bad dynamic. Staff generally come to a governmental enterprise believing in the goals of the enterprise. These goals align with their own values. But leaders, often unconsciously, betray those goals in service of their own egos – self-protection or self-advancement. Staff then lose faith in the enterprise’s commitment to its mission, and turn their backs on the larger organization, trusting only a few close coworkers.

Rather than engaging in compliance requirements to demand commitment to the enterprise, new leaders need to re-establish the moral compact with staff that all, including the leadership, are called to serve not their egos, but the purposes of the enterprise. It’s my experience that the restoration of that moral compact revives the original passion and commitment of most staff to the purposes of the enterprise.

So the passion is there! We try to show that large organizations can restore a moral component to the mission, and that management is committed to that component. This can help the staff to revive that long-suppressed hunger for the mission, and for that essential part of themselves.

Q: Even at the municipal level?

Years after my Boston Housing assignment, I was stopped by a cop in Boston. He said, “You don’t remember me, but I worked in public housing when you were there. My buddies and I still get together to talk about that. It was the most exciting job in our lives.”

Many thanks, Harry.

It has been, for many years, one of the most-studied and most-improved-upon models in financial history. It is also arguably the precursor to the consumer-oriented credit models we are so familiar with. If Ed Altman had started a ratings agency instead of an academic career, he would probably be one of the richest people on earth.

After I began consulting to companies wishing to improve financial results, I started to formulate my own predictive model. I called it “the humility business,” because I observed that large companies with big problems had two overarching conditions in place: large debt and an ambitious CEO.

And ambition was the leading indicator. The first time I thought of this I was watching a TV commercial for Eastern Airlines, which had just entered bankruptcy. The new CEO paid a bundle to blanket the airwaves with a commercial showing him standing in a hangar, announcing to the remaining employees that the company was entering a first-class-only marketing push.

That is, the company had already publicly and legally admitted that it could not pay its debt, and therefore was seeking court protection, and was going to spend cash that would otherwise go to its legal creditors in order to convert every plane in the fleet to his new and unproven venture.

“What audacity,” I thought, “unbalanced by any humility.” There was apparently no long-term financing plan, marketing, pricing, or costing. Just this guy on TV telling people how he was going to save Eastern.

The company folded permanently soon after the required financial reports got to the bankruptcy judge. Chapter 11 gives control of the business to management as long as they act as a fiduciary to creditors. Spending millions of dollars on new first-class seats when creditors were waiting for their old debt payments did not qualify as fulfilling that responsibility.

For a while after that, I would speak to business school classes on turnarounds and propose that we play a game, nominating and voting on companies that have high debt and overarching ambition. These, we would predict, would go into bankruptcy. Only later – perhaps months later – would we find out if we had correctly picked winners.

The predictions always came true. Federated Department Stores was a winner, as was Northwest Airlines. Another notable winner was Mr. Donald Trump, who won twice, once for a casino venture and another for a hotel venture. They both, in fact, entered Chapter 11.

In 2005, I stopped doing the game at business schools, because a class at the UW-Madison nominated and voted for the U.S. government going into the equivalent of bankruptcy. I thought the answer was foolish on its face.

Maybe, given the events of this week, I should have trusted the model more.

Anyway, now I work with middle-market companies and have come to another realization: Entrepreneurs do not easily ask for help. They are energetic, relentless problem-solvers and often feel that the issues that their companies face are close to being resolved.

They think they need just one more marketing call, one more new product push, one more new idea to implement.

As a matter of fact, entrepreneurs are so restless in their problem-solving that I have a good predictor for when someone might need some outside help: lack of sleep. When business problems are so pervasive that the businessperson goes over them obsessively throughout the day, thinking about them often continues past bedtime.

Not that the person complains. But a loved one will frequently put down his or her foot, strongly suggesting that that lack of sleep is a health hazard. Then I meet the businessperson, usually introduced via an attorney or accountant I have worked with before.

Is lack of sleep that best predictor of a middle-market company needing outside assistance? Probably not, because it is an emotional indicator, and not an objective one.

So I recently formulated a self-assessment questionnaire that might address the major issues of a middle-market company needing some practical help. It covers marketing, organization, safety, operations, and finances. It is not designed to be a scientific study – it’s more of a checklist for that restless entrepreneurial mind. But it also asks if sleeplessness is an issue.

I have a beta version on my website: It can be found here.

Feel free to look it over. I would appreciate any feedback you might have on the test, the conclusions, and what you might have learned from the exercise.

In 1939, my grandfather’s house was repossessed.

Not in 1929, the year that the Wall Street crash signaled the beginning of the depression. It was 1939 – after nearly 10 years of faithful payments on the family’s sole investment.

It was a small three bedroom Tudor-style house with an oak tree the family planted upon moving in. It had housed a family of five until my father went off to college. It was 90% paid off at the time of foreclosure.

When the house was lost, my father also lost his chance at college. He came to the new family home, a cold-water flat in a not-so-nice neighborhood, and got a job as a messenger.

This story haunts me because it happened 10 years into the depression. One can only imagine that the family had thought they had bested the bad times, keeping payments up on the house and all. Certainly, it is hard to imagine that during the 10 years the family would have contemplated losing the house. But the depression lasted longer, with more ups and downs than they imagined.

We had our crash in 2008, with the failure of investment institutions and the announcement of a financial rescue plan even as the government had a hard time articulating the cause or effects of the crash.

So now, in 2011, what year are we in? Are we in a safe and secure post-crash recovery, or are we bouncing around, just waiting for our 1939 to cause disaster?

To answer the question, I searched on the internet for graphs on long term economic trends. Let’s see what year the economic data of today most resemble. Since I looked at graphs, I don’t precisely know that the stats and these are generalizations. Take a look here for an idea of all this data in one place.

• Housing starts – 587,600 in 2010. The average for the prior 20 years was 1.5 million. The last 50 years saw a low of 843,000.
• Home prices. The index of 115 is the same as about 2002 – just as we were coming off the post 9-11 shock.
• Capacity utilization. How busy are our factories? About 77%, same as 2002 and 1984 – both recovery years.
• Inflation. Consumer prices as calculated by the labor department (they will reflect lower rent costs, even though almost no one is paying lower rents): 1.1%. Same as 1955-56.
• GNP – well, it looks like 2007. That means GNP per capita is probably more like the late 1990s, due to population increase.
• How are our exports? Fifteen percent, same as 2009 and 1958, both recession years.
• Cost of natural gas. ($mBTU) $4 – the same as 2003.
• The savings rate is about 5%, about the same as 1995. The current trend is up, and the trend in the ’90s, as we now know, was headed to zero.
• Employees in the United States appear to total about 130 million. This is the same as 1996. The resulting unemployment rate of about 9% was last seen in the 1981 recession.
• The government deficit as a percent of GDP is about 8.9%. This is the same as 2009, and before that the graph hits that level in 1945.
• The Dow Jones average of 30 industrial stocks was at the level of 12,000 in 2007 – on the way up to 14,000 before the crash.

What’s my conclusion? I think we have the continued fallout of years of overinvestment in the wrong things and underinvestment in the right things. Wrong things were big houses, the right things productive capacity. The lack of demand is shocking. (Developed economies are NOT supposed to give back 15 years of prosperity at one shot.) So the government deficit is going to stay high for a while, I predict.

Because the simple math is that if the government deficit is reduced by 4 percentage points to equal what it was (as a percent of GDP) in 1986, the reduction would cause almost a dollar-for-dollar reduction in GDP.

That puts us back in recession. Some more of us could lose our houses. We could go back to 1939.

However, if we do not make medium term (say 3-5 years) plans to reduce the deficit, the international markets could decide to reduce it for us. And then we definitely replay some very bad years.

I. Capping CAPM

A Google search on the Capital Asset Pricing Model returns over 1.2 million hits. This model, taught in finance courses as “Cap-em,” indicates that the expected rate of return of a security is the risk-free rate PLUS beta times the difference between the market rate of return and the risk-free rate. Beta is the variability of pricing of the asset:

Ra = Rf + ß(Rm-Rf)

In other words, a security is priced based on the risk-free rate plus the expected variability of return.

In millions of texts, the risk-free rate is the U.S. government security of the appropriate term, say 10 years.

And millions of students instinctively understood the risk-free portion of the formula, but struggled with the concept of beta and risk. How do you calculate beta? If beta is a calculated variability, what is the appropriate time period to use for the variability?

Interestingly, with the publication of Nassim Nicholas Taleb’s The Black Swan: The Impact of the Highly Improbable, we began to see that our understanding of variability, and therefore risk, was limited to our own preferred time horizons. We tend to view risk as what we have experienced recently. If house prices tended to go up recently, the risk of them going down, to us, appears small.

Taleb showed us that “black swan” events (nuclear accidents, tsunamis, market crashes, political upheavals) are more likely than our own limited experience has led us to believe. Markets had been underpricing the risks of these events in securities.

And now, zealots in Congress have taught us a new CAPM message: that the risk-free rate is not risk-free, and that the U.S.’ full faith and credit can be taken hostage.

Millions of textbooks will have to be rewritten, and we as a country will be infinitely poorer for it. Because when all the securities-holders in the world are not sure what the price of their asset is based on, markets will lose value, probably dramatically and perhaps permanently.

Just ask the black swan.

II. Accounting for Murdoch

The questioning of Rupert and James Murdoch, chairman and CEO and deputy chief operating officer, respectively, of the family-controlled News Corp., could have used a little business discipline.

Rupert made it sound as if the whole enterprise was an amalgamation of people that he trusted but should not have. If one believes this story line, one could have felt sorry for the man.

The first question is on product. If the editorial product has consistency and (ahem) integrity, there should be policies and procedures regarding the role of the editor. The editor is the quality assurance officer for editorial.

What do those policies determine to be the level of investigation the editor pursues in any story? Fact-checking? Source identification?

What about keeping notes and source documents for later follow-up and, as appears inevitable in Great Britain, defense of libel suits?

Investigators should focus on the policies, procedures, notes, and documents – or perhaps the lack of them.

The second is accounting. What are the approved expense levels for each executive? What are the controls, over all material expenditures? (And $3.2 million in out-of-court settlements is certainly material.) How is it that someone can demand a check from accounting and simply say that it is for James? If that is true, as reported, there would certainly appear to be a lack of financial control in the company – except by family members.

The board of directors has a fiduciary (that is, protective) duty to News Corp. shareholders. They, and the appropriate financial authorities, should be investigating to find the answers to these questions.

A recent article in the Wall Street Journal was titled “Congress’s Carried Interest Tax Folly” (May 24, 2010). The subtitle was, “The latest soak-the-rich scheme will mean less capital investment and fewer new jobs.”

I may agree with the sentiments of the headline, but on the facts, the sub-head is all wrong. One only has to turn to the first paragraph of the article, which states that “Congress is preparing to enter into a tax increase in long-term investment,” to find a falsehood. The fact is that Congress is preparing a reversal of a tax break won for many years on the so-called carried interest income of partnership fund managers, not investors.

To make this clear, let’s define the parties. The fund manager arranges for investors (typically pension fund, wealthy family or university endowment) to invest. The cost of the manager’s services includes two fees: one expressed as a percentage of the monies earned (say, two percent per annum), and a second fee that gets paid based on part of the hoped-for eventual success of the investment. The success portion of the fee is called the carried interest. Fund managers are often general partners in partnership investment vehicles, and it is in that specific role — general partners — that the tax on managers’ carried interest is expected to go up.

This is a big concern to some because the investments that many fund managers have been putting money in — LBOs, venture capital, real estate — have not done as well as they did in the late ’90s and early 2000s. The managers are feeling that additional bad news could irrevocably harm their interests, or even their industry. I don’t know if that is true or not, but it is certainly an argument that I would like to hear, as opposed to the poppycock from the Wall Street Journal claiming less investment capital and fewer jobs.

Why is the tax going up? Because Congress is considering a reversal of a curious loophole that heretofore has been available only to the general partners. The loophole treats the general partner’s carried interest as a long-term capital gain.

But carried interest is not an investment. It is simply a contractual arrangement made by a fund manager seeking — dare I say it? — a tax on the results earned by the capital. Contractual arrangements of this type have traditionally been seen by the IRS as ordinary income — the same way royalties on music, a contractual arrangement relating to uncertain future income, is seen.

For individuals and most corporations, royalties and carried interest both get taxed at ordinary rates.

So if Lady Gaga (the person) sings a song and gets taxed at ordinary rates, why would we give preferential tax rates to her if she formed a partnership to collect royalties? We wouldn’t.

So why would we for certain fund managers?

Power politics, defined here as wealthy fund managers lobbying for a loophole, is the only difference. The unwinding of the advantage is being portrayed as an uneconomic venture when, in fact, it is simply reversing the unfair, rent-seeking gain that the partnerships are seeking over the rest of us.

To test the veracity of the argument, consider this: if the taxing of carried interest on managers is changed back to its original contractual basis, will the investors — the pension funds that provide the capital for the venture — invest any less?

Or putting it another way, if Lady Gaga were to form a partnership and her agent is taxed differently, would she sing any less?

I don’t think so. And if you counter that the price of funds management will go up because the tax treatment is being changed, tell me this: did it go down when the industry got its bargained-for exemption?

But there is no appetite to revive the Obama administration’s fiscal stimulus, which apparently intended to give states block grants to keep doing what they were doing, or to provide nimble political ear-markers with the big cardboard checks suitable for press-release photos.

I take no pride in saying this. There is (or at least, was) an argument to be made for government spending in the time of a debt-fired liquidity trap (which is when people and companies are paying down debt and not using cash to be someone else’s customer).

Here is the argument: the economy is made up of consumption, investment, (usually small) net exports, and government.

When there is a terrible decline in consumption and investment, government can step in.

That is what President Franklin Roosevelt did in the mid-1930s: created visible and meaningful work for millions, all on the public dime.

But the country won’t stand for it in 2011.

Another government stimulus came in the past year by way of the Federal Reserve, which instituted two rounds of so-called quantitative easing, designed to add money to the economy. The theory here is that since banks are taking money out of the economy, the Fed’s purchasing of government securities would put real cash back in, through bond dealer desks and the banks’ own checking accounts.

This appears to have worked, in its limited way, as the investors put the cash into the stock market, propping up asset prices. People tend to spend a portion of their newfound wealth, as we discovered when both stocks and house prices were going up at the same time.

But it is debatable as to how much actual spending has trickled over to Main Street as a result of QE and the desire for wealth effects. I think we all still feel pretty poor.

So I suggest we do a Main Street-only stimulus plan. I call it:

“Buy loan maturities.”

Okay, gotta work on the program name. But it will more directly affect the fortunes of small businesses than either the fiscal or monetary stimulus plans have done.

Here is the proposal: the Federal Reserve will pay out a portion of any loan maturing in 2011 and 2012 that was made to a U.S. employer of five to 1,000 full-time people. The bank being bought out will administer a 48-month extension of those maturities on behalf of the Federal Reserve.

Why these dates, amounts, and timetables? To change the economic psychology and get the Main Street juices flowing.

Because most companies have been feeling that they must reduce the risks inherent in owing bank debt. And the banks have been feeling that they must either reduce the number of loans outstanding – especially to the problem, slow-paying borrowers – or to raise more capital. So they have chosen to reduce the loans.

So everyone is in debt-paydown quicksand, and they are not hiring.

But if the competitive landscape is changed by companies being free to invest in expansion, they might do so. The reasoning is that, if they do not, their competitors, buoyed by the same program, and understanding the opportunities during this period, might.

So the reinvestment of nearly two years of bank principal could result in new capital spending, new retail expansions, and new hiring.

By definition, the program would reach out-of-the-way communities as quickly and as effectively as the former program enriched the bond dealers. A little bit of movement on the local front could mean new people moving in, old people selling or renting their houses, a new spring in the step of the community.

The practical side can be worked out – and I am not concerned that this should be an issue. My only concern is that the program be big enough to make a change to the liquidity, stability, and propensity to invest in our middle-market companies.

Because they represent 80% of the hiring in the country, and only changing their fortunes will mark a change to the unemployment rate

The Hole of Wit

May 4, 2010

Let’s talk about the state of our national dialogue, which has become increasingly strident, with name-calling, character assaults and thoughtless throw-offs the standard of the day. It is tiresome stuff. In bars perhaps this can be expected, but in our media (including blogs) we need to strive for a higher standard.

My fear is that national derision, which is more potent today given the technology at hand, will literally tear the nation in two. In last-century Spain, taunts devolved into political meetings, riots and a civil war.

We need to ensure our efforts are safer, as well as more entertaining. What we need is more wit. It provides a standard of intelligence, as well as self-protection. I have four prescriptions for this:

1. Be original. Remember the first football spectator you saw shirtless and in body paint? A heavy set guy, rooting for his team in a snowstorm? He made a statement about the team and about himself. He brought a smile and created a memory. 

   The second guy to take his shirt off? Just a future pneumonia patient who needed a shower.

2. Show some grace. The true sign of a wit is a sign that you are willing to concede something to the other point of view. Give a little. You get extra points for self-effacement at the same time. The gold standard for this in our time is Ronald Regan’s criticism of Bill Clinton in the 1992 Republican convention. Reagan had always been criticized for being too old for government work, and his speech tipped his hat to an old adversary, Senator Lloyd Bentzen, by borrowing his words in a new way:”This fellow they’ve nominated claims he’s the new Thomas Jefferson. Well let me tell you something; I knew Thomas Jefferson. He was a friend of mine and Governor, you’re no Thomas Jefferson!”

   You don’t care about grace, you say? Well then, you have two choices: either be forgettable, or show no grace. If you are forgettable, why bother? And if you want to show no grace, are you willing to be remembered for it?

3. Measured. Hey, take it easy! I was once fulminating about one thing or another and a friend stopped me. “It’s as if you think this is the end of the Republic,” he said. “We’ll survive that, don’t you think?”
   He was right. I was taking the headline of the moment and making it into an epic of disaster proportions. Taxes, education, energy, even military might … all are topics we can discuss today and tomorrow. No topic is worth ending the discussion forever. Only nuclear bombs have the final word.
4. Secular. Messiahs and prophets know the mind of the Almighty. But these people are in short supply and probably don’t need a blog. What is not currently in short supply is the number of figures who confuse their opinions with sacred words. Dueling religious prescriptions do not change any minds.If you are simply interested in using your spare time to declaim your faith, might I suggest you go door-to-door? Among other benefits, you will experience an abundance of healthful fresh air