Back in late August, I wrote a post discussing my initial thoughts about Michael Lewis' The Big Short. I began the piece with a nod to online shopping and economic efficiency by writing,
"I went ahead and bought two of his subsequent books, Moneyball and The Big Short. Incidentally, in keeping with the times, I ordered both as nearly-virgin, used copies from Amazon resellers for no more than $10 each, including shipping. The latter arrived looking every bit like a brand new, unopened book."
Imagine my surprise when a reader contacted me yesterday and wrote, among much, much more verbiage, most of it economically illiterate and whiny, in two emails,
"But this this email doesn't concern that--it's about your recommendation to buy Lewis's book used for 6 bucks. As an author, that suggestion is appalling to me and displays a profound lack of knowledge of what it means to be a writer in America or how the publishing world works, and how the writer gets screwed if you follow that advice.
Most of us, especially literary novelists, need other jobs. We need people to buy our books new. It means survival. It means getting published again. I sold about 3,500 copies of my first novel. But it is estimated I have sold more than twice that many "used." Not only didn't I get a penny in royalties from those books, I didn't get credit when I went to sell my new novel. I happen to be in a rarefied position as a novelist with a great and sympathetic publisher. Had I chosen to try to go to a "big house" as many of the agents I spoke to urged me to do with my second book, the difference between selling 3,500 on a medium sized, if prestigious press vs. 7,000 is huge when asking for an advance. If I'd originally signed with a big house and sold three thousand copies, there's a good chance I wouldn't even have gotten a contract offer for a second book.
Of course, my primary aim is to have people read my work.
I've done scores of panels and readings over the years and I ask the audience to buy new books of living authors. Fine by me if you want to buy Gatsby used.
I work as a university professor teaching novel and short fiction to grads and undergrads-- 3/4 pay for full time schedule of teaching and I've been doing it for a decade. I edit a literary magazine for minimal pay because I love it. My choice.
When you buy a used book from a discount seller, I consider that piracy- you are getting my creation/work and I don't get a dime. Not my choice at all. I have done the work and I deserve to get paid for it. Those people making a living reselling books would have my respect and could resell all the books they want if they paid a rightful sum to the author. All I want is the 12- 15 % per cent of what they sell it for- what I'd get from a full price pb book. Unfortunately, there is no way to police this even if it were made legal.
By saving six bucks in paying a reseller you may think you're being smart and saving money (or as my mom would say "acting like a cheapskate.") That is short sighted and wrong headed. If you believe in the Social Darwinist concept of survival of the most amoral and selfish, with profit as the only consideration, then I understand your position and there is nothing to discuss."
A few passages from my replies to this teacher/editor/author were,
"What about all those people who now make a living recycling books people don't want and reselling them? And all those saved trees, heaven forbid, if you are a Greenie.
Sorry, but you sound like one of those people in Maine who used to wail about wanting the good old days of lush jobs making shoes so that Americans could pay twice as much for them, instead of realizing a higher standard of living from Asian-made footwear.
My advice is to rely less on printed material and figure out your pricing strategy for online copies.
I will continue, where appropriate, to remind people to buy excellent used copies, like new, for as little as $6, plus shipping.
Especially if they want the book, but loathe the author!
Totally understand your refusal to sign used books. Agree galleys are illegal.
Look, if you want to write, write. And accept that the market will pay you what your work is worth. Period. When someone like you begins to whine about 'art,' it usually means you want a subsidy to pursue you pet projects.
You missed you era- as a state-supported artist in the Soviet Union. I sense a kinship between you and that mindset.
I highlighted what I consider to be essential passages from the reader's and my emails in color (blue for him, red for me).
It's funny how some people want the laws of economics suspended for themselves. But not for others.
My reader assures me that his "primary aim is to have people read (his) work." But spends two emails griping that he can't get paid what he feels his work is worth.
Well, I'm a writer, too. I write this blog daily, and have done so since September 15, 2005. I've written almost 2,000 posts. Many are linked, reposted, cited, etc. on other media. I don't get a dime for most of it- just a measly $15 or so per month for a redistribution agreement which allows that distributor's customers to copy and use my (and other bloggers') content without copyright violation.
I write for several reasons. First, to anecdotally reinforce my proprietary research findings. Second, to maintain my strategy development and analytical capabilities. Third, to contribute my own insights to the general mix of business-oriented media. That I do so for free, of course, essentially aids in depressing the value of all such content.
Just over three years ago, my posts concerning GE and Jeff Immelt's mismanagement of the firm were noticed and read by the staff of Fox News' Bill O'Reilly's The Factor program. I subsequently appeared on an episode to discuss that situation. Such is the occasional influence of even a free blog like mine. I have about 50 readers who follow via RSS feeds and, depending upon the week, between 60 and 100 average daily visitors. Substantially more when I write a popular column which is found by readers searching on the topic.
The truth is, the combination of digital and online technology makes all content- video, text, audio- expensive and difficult to publish without losing control or accepting that copies may be resold with no more revenue accruing to the content creator.
I'll bet my whining reader thinks it's wrong and illegal for the buyer of a living artist's painting to resell it and keep all the money from that sale.
Here are my thoughts on the reader's arguments.
First, one's creative published work is worth what others will pay. Period. Not what you wish they would pay, or think they should pay in some other, ideal parallel universe.
Used books have been around, bought and sold, for hundreds of years. Moving it online to Amazon makes it far more efficient. And efficiency does matter. That's what economics does- finds efficient means of production of desired goods and services with fewer resources. In this case, the cost of finding and acquiring used books is much lower than in pre-Amazon times. And fewer trees are cut, energy used to acquire a used book.
Knowing this, an author has a choice regarding pricing. It is simply ludicrous for my reader to demand an ongoing royalty from each sale of a specific copy of his book. I suppose the only way to emulate that is to sell only to lending libraries, and at prices which capture the multiple-usage nature of that channel.
Or publish his works in the same manner as music services which only rent out the use of songs for a defined period of time. If rent isn't paid, the song's usage license expires. Same with downloadable video which expires after a specific time period has elapsed.
So my reader has choices. He just seems not to like them. Yet he chooses to continue to write and attempt to publish.
Second, he's a little late to the game in terms of even bothering with publishers. I recently read a Wall Street Journal piece which focused on an Amazon top ten-selling book which was self-published. There are now choices for how to electronically self-publish and distribute one's literary product. With the continuing demise of bookstore chains, it's debatable for how long conventional publishers will matter all that much to the average non-textbook author.
I had this very discussion with a friend who is a recently-retired English teacher. His wife is becoming an Amazon reseller in order to recycle my friend's extensive collection of used books. He agreed that self-publishing is the more sensible option for most individual authors of creative writing.
Third, whenever you read or hear someone complain about being treated unfairly when they freely enter the market to sell their labors, you should suspect their logic and/or motives. What we have in the case of the reader who emailed me is, I believe, the struggling/wounded artist who simply thinks that because he is an artist, he deserves the value he places on his work. That society should arrange things so he receives that.
Thus my remark about his missing his calling as a writer during the height of the Soviet era. Assuming he'd have accepted everything else about that era's Soviet system.
And, by the way, as an example of his lack of clear thinking, just because an author is dead does not mean my reader should condone buying that author's work as used. His position, to be consistent, should be that nobody should ever buy a used copy of any book not in the public domain if a single new, unpurchased copy exists somewhere. After all, the rights to royalties of such books are owned by someone, even if the author is dead.
I don't resent being told I'm a "cheapskate" for buying excellent, like-new used books. It's no different than buying something on eBay, at a consignment shop or estate sale. Or a house!
Recycling previously-owned goods is as old as humanity and trading. It's basic, sensible human economic behavior. To now rail against buying used books from Amazon, but not decry the purchase of any used item ever, is to be a technological Luddite. Which I believe my reader is.
I don't buy used clothing or cars. Everyone has their particular behavior process with respect to how they value various aspects of various goods. To me, a like-new copy of a book is well worth purchasing at a fraction of the list retail price. And I'll do it whenever possible.
It's just good economics. It effectively improves my standard of living.
If my reader doesn't like the fact that I, and, evidently, tens of thousands of other Americans put no psychic value, for which we will pay, on only buying unused, new books, well, I don't care.
It's not short-sighted. Most authors write because they want to write. They know, or can estimate, the economic value of their work beforehand. None to my knowledge expect to earn money from the resale of their used works.
Saturday, October 01, 2011
Friday, September 30, 2011
HP Gets It Almost Right Compensating Meg Whitman as Its New CEO
I recently wrote about the effect on the mass of unemployed managers seeing Meg Whitman, an HP board member and ex-eBay CEO, become the new CEO of HP. Specifically, I claimed that it was painful for those unemployed former corporate executives to,
"see Whitman asked to take a lushly-compensated job for which even pundits on the business cable networks this morning assert she has no serious credentials to qualify."
So I was partially pleased to read in this morning's Wall Street Journal that Whitman is working as a dollar a year CEO.
Good for her, and good for HP's board.
Here's the rest of her compensation deal, as reported in the Online Journal today,
"Whitman also was granted options to buy 1.9 million H-P shares over eight years. She can’t cash out most of the options until H-P stock’s price reaches 120% or more of the company’s current share price. Whitman’s target bonus for fiscal 2012 is $2.4 million, H-P says."
The print version is slightly different. It says that HP stock has to rise by 40% to fully pay out. It also says the "maximum opportunity equal to 2.5 times the target, subject to performance criteria."
Well, it's close, but no cigar.
You see, were there to be an unexpected upsurge in the S&P, HP's equity price will be lifted, regardless of Whitman's accomplishments, along with the index.
What HP's board should do is condition Whitman's payout on HP's equity gaining 40% above the S&P over the period, and no more than, say, 2 out of the 8 years having a total return less than that of the S&P.
That way, Whitman is conditioned against both rises and declines in the S&P which would make the 40% target meaningless.
I don't frankly understand why boards full of allegedly smart members fail to insulate CEO performance from the obvious correlation of the firm's equity price with the broader market.
If Whitman can keep HP from declining as much as the S&P in a severe downdraft, or propel it 40% above a rising S&P, then that's worth the bonus she is being offered.
But it has to be flexibly conditioned to account for the S&P's performance, not simply fixed over time.
"see Whitman asked to take a lushly-compensated job for which even pundits on the business cable networks this morning assert she has no serious credentials to qualify."
So I was partially pleased to read in this morning's Wall Street Journal that Whitman is working as a dollar a year CEO.
Good for her, and good for HP's board.
Here's the rest of her compensation deal, as reported in the Online Journal today,
"Whitman also was granted options to buy 1.9 million H-P shares over eight years. She can’t cash out most of the options until H-P stock’s price reaches 120% or more of the company’s current share price. Whitman’s target bonus for fiscal 2012 is $2.4 million, H-P says."
The print version is slightly different. It says that HP stock has to rise by 40% to fully pay out. It also says the "maximum opportunity equal to 2.5 times the target, subject to performance criteria."
Well, it's close, but no cigar.
You see, were there to be an unexpected upsurge in the S&P, HP's equity price will be lifted, regardless of Whitman's accomplishments, along with the index.
What HP's board should do is condition Whitman's payout on HP's equity gaining 40% above the S&P over the period, and no more than, say, 2 out of the 8 years having a total return less than that of the S&P.
That way, Whitman is conditioned against both rises and declines in the S&P which would make the 40% target meaningless.
I don't frankly understand why boards full of allegedly smart members fail to insulate CEO performance from the obvious correlation of the firm's equity price with the broader market.
If Whitman can keep HP from declining as much as the S&P in a severe downdraft, or propel it 40% above a rising S&P, then that's worth the bonus she is being offered.
But it has to be flexibly conditioned to account for the S&P's performance, not simply fixed over time.
Fortune's Most Powerful Businesswomen
Yesterday morning, I caught a few minutes of CNBC's typical shallow business reporting. The segment featured Fortune's 2011 edition of their annual 'most powerful women in business' rankings.
Kraft's Irene Rosenfeld (CEO since June 2006) has, according to the magazine, replaced Pepsi's Indra Nooyi (CEO since 2007) at number one. Nooyi slipped to second place.
Nearby is a two-year price chart for Rosenfeld's Kraft, Nooyi's Pepsi and the S&P500 Index.
Kraft isn't such a bad call over the recent period. It's up 30% over the period, although I think the Cadbury acquisition, which fueled it (late 2009-early 2010), was largely unnecessary. After all, as I wrote in this post, all Rosenfeld did was buy it, then combine the two firms' confectionery businesses and announce a spin-off. It's not too much of a stretch to suggest that much of Kraft's/Rosenfeld's recent outperformance was from Cadbury, not her own organic businesses.
In effect, she overpaid for Cadbury's growth, then added Kraft's similar units for a spinoff. Which could have been done separately, as I originally suggested. Now she's spinning off the part which appears to have driven the combined firms' outperformance of the S&P.
Pepsi's Nooyi, though, is clearly struggling. How does such failure make her a powerful business woman?
The second chart shows the same three price series over the past five years, since Rosenfeld owns that track record entirely, and Nooyi owns most of Pepsi's for the period.
While Nooyi's performance is relatively less-worse than the other two, Rosenfeld's is, not surprisingly, less good. The Cadbury acquisition turned things around for Kraft, which means, in effect, that if you held the shares when Rosenfeld took over Kraft, you saw a loss nearly the same as the S&P.
So from a longer, more accurate historical perspective, neither of Fortune's top two most powerful businesswomen have managed to significantly outperform the S&P. They barely beat the index, and destroyed value for their shareholders.
And Fortune celebrates these two women CEOs? What- as role models?
Why?
Kraft's Irene Rosenfeld (CEO since June 2006) has, according to the magazine, replaced Pepsi's Indra Nooyi (CEO since 2007) at number one. Nooyi slipped to second place.
Kraft isn't such a bad call over the recent period. It's up 30% over the period, although I think the Cadbury acquisition, which fueled it (late 2009-early 2010), was largely unnecessary. After all, as I wrote in this post, all Rosenfeld did was buy it, then combine the two firms' confectionery businesses and announce a spin-off. It's not too much of a stretch to suggest that much of Kraft's/Rosenfeld's recent outperformance was from Cadbury, not her own organic businesses.
In effect, she overpaid for Cadbury's growth, then added Kraft's similar units for a spinoff. Which could have been done separately, as I originally suggested. Now she's spinning off the part which appears to have driven the combined firms' outperformance of the S&P.
The second chart shows the same three price series over the past five years, since Rosenfeld owns that track record entirely, and Nooyi owns most of Pepsi's for the period.
While Nooyi's performance is relatively less-worse than the other two, Rosenfeld's is, not surprisingly, less good. The Cadbury acquisition turned things around for Kraft, which means, in effect, that if you held the shares when Rosenfeld took over Kraft, you saw a loss nearly the same as the S&P.
So from a longer, more accurate historical perspective, neither of Fortune's top two most powerful businesswomen have managed to significantly outperform the S&P. They barely beat the index, and destroyed value for their shareholders.
And Fortune celebrates these two women CEOs? What- as role models?
Why?
Thursday, September 29, 2011
Vik Pandit's Outlook- Who Really Cares?
This morning has already brought some delicious financial sector comedy my way, courtesy of CNBC and Bloomberg television.
First, a financial sector headhunter appeared on Bloomberg to pronounce UBS in possession of a "deep bench" of talent to replace recently-departed CEO Oswald Grubel.
My late boss and mentor, Chase Manhattan Bank SVP of Corporate Strategy and Development, Gerry Weiss, would have burst out laughing at the headhunter's remark. Gerry was fond of noting that, even back then, in the 1980s, money center banks had a mix of businesses much broader than most non-financial diversified conglomerates. These ranged from trading, asset management, corporate lending, custody, and trust to consumer lending, deposits, and various other fee-based businesses.
It's rare that a bank CEO was ever actually adept at managing the entire mess. Since most large bank CEOs rise through one chain of businesses or functions- institutional, consumer, or IT (think John Reid and Art Ryan), it's almost impossible to find a senior executive who is genuinely widely-experienced in most areas of a modern commercial bank.
UBS will probably be lucky if their next CEO is only as mediocre as Grubel was.
Then we come to Vik Pandit.
He was on CNBC this morning via a recorded clip, and cited on Bloomberg, as assuring one and all that the Euro-crisis will be calmly resolved. And, in an apparently coincidentally-timed Wall Street Journal piece citing the Citi CEO, Vik also wants everyone to know that his bank will be an island of stability amidst the global financial turbulence.
I always get a kick out of how the business media glorify and hang on every word of a CEO of a large industrial or financial concern who, prior to being that, was a virtual nobody.
In Pandit's case, he was a fairly anonymous Morgan Stanley middle-office executive. Frustrated by his apparent career path there, he left to co-found a hedge fund. Then had the incredible good fortune of being offered a job to head Citi's alternative investments group by non-executive, but highly-paid chairman Bob Rubin. Who, as a sweetener, had Citigoup buy Vik's Old Lane hedge fund, although it had less than five years of operating history. An absolutely unheard of deal. No large financial firms pay cash for unproven hedge fund strategies lacking long live track records.
Sure enough, Vik's fund cratered a few years later. After he had been elevated from asset management to CEO at the bank.
With that as a career background, and Citi's organizational prowess landing it in the federal ICU in 2008, why would anyone care what this overcompensated clown thinks about any economy or financial crisis?
Gerry Weiss used to tell those of us who worked for him that Chase's senior executives were so inept that most of them likely said to themselves as they looked in the mirror to shave each morning,
'God, don't let this be the day they find out that I really have no idea what I'm doing, and don't deserve the large amount of money they are paying me.'
First, a financial sector headhunter appeared on Bloomberg to pronounce UBS in possession of a "deep bench" of talent to replace recently-departed CEO Oswald Grubel.
My late boss and mentor, Chase Manhattan Bank SVP of Corporate Strategy and Development, Gerry Weiss, would have burst out laughing at the headhunter's remark. Gerry was fond of noting that, even back then, in the 1980s, money center banks had a mix of businesses much broader than most non-financial diversified conglomerates. These ranged from trading, asset management, corporate lending, custody, and trust to consumer lending, deposits, and various other fee-based businesses.
It's rare that a bank CEO was ever actually adept at managing the entire mess. Since most large bank CEOs rise through one chain of businesses or functions- institutional, consumer, or IT (think John Reid and Art Ryan), it's almost impossible to find a senior executive who is genuinely widely-experienced in most areas of a modern commercial bank.
UBS will probably be lucky if their next CEO is only as mediocre as Grubel was.
Then we come to Vik Pandit.
He was on CNBC this morning via a recorded clip, and cited on Bloomberg, as assuring one and all that the Euro-crisis will be calmly resolved. And, in an apparently coincidentally-timed Wall Street Journal piece citing the Citi CEO, Vik also wants everyone to know that his bank will be an island of stability amidst the global financial turbulence.
I always get a kick out of how the business media glorify and hang on every word of a CEO of a large industrial or financial concern who, prior to being that, was a virtual nobody.
In Pandit's case, he was a fairly anonymous Morgan Stanley middle-office executive. Frustrated by his apparent career path there, he left to co-found a hedge fund. Then had the incredible good fortune of being offered a job to head Citi's alternative investments group by non-executive, but highly-paid chairman Bob Rubin. Who, as a sweetener, had Citigoup buy Vik's Old Lane hedge fund, although it had less than five years of operating history. An absolutely unheard of deal. No large financial firms pay cash for unproven hedge fund strategies lacking long live track records.
Sure enough, Vik's fund cratered a few years later. After he had been elevated from asset management to CEO at the bank.
With that as a career background, and Citi's organizational prowess landing it in the federal ICU in 2008, why would anyone care what this overcompensated clown thinks about any economy or financial crisis?
Gerry Weiss used to tell those of us who worked for him that Chase's senior executives were so inept that most of them likely said to themselves as they looked in the mirror to shave each morning,
'God, don't let this be the day they find out that I really have no idea what I'm doing, and don't deserve the large amount of money they are paying me.'
Francesco Guerrera's Flawed Euro Debt Solution in the WSJ
I read with some degree of disbelief How To Repair Continent's Ills, a column by Francesco Guerrera in Tuesday's edition of The Wall Street Journal. Guerrera is evidently the paper's Money & Investing editor. Perhaps that explains how his bad idea for resolving the Euro debt crisis managed to escape onto the pages of the Journal that day.
Here's the last part of his piece, where, after describing his understanding of the problem and alternative solutions, he proposes his own,
"There is, however, a third way and it passes through Omaha. Europe should copy the way Warren Buffett buys into companies in times of trouble.
In 2008, when Goldman Sachs Group Inc. and General Electric Co. needed cash and a jolt of confidence, the legendary investor demanded nonvoting preferred stock with a fat annual dividend and warrants to buy shares at reduced prices in the future. He recently struck a similar deal with Bank of America Corp.
Translated into Europe, the Sage's playbook could work thus: Ailing European banks would issue contingent convertible bonds, affectionately known as co-cos, to European authorities, and, crucially, private investors.
The bonds would pay a big annual interest to entice buyers as well as carrying the promise that they will convert into equity if banks' capital falls below a specified level by, say, 2013.
This approach would achieve two symbiotic aims.
It would enable EU institutions to support banks without having to own them. And it would offer investors a belt-and-suspenders approach: a tasty dividend every year and free equity if banks' capital levels slip.
Banks and their shareholders, who are at risk of being diluted if the co-cos convert, might not like the idea of diverting profits to pay outsiders but, then again, beggars can't be choosers.
A more relevant question is whether investors would participate in such a plan. Unwilling to take my own word for it, I asked two fund managers—one from a savvy hedge fund and another from a large bond fund.
"With a big dividend, I would go for it," said the hedgie. "If the governments are in and there is the prospect of conversion, there is money to be made here." The bond-fund honcho also sounded positive but, being less outspoken, muttered something about being adequately compensated for risk.
Coupled with other programs—namely the provision of day-to-day liquidity from the European Central Bank—the "Buffett recap" might be the best way to avoid a ruinous credit crunch in Europe.
Now all we need is action."
It's tough to know where to start shredding Guerrera's bad thinking. But I'll try.
Let's start with the Buffett example. Guerrera is mistaken if he thinks Buffett's preferred equity investments in GE, Goldman and BofA can simply be copied for every potentially troubled European bank.
Buffett knew, in 2008, that GE and Goldman were both "too big to fail," and reasonably good bets for long term survivability. They weren't in trouble because of basic business weakness, so much as poor decisions to fund short in a market that suddenly dried up. With BofA this summer, it's still "too big to fail," only this time actually written into law, plus, again, a sense that the worst outcome is a smaller BofA, not an insolvent one.
If Buffett thought it was worth doing this for SocGen, UBS, or any other continental bank, well, I'm sure he'd be doing it, and we'd have heard about it already. Chris Flowers, in his remarks on Bloomberg Tuesday, mentioned something I didn't include in yesterday's post. He noted that US banks typically have more deposits than liabilities in the form of loans, while European banks are the opposite, relying heavily on purchased money for funding.
European banks simply aren't identical in structure or nature to their American cousins. And the US dollar is the world's reserve currency, is controlled by just one nation, and, thus, is unlikely to, itself, disintegrate in the wake of a financial sector panic. You can't say that of the Euro, which is the currency in which one assumes the bonds would be issued.
Further, the "co-co's," as Guerrera calls them, are hardly doubly-safe. Kyle Bass derides anyone who thinks the banks which would be issuing these liabilities have any reliable long term equity value. So investors could easily lose the dividend as the bank fails, thus also losing the principal, too.
Strike One.
Next, Guerrera overlooks the simple reality that Europe is not America. See my post discussing Kyle Bass' remarks on this crucial topic. It's just not true that the many European sources of financial, political and legislative power are as concentrated and able to stave off financial and economic catastrophe as was the US.
Strike Two.
Finally, we have Guerrera hanging his entire thesis' evaluation on the opinions of two anonymous hedge fund managers. Or people employed at hedge funds. Perhaps not even their wealthy, savvy founders/owners.
Why are hedge fund the right segment to which to listen for this evaluation? How about private equity? Aren't they, as Chris Flowers was asked, the type of firm to express support and interest in this sort of thing? Because Flowers indicated his firm has increased cash levels and is basically staying on the sidelines, away from the Euro problems.
Then, if you felt hedge fund employees are the right group to ask for an opinion on Euro solutions, how much credibility do you attach to only two of them? Perhaps if Guerrera divulged that he'd talked with the founders of 10-20 large hedge funds, and provided their total assets under management, to indicate size, skill and potential influence in and affect on markets, it would be different.
But he didn't, so it's not.
Moreover, Guerrera downplays the two sources' misgivings, which he actually mentioned. They aren't trivial points, if you reread them.
Strike Three, Francesco.
You're idea's out.
What puzzles me is why the Journal's senior management let Guerrera publish an idea containing so many flaws.
Here's the last part of his piece, where, after describing his understanding of the problem and alternative solutions, he proposes his own,
"There is, however, a third way and it passes through Omaha. Europe should copy the way Warren Buffett buys into companies in times of trouble.
In 2008, when Goldman Sachs Group Inc. and General Electric Co. needed cash and a jolt of confidence, the legendary investor demanded nonvoting preferred stock with a fat annual dividend and warrants to buy shares at reduced prices in the future. He recently struck a similar deal with Bank of America Corp.
Translated into Europe, the Sage's playbook could work thus: Ailing European banks would issue contingent convertible bonds, affectionately known as co-cos, to European authorities, and, crucially, private investors.
The bonds would pay a big annual interest to entice buyers as well as carrying the promise that they will convert into equity if banks' capital falls below a specified level by, say, 2013.
This approach would achieve two symbiotic aims.
It would enable EU institutions to support banks without having to own them. And it would offer investors a belt-and-suspenders approach: a tasty dividend every year and free equity if banks' capital levels slip.
Banks and their shareholders, who are at risk of being diluted if the co-cos convert, might not like the idea of diverting profits to pay outsiders but, then again, beggars can't be choosers.
A more relevant question is whether investors would participate in such a plan. Unwilling to take my own word for it, I asked two fund managers—one from a savvy hedge fund and another from a large bond fund.
"With a big dividend, I would go for it," said the hedgie. "If the governments are in and there is the prospect of conversion, there is money to be made here." The bond-fund honcho also sounded positive but, being less outspoken, muttered something about being adequately compensated for risk.
Coupled with other programs—namely the provision of day-to-day liquidity from the European Central Bank—the "Buffett recap" might be the best way to avoid a ruinous credit crunch in Europe.
Now all we need is action."
It's tough to know where to start shredding Guerrera's bad thinking. But I'll try.
Let's start with the Buffett example. Guerrera is mistaken if he thinks Buffett's preferred equity investments in GE, Goldman and BofA can simply be copied for every potentially troubled European bank.
Buffett knew, in 2008, that GE and Goldman were both "too big to fail," and reasonably good bets for long term survivability. They weren't in trouble because of basic business weakness, so much as poor decisions to fund short in a market that suddenly dried up. With BofA this summer, it's still "too big to fail," only this time actually written into law, plus, again, a sense that the worst outcome is a smaller BofA, not an insolvent one.
If Buffett thought it was worth doing this for SocGen, UBS, or any other continental bank, well, I'm sure he'd be doing it, and we'd have heard about it already. Chris Flowers, in his remarks on Bloomberg Tuesday, mentioned something I didn't include in yesterday's post. He noted that US banks typically have more deposits than liabilities in the form of loans, while European banks are the opposite, relying heavily on purchased money for funding.
European banks simply aren't identical in structure or nature to their American cousins. And the US dollar is the world's reserve currency, is controlled by just one nation, and, thus, is unlikely to, itself, disintegrate in the wake of a financial sector panic. You can't say that of the Euro, which is the currency in which one assumes the bonds would be issued.
Further, the "co-co's," as Guerrera calls them, are hardly doubly-safe. Kyle Bass derides anyone who thinks the banks which would be issuing these liabilities have any reliable long term equity value. So investors could easily lose the dividend as the bank fails, thus also losing the principal, too.
Strike One.
Next, Guerrera overlooks the simple reality that Europe is not America. See my post discussing Kyle Bass' remarks on this crucial topic. It's just not true that the many European sources of financial, political and legislative power are as concentrated and able to stave off financial and economic catastrophe as was the US.
Strike Two.
Finally, we have Guerrera hanging his entire thesis' evaluation on the opinions of two anonymous hedge fund managers. Or people employed at hedge funds. Perhaps not even their wealthy, savvy founders/owners.
Why are hedge fund the right segment to which to listen for this evaluation? How about private equity? Aren't they, as Chris Flowers was asked, the type of firm to express support and interest in this sort of thing? Because Flowers indicated his firm has increased cash levels and is basically staying on the sidelines, away from the Euro problems.
Then, if you felt hedge fund employees are the right group to ask for an opinion on Euro solutions, how much credibility do you attach to only two of them? Perhaps if Guerrera divulged that he'd talked with the founders of 10-20 large hedge funds, and provided their total assets under management, to indicate size, skill and potential influence in and affect on markets, it would be different.
But he didn't, so it's not.
Moreover, Guerrera downplays the two sources' misgivings, which he actually mentioned. They aren't trivial points, if you reread them.
Strike Three, Francesco.
You're idea's out.
What puzzles me is why the Journal's senior management let Guerrera publish an idea containing so many flaws.
Wednesday, September 28, 2011
Snapshots From Yesterday's Markets Coverage
As I listened to CNBC and Bloomberg yesterday morning, two segments caught my attention. Since I'm writing this on Tuesday morning, I don't know what the S&P close was for the day, but I'm assuming it remained at or above 1190.
The first, on CNBC, involved a portfolio manager being interviewed by Melissa Lee. I rarely watch the network past 9AM, since I can't stand the overly-pompous, self-important Jim Cramer, now a regular co-anchor at that timeslot. In any case, Lee was on the floor of the NYSE interviewing people amidst the equity market's surprising rise to around 1190 on the S&P.
I didn't catch the man's name with whom Lee spoke. He wore a suit, so that made him not a floor trader. He matter of factly predicted that this was a rally into which many investors are selling. That it ignores the very real, large-scale European financial problems which are nowhere near resolved.
I recall, at the end of his sobering remarks to Lee, him saying, in answer to her stock inquiry about positions, that,
'We have a long way down to go from here before it's over.'
Perhaps we often filter in order to hear what we want to hear, but I must admit that I share the guy's sentiments. My proprietary volatility measure remains high. For options positions, it would signal puts. My proprietary equity allocation signal has been touching levels, on the worst days of this month, which suggest short positions in only another month or so.
Later, around 10:45AM, on Bloomberg, veteran, well-respected private equity investor J. Christopher Flowers was interviewed prior to his departing on a trip to Europe.
The Bloomberg anchor asked Flowers to compare the current European crisis to what he's seen in the past few years, including the US financial crisis of 2008. Flowers replied, without hesitation, that it's worse now.
He allowed that there was a chance that things might work out, but he wasn't at all sure. His demeanor seemed rather sober and grim. Unlike Kyle Bass, he wasn't firmly coming out and announcing a bet on financial defaults in Europe. But he clearly believes its very possible.
Then, just as I began writing this, a guest on Bloomberg noted that the equities rally of the past few days may be a result of reported needs by large US pension funds to get longer on equities. He cited over-exposure to the fixed-income problems in the market, and/or a need for higher returns, due to low-interest rate policies at the Fed. Then he noted the quarter's end on Friday, and warned that much of what we are seeing this week may, in fact, simply be window-dressing for that date.
In closing, he cautioned against remaining long at the market's close on Friday.
The first, on CNBC, involved a portfolio manager being interviewed by Melissa Lee. I rarely watch the network past 9AM, since I can't stand the overly-pompous, self-important Jim Cramer, now a regular co-anchor at that timeslot. In any case, Lee was on the floor of the NYSE interviewing people amidst the equity market's surprising rise to around 1190 on the S&P.
I didn't catch the man's name with whom Lee spoke. He wore a suit, so that made him not a floor trader. He matter of factly predicted that this was a rally into which many investors are selling. That it ignores the very real, large-scale European financial problems which are nowhere near resolved.
I recall, at the end of his sobering remarks to Lee, him saying, in answer to her stock inquiry about positions, that,
'We have a long way down to go from here before it's over.'
Perhaps we often filter in order to hear what we want to hear, but I must admit that I share the guy's sentiments. My proprietary volatility measure remains high. For options positions, it would signal puts. My proprietary equity allocation signal has been touching levels, on the worst days of this month, which suggest short positions in only another month or so.
Later, around 10:45AM, on Bloomberg, veteran, well-respected private equity investor J. Christopher Flowers was interviewed prior to his departing on a trip to Europe.
The Bloomberg anchor asked Flowers to compare the current European crisis to what he's seen in the past few years, including the US financial crisis of 2008. Flowers replied, without hesitation, that it's worse now.
He allowed that there was a chance that things might work out, but he wasn't at all sure. His demeanor seemed rather sober and grim. Unlike Kyle Bass, he wasn't firmly coming out and announcing a bet on financial defaults in Europe. But he clearly believes its very possible.
Then, just as I began writing this, a guest on Bloomberg noted that the equities rally of the past few days may be a result of reported needs by large US pension funds to get longer on equities. He cited over-exposure to the fixed-income problems in the market, and/or a need for higher returns, due to low-interest rate policies at the Fed. Then he noted the quarter's end on Friday, and warned that much of what we are seeing this week may, in fact, simply be window-dressing for that date.
In closing, he cautioned against remaining long at the market's close on Friday.
Kodak's New Funding Troubles
"If that chart is Perez' idea of a turnaround, I'd hate to see his notion of failure.
According to the charts accompanying the Journal's article, sales at the firm have fallen from slightly over $10B in 2006 to an expected less than $3B this year. Kodak lost money in each of the past three years and is forecast to do so again this year."
Then I read Tuesday's Wall Street Journal article concerning Kodak's shares losing "more than a quarter of their value Monday."
The current five-year price chart for Kodak and the S&P500 Index, seen above, now reveals the former to have lost more than 80% of it's value over the period.
Back when I wrote last month's post about Kodak, its market value was already judged by some analysts to have fallen below the value of its patent portfolio.
What changed?
Kodak drew down its bank credit line by $160MM. It has $75MM left on the facility.
A Kodak official said that the drawdown was because money earned overseas was not being repatriated. Whether true, or not, the reality is that Kodak has been a basket case since January of 2009. The S&P has risen steadily since then, while Kodak's equity price has been a roller coaster, ending down.
I'm not surprised to learn that CEO Perez' contract runs out in 2013. No wonder he's moving heaven and earth to keep the victim...errr...company afloat a little longer.
I continue to believe, as I stated in prior posts concerning Kodak and Perez, that the firm should have been sold or liquidated long ago, to provide shareholders with some residual value. Now it may be too late for any significant value recapture.
Tuesday, September 27, 2011
First Meg Whitman- Now Chelsea Clinton
Recently we had the spectacle of HP reaching out to one of its own board members, Meg Whitman, to make her the company's new CEO. I wrote in that post,
"Here's what struck me this morning.
How frustrating must it be for the millions of unemployed, formerly middle- and/or senior-managers in America who can't get replies to inquiries, or interviews, or jobs, because those hiring consider them unqualified or insufficiently qualified.
Now they see Meg Whitman, who has never run a hardware or software company, simply given the job of CEO of a large one which does both."
Now I learn in this morning's Wall Street Journal that former First Daughter Chelsea Clinton has been, at age 31, named to the board of Barry Diller's IAC/InterActive.
The article discloses that,
"Ms. Clinton doesn't have much experience with public companies, though she worked in her 20s at consulting firm McKinsey & Co. and hedge fund Avenue Capital. She is pursuing a doctorate at Oxford University as well as working at New York University, the Clinton Foundation and the Clinton Global Initiative."
You can't blame Ms. Clinton for being showered with all those opportunities. She was simply born into the role, rather like the child of a reigning king or queen.
By the way, this isn't some ceremonial post. It comes with a $50K annual retainer and a grant of $250K of restricted IAC stock.
But doesn't this make you question Diller's judgement? If you are a shareholder of IAC, don't you wonder if Diller has any sense of responsible corporate governance?
We're not talking about a 31 year old who has won a Nobel Prize, or filed several key patents for a notable invention. Or won a Pulitzer, or, to my knowledge, done anything remarkable to merit being given a say in the oversight and direction of a media company.
Again, there must be thousands of young, unemployed college and advanced program graduates looking at this appointment with a sense of angst.
But the truth is, life's unfair. Luck plays a huge role in the lives of many people, and it's totally uncontrollable.
Still, you'd like to think there would be some credible basis on which a largely unaccomplished young woman is given a board seat at IAC. Not just because of whose daughter she happens to be.
This sort of thing is what gives the left ammunition for its class warfare, including pushing for higher tax rates on "the rich." And seeing this story concerning Chelsea Clinton, it becomes harder to disagree with some of their contentions that the rich are different and often don't earn what they are given.
"Here's what struck me this morning.
How frustrating must it be for the millions of unemployed, formerly middle- and/or senior-managers in America who can't get replies to inquiries, or interviews, or jobs, because those hiring consider them unqualified or insufficiently qualified.
Now they see Meg Whitman, who has never run a hardware or software company, simply given the job of CEO of a large one which does both."
Now I learn in this morning's Wall Street Journal that former First Daughter Chelsea Clinton has been, at age 31, named to the board of Barry Diller's IAC/InterActive.
The article discloses that,
"Ms. Clinton doesn't have much experience with public companies, though she worked in her 20s at consulting firm McKinsey & Co. and hedge fund Avenue Capital. She is pursuing a doctorate at Oxford University as well as working at New York University, the Clinton Foundation and the Clinton Global Initiative."
You can't blame Ms. Clinton for being showered with all those opportunities. She was simply born into the role, rather like the child of a reigning king or queen.
By the way, this isn't some ceremonial post. It comes with a $50K annual retainer and a grant of $250K of restricted IAC stock.
But doesn't this make you question Diller's judgement? If you are a shareholder of IAC, don't you wonder if Diller has any sense of responsible corporate governance?
We're not talking about a 31 year old who has won a Nobel Prize, or filed several key patents for a notable invention. Or won a Pulitzer, or, to my knowledge, done anything remarkable to merit being given a say in the oversight and direction of a media company.
Again, there must be thousands of young, unemployed college and advanced program graduates looking at this appointment with a sense of angst.
But the truth is, life's unfair. Luck plays a huge role in the lives of many people, and it's totally uncontrollable.
Still, you'd like to think there would be some credible basis on which a largely unaccomplished young woman is given a board seat at IAC. Not just because of whose daughter she happens to be.
This sort of thing is what gives the left ammunition for its class warfare, including pushing for higher tax rates on "the rich." And seeing this story concerning Chelsea Clinton, it becomes harder to disagree with some of their contentions that the rich are different and often don't earn what they are given.
Moral Bankruptcy Among Hedge Fund Managers
This topic was one I listed in my post discussing my reaction to Michael Lewis' recent book on the recent mortgage-backed bond-led financial crisis, The Big Short.
Almost two weeks ago, I wrote this post discussing the recent UBS so-called rogue trader, and how it compared or contrasted with the story in Lewis' book concerning Morgan Stanley bond trader Howie Hubler.
For what it's worth, yesterday's Wall Street Journal reported that UBS' CEO resigned over the comparatively small $2.3B trading scandal. Comparatively small in relation to Hubler's 2007 $9B loss. As I noted in the second linked post, John Mack didn't resign over that much larger loss. But you can read my thoughts on the matter in the post.
Regarding today's topic, I touched on it in this post a few days later, concerning Goldman's closing of its Global Alpha fund, writing, in part,
"Even at just an average size of $5B, Global Alpha was probably earning at least $100MM annually in management fees, and who knows how much more by executing the fund's trades on Goldman's own desks? Then there are the incentive fees in the good years, which for the year in which it earned 30+%, translates into another 6% of assets, or $300MM in additional revenues. The fund doesn't take a share of losses, so this asymmetric payoff, along with redemption lockups, can quickly result in sizable income for Goldman.
Add in the fund manager's probable large cuts for not leaving to join folks like Asness in the true private hedge fund business, and you have Global Alpha becoming a gigantic funnel for client assets being transferred to Goldman fund managers, bit by bit.
Heads, both parties win, tails, the client loses and, eventually, departs.
From Goldman's perspective, it's even richer than brokerage or proprietary trading, because there's a nice fixed fee, regardless of the client's losses. Yes, over time the fund can tank, as Global Alpha eventually did. But the problem is firewalled to just that fund.
If Goldman was able to manage an average of $5B for almost 15 years in Global Alpha, I'm sure it was a very lucrative venture for the firm and the fund's managers, regardless of how much the fund's investors ultimately lost before redeeming.
This is a theme on which Michael Lewis touched in The Big Short. Something most people can't quite comprehend.
When fund assets reach such large sizes that fixed fees alone provide adequate revenues, in a very few years, the firm and the fund's managers can become sufficiently wealthy from their cuts that they simply don't have to care so much as they may have initially what happens to their investors' money."
Perhaps the best example of this is Lewis' telling of the story of Wing Chau. Mr. Chau had been,
"making $140,000 a year managing a portfolio for the New York Life Insurance Company. In one year as a CDO manager, he'd taken home $26 million, the haul from half a dozen lifetimes of working at New York Life.
Now, almost giddily, Chau explained to Esiman that he simply passed all the risk that the underlying home loans would default on to the big investors who had hired him to vet the bonds. His job was to be the CDO "expert," but he actually didn't spend a lot of time worrying about what was in the CDOs. His goal, he explained, was to maximize the dollars in his care."
Chau managed, or should I write mismanaged, CDOs for an outfit named Harding Advisory. Harding, Lewis writes,
"would be the world's biggest subprime CDO manager.....had established itself as the go-to buyer for Merrill Lynch's awesome CDO machine, notorious not only for its rate of production but also for its industrial waste (its CDOs were later proven to be easily the worst.)"
The details of what Wing Chau was supposed to do are fairly arcane, and can be found on page 141 of Lewis' book. Suffice to say, it was intended to safeguard investors' interests by continually staying abreast of the value and condition of defaults within various mortgage-backed bonds.
I can't find a reference by Lewis to just how many billions of dollars Chau had under his care, but if he was earning even as much at 5% to take home $26MM, then the figure would be in the $4-6B range. It was probably much larger.
Lewis is careful not to quote Chau but, rather, pretty clearly report his remarks about how much he earned, and his goal of simply maximizing dollars under management, as hearsay through Eisman.
But it's totally believable. Elsewhere in that chapter, Spider Man at The Venetian, referring to an industry conference at which the conversation took place, Lewis paints a larger picture of an industry with many small players purporting to do what Mr. Chau did. Much like the unexamined CDO insurance, in the form of derivatives, which AIG sold to fund managers like Mike Burry, mentioned in this earlier post, this cottage industry of middlemen ostensibly monitoring institutional investors' CDOs seems to have been largely unregulated.
So the first point of this post is to reinforce what I noted in the earlier piece on Global Alpha. Investors need to consider what the income dynamics are for their money managers when investing with funds other than plain vanilla actively-managed mutual funds.
It apparently escapes the notice of many investors that for sufficiently large funds, earning just one or two years' of 2% management fees from a just a few years of operation can make a very few people rather wealthy. If they actually had a good performance in the early years, and the fund grew by attracting new money, without corresponding growth in the analytic, investment and trading functions, then those lucky fund owners and employees could very well enjoy a windfall which would satisfy the average working person without ever actually having another good performance year. The numbers I used in the Global Alpha post for both that fund, and John Paulson's fund, make the point fairly clearly.
Most people just can't conceive what the 2 & 20 hedge fund formula can earn for a fund when the 2% is levied on billions of dollars of client assets. One billion dollars yields $20MM. If a fund owner takes home just 10% of that, how many years must he do so before his personal wealth function's minimum threshold is satisfied? Not too many.
The other point of this post has to do with what Lewis wrote about hedge fund manager Mike Burry, a subject of my first Lewis post, linked above. It partially involves two topics that I want to address from Lewis' book- fund manager behavior and the nature of bespoke instruments like the credit swaps Burry bought.
"Then Burry, seeking to profit from the troubles of companies involved in sub-prime finance, shifts from equities to debt, buying derivatives on CDOs which he is certain will lose the bulk of their value due to underlying defaults. His investors, learning of this, want to, but can't redeem their funds because of Burry's lock-up rules.
Then Burry manages to coax, badger and persuade several banks to sell him the derivatives he wants on selected mortgage-backed CDOs. Eventually, the banks catch on and begin doing the same, all the while Burry and the traders at these banks lie to each other about exactly what they are doing.
What's ironic is that Lewis paints Burry as the most honest of hedge fund managers, eschewing a fixed management fee. But he doesn't adequately, in my opinion, explain the very serious fraud Burry committed when he informed his investors and backers that he'd completely changed the investments in his portfolio. That Burry survived this is even more immense luck."
Now that I've read the rest of the book, I know that Burry fought with his investors throughout 2007. Because of his no-fee management philosophy, he had to fire the bulk of his staff as his fund faced redemptions while the instruments he had bought for the portfolio, credit swaps, failed to rise in value, being non-exchange traded assets which were only quoted by a few brokers and market participants. Since most of Wall Street chose to ignore the gathering storm of collapsing mortgage, and mortgage-backed bond values, they also chose to undervalue derivatives which bet on such a collapse.
Thus, Burry fumed that his investors weren't patient enough, although the instruments which Burry chose to buy were, in fact, not salable at values which were implied by market conditions. Here's a passage on page 223 describing this phenomenon,
"Twenty-two days later, on August 31, 2007, Michael Burry lifted the side pocket and began to unload his own credit default swaps in earnest. His investors could have their money back. There was now more than twice as much of it as they had given him. Just a few months earlier, Burry was being offered 200 basis points- or 2 percent of the principal- for his credit default swaps, which peaked at $1.9 billion. Now he was being offered 75, 80, and 85 points by Wall Street firms desperate to cushion their fall. At the end of the quarter, he'd report that the fund was up by more than 100 percent. By the end of the year, in a portfolio of less than $550 million, he would have realized profits of more than $720 million. Still he heard not a peep from his investors."
Eventually, Burry and Greenblatt' Gotham Capital, his original investor and backer, turned on each other. Burry "kicked them out" of his fund, sarcastically replying to Greenblatt's inquiry regarding the value of his stake that he keep the "tens of millions of dollars" Gotham had tried to keep Burry from earning, and "call it even?"
Then Burry shut his fund.
Let me reiterate that I like Michael Lewis' writing. He makes otherwise obscure financial issues clear to laymen while, for people like me, with industry experience, he provides behind the scenes information concerning major events and news stories.
But Lewis was a Salomon bond salesman, not a portfolio manager. Nor a salesman for a portfolio management firm. So I think he misses a very important aspect of Burry's story. One which, frankly, puts me on the side of Burry's angry investors.
As I noted in my earlier post about this point, Burry deliberately went out of his chosen area of expertise when he took an equity portfolio into the uncharted territory of custom-crafted credit swaps. Those were derivatives with no continuous, large and deeply-liquid pool of buyers and sellers which provided an accurate, moving price reflecting their real value at any moment the markets were open.
His investors felt justifiably upset for two reasons. The first is that he didn't stick to what he did which originally motivated them to trust him with their money. The second is that, if these investors wanted to invest in mortgage-backed bond credit default swaps, maybe they'd have searched for other managers who did that, and not chosen Burry.
[Additional note: In the original posting of this piece, I neglected to mention cost of carry. For investors used to equity portfolios with occasional hedging using options, Burry's use of swaps, which, like all insurance, require the ongoing payment of premiums, must have come as a shock. I believe premiums were something like 2% of face value. With options, there is a one-time premium, but they expire. For swaps, to remain in force, the carry must be paid. This was another reason Burry evidently angered his investors, but chose to ignore the consequences of his unilateral move into fixed income derivatives.]
Burry clearly ignored this possibility. Unfortunately, I think Michael Lewis did, as well. Perhaps he develops bonds with the subjects of his personal interest storylines. Those anecdotal plot lines which so nicely color and personalize his book. But it seems to me that Lewis lost his objectivity in Burry's case.
By late 2007, when Burry and his investors and backers were in full tilt at each other, the swaps were sold for what Lewis explains was a huge profit. In retrospect, the investors and backers look like ungrateful, nasty, childish recipients of Burry's largess.
But that's in hindsight. For over two years, from May, 2005 until August, 2007, Burry's investors were strapped into their seats for a ride with no clear destination. Burry invoked side pocket and redemption clauses to keep his investors from withdrawing their money.
Let me tell you, from experience working with hedge funds, investors do not like uncertainty or risk. It's not correct to say, or believe, that, in the end, having made unbelievable profits, all will be forgiven. It won't be.
For every Mike Burry, investors can think of a LTCM or Nick Leeson at now-defunct Barings Bank. Impassioned portfolio managers don't see things objectively. I was once told by the head of research at Bernstein that I needn't worry about anyone with an existing equity strategy stealing mine. He told me, to paraphrase,
'Another equity strategist/manager will stick with his own approach, even as it keeps losing money, rather than steal yours, if it's making money. He'll swear that his method has just hit a temporary bad patch, or that he will fix it, and he doesn't need your strategy.'
Amazingly, he was right. And it's that attitude which must have worried- frightened- Burry's investors and backers.
Moreover, once Burry had this conflict with his investors, due to his deliberate departure from subjectively selecting equities, it is very likely that he would have had little luck attracting new investors. After explaining what he'd done, how brilliant he'd been to completely leave his typical area of expertise and subject his investors to years of profitless risk in arcane, seldom-traded swaps, not many other investors would probably have signed up for a ride on Burry's roller coaster fund management ride.
The first point of this post- to beware of huge hedge funds and their underlying profit motive- is one about which investors can do something. They can ask about fund sizes and fees, expenses, and figure out whether actually making money for clients is crucial to the fund's own internal profit objectives.
The second point- getting trapped in a fund which switches what it holds- is harder to guard against. That is, unless a manager openly tells you he's done that before, or wouldn't hesitate to do it, you won't know until it's too late.
In either case, though, the solution is the same, and it's an old one. In a word.....
Diversification.
Investors can rarely suffer from diversifying among managers.
Want more proof? Here's another word.....
Madoff.
Almost two weeks ago, I wrote this post discussing the recent UBS so-called rogue trader, and how it compared or contrasted with the story in Lewis' book concerning Morgan Stanley bond trader Howie Hubler.
For what it's worth, yesterday's Wall Street Journal reported that UBS' CEO resigned over the comparatively small $2.3B trading scandal. Comparatively small in relation to Hubler's 2007 $9B loss. As I noted in the second linked post, John Mack didn't resign over that much larger loss. But you can read my thoughts on the matter in the post.
Regarding today's topic, I touched on it in this post a few days later, concerning Goldman's closing of its Global Alpha fund, writing, in part,
"Even at just an average size of $5B, Global Alpha was probably earning at least $100MM annually in management fees, and who knows how much more by executing the fund's trades on Goldman's own desks? Then there are the incentive fees in the good years, which for the year in which it earned 30+%, translates into another 6% of assets, or $300MM in additional revenues. The fund doesn't take a share of losses, so this asymmetric payoff, along with redemption lockups, can quickly result in sizable income for Goldman.
Add in the fund manager's probable large cuts for not leaving to join folks like Asness in the true private hedge fund business, and you have Global Alpha becoming a gigantic funnel for client assets being transferred to Goldman fund managers, bit by bit.
Heads, both parties win, tails, the client loses and, eventually, departs.
From Goldman's perspective, it's even richer than brokerage or proprietary trading, because there's a nice fixed fee, regardless of the client's losses. Yes, over time the fund can tank, as Global Alpha eventually did. But the problem is firewalled to just that fund.
If Goldman was able to manage an average of $5B for almost 15 years in Global Alpha, I'm sure it was a very lucrative venture for the firm and the fund's managers, regardless of how much the fund's investors ultimately lost before redeeming.
This is a theme on which Michael Lewis touched in The Big Short. Something most people can't quite comprehend.
When fund assets reach such large sizes that fixed fees alone provide adequate revenues, in a very few years, the firm and the fund's managers can become sufficiently wealthy from their cuts that they simply don't have to care so much as they may have initially what happens to their investors' money."
Perhaps the best example of this is Lewis' telling of the story of Wing Chau. Mr. Chau had been,
"making $140,000 a year managing a portfolio for the New York Life Insurance Company. In one year as a CDO manager, he'd taken home $26 million, the haul from half a dozen lifetimes of working at New York Life.
Now, almost giddily, Chau explained to Esiman that he simply passed all the risk that the underlying home loans would default on to the big investors who had hired him to vet the bonds. His job was to be the CDO "expert," but he actually didn't spend a lot of time worrying about what was in the CDOs. His goal, he explained, was to maximize the dollars in his care."
Chau managed, or should I write mismanaged, CDOs for an outfit named Harding Advisory. Harding, Lewis writes,
"would be the world's biggest subprime CDO manager.....had established itself as the go-to buyer for Merrill Lynch's awesome CDO machine, notorious not only for its rate of production but also for its industrial waste (its CDOs were later proven to be easily the worst.)"
The details of what Wing Chau was supposed to do are fairly arcane, and can be found on page 141 of Lewis' book. Suffice to say, it was intended to safeguard investors' interests by continually staying abreast of the value and condition of defaults within various mortgage-backed bonds.
I can't find a reference by Lewis to just how many billions of dollars Chau had under his care, but if he was earning even as much at 5% to take home $26MM, then the figure would be in the $4-6B range. It was probably much larger.
Lewis is careful not to quote Chau but, rather, pretty clearly report his remarks about how much he earned, and his goal of simply maximizing dollars under management, as hearsay through Eisman.
But it's totally believable. Elsewhere in that chapter, Spider Man at The Venetian, referring to an industry conference at which the conversation took place, Lewis paints a larger picture of an industry with many small players purporting to do what Mr. Chau did. Much like the unexamined CDO insurance, in the form of derivatives, which AIG sold to fund managers like Mike Burry, mentioned in this earlier post, this cottage industry of middlemen ostensibly monitoring institutional investors' CDOs seems to have been largely unregulated.
So the first point of this post is to reinforce what I noted in the earlier piece on Global Alpha. Investors need to consider what the income dynamics are for their money managers when investing with funds other than plain vanilla actively-managed mutual funds.
It apparently escapes the notice of many investors that for sufficiently large funds, earning just one or two years' of 2% management fees from a just a few years of operation can make a very few people rather wealthy. If they actually had a good performance in the early years, and the fund grew by attracting new money, without corresponding growth in the analytic, investment and trading functions, then those lucky fund owners and employees could very well enjoy a windfall which would satisfy the average working person without ever actually having another good performance year. The numbers I used in the Global Alpha post for both that fund, and John Paulson's fund, make the point fairly clearly.
Most people just can't conceive what the 2 & 20 hedge fund formula can earn for a fund when the 2% is levied on billions of dollars of client assets. One billion dollars yields $20MM. If a fund owner takes home just 10% of that, how many years must he do so before his personal wealth function's minimum threshold is satisfied? Not too many.
The other point of this post has to do with what Lewis wrote about hedge fund manager Mike Burry, a subject of my first Lewis post, linked above. It partially involves two topics that I want to address from Lewis' book- fund manager behavior and the nature of bespoke instruments like the credit swaps Burry bought.
"Then Burry, seeking to profit from the troubles of companies involved in sub-prime finance, shifts from equities to debt, buying derivatives on CDOs which he is certain will lose the bulk of their value due to underlying defaults. His investors, learning of this, want to, but can't redeem their funds because of Burry's lock-up rules.
Then Burry manages to coax, badger and persuade several banks to sell him the derivatives he wants on selected mortgage-backed CDOs. Eventually, the banks catch on and begin doing the same, all the while Burry and the traders at these banks lie to each other about exactly what they are doing.
What's ironic is that Lewis paints Burry as the most honest of hedge fund managers, eschewing a fixed management fee. But he doesn't adequately, in my opinion, explain the very serious fraud Burry committed when he informed his investors and backers that he'd completely changed the investments in his portfolio. That Burry survived this is even more immense luck."
Now that I've read the rest of the book, I know that Burry fought with his investors throughout 2007. Because of his no-fee management philosophy, he had to fire the bulk of his staff as his fund faced redemptions while the instruments he had bought for the portfolio, credit swaps, failed to rise in value, being non-exchange traded assets which were only quoted by a few brokers and market participants. Since most of Wall Street chose to ignore the gathering storm of collapsing mortgage, and mortgage-backed bond values, they also chose to undervalue derivatives which bet on such a collapse.
Thus, Burry fumed that his investors weren't patient enough, although the instruments which Burry chose to buy were, in fact, not salable at values which were implied by market conditions. Here's a passage on page 223 describing this phenomenon,
"Twenty-two days later, on August 31, 2007, Michael Burry lifted the side pocket and began to unload his own credit default swaps in earnest. His investors could have their money back. There was now more than twice as much of it as they had given him. Just a few months earlier, Burry was being offered 200 basis points- or 2 percent of the principal- for his credit default swaps, which peaked at $1.9 billion. Now he was being offered 75, 80, and 85 points by Wall Street firms desperate to cushion their fall. At the end of the quarter, he'd report that the fund was up by more than 100 percent. By the end of the year, in a portfolio of less than $550 million, he would have realized profits of more than $720 million. Still he heard not a peep from his investors."
Eventually, Burry and Greenblatt' Gotham Capital, his original investor and backer, turned on each other. Burry "kicked them out" of his fund, sarcastically replying to Greenblatt's inquiry regarding the value of his stake that he keep the "tens of millions of dollars" Gotham had tried to keep Burry from earning, and "call it even?"
Then Burry shut his fund.
Let me reiterate that I like Michael Lewis' writing. He makes otherwise obscure financial issues clear to laymen while, for people like me, with industry experience, he provides behind the scenes information concerning major events and news stories.
But Lewis was a Salomon bond salesman, not a portfolio manager. Nor a salesman for a portfolio management firm. So I think he misses a very important aspect of Burry's story. One which, frankly, puts me on the side of Burry's angry investors.
As I noted in my earlier post about this point, Burry deliberately went out of his chosen area of expertise when he took an equity portfolio into the uncharted territory of custom-crafted credit swaps. Those were derivatives with no continuous, large and deeply-liquid pool of buyers and sellers which provided an accurate, moving price reflecting their real value at any moment the markets were open.
His investors felt justifiably upset for two reasons. The first is that he didn't stick to what he did which originally motivated them to trust him with their money. The second is that, if these investors wanted to invest in mortgage-backed bond credit default swaps, maybe they'd have searched for other managers who did that, and not chosen Burry.
[Additional note: In the original posting of this piece, I neglected to mention cost of carry. For investors used to equity portfolios with occasional hedging using options, Burry's use of swaps, which, like all insurance, require the ongoing payment of premiums, must have come as a shock. I believe premiums were something like 2% of face value. With options, there is a one-time premium, but they expire. For swaps, to remain in force, the carry must be paid. This was another reason Burry evidently angered his investors, but chose to ignore the consequences of his unilateral move into fixed income derivatives.]
Burry clearly ignored this possibility. Unfortunately, I think Michael Lewis did, as well. Perhaps he develops bonds with the subjects of his personal interest storylines. Those anecdotal plot lines which so nicely color and personalize his book. But it seems to me that Lewis lost his objectivity in Burry's case.
By late 2007, when Burry and his investors and backers were in full tilt at each other, the swaps were sold for what Lewis explains was a huge profit. In retrospect, the investors and backers look like ungrateful, nasty, childish recipients of Burry's largess.
But that's in hindsight. For over two years, from May, 2005 until August, 2007, Burry's investors were strapped into their seats for a ride with no clear destination. Burry invoked side pocket and redemption clauses to keep his investors from withdrawing their money.
Let me tell you, from experience working with hedge funds, investors do not like uncertainty or risk. It's not correct to say, or believe, that, in the end, having made unbelievable profits, all will be forgiven. It won't be.
For every Mike Burry, investors can think of a LTCM or Nick Leeson at now-defunct Barings Bank. Impassioned portfolio managers don't see things objectively. I was once told by the head of research at Bernstein that I needn't worry about anyone with an existing equity strategy stealing mine. He told me, to paraphrase,
'Another equity strategist/manager will stick with his own approach, even as it keeps losing money, rather than steal yours, if it's making money. He'll swear that his method has just hit a temporary bad patch, or that he will fix it, and he doesn't need your strategy.'
Amazingly, he was right. And it's that attitude which must have worried- frightened- Burry's investors and backers.
Moreover, once Burry had this conflict with his investors, due to his deliberate departure from subjectively selecting equities, it is very likely that he would have had little luck attracting new investors. After explaining what he'd done, how brilliant he'd been to completely leave his typical area of expertise and subject his investors to years of profitless risk in arcane, seldom-traded swaps, not many other investors would probably have signed up for a ride on Burry's roller coaster fund management ride.
The first point of this post- to beware of huge hedge funds and their underlying profit motive- is one about which investors can do something. They can ask about fund sizes and fees, expenses, and figure out whether actually making money for clients is crucial to the fund's own internal profit objectives.
The second point- getting trapped in a fund which switches what it holds- is harder to guard against. That is, unless a manager openly tells you he's done that before, or wouldn't hesitate to do it, you won't know until it's too late.
In either case, though, the solution is the same, and it's an old one. In a word.....
Diversification.
Investors can rarely suffer from diversifying among managers.
Want more proof? Here's another word.....
Madoff.
Monday, September 26, 2011
Larry Lindsay's Succinct View of the Euro Debt Crisis
I caught some of Larry Lindsay's appearance on CNBC this morning from 7-8AM. While working while listening to the chatter in background, I didn't really hear anything of note until his closing comments.
On the subject of the European debt crisis, Lindsay remarked, to paraphrase,
'The ECB only has about 11B euros. The various national central banks in the EU have about 70B Euros. That's it. So that is why they all look to the EFSF to provide Euros to resolve the crisis.
It's sort of a circularity.'
Not quite the gritty detail of Kyle Bass' game theory and originally-commissioned research on the attitudes of German citizens towards bailing out Greece, Spain, Italy and whoever else winds up insolvent. But Lindsay implies the same end.
That is, insufficient existing funds to simply pay off existing sovereign loans at face value. Thus necessitating defaults, probable bank insolvencies, bankruptcies, and then a re-start of European finance after all concerned have experienced the actual losses from holding either affected sovereign debt, bank equities, or bank liabilities.
Sometimes it's helpful to hear several different approaches to the analysis of an important developing phenomenon. This seems to be one of those times.
On the subject of the European debt crisis, Lindsay remarked, to paraphrase,
'The ECB only has about 11B euros. The various national central banks in the EU have about 70B Euros. That's it. So that is why they all look to the EFSF to provide Euros to resolve the crisis.
It's sort of a circularity.'
Not quite the gritty detail of Kyle Bass' game theory and originally-commissioned research on the attitudes of German citizens towards bailing out Greece, Spain, Italy and whoever else winds up insolvent. But Lindsay implies the same end.
That is, insufficient existing funds to simply pay off existing sovereign loans at face value. Thus necessitating defaults, probable bank insolvencies, bankruptcies, and then a re-start of European finance after all concerned have experienced the actual losses from holding either affected sovereign debt, bank equities, or bank liabilities.
Sometimes it's helpful to hear several different approaches to the analysis of an important developing phenomenon. This seems to be one of those times.
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