I opened this morning's edition of the Wall Street Journal to the Money & Investing section to read a chilling set of statistics.
According to an article about MBA program graduates,
"Employers such as banks, hedge funds, investment managers, private equity and venture capital firms hired 39% of job-seeking 2011 graduates at Harvard Business School and the Yale School of Management, 36% at the Stanford Graduate School of Business and 51% at Columbia Business School."
You see, many years ago, I read of similar numbers at a then-hot technology company.
If my memory is correct, Atari had the dubious distinction of hiring a quarter of the Harvard Business School class the year before it went bankrupt. At the time, someone wrote a waggish Journal editorial suggesting using the HBS hiring figures as a sort of early warning indicator for companies or sectors about to implode.
Reading that passage from this morning's Journal piece, I find troubling parallels to that article from around 1980.
First, banks are basically utilities. I don't see MBAs adding much value there. Investment management companies would seem to need new ideas born of experience and judgement, not mostly young, fresh-faced MBAs eager to be the marginal 10K analysts.
Packing more MBAs into venture capital firms, hedge funds and private equity firms seems to be adding capacity to an already over-served group of markets.
I don't have a problem with value being added by astute investing, whether it be via venture capital or private equity placements. Or shrewed investment, either in public or hedge funds. But most new firms in these areas are started by veterans with money. Adding MBAs is adding capacity without much actual initial value.
It would seem, in the current market situation, that at least the US is somewhat over-served by financial service providers. So seeing such large numbers of graduates from the better-ranked business schools flood into the financial sector seems troubling.
Showing posts with label Hedge Funds. Show all posts
Showing posts with label Hedge Funds. Show all posts
Friday, October 21, 2011
Tuesday, September 27, 2011
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.
Saturday, September 17, 2011
William Ackman On Pershing Square's Fascination with JCPenney
I caught Pershing Square hedge fund manger William Ackman on CNBC last week extolling JC Penney, of which his fund has become a major owner.
Perhaps it's only me, but I found him to be somewhat delusional, going on about Penney's real estate values and locations, a 'jeans bar' to be like an Apple store's 'genius bar,' and his seeming reliance on his mother's and wife's views.
Contrast this with Kyle Bass' hedge fund commissioning market research in Germany pursuant to his investments in the Eurocrisis.
Didn't Ackman unsuccessfully tried to force Target to mortgage its real estate values several years ago? Then failed to take over or rescue Borders more recently?
Here's a chart depicting price series for Penney, Target, Sears Holdings and the S&P500 Index for the past five years.
Perhaps it's only me, but I found him to be somewhat delusional, going on about Penney's real estate values and locations, a 'jeans bar' to be like an Apple store's 'genius bar,' and his seeming reliance on his mother's and wife's views.
Contrast this with Kyle Bass' hedge fund commissioning market research in Germany pursuant to his investments in the Eurocrisis.
Didn't Ackman unsuccessfully tried to force Target to mortgage its real estate values several years ago? Then failed to take over or rescue Borders more recently?
Here's a chart depicting price series for Penney, Target, Sears Holdings and the S&P500 Index for the past five years.Not surprisingly, Target and the S&P have outperformed Ed Lampert's Sears and the Penney. Lampert hasn't seemed to have done all that well with his Sears/KMart conglomeration. Despite seeing this, Ackman seems to believe that, though also a hedge fund manager, he has the magic touch for retail success.
Retail is a very tough business. Why these hedge fund guys think they can just swarm into an underperforming retailer, buy control and force it to revert back up to some better-performing mean is beyond me.
Sometimes, underperformers, especially retailers, are so for a valid reason. And they aren't likely to come back from the ailing/dead. Customer perceptions and buying habits aren't necessarily easily changed, once soured on a brand or retailer.
I guess we'll see how magical Ackman's- and his wife's and mother's- touches are at Penney in the months/years ahead.
Thursday, September 15, 2011
Kyle Bass On CNBC Yesterday
I saw Kyle Bass' appearance yesterday on David Faber's noontime CNBC program which originated from the Seeking Alpha conference.
Bass was on as a guest in order to solicit his unvarnished, blunt opinions regarding the European financial troubles. Specifically, the sovereign debt problems of Greece, Spain, Ireland and Italy, and the accompanying potential insolvency of European banks holding said paper.
When asked for his reaction to US Treasury Secretary Geithner's contention, in an interview earlier that day on CNBC, that no European bank would be allowed to fail "like Lehman did," Bass replied that, technically, he agreed with and believed Geithner's assertion. European regulators, Bass said, would not let any of their large banks just collapse as the US allowed Lehman to do. But in the next breath, Bass said,
'That doesn't mean the equity of those banks is worth anything. Nor their debt.'
He then proceeded to enumerate the problems he saw for any simple Euro-solution, including the myth of a single European-wide TARP-like fund.
In effect, in one sentence, Kyle Bass demolished Geithner's attempt to soothe markets regarding the European financial crisis and revealed the Treasury secretary's insistence that there won't be a European Lehman as a distinction without any real difference.
Then Bass said something which I'll return to, again, in a later post about Michael Lewis' The Big Short. Bass referred to primary market research which his fund commissioned among German citizens to ascertain the opinions of that nation's residents to bailing out the rest of Europe.
This sort of on-the-ground, gritty detailed research was also the hallmark of Bass and others during the building mortgage-backed securities fiasco of 2007-08. It temporarily stunned me that here was a hedge fund manager actually having extensive primary research conducted in order to better his odds of correctly resolving what he called, several times, the game theory problem of how the European financial system will evolve through the default, by whatever name you wish to call it, that Bass sees as inevitable and unavoidable.
Mind you, as far back as last summer and fall, Bass was on CNBC warning viewers that the apparent market values of sovereign debt, and the health of the region's large banks, were not accurate. That the situation was far more dire than it appeared.
I respect and very much enjoyed Bass' detailed explanation of the processes actually necessary, including, to use his term, 'that messy democratic process' of individual country legislatures voting to enact their individual TARP-like funds. I can't possibly capture in this piece the intensity and density of Bass' remarks, but they were extremely convincing on several points.
First, there will be European country defaults. Second, there will be corresponding private sector bank insolvencies. Third, a lot of money will be lost by holders of securities issued by the defaulting countries and bankrupt banks. Fifth, the effect on the US will involve both capital losses and overall economic trade reductions. Sixth, after all this, the global financial and economic systems will then have to pick up and move along, losses absorbed, and work with the resulting situations.
Bass was on as a guest in order to solicit his unvarnished, blunt opinions regarding the European financial troubles. Specifically, the sovereign debt problems of Greece, Spain, Ireland and Italy, and the accompanying potential insolvency of European banks holding said paper.
When asked for his reaction to US Treasury Secretary Geithner's contention, in an interview earlier that day on CNBC, that no European bank would be allowed to fail "like Lehman did," Bass replied that, technically, he agreed with and believed Geithner's assertion. European regulators, Bass said, would not let any of their large banks just collapse as the US allowed Lehman to do. But in the next breath, Bass said,
'That doesn't mean the equity of those banks is worth anything. Nor their debt.'
He then proceeded to enumerate the problems he saw for any simple Euro-solution, including the myth of a single European-wide TARP-like fund.
In effect, in one sentence, Kyle Bass demolished Geithner's attempt to soothe markets regarding the European financial crisis and revealed the Treasury secretary's insistence that there won't be a European Lehman as a distinction without any real difference.
Then Bass said something which I'll return to, again, in a later post about Michael Lewis' The Big Short. Bass referred to primary market research which his fund commissioned among German citizens to ascertain the opinions of that nation's residents to bailing out the rest of Europe.
This sort of on-the-ground, gritty detailed research was also the hallmark of Bass and others during the building mortgage-backed securities fiasco of 2007-08. It temporarily stunned me that here was a hedge fund manager actually having extensive primary research conducted in order to better his odds of correctly resolving what he called, several times, the game theory problem of how the European financial system will evolve through the default, by whatever name you wish to call it, that Bass sees as inevitable and unavoidable.
Mind you, as far back as last summer and fall, Bass was on CNBC warning viewers that the apparent market values of sovereign debt, and the health of the region's large banks, were not accurate. That the situation was far more dire than it appeared.
I respect and very much enjoyed Bass' detailed explanation of the processes actually necessary, including, to use his term, 'that messy democratic process' of individual country legislatures voting to enact their individual TARP-like funds. I can't possibly capture in this piece the intensity and density of Bass' remarks, but they were extremely convincing on several points.
First, there will be European country defaults. Second, there will be corresponding private sector bank insolvencies. Third, a lot of money will be lost by holders of securities issued by the defaulting countries and bankrupt banks. Fifth, the effect on the US will involve both capital losses and overall economic trade reductions. Sixth, after all this, the global financial and economic systems will then have to pick up and move along, losses absorbed, and work with the resulting situations.
Thursday, August 11, 2011
The Curious Case of Fletcher Asset Management
Just a little over a month ago, on July 7th, the Wall Street Journal's Money & Investing section had, as its lead headline, "Highflier Tells Clients to Wait."
It seems that Alphonse Fletcher, said to, have "made a splash on Wall Street in the 1990s, reporting 300%-a-year returns at his firm," and "told of going 11 years without a single losing month," may have bamboozled three Louisiana public union pension boards.
Fletcher made them an offer, so to speak, which they could not refuse- "an investment assured of returning 12% a year."
When asked by the three pension boards for the return of their money recently, Fletcher "sent them promissory notes "in satisfaction of this redemption request" that pledged repayment within two years."
And you wonder why we have underfunded public pension funds? Who even knows who sits on the investment committees of these three Louisiana state public union pension funds? Somehow, I am guessing not people with requisite experience relevant to and adequate for the task.
Apparently it's not even clear just how much money Fletcher's fund complex actually runs. The Journal alleges that it is probably close to $200MM, although Fletcher, by double-counting amounts that one fund invests with another within its complex, gave a figure of some $500MM.
The story reads like Hillary Clinton's legendary gains from funds managed by "Red" Bone. In that case, Red essentially decided, after the fact, where Hillary's money had been that period, and credited her account thus.
Between the guaranteed minimum 12% return and the many cross-feeds of funds from one element of Fletcher's complex into others, one gets the sense that the same scheme was afoot in this recent case.
In the Journal's July 16-17 weekend edition, it updated the Fletcher saga. By then, all three Louisiana unions' pension funds had requested the return of their total investments of $143MM. This sum would seem to be the bulk of Fletcher's investments, if the Journal's earlier-stated, $200MM figure is close to correct.
The articles made for interesting and, frankly, fun reading. As I read each subsequent paragraph, I grew more curious as to who could possibly be so stupid as to invest so much public union pension money with a manager who promised- promised- a minimum return of 12% per annum. That's more than the S&P averaged before the recent flat decade.
Mind you, we're not talking about Steve Cohen or Jim Simons. Fletcher was described in the earlier article as a once-promising equities trader at Kidder Peabody who sued over a bonus dispute and for racial prejudice. He was involved in another racially-based lawsuit with the prominent New York city co-op, the Dakota.
Honestly, it reads like something out of a Tom Wolfe novel (Bonfire of the Vanities) except, sadly, it's all true.
I believe it was Forrest Gump, who hailed from the same general region, who said,
"Stupid is as stupid does."
Now, ask yourself, how will more federal financial regulation stop the idiots in Louisiana in charge of public union pension money from making more stupid mistakes like this in the future?
It seems that Alphonse Fletcher, said to, have "made a splash on Wall Street in the 1990s, reporting 300%-a-year returns at his firm," and "told of going 11 years without a single losing month," may have bamboozled three Louisiana public union pension boards.
Fletcher made them an offer, so to speak, which they could not refuse- "an investment assured of returning 12% a year."
When asked by the three pension boards for the return of their money recently, Fletcher "sent them promissory notes "in satisfaction of this redemption request" that pledged repayment within two years."
And you wonder why we have underfunded public pension funds? Who even knows who sits on the investment committees of these three Louisiana state public union pension funds? Somehow, I am guessing not people with requisite experience relevant to and adequate for the task.
Apparently it's not even clear just how much money Fletcher's fund complex actually runs. The Journal alleges that it is probably close to $200MM, although Fletcher, by double-counting amounts that one fund invests with another within its complex, gave a figure of some $500MM.
The story reads like Hillary Clinton's legendary gains from funds managed by "Red" Bone. In that case, Red essentially decided, after the fact, where Hillary's money had been that period, and credited her account thus.
Between the guaranteed minimum 12% return and the many cross-feeds of funds from one element of Fletcher's complex into others, one gets the sense that the same scheme was afoot in this recent case.
In the Journal's July 16-17 weekend edition, it updated the Fletcher saga. By then, all three Louisiana unions' pension funds had requested the return of their total investments of $143MM. This sum would seem to be the bulk of Fletcher's investments, if the Journal's earlier-stated, $200MM figure is close to correct.
The articles made for interesting and, frankly, fun reading. As I read each subsequent paragraph, I grew more curious as to who could possibly be so stupid as to invest so much public union pension money with a manager who promised- promised- a minimum return of 12% per annum. That's more than the S&P averaged before the recent flat decade.
Mind you, we're not talking about Steve Cohen or Jim Simons. Fletcher was described in the earlier article as a once-promising equities trader at Kidder Peabody who sued over a bonus dispute and for racial prejudice. He was involved in another racially-based lawsuit with the prominent New York city co-op, the Dakota.
Honestly, it reads like something out of a Tom Wolfe novel (Bonfire of the Vanities) except, sadly, it's all true.
I believe it was Forrest Gump, who hailed from the same general region, who said,
"Stupid is as stupid does."
Now, ask yourself, how will more federal financial regulation stop the idiots in Louisiana in charge of public union pension money from making more stupid mistakes like this in the future?
Wednesday, May 04, 2011
Starbucks, Yahoo & David Einhorn
Various business media carried stories yesterday concerning Starbucks and Yahoo. Since both were one-time selections in my equity portfolios, I was curious as to the dynamics accounting for positive, or negative, aspects of each company's current buzz.
For Starbucks, a Wall Street Journal story described the coffee roaster chain's steady stock price rise since the depths of the 2008-09 market lows, but cautioned that rising coffee bean prices could affect future profit growth.
Upon reviewing the company's five-year equity prices, relative to the S&P500, I saw that it has, indeed, reached new highs for the period.
I know I've written posts in recent years concerning the company's various strategies involving food, pruning store locations, and selling instant coffee.
But, for me, any solid, genuine rebirth of the company should be driven by revenue and profit growth. What I found when I checked my own numbers was somewhat surprising.
Annual revenue growth rates for Starbucks before the recession were in the 17-21% range. Rather robust, no pun intended. Since bottoming with the recession, the last two years' growth rates have been anemic by comparison- less than half a percent, and 8%. Profit growth rates are, of course, distorted by the recession and the chain's store closings. But pre-recession profit growth was in the 15-22% range, while subsequent growth has been negative, then uninterpretably high, thanks to such low profits in mid-2009. But from last year's first quarter to this year's, profits grew 38%. Hardly faltering.
Still, that said, two years is hardly sufficient time to declare Starbucks a consistently superior performer. Believe or not, my proprietary research has found that such performance is not rare by any means.
The question one has to ask, of course, is to what extent this is repeatable for another few years. Perhaps Starbucks' focus on overseas growth will allow it to regain an ability to earn consistently superior total returns, thanks to detatching its growth from the US economy and consumer, and going overseas for more revenue growth. With a softening US economy apparently ahead, Starbucks' domestic business could be headed for another flattening like that of the recent recession.
Then we turn to Yahoo, the other recent subject of much media attention. This time, it's not Carol Bartz in the spotlight, but hedge fund raider David Einhorn.
Einhorn has amassed a position in the company's equity and favorably commented on its China properties and recent 'shareholder-friendly' changes.
I'm sure remarks like that from Einhorn send chills through Bartz. Increased equity accumulation, requests for board seats, and a spinoff of Yahoo's Chinese interests can't be far behind, can they?
I suppose since Yahoo's equity price has been flat for so long, Einhorn is getting a bargain. Assuming, that is, his math on breakup values is correct, and he is able to effect that.
What I wonder, however, is how long his investors tend to wait for payoffs in these types of moves? Perhaps the patient, trusting nature of his investors gives Einhorn time to wait for Yahoo/Bartz to eventually come around to accept his type of bear hug.
But fellow hedge fund/company acquirer Eddie Lampert's Sears reported falling sales just the other day. His foray into retail hasn't had such a happy ending yet.
Of course, Einhorn probably doesn't want to run any part of Yahoo, so much as put pieces into play and hopefully make much, much more on the skyrocketing value of the Chinese properties than he will lose on the rest of Yahoo. In that regard, it's likely a safer play.
Assuming he can get the firm split up reasonably soon.
Then, again, I've argued that Bartz should just sell or liquidate the firm. This may be one of the last opportunities for a Yahoo CEO to create some value for shareholders from a position of any strength whatsoever. Maybe Einhorn's interest should be greeted with an accommodating attitude. It may be quite some time before another suitor with such manners comes calling.
For Starbucks, a Wall Street Journal story described the coffee roaster chain's steady stock price rise since the depths of the 2008-09 market lows, but cautioned that rising coffee bean prices could affect future profit growth.
I know I've written posts in recent years concerning the company's various strategies involving food, pruning store locations, and selling instant coffee.
But, for me, any solid, genuine rebirth of the company should be driven by revenue and profit growth. What I found when I checked my own numbers was somewhat surprising.
Annual revenue growth rates for Starbucks before the recession were in the 17-21% range. Rather robust, no pun intended. Since bottoming with the recession, the last two years' growth rates have been anemic by comparison- less than half a percent, and 8%. Profit growth rates are, of course, distorted by the recession and the chain's store closings. But pre-recession profit growth was in the 15-22% range, while subsequent growth has been negative, then uninterpretably high, thanks to such low profits in mid-2009. But from last year's first quarter to this year's, profits grew 38%. Hardly faltering.
Still, that said, two years is hardly sufficient time to declare Starbucks a consistently superior performer. Believe or not, my proprietary research has found that such performance is not rare by any means.
The question one has to ask, of course, is to what extent this is repeatable for another few years. Perhaps Starbucks' focus on overseas growth will allow it to regain an ability to earn consistently superior total returns, thanks to detatching its growth from the US economy and consumer, and going overseas for more revenue growth. With a softening US economy apparently ahead, Starbucks' domestic business could be headed for another flattening like that of the recent recession.
Then we turn to Yahoo, the other recent subject of much media attention. This time, it's not Carol Bartz in the spotlight, but hedge fund raider David Einhorn.
Einhorn has amassed a position in the company's equity and favorably commented on its China properties and recent 'shareholder-friendly' changes.
I'm sure remarks like that from Einhorn send chills through Bartz. Increased equity accumulation, requests for board seats, and a spinoff of Yahoo's Chinese interests can't be far behind, can they?
I suppose since Yahoo's equity price has been flat for so long, Einhorn is getting a bargain. Assuming, that is, his math on breakup values is correct, and he is able to effect that.
What I wonder, however, is how long his investors tend to wait for payoffs in these types of moves? Perhaps the patient, trusting nature of his investors gives Einhorn time to wait for Yahoo/Bartz to eventually come around to accept his type of bear hug.
But fellow hedge fund/company acquirer Eddie Lampert's Sears reported falling sales just the other day. His foray into retail hasn't had such a happy ending yet.
Of course, Einhorn probably doesn't want to run any part of Yahoo, so much as put pieces into play and hopefully make much, much more on the skyrocketing value of the Chinese properties than he will lose on the rest of Yahoo. In that regard, it's likely a safer play.
Assuming he can get the firm split up reasonably soon.
Then, again, I've argued that Bartz should just sell or liquidate the firm. This may be one of the last opportunities for a Yahoo CEO to create some value for shareholders from a position of any strength whatsoever. Maybe Einhorn's interest should be greeted with an accommodating attitude. It may be quite some time before another suitor with such manners comes calling.
Wednesday, March 23, 2011
Paul Singer On Inflation, Dodd-Frank Regulation, & The Next Financial Meltdown
This past weekend's Wall Street Journal main interview was with hedge fund manager Paul Singer. I can't say I was acquainted with his work prior to reading the interview, but I was heartened, in a way, that so much of what he espoused was similar to some of my own previously-written views.
For example, Singer was unequivocal regarding coming inflation. When a guy like this begins citing 1930s era European treatises on the Germany currency debasement, you should be worried. I already am, but, of course, Helicopter Ben keeps telling people like me to have faith and quit being concerned.
Let me put it this way. Singer has built a multi-billion hedge fund by relying on his own analyses, conclusions and instincts. Ben The Bernanke is a high-level civil servant who will probably be offered another high-level, lucrative position after being Fed Chairman, no matter how badly he messes up in that role.
Of the two, Singer or Bernanke, whom do you think has the greater risk in being wrong, and, therefore, is more likely to get the current economic situation correct? And, by the way, Bernanke, as a sitting Fed Chairman, pretty much has to cheer lead on topics like saying economic growth is coming or here, inflation won't be a problem, and the world's investors won't be concerned about continued US monetary debasement.
For once, in Singer, I've found someone who echoes my own views of large US commercial banks as totally unattractive investments. James Freeman's interview quotes him as saying,
"You don't know the financial condition of [Citigroup], JP Morgan, Bank of America, any of them. Mr. Singer believes the big banks still carry too much leverage, and he doesn't trust regulators to monitor them effectively.
The largest financial institutions, he says, are "a random collection of survivors. Almost none of the survivors exist because of their perspicacity, risk controls and sound management- even the ones that are vaunted along those lines...How and why do they exist? Mostly on accident, meaning who got bailed out first and who was saved next and how did people feel and what did people say the weekend Merrill was under pressure [in September 2008]." "
Singer goes further in the next paragraphs, citing one of my own favorite risks- counterparty. He says that his fund complex has removed itself as much as possible from having any of the large US commercial banks and "the Street" as counterparties.
Singer sees Dodd-Frank as I, and many others, do, as described in the interview thus,
"The authors of Dodd-Frank claim that the law prevents the government from bailing out any particular firm, but the Fed can still provide emergency loans to a failing giant as long as it offers similar financing to other firms.
"It's a very important part of this equation that a few survivors exist in this peculiar relationship with government, having to kowtow to government, make relationships with regulators," says Mr. Singer. "Are they puppets of the government? Are they cronies of the government? Will their lending be affected by the perceived whims or beliefs of the particular government regulators existing at a particular time? Yes."
If the government deems a firm not "systemically important," Mr. Singer forecasts, it could spell its doom. "Small and medium-sized financial institutions may be disadvantaged, may be sacrificed in the next crisis to protect these behemoths," he says.
It gets even worse, Mr. Singer says, if the government ever deems a financial giant "in danger of default"—a judgment that can be made without the consent of the firm or its investors. The business is then taken over by the Federal Deposit Insurance Corporation, with its Orderly Liquidation Authority.
Once in charge of the firm, the government can discriminate among similarly situated creditors and transfer assets out of the business at will. Because of this, says Mr. Singer, creditors and trading counterparties might flee even faster than they would from a firm headed toward bankruptcy, where at least there is established law instead of regulator discretion.
"You don't know how you will be treated," he says of financial institutions under the new FDIC regime. "If there are companies that are also counterparties alongside you but they've been designated systemically important, that's a clue. It's like a game of treasure hunt. It's a clue that you're going to get disadvantaged compared to them."
So maybe FDIC chairman Sheila Bair and the authors of Dodd-Frank were right about one thing: Perhaps their new process for resolving failing giants really will discourage some people from lending to the biggest banks—but only at the worst possible moment.
The problem, in Mr. Singer's view, will be the jarring shift from one day being an investor in a member of the "systemically important" club, to the next day being a creditor whose claim is determined by bureaucratic whim. This may be welcome news to government pension funds that will want to be bailed out, but certainly not for private investors.
The speed at which a firm will collapse as word gets around that it might be headed to FDIC resolution could be "amazing," says Mr. Singer. And that "speed will drive the size of the losses."
This "atmosphere of unpredictability" is harmful to America's place in the financial world, he says, and "it doesn't make the system any safer. . . . This is nuts to be identifying systemically important institutions." He views it as a poor "substitute for creating soundness and reasonable levels of leverage throughout the system."
Phrases like "bureaucratic whim" ought to make you cringe. Don't you think they have that effect on investors in, lenders and counterparties to such institutions? I do. Singer's comments confirm what many others, including me, have contended, i.e., that the comparatively predictable existing bankruptcy laws have been replaced by liquidation-by-whim and cronyism. Singer is correct to predict that funds will leave a troubled firm much faster than anyone can imagine. And, ironically, that being in a group of selectively preferred, "systematically important" designated firms lending to or investing in a large bank is actually dangerous, because you will be the least-advantaged party. The one most likely to be at the very end of any line to collect on funds due.
Thus, in Singer's view, you have government-backed large institutions continuing with risky behaviors, and counterparties like them doing the same. This, he worries, is the seed bed for the next financial meltdown. Dodd-Frank and the FDIC have replaced uncertainty with respect to government backing for large firms in the event of another financial crisis with absolute certainty that select "systematically important" banking firms will be rescued. Moral hazard is now legislatively and regulatorily banished, leading to another round of excessive risk-taking.
The final passage of Freeman's interview says a lot about Singer,
"One reason his firm has survived for 34 years, he says, is that "we try to be very respectful of the unpredictability of markets. We try to at all times at least assume that the world is not being properly run." A safe assumption. "
Sad but, in this case, so true.
For example, Singer was unequivocal regarding coming inflation. When a guy like this begins citing 1930s era European treatises on the Germany currency debasement, you should be worried. I already am, but, of course, Helicopter Ben keeps telling people like me to have faith and quit being concerned.
Let me put it this way. Singer has built a multi-billion hedge fund by relying on his own analyses, conclusions and instincts. Ben The Bernanke is a high-level civil servant who will probably be offered another high-level, lucrative position after being Fed Chairman, no matter how badly he messes up in that role.
Of the two, Singer or Bernanke, whom do you think has the greater risk in being wrong, and, therefore, is more likely to get the current economic situation correct? And, by the way, Bernanke, as a sitting Fed Chairman, pretty much has to cheer lead on topics like saying economic growth is coming or here, inflation won't be a problem, and the world's investors won't be concerned about continued US monetary debasement.
For once, in Singer, I've found someone who echoes my own views of large US commercial banks as totally unattractive investments. James Freeman's interview quotes him as saying,
"You don't know the financial condition of [Citigroup], JP Morgan, Bank of America, any of them. Mr. Singer believes the big banks still carry too much leverage, and he doesn't trust regulators to monitor them effectively.
The largest financial institutions, he says, are "a random collection of survivors. Almost none of the survivors exist because of their perspicacity, risk controls and sound management- even the ones that are vaunted along those lines...How and why do they exist? Mostly on accident, meaning who got bailed out first and who was saved next and how did people feel and what did people say the weekend Merrill was under pressure [in September 2008]." "
Singer goes further in the next paragraphs, citing one of my own favorite risks- counterparty. He says that his fund complex has removed itself as much as possible from having any of the large US commercial banks and "the Street" as counterparties.
Singer sees Dodd-Frank as I, and many others, do, as described in the interview thus,
"The authors of Dodd-Frank claim that the law prevents the government from bailing out any particular firm, but the Fed can still provide emergency loans to a failing giant as long as it offers similar financing to other firms.
"It's a very important part of this equation that a few survivors exist in this peculiar relationship with government, having to kowtow to government, make relationships with regulators," says Mr. Singer. "Are they puppets of the government? Are they cronies of the government? Will their lending be affected by the perceived whims or beliefs of the particular government regulators existing at a particular time? Yes."
If the government deems a firm not "systemically important," Mr. Singer forecasts, it could spell its doom. "Small and medium-sized financial institutions may be disadvantaged, may be sacrificed in the next crisis to protect these behemoths," he says.
It gets even worse, Mr. Singer says, if the government ever deems a financial giant "in danger of default"—a judgment that can be made without the consent of the firm or its investors. The business is then taken over by the Federal Deposit Insurance Corporation, with its Orderly Liquidation Authority.
Once in charge of the firm, the government can discriminate among similarly situated creditors and transfer assets out of the business at will. Because of this, says Mr. Singer, creditors and trading counterparties might flee even faster than they would from a firm headed toward bankruptcy, where at least there is established law instead of regulator discretion.
"You don't know how you will be treated," he says of financial institutions under the new FDIC regime. "If there are companies that are also counterparties alongside you but they've been designated systemically important, that's a clue. It's like a game of treasure hunt. It's a clue that you're going to get disadvantaged compared to them."
So maybe FDIC chairman Sheila Bair and the authors of Dodd-Frank were right about one thing: Perhaps their new process for resolving failing giants really will discourage some people from lending to the biggest banks—but only at the worst possible moment.
The problem, in Mr. Singer's view, will be the jarring shift from one day being an investor in a member of the "systemically important" club, to the next day being a creditor whose claim is determined by bureaucratic whim. This may be welcome news to government pension funds that will want to be bailed out, but certainly not for private investors.
The speed at which a firm will collapse as word gets around that it might be headed to FDIC resolution could be "amazing," says Mr. Singer. And that "speed will drive the size of the losses."
This "atmosphere of unpredictability" is harmful to America's place in the financial world, he says, and "it doesn't make the system any safer. . . . This is nuts to be identifying systemically important institutions." He views it as a poor "substitute for creating soundness and reasonable levels of leverage throughout the system."
Phrases like "bureaucratic whim" ought to make you cringe. Don't you think they have that effect on investors in, lenders and counterparties to such institutions? I do. Singer's comments confirm what many others, including me, have contended, i.e., that the comparatively predictable existing bankruptcy laws have been replaced by liquidation-by-whim and cronyism. Singer is correct to predict that funds will leave a troubled firm much faster than anyone can imagine. And, ironically, that being in a group of selectively preferred, "systematically important" designated firms lending to or investing in a large bank is actually dangerous, because you will be the least-advantaged party. The one most likely to be at the very end of any line to collect on funds due.
Thus, in Singer's view, you have government-backed large institutions continuing with risky behaviors, and counterparties like them doing the same. This, he worries, is the seed bed for the next financial meltdown. Dodd-Frank and the FDIC have replaced uncertainty with respect to government backing for large firms in the event of another financial crisis with absolute certainty that select "systematically important" banking firms will be rescued. Moral hazard is now legislatively and regulatorily banished, leading to another round of excessive risk-taking.
The final passage of Freeman's interview says a lot about Singer,
"One reason his firm has survived for 34 years, he says, is that "we try to be very respectful of the unpredictability of markets. We try to at all times at least assume that the world is not being properly run." A safe assumption. "
Sad but, in this case, so true.
Thursday, December 09, 2010
Barnes & Noble + Borders: William Ackman Plays Modern-Day JP Morgan
Tuesday's Wall Street Journal featured an article describing hedge fund manager William Ackman's bid to reprise J.P. Morgan's historic industrial reorganization role with his bid, as an owner of Borders, to merge that firm with Barnes & Noble. The story noted,
"The threats posed to the big store chains were underscored Monday, when Google Inc. unveiled its new online bookstore, a retailing venture that adds a major player to a crowd of digital sellers that includes Amazon.com Inc. and Apple Inc.
A hedge fund managed by Borders investor William Ackman is now offering to finance a bid of $960 million in cash, or $16 per share, for Borders to buy the much bigger Barnes & Noble, which put itself up for sale in August. Mr. Ackman, whose Pershing Square Capital Management LP holds 37.3% of Borders shares, made his offer in a regulatory filing that became public Monday.
The past year has been rocky for Barnes & Noble. In November 2009, the company adopted a "poison pill" antitakeover defense after activist investor Ronald Burkle and his Yucaipa Cos. purchased nearly 20% of its stock. In August, the retailer put itself up for sale. Mr. Burkle launched a nasty proxy fight for board representation, a bid that was defeated in late September.
A marriage of the two book behemoths could lead to some significant cost savings through economies of scale. Barnes & Noble also has proven to be a more adept operator, with skills that it could be applied throughout a single, combined chain. But a combination of the No. 1 and No. 2 bookstore chains in the U.S. would face headwinds, including antitrust scrutiny and Borders' own shaky finances."
I guess since Ackman already has such a large stake in Borders, conventional concerns regarding whether the merger's cost savings can really offset changing consumer behaviors with respect to bricks and mortar book retailing may be moot. He has to minimize damage to his existing investment, short of simply bailing out.
The Journal article went on to identify the most likely reason that Ackman wants Borders unified with its large competitor,
"Mr. Ackman's proposal may be a bet on Barnes & Noble's rapid investment in digital bookselling, built on its Nook e-reader device and e-book offerings. Recently, the retailer introduced a Nook Color reader, and claims to have captured about 20% of the digital book market, which Forrester Research says could more than triple to $966 million in revenue this year. Borders sells e-books through a bookstore powered by Kobo Inc., a Toronto-based e-retailer in which it is an investor.
Observers say Mr. Ackman's bid for Barnes & Noble may be an attempt to help Borders survive. But because Borders is facing even bigger challenges than Barnes & Noble, it may not be seen favorably as an acquirer."
This makes sense, of course, for Ackman and Borders. But why would Barnes & Noble allow itself to be low-balled for its more valuable asset, its burgeoning online reader business? Won't other bidders keep a realistic, market-based value on that which will prevent Ackman from stealing it on the cheap?
The story provided some detail on past merger ideas for the two firms, explaining,
"The idea of joining the two companies has been floated before. In May 2008, Barnes & Noble assembled a team of executives and advisers to study the possibility of acquiring Borders, which had put itself up for sale. But in August of that year, Barnes & Noble decided against making an offer.
Mr. Ackman had also pursued the idea. In November 2008, Mr. Ackman, then the second largest investor in Barnes & Noble, with a bit more than 10% of the stock, tried to get the book giant to buy Borders, arguing that the combined business would be stronger than either operating independently. He also owned more than 11% of Borders at the time.
His efforts were rebuffed by Barnes & Noble, however, which was concerned about inheriting Borders' real estate portfolio and lengthy store leases. Mr. Ackman later sold his Barnes & Noble stock. It is unclear whether he owns any shares today."
It's unclear to me why Ackman has so diligently and doggedly pursued either physical book retailer over the past few years. With Amazon and Google targeting the space, and Apple's recent iPad adding to the mix, it wouldn't seem to be an easy product/market in which to earn substantial gains by maneuvering with the remaining two, damaged retailers, would it?
Ackman has a track record as a smart investor. But, then, so did Ed Lampert before his plunge into owning retailers K-Mart and Sears.
Nearby is a price chart for Borders (BGP), Barnes & Noble (BKS), and the S&P500 Index for the past five years.
Why on earth would anyone have bought into these turkeys even as long as three years ago? Their underperformance has only increased since then.
I suppose Ackman has a very short-term, 'turnaround' sort of mentality that seeks a quick, abrupt rise in share price from an unexpected reorganization, followed by a hasty exit from his positions.
Somehow, though, JP Morgan's steel-sector integrations of a century ago seem to have involved an industry with much more growth and opportunity ahead of it than Ackman's book retailers have.
I'm just not seeing the logic to this situation for Ackman, other than desperation to rescue some value from his 1/3+ ownership of the worse-performing, lesser-sized turkey in the sector. Is Ackman hoping, if successful, to sell the Nook business and eventually realize real estate gains from the resulting moribund combined bookselling business? He tried that when he approached Target, but was rebuffed. Here, he is already heavily invested, and the prospects are dimmer, so his motivations might be heightened.
"The threats posed to the big store chains were underscored Monday, when Google Inc. unveiled its new online bookstore, a retailing venture that adds a major player to a crowd of digital sellers that includes Amazon.com Inc. and Apple Inc.
A hedge fund managed by Borders investor William Ackman is now offering to finance a bid of $960 million in cash, or $16 per share, for Borders to buy the much bigger Barnes & Noble, which put itself up for sale in August. Mr. Ackman, whose Pershing Square Capital Management LP holds 37.3% of Borders shares, made his offer in a regulatory filing that became public Monday.
The past year has been rocky for Barnes & Noble. In November 2009, the company adopted a "poison pill" antitakeover defense after activist investor Ronald Burkle and his Yucaipa Cos. purchased nearly 20% of its stock. In August, the retailer put itself up for sale. Mr. Burkle launched a nasty proxy fight for board representation, a bid that was defeated in late September.
A marriage of the two book behemoths could lead to some significant cost savings through economies of scale. Barnes & Noble also has proven to be a more adept operator, with skills that it could be applied throughout a single, combined chain. But a combination of the No. 1 and No. 2 bookstore chains in the U.S. would face headwinds, including antitrust scrutiny and Borders' own shaky finances."
I guess since Ackman already has such a large stake in Borders, conventional concerns regarding whether the merger's cost savings can really offset changing consumer behaviors with respect to bricks and mortar book retailing may be moot. He has to minimize damage to his existing investment, short of simply bailing out.
The Journal article went on to identify the most likely reason that Ackman wants Borders unified with its large competitor,
"Mr. Ackman's proposal may be a bet on Barnes & Noble's rapid investment in digital bookselling, built on its Nook e-reader device and e-book offerings. Recently, the retailer introduced a Nook Color reader, and claims to have captured about 20% of the digital book market, which Forrester Research says could more than triple to $966 million in revenue this year. Borders sells e-books through a bookstore powered by Kobo Inc., a Toronto-based e-retailer in which it is an investor.
Observers say Mr. Ackman's bid for Barnes & Noble may be an attempt to help Borders survive. But because Borders is facing even bigger challenges than Barnes & Noble, it may not be seen favorably as an acquirer."
This makes sense, of course, for Ackman and Borders. But why would Barnes & Noble allow itself to be low-balled for its more valuable asset, its burgeoning online reader business? Won't other bidders keep a realistic, market-based value on that which will prevent Ackman from stealing it on the cheap?
The story provided some detail on past merger ideas for the two firms, explaining,
"The idea of joining the two companies has been floated before. In May 2008, Barnes & Noble assembled a team of executives and advisers to study the possibility of acquiring Borders, which had put itself up for sale. But in August of that year, Barnes & Noble decided against making an offer.
Mr. Ackman had also pursued the idea. In November 2008, Mr. Ackman, then the second largest investor in Barnes & Noble, with a bit more than 10% of the stock, tried to get the book giant to buy Borders, arguing that the combined business would be stronger than either operating independently. He also owned more than 11% of Borders at the time.
His efforts were rebuffed by Barnes & Noble, however, which was concerned about inheriting Borders' real estate portfolio and lengthy store leases. Mr. Ackman later sold his Barnes & Noble stock. It is unclear whether he owns any shares today."
It's unclear to me why Ackman has so diligently and doggedly pursued either physical book retailer over the past few years. With Amazon and Google targeting the space, and Apple's recent iPad adding to the mix, it wouldn't seem to be an easy product/market in which to earn substantial gains by maneuvering with the remaining two, damaged retailers, would it?
Nearby is a price chart for Borders (BGP), Barnes & Noble (BKS), and the S&P500 Index for the past five years.
Why on earth would anyone have bought into these turkeys even as long as three years ago? Their underperformance has only increased since then.
I suppose Ackman has a very short-term, 'turnaround' sort of mentality that seeks a quick, abrupt rise in share price from an unexpected reorganization, followed by a hasty exit from his positions.
Somehow, though, JP Morgan's steel-sector integrations of a century ago seem to have involved an industry with much more growth and opportunity ahead of it than Ackman's book retailers have.
I'm just not seeing the logic to this situation for Ackman, other than desperation to rescue some value from his 1/3+ ownership of the worse-performing, lesser-sized turkey in the sector. Is Ackman hoping, if successful, to sell the Nook business and eventually realize real estate gains from the resulting moribund combined bookselling business? He tried that when he approached Target, but was rebuffed. Here, he is already heavily invested, and the prospects are dimmer, so his motivations might be heightened.
Tuesday, October 19, 2010
Pension Funds, Equities & Equity Market Performance In The Near Term
Yesterday's Wall Street Journal featured a long article detailing how US corporate and union pensions have taken dramatic steps to limit their exposure to and investments in equities.
Even as the percentage of funded pension obligations among S&P 500 companies fell from over 100% in 2007 to less than 75% this year, there's evidently a stampede among them to more closely fund expected pension payments and stop focusing on longer term total returns.
Of course, long term total return-focused investing has been, for years, synonymous with large percentage holdings of US equities.
In a chart comparing 2005 equity investments to 2009, major company pension funds exhibited declines from the 60-70% range down to 30-50%.
That's a stunning drop for such large institutional investors. One assumes that union and other pension funds have behaved similarly.
The reason, of course, is the so-called 'lost decade' in equity performance from 2000-2009. The Journal piece states that state and local governments "oversee $2.8 trillion in assets," while corporate pensions assets are roughly $2 trillion.
Another solution is a move to cap and close current defined-benefit plans, shifting to 401K plans held by individuals for future pension obligations.
With this excellent article as fresh information on the motivations, current and planned moves of some $5 trillion of institutional assets from equities to fixed income, my question is this.
Will the rush of so much money reputed to be 'on the sidelines,' about to pour into US equities in order to catch up to the current year S&P's ~4% return, still occur?
With US pension funds holding back from equities, will hedge funds alone be sufficient to cause the prophesied, magical lift in the fourth quarter for US equity indices?
If one believes the Journal article, a very large amount of assets are shifting away from US equities in a secular fashion. It doesn't mean shorter-term trends won't still be intact, but it would seem that the levels at which those trends occur will be lower.
Various estimates of the current US equity markets capitalization range from $35-40 trillion. At that level, $5 trillion in wary institutional assets represents between 1/8 and 1/7 of the market. That would seem to be a non-trivial chunk of assets which aren't going to be rushing into a rising US equity market.
Perhaps, regardless of employment or US corporate earnings, equity indices such as the S&P500 and Dow Jones are going to experience muted rises in the next few years, as fewer assets stream into rising markets.
Even as the percentage of funded pension obligations among S&P 500 companies fell from over 100% in 2007 to less than 75% this year, there's evidently a stampede among them to more closely fund expected pension payments and stop focusing on longer term total returns.
Of course, long term total return-focused investing has been, for years, synonymous with large percentage holdings of US equities.
In a chart comparing 2005 equity investments to 2009, major company pension funds exhibited declines from the 60-70% range down to 30-50%.
That's a stunning drop for such large institutional investors. One assumes that union and other pension funds have behaved similarly.
The reason, of course, is the so-called 'lost decade' in equity performance from 2000-2009. The Journal piece states that state and local governments "oversee $2.8 trillion in assets," while corporate pensions assets are roughly $2 trillion.
Another solution is a move to cap and close current defined-benefit plans, shifting to 401K plans held by individuals for future pension obligations.
With this excellent article as fresh information on the motivations, current and planned moves of some $5 trillion of institutional assets from equities to fixed income, my question is this.
Will the rush of so much money reputed to be 'on the sidelines,' about to pour into US equities in order to catch up to the current year S&P's ~4% return, still occur?
With US pension funds holding back from equities, will hedge funds alone be sufficient to cause the prophesied, magical lift in the fourth quarter for US equity indices?
If one believes the Journal article, a very large amount of assets are shifting away from US equities in a secular fashion. It doesn't mean shorter-term trends won't still be intact, but it would seem that the levels at which those trends occur will be lower.
Various estimates of the current US equity markets capitalization range from $35-40 trillion. At that level, $5 trillion in wary institutional assets represents between 1/8 and 1/7 of the market. That would seem to be a non-trivial chunk of assets which aren't going to be rushing into a rising US equity market.
Perhaps, regardless of employment or US corporate earnings, equity indices such as the S&P500 and Dow Jones are going to experience muted rises in the next few years, as fewer assets stream into rising markets.
Friday, September 24, 2010
David Tepper On CNBC This Morning
CNBC's 6-9am program featured a half-hour segment, ending at 8:30, with David Tepper, founder and head of the $12B+ hedge fund Appaloosa Management. I'm sure it's already a featured clip on the network's website, and will remain in the paid portion for some time.
Tepper said a lot during his half hour as the program's only guest. But there were two comments which, for me, were especially notable.
The first was his nonchalance concerning the bet his hedge fund made on US bank equities and debt in 2009. According to Tepper, Treasury published a white paper declaring, in advance, the bank equities it would purchase, and at what prices. Citing the failure to comply with this document as fraud under SEC rules, Tepper claimed that it was easy to go long in the bank instruments which delivered Appaloosa's reported 100%+ gains for 2009.
"Sometimes, it's that easy," the 17-year veteran hedge fund manager observed.
Despite questions from Becky Quick and Joe Kernen concerning the changes in federal government actions, versus stated intent, for TARP, and its quixotic behavior two years ago this fall, Tepper remained calmly insistent that Appaloosa's long positions going into 2009 were a simple, riskless move.
I can't help believe that Tepper is putting a different face on those risks now then he and his team viewed them two years ago.
For example, the federal government enjoys sovereign immunity from many lawsuits. And it's very unlikely that any administration would allow its SEC head to bring action against its Treasury Secretary or the Fed for failing to act upon a 'white paper.'
I'm sorry, but I just don't buy Tepper's characterization of his funds' positions as essentially riskless and a no brainer in late 2008 and early 2009.
If he'd been wrong, and Treasury had had second thoughts, we'd have read about Appaloosa's horrendous losses. And maybe a feeble attempt to bring suit. Which probably would have brought heat from the SEC to quash the attempt at forcing Treasury to follow through.
The second interesting comment from Tepper arguably began to turn equity market futures this morning. When asked about his views for the rest of the year, Tepper didn't hesitate to say he was longer than usual, and fully expected the Fed to make good on its desire to facilitate US economic growth.
According to Tepper, between continued easy money, borrowing, and/or, if necessary, QE2, he's confident that the Fed will get its wish. As he put it, to paraphrase,
'If the Fed continues easing, equities will do well, but bonds will get killed. If, on the other hand, that doesn't ignite growth, and they need to do more quantitative easing, then everything will do well for the remainder of the year.'
Tepper didn't say there wouldn't be a price to be paid for all of this easing. He simply reiterated his early comment about 2009, i.e., you should believe the Fed and Treasury when they say they want to assure an economic result which, in the short term, they have the means to effect.
Having seen some prior examples of a market heavyweight's comments on CNBC seem to move the S&P and Dow futures, I'm not at all dismissive of the impact of David Tepper's remarks. When he began speaking, the S&P futures were around 1122. Now, at 9am, an hour later, they are around 1133, with the added help of some positive economic news.
One has to wonder why Tepper suddenly appeared on CNBC this morning. Was it a function of the equity markets falling back from their recent, multi-month highs? Was Tepper concerned about the fate of his long positions?
I don't believe in coincidences of this sort. A few months ago, Doug Kass, a noted bear and also a guest/host on CNBC earlier this morning, made public his belief that equities had hit a bottom and, sure enough, they began a march upward that morning.
No matter how talented the equity manager, whether public or private/hedge fund in nature, I can't help but see them all merely talking their books when they agree to appear on CNBC.
Tepper said a lot during his half hour as the program's only guest. But there were two comments which, for me, were especially notable.
The first was his nonchalance concerning the bet his hedge fund made on US bank equities and debt in 2009. According to Tepper, Treasury published a white paper declaring, in advance, the bank equities it would purchase, and at what prices. Citing the failure to comply with this document as fraud under SEC rules, Tepper claimed that it was easy to go long in the bank instruments which delivered Appaloosa's reported 100%+ gains for 2009.
"Sometimes, it's that easy," the 17-year veteran hedge fund manager observed.
Despite questions from Becky Quick and Joe Kernen concerning the changes in federal government actions, versus stated intent, for TARP, and its quixotic behavior two years ago this fall, Tepper remained calmly insistent that Appaloosa's long positions going into 2009 were a simple, riskless move.
I can't help believe that Tepper is putting a different face on those risks now then he and his team viewed them two years ago.
For example, the federal government enjoys sovereign immunity from many lawsuits. And it's very unlikely that any administration would allow its SEC head to bring action against its Treasury Secretary or the Fed for failing to act upon a 'white paper.'
I'm sorry, but I just don't buy Tepper's characterization of his funds' positions as essentially riskless and a no brainer in late 2008 and early 2009.
If he'd been wrong, and Treasury had had second thoughts, we'd have read about Appaloosa's horrendous losses. And maybe a feeble attempt to bring suit. Which probably would have brought heat from the SEC to quash the attempt at forcing Treasury to follow through.
The second interesting comment from Tepper arguably began to turn equity market futures this morning. When asked about his views for the rest of the year, Tepper didn't hesitate to say he was longer than usual, and fully expected the Fed to make good on its desire to facilitate US economic growth.
According to Tepper, between continued easy money, borrowing, and/or, if necessary, QE2, he's confident that the Fed will get its wish. As he put it, to paraphrase,
'If the Fed continues easing, equities will do well, but bonds will get killed. If, on the other hand, that doesn't ignite growth, and they need to do more quantitative easing, then everything will do well for the remainder of the year.'
Tepper didn't say there wouldn't be a price to be paid for all of this easing. He simply reiterated his early comment about 2009, i.e., you should believe the Fed and Treasury when they say they want to assure an economic result which, in the short term, they have the means to effect.
Having seen some prior examples of a market heavyweight's comments on CNBC seem to move the S&P and Dow futures, I'm not at all dismissive of the impact of David Tepper's remarks. When he began speaking, the S&P futures were around 1122. Now, at 9am, an hour later, they are around 1133, with the added help of some positive economic news.
One has to wonder why Tepper suddenly appeared on CNBC this morning. Was it a function of the equity markets falling back from their recent, multi-month highs? Was Tepper concerned about the fate of his long positions?
I don't believe in coincidences of this sort. A few months ago, Doug Kass, a noted bear and also a guest/host on CNBC earlier this morning, made public his belief that equities had hit a bottom and, sure enough, they began a march upward that morning.
No matter how talented the equity manager, whether public or private/hedge fund in nature, I can't help but see them all merely talking their books when they agree to appear on CNBC.
Tuesday, June 15, 2010
Sebastian Mallaby On CNBC
Apparently Sebastian Mallaby's recent editorial, on which I commented yesterday, in the Wall Street Journal, was part of a well-orchestrated publicity campaign for his new book.
I didn't catch the book's name, but Mallaby was stumping for it on CNBC yesterday morning. When pushed, he made the same lame arguments about average hedge fund leverage on air that he did in his Journal editorial.
Mallaby wasn't any more convincing in person than in print. I didn't hear him address the over-leveraged hedge fund disasters, such as LTCM. Nor how the highly-leveraged hedge funds' dumping of positions in 2008 contributed to the market's downward shear.
From what I saw and read, Mallaby appears to simply ignoring the evidence that doesn't fit his particular hypothesis.
I didn't catch the book's name, but Mallaby was stumping for it on CNBC yesterday morning. When pushed, he made the same lame arguments about average hedge fund leverage on air that he did in his Journal editorial.
Mallaby wasn't any more convincing in person than in print. I didn't hear him address the over-leveraged hedge fund disasters, such as LTCM. Nor how the highly-leveraged hedge funds' dumping of positions in 2008 contributed to the market's downward shear.
From what I saw and read, Mallaby appears to simply ignoring the evidence that doesn't fit his particular hypothesis.
Monday, June 14, 2010
In Praise of Hedge Funds?
The weekend edition of the Wall Street Journal featured a long article in defense of hedge funds as a stabilizer in our financial system.
Distilled to its essence, the article cites several features of hedge funds which contribute to healthy market dynamics and don't drain taxpayers.
Specifically, it notes that hedge funds, due to the owners/managers receiving a sizable share of the funds' profits, tend to: identify genuine profit opportunities which make positive, risk-adjusted returns; manage risk better than insured public financial entities; through their ability to short equities, contribute to pricing efficiencies; don't require nor expect public funds to rescue them from failure.
All these points are true. The one caveat comes at the end of the piece. Sebastian Mallaby, the author of the long editorial, contends that the average hedge fund is much less leveraged than the average bank. That may be true, but it's not the averages that should worry us.
Rather, as noted in my comments on Scott Patterson's recent book, The Quants, here and here, and a related post here, leverage and risk management are the Achilles Heels of these outfits.
In this later post, I describe Larry Kelly's risk management theorem, derived from Shannon's information theory. Ed Thorp, the godfather of the modern quants, mentioned so lavishly in Patterson's book, revered Kelly and his Criterion. Kelly's Criterion is absolutely crucial in its focus on risk management via bet size.
None of this made it from Thorp to his progeny, nor, really, into Patterson's book. Patterson mentions Kelly in an aside so vague it originally escaped my attention. Luckily, a retired Bell Labs colleague lent me Poundstone's tome on Kelly.
It's leverage that makes otherwise-reasonable strategies toxic. Especially when, as Patterson did emphasize, several large hedge funds are pursuing the same instruments and investing with similar strategies.
As I've written in earlier posts, blame the lenders, usually commercial banks, for not adequately supervising hedge fund positions and risks. Blame the hedge fund managers for being ignorant of Kelly's work.
Mallaby's lengthy ode to hedge funds is sensible until that last, fatal passage about leverage.
If too much capital is employed, and leveraged up, by several investors, into the same positions, that, in itself, makes for an inefficient, risky market. With today's lightning-fast trading systems, it's virtually impossible for all that capital to exit without losses. Those losses then magnify the downward price spirals in the markets for the affected instruments.
I'm not at all sure that most of the offending hedge fund managers who came so close to death prior to the TARP's rescue learned anything. In Mallaby's ideal world, they would have been wiped out, and more prudent hedge funds would have, in a Darwinian consequence, survived to expand and fill the vacant market niches.
But that's not what happened. So it's debatable whether, in even today's environment, nearly two years later, large, highly-leveraged quantitative hedge funds are a benefit to our financial system.
Mallaby didn't explicitly endorse the quants, but most of his modern examples were quantitative funds. And it is precisely this variety which is vulnerable to such large, immediate losses from over-use of leverage.
Distilled to its essence, the article cites several features of hedge funds which contribute to healthy market dynamics and don't drain taxpayers.
Specifically, it notes that hedge funds, due to the owners/managers receiving a sizable share of the funds' profits, tend to: identify genuine profit opportunities which make positive, risk-adjusted returns; manage risk better than insured public financial entities; through their ability to short equities, contribute to pricing efficiencies; don't require nor expect public funds to rescue them from failure.
All these points are true. The one caveat comes at the end of the piece. Sebastian Mallaby, the author of the long editorial, contends that the average hedge fund is much less leveraged than the average bank. That may be true, but it's not the averages that should worry us.
Rather, as noted in my comments on Scott Patterson's recent book, The Quants, here and here, and a related post here, leverage and risk management are the Achilles Heels of these outfits.
In this later post, I describe Larry Kelly's risk management theorem, derived from Shannon's information theory. Ed Thorp, the godfather of the modern quants, mentioned so lavishly in Patterson's book, revered Kelly and his Criterion. Kelly's Criterion is absolutely crucial in its focus on risk management via bet size.
None of this made it from Thorp to his progeny, nor, really, into Patterson's book. Patterson mentions Kelly in an aside so vague it originally escaped my attention. Luckily, a retired Bell Labs colleague lent me Poundstone's tome on Kelly.
It's leverage that makes otherwise-reasonable strategies toxic. Especially when, as Patterson did emphasize, several large hedge funds are pursuing the same instruments and investing with similar strategies.
As I've written in earlier posts, blame the lenders, usually commercial banks, for not adequately supervising hedge fund positions and risks. Blame the hedge fund managers for being ignorant of Kelly's work.
Mallaby's lengthy ode to hedge funds is sensible until that last, fatal passage about leverage.
If too much capital is employed, and leveraged up, by several investors, into the same positions, that, in itself, makes for an inefficient, risky market. With today's lightning-fast trading systems, it's virtually impossible for all that capital to exit without losses. Those losses then magnify the downward price spirals in the markets for the affected instruments.
I'm not at all sure that most of the offending hedge fund managers who came so close to death prior to the TARP's rescue learned anything. In Mallaby's ideal world, they would have been wiped out, and more prudent hedge funds would have, in a Darwinian consequence, survived to expand and fill the vacant market niches.
But that's not what happened. So it's debatable whether, in even today's environment, nearly two years later, large, highly-leveraged quantitative hedge funds are a benefit to our financial system.
Mallaby didn't explicitly endorse the quants, but most of his modern examples were quantitative funds. And it is precisely this variety which is vulnerable to such large, immediate losses from over-use of leverage.
Friday, June 04, 2010
A New Exodus of Traders From Banks To Hedge Funds
Right on cue, with the recent passage by both Houses of Congress of some form of FINREG bill, traders at publicly-held firms are heading for the exits. The exodus was heralded by yesterday's Wall Street Journal's Money & Investing section's lead article, Hotshot Traders Leave Street.
Seasoned traders at several large commercial banks are now leaving to either start their own hedge funds, or take seed capital from established private funds, such as Citadel.
According to the Journal article, several existing hedge funds have created new structures to fund and, thus, capture some of the newly-fleeing talent from the publicly-held banks.
The only comment I would add is that these hotshots are, in reality, something like a third wave of such an exodus. There haven't been that many stellar performers remaining in the publicly-owned finance sector for some years. What we are now seeing is merely the latest purging of top, young talent following a well-worn path to the shadowy world of hedge funds.
This phenomenon ought to give legislators and would-be regulators pause. After all, doesn't that leave commercial bank trading in the hands of lesser talent? And push the better traders into a less-regulated part of the industry, where oversight is far scarcer, and leverage potentially much greater?
Sounds like a recipe for more counterparty risk and heavy sector losses, as the latest batch of smart young things head off to risk other people's money and pay themselves handsomely in the process, doesn't it?
Seasoned traders at several large commercial banks are now leaving to either start their own hedge funds, or take seed capital from established private funds, such as Citadel.
According to the Journal article, several existing hedge funds have created new structures to fund and, thus, capture some of the newly-fleeing talent from the publicly-held banks.
The only comment I would add is that these hotshots are, in reality, something like a third wave of such an exodus. There haven't been that many stellar performers remaining in the publicly-owned finance sector for some years. What we are now seeing is merely the latest purging of top, young talent following a well-worn path to the shadowy world of hedge funds.
This phenomenon ought to give legislators and would-be regulators pause. After all, doesn't that leave commercial bank trading in the hands of lesser talent? And push the better traders into a less-regulated part of the industry, where oversight is far scarcer, and leverage potentially much greater?
Sounds like a recipe for more counterparty risk and heavy sector losses, as the latest batch of smart young things head off to risk other people's money and pay themselves handsomely in the process, doesn't it?
Thursday, May 20, 2010
The Shadow Banking Safety Net?
A few days ago, on CNBC, guest Steve Crawford, late of Morgan Stanley, advanced the notion that current Senate regulatory efforts to shove risky trading out of regulated banks and into a "shadow banking system" won't keep the federal government from bailing out that sector, too.
This seemed to be an unsubstantiated claim.
Crawford didn't name names, but alleged that "shadow banks" had already been bailed out in the recent crisis, so there was no real discrimination, new legislation, or not.
I wonder which companies he considered to be shadow banks which were saved?
To me, any publicly-held, private sector entity which has material regulation of some sort is not a "shadow bank."
For example, I'd say that hedge funds and private equity groups are "shadow banks." Private equity lends, does leveraged buyouts and, at the upper end, can engage in significant proprietary trading.
Hedge funds clearly meet the trading units of heavily-regulated banks in the marketplace. But the hedge funds enjoy notoriously lighter regulatory burdens than their publicly-held competitors.
I'm not aware of any private equity or hedge fund groups being rescued in late 2008, are you? In fact, a few hedge funds went under, though I can't recall specific names. Other than LTCM, in 1998, no hedge fund, to my knowledge, has been the subject of a coordinated, government-led action to preserve markets.
Even in the case of LTCM, the firm wasn't saved. Rather, there was concern for counterparty losses due to the lack of bids for assets held by the firm, causing financial markets to crater as a by-product.
Counterparties and other large institutions contributed to the orderly unwinding of LTCM positions, but the firm's owners lost everything.
So I confess to not really understanding why Crawford is so worried about shadow banks. Existing hedge funds and private equity firms would pose risks due to unwise levels of leverage. But surely their lenders are capable of judging for themselves what those balance sheets can handle. At least better than an army of civil servants who have yet to forestall a financial crisis due to their exercise of their lawful supervisory powers.
This seemed to be an unsubstantiated claim.
Crawford didn't name names, but alleged that "shadow banks" had already been bailed out in the recent crisis, so there was no real discrimination, new legislation, or not.
I wonder which companies he considered to be shadow banks which were saved?
To me, any publicly-held, private sector entity which has material regulation of some sort is not a "shadow bank."
For example, I'd say that hedge funds and private equity groups are "shadow banks." Private equity lends, does leveraged buyouts and, at the upper end, can engage in significant proprietary trading.
Hedge funds clearly meet the trading units of heavily-regulated banks in the marketplace. But the hedge funds enjoy notoriously lighter regulatory burdens than their publicly-held competitors.
I'm not aware of any private equity or hedge fund groups being rescued in late 2008, are you? In fact, a few hedge funds went under, though I can't recall specific names. Other than LTCM, in 1998, no hedge fund, to my knowledge, has been the subject of a coordinated, government-led action to preserve markets.
Even in the case of LTCM, the firm wasn't saved. Rather, there was concern for counterparty losses due to the lack of bids for assets held by the firm, causing financial markets to crater as a by-product.
Counterparties and other large institutions contributed to the orderly unwinding of LTCM positions, but the firm's owners lost everything.
So I confess to not really understanding why Crawford is so worried about shadow banks. Existing hedge funds and private equity firms would pose risks due to unwise levels of leverage. But surely their lenders are capable of judging for themselves what those balance sheets can handle. At least better than an army of civil servants who have yet to forestall a financial crisis due to their exercise of their lawful supervisory powers.
Tuesday, March 09, 2010
Passive Risk Management Tools
Almost a month ago, I wrote this (second) review of Wall Street Journal reporter Scott Patterson's recently-published book, The Quants.
The book's early chapters, on which I did not dwell in my review, discuss Ed Thorp's early exposure to Claude Shannon at MIT and, through Shannon, the work of John Larry Kelly.
Thorp was the prototypical quant hedge fund manager, but, in a sense, he simply followed, then outstripped, Shannon's and Kelly's own instincts of applying information theory to gambling opportunities, or any other situation in which imperfect information allowed for profitable employment of risk capital.
As I sped through the early chapters of Patterson's tale, I noted the mention of Kelly's name and general idea, but, since Patterson never focused on it, neither did I.
Fortunately, one of my friends and former colleagues, once a member of Bell Labs' EMT staff, reads this (and its companion political) blog on a daily basis. Thinking I'd find Kelly's work useful, he lent me William Poundstone's Fortune's Formula, published in 2005. The linked page on Kelly is from Poundstone's website.
Here is a paper Ed Thorp wrote concerning Kelly's Criterion over a decade ago.
My friend has been considering applications of Kelly's Criterion to his own work involving defense project management, so passing on the references and book to me were topical for him.
When I began reading Fortune's Formula, I found it engaging, but not particularly compelling. Until I came to Poundstone's painstaking explanation of how elegant Kelly's application of Shannon's theory was in the area of risk capital investment, be it at the track, casino, or securities markets.
Unlike the unsuccessful active risk management methods applied by traders before and during the financial market meltdowns of 1987, 1998 and 2008, Kelly's approach is passive in nature. The difference is important.
As Patterson portrayed in the latter chapters of his book, the major quant hedge funds employed pretty much similar VAR-based risk management systems. These systems naively assumed that, in the event of sharp losses in portfolio positions, there would exist a relatively unfettered ability to sell, or buy, the offsetting leg of existing portfolio positions, in order to hedge exposure.
Patterson didn't really dwell on the details of Ed Thorp's original employment of what Poundstone correctly identified as 'delta hedging.' It's an active risk management approach for adjusting hedges between equities and the companion warrant or option position.
Thorp originally did this in relative isolation and obscurity, with little in the way of market pressure from similar strategies swinging tens or hundreds of millions of dollars of such activity.
In the 1980s, the variant of active risk management was known as portfolio insurance. And it failed in 1987. When major trading operations all attempted to hedge the plummeting values of their positions in major indices, the values of which they were arbitraging, values plunged even further and orders went unfilled.
In 1998, similar results occurred in the last gasp of pre-swaps markets amidst a panic. In that era, there were quite a few statistical arbitrage clone funds, but only LTCM was actually brought down by the market plunge.
The 2007-08 financial market meltdown featured newer instruments, e.g., CDOs and swaps. But, in reality, these were simply variants of older financial products, albeit inherently possessing greater risks.
And, thus, when market values reversed their ascent, and active hedges became unbalanced, the usual stampede of many managers employing similar strategies to sell additional exposure in order to re-align their hedges once again failed.
Among my more experienced securities markets friends, and me, we agree on the notion that risk management solutions need to be passive and in place before a market event, because active risk management approaches never actually work as planned. A sort of 'fallacy of composition' defeats them, as abstruse investment strategies, employed in parallel by many smart quants, simultaneously react identically, pushing market values even further in the direction that is already causing them such large losses.
Kelly's Criterion is the ultimate passive risk management tool because it addresses the size of the investment, and is not affected, per se, by the actions of others. In fact, one of the valuable extensions of Kelly's work by Thorp was his apparent refusal to leverage his funds.
This was something ignored by the next generation of quants, including his own acolyte, Ken Griffin, founder of Citadel.
Reading Poundstone, on Kelly, provides a very clear, refreshing portrait of a seriously intelligent, rigorous mind grappling with the realities of risk capital deployment. And Thorp, with his casino beginnings, understood this perspective intuitively.
Sadly, quant kids two generations and more on, do not.
And that is why active risk management has been so ineffective. It becomes not a matter of discretion, but of survival.
That is, in Thorp's world, trimming the exposure to a Kelly bet is advantageous, but not essential. Because the bet was scaled according to rigorous theoretical principles, losing it all isn't crippling.
When that bet is with 3x, or more, levered money, you only have a 25-33% loss cushion before you've burned through equity and are out borrowed money.
The gambler's ruin. Busted.
Needless to say, we've already begun working on applications of the Kelly Criterion to our proprietary options investment strategies. As a passive, rigorously theoretical and internally-focused approach, it meets our criteria.
The book's early chapters, on which I did not dwell in my review, discuss Ed Thorp's early exposure to Claude Shannon at MIT and, through Shannon, the work of John Larry Kelly.
Thorp was the prototypical quant hedge fund manager, but, in a sense, he simply followed, then outstripped, Shannon's and Kelly's own instincts of applying information theory to gambling opportunities, or any other situation in which imperfect information allowed for profitable employment of risk capital.
As I sped through the early chapters of Patterson's tale, I noted the mention of Kelly's name and general idea, but, since Patterson never focused on it, neither did I.
Fortunately, one of my friends and former colleagues, once a member of Bell Labs' EMT staff, reads this (and its companion political) blog on a daily basis. Thinking I'd find Kelly's work useful, he lent me William Poundstone's Fortune's Formula, published in 2005. The linked page on Kelly is from Poundstone's website.
Here is a paper Ed Thorp wrote concerning Kelly's Criterion over a decade ago.
My friend has been considering applications of Kelly's Criterion to his own work involving defense project management, so passing on the references and book to me were topical for him.
When I began reading Fortune's Formula, I found it engaging, but not particularly compelling. Until I came to Poundstone's painstaking explanation of how elegant Kelly's application of Shannon's theory was in the area of risk capital investment, be it at the track, casino, or securities markets.
Unlike the unsuccessful active risk management methods applied by traders before and during the financial market meltdowns of 1987, 1998 and 2008, Kelly's approach is passive in nature. The difference is important.
As Patterson portrayed in the latter chapters of his book, the major quant hedge funds employed pretty much similar VAR-based risk management systems. These systems naively assumed that, in the event of sharp losses in portfolio positions, there would exist a relatively unfettered ability to sell, or buy, the offsetting leg of existing portfolio positions, in order to hedge exposure.
Patterson didn't really dwell on the details of Ed Thorp's original employment of what Poundstone correctly identified as 'delta hedging.' It's an active risk management approach for adjusting hedges between equities and the companion warrant or option position.
Thorp originally did this in relative isolation and obscurity, with little in the way of market pressure from similar strategies swinging tens or hundreds of millions of dollars of such activity.
In the 1980s, the variant of active risk management was known as portfolio insurance. And it failed in 1987. When major trading operations all attempted to hedge the plummeting values of their positions in major indices, the values of which they were arbitraging, values plunged even further and orders went unfilled.
In 1998, similar results occurred in the last gasp of pre-swaps markets amidst a panic. In that era, there were quite a few statistical arbitrage clone funds, but only LTCM was actually brought down by the market plunge.
The 2007-08 financial market meltdown featured newer instruments, e.g., CDOs and swaps. But, in reality, these were simply variants of older financial products, albeit inherently possessing greater risks.
And, thus, when market values reversed their ascent, and active hedges became unbalanced, the usual stampede of many managers employing similar strategies to sell additional exposure in order to re-align their hedges once again failed.
Among my more experienced securities markets friends, and me, we agree on the notion that risk management solutions need to be passive and in place before a market event, because active risk management approaches never actually work as planned. A sort of 'fallacy of composition' defeats them, as abstruse investment strategies, employed in parallel by many smart quants, simultaneously react identically, pushing market values even further in the direction that is already causing them such large losses.
Kelly's Criterion is the ultimate passive risk management tool because it addresses the size of the investment, and is not affected, per se, by the actions of others. In fact, one of the valuable extensions of Kelly's work by Thorp was his apparent refusal to leverage his funds.
This was something ignored by the next generation of quants, including his own acolyte, Ken Griffin, founder of Citadel.
Reading Poundstone, on Kelly, provides a very clear, refreshing portrait of a seriously intelligent, rigorous mind grappling with the realities of risk capital deployment. And Thorp, with his casino beginnings, understood this perspective intuitively.
Sadly, quant kids two generations and more on, do not.
And that is why active risk management has been so ineffective. It becomes not a matter of discretion, but of survival.
That is, in Thorp's world, trimming the exposure to a Kelly bet is advantageous, but not essential. Because the bet was scaled according to rigorous theoretical principles, losing it all isn't crippling.
When that bet is with 3x, or more, levered money, you only have a 25-33% loss cushion before you've burned through equity and are out borrowed money.
The gambler's ruin. Busted.
Needless to say, we've already begun working on applications of the Kelly Criterion to our proprietary options investment strategies. As a passive, rigorously theoretical and internally-focused approach, it meets our criteria.
Wednesday, February 24, 2010
General Growth Properties' Fall From Grace
I have read, with some dismay, the articles concerning Simon Properties' bid to take over the remains of General Growth Properties.
My own connection with the firm, though brief and passing, goes back to 2000.
At the time, a prominent hedge fund manager and former Salomon Brothers partner offered to assemble a hedge fund around my equity strategy. His anchor investor, as it were, was GGP's then-chairman, Matthew Bucksbaum. At the time, Bucksbaum was a billionaire, thanks to his personal investments in GGP. The firm had been built by his family over decades, then gone public as a REIT, providing substantial, liquid wealth for them.
As part of the process of securing Bucksbaum's investment, the partner assembling the hedge fund asked me to do some analysis of GGP's competitors, and GGP, using the consulting version of my research. It was to be a threefold activity: a chance for Matt Bucksbaum to evaluate me and my work; a good faith provision of free analysis, and; a formal reply to a question Bucksbaum had regarding GGP's valuation relative to his company's peers. Vornado, Simons and Rouse were among the REITs which I analyzed.
It didn't take me long to do the analysis, nor identify a probable cause of GGP's relatively lower valuation, particularly when compared to Vornado. Put simply, GGP had a bad habit of selling properties when they had accrued substantial gains, providing shareholders at those times with extraordinary gains. Thereafter, investors knew such gains would be years in coming.
Consequently, GGP's earnings were more volatile than Vornado's, and its valuation was lower, due to this lack of consistency. I provided some guidance as to how GGP could improve its earnings consistency, and offered to provide additional presentations to the firm's management team.
Bucksbaum understood my analysis, conclusions, and recommendations, though he evidently declined to pursue them further.
However, he agreed to back our hedge fund.
When I read of GGP's sudden spiral toward bankruptcy in the last year or so, it took me back to my meetings with Bucksbaum in the spring of 2000. I can't, of course, estimate how much of GGP's troubles were due to the operating policies which I identified as probably depressing the firm's value to investors. Articles in the Wall Street Journal suggested that, like investment and commercial banks, and many hedge funds, GGP had unwisely used too much short term borrowed funding. Adding to that problem, the firm's COO, Matthew's son, John, had apparently borrowed heavily against family-owned GGP shares. When margin calls came due during the 2008 financial debacle, the firm's and family's fortunes began to rapidly unravel.
Last I read, Matthew Bucksbaum was reduced to being worth only tens of millions. Still more money than most Americans will see at his age. But something like 1% of his peak net worth.
A good lesson in how fleeting business success can sometimes be.
My own connection with the firm, though brief and passing, goes back to 2000.
At the time, a prominent hedge fund manager and former Salomon Brothers partner offered to assemble a hedge fund around my equity strategy. His anchor investor, as it were, was GGP's then-chairman, Matthew Bucksbaum. At the time, Bucksbaum was a billionaire, thanks to his personal investments in GGP. The firm had been built by his family over decades, then gone public as a REIT, providing substantial, liquid wealth for them.
As part of the process of securing Bucksbaum's investment, the partner assembling the hedge fund asked me to do some analysis of GGP's competitors, and GGP, using the consulting version of my research. It was to be a threefold activity: a chance for Matt Bucksbaum to evaluate me and my work; a good faith provision of free analysis, and; a formal reply to a question Bucksbaum had regarding GGP's valuation relative to his company's peers. Vornado, Simons and Rouse were among the REITs which I analyzed.
It didn't take me long to do the analysis, nor identify a probable cause of GGP's relatively lower valuation, particularly when compared to Vornado. Put simply, GGP had a bad habit of selling properties when they had accrued substantial gains, providing shareholders at those times with extraordinary gains. Thereafter, investors knew such gains would be years in coming.
Consequently, GGP's earnings were more volatile than Vornado's, and its valuation was lower, due to this lack of consistency. I provided some guidance as to how GGP could improve its earnings consistency, and offered to provide additional presentations to the firm's management team.
Bucksbaum understood my analysis, conclusions, and recommendations, though he evidently declined to pursue them further.
However, he agreed to back our hedge fund.
When I read of GGP's sudden spiral toward bankruptcy in the last year or so, it took me back to my meetings with Bucksbaum in the spring of 2000. I can't, of course, estimate how much of GGP's troubles were due to the operating policies which I identified as probably depressing the firm's value to investors. Articles in the Wall Street Journal suggested that, like investment and commercial banks, and many hedge funds, GGP had unwisely used too much short term borrowed funding. Adding to that problem, the firm's COO, Matthew's son, John, had apparently borrowed heavily against family-owned GGP shares. When margin calls came due during the 2008 financial debacle, the firm's and family's fortunes began to rapidly unravel.
Last I read, Matthew Bucksbaum was reduced to being worth only tens of millions. Still more money than most Americans will see at his age. But something like 1% of his peak net worth.
A good lesson in how fleeting business success can sometimes be.
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