What Hedge Funds Have Not Learned Since 1998

As I have read more accounts of the unfolding turbulence in the credit markets, and its spillover into equity markets, a few cardinal lessons continue to loom large.

First, as I noted last week in this post on risk, there exist arcane, exotic debt instruments which, in many cases, simply have no market. No bids are available, and, so, the effective 'market' price falls to zero.

Second, to paraphrase Wilbur Ross, a self-made tycoon via conventional buying, improving and selling mundane businesses, and CNBC's guest host this morning,

'when someone mentions two words, financial engineering, you know it's really an attempt to underprice risk.'

I could not say it any better. Rather than microscopically price risk correctly to the nth degree, CDOs have, instead, allowed originators to bury risk in amongst tranches of some portfolios of loans, and, in some cases, further mix them with other types of loans. That's not how the instruments were originally marketed, but that's how they now are used.

As we see in the current market turmoil, risk has come to be defined by qualitative factors, such as a security not being a CDO, or having anything remotely to do with housing finance.

Third, despite the post-LTCM crises shift away from leverage usage by hedge funds, such usage has, it turns out, returned with a vengeance. Nothing like an up market to give comfort to even institutional investors, and sustain unwise, lax policies.

By using leverage again, these hedge funds have been caught on margin calls while holding hard-to-price exotic securities. Usually CDOs or other debt instruments.

Fourth, when many smart people pile into an investment style by starting hedge funds, borrow money, and use similar, programmatic trading models to hedge and invest, it is not surprising that, when risk becomes important, and some of the instruments used by these funds to hedge suddenly lack 'markets' into which to sell. The result is for those funds to essentially lose most of their value.

My partner asked,

"But what else should they have done to earn returns? What other options did they have?"

My response is that they were always excess supply in the investment world. Many large, sophisticated institutional and individual investors will now lose a lot of money because they chased a chimera- outsized returns with no perceptible incremental risk.

It's unclear whether, except under purely bull market conditions, these funds, with their similar automatic hedging programs, ever really offered sustainable excess returns over the market, for the risk they incurred.

Put lessons three and four together, and you get the new hedge fund whiz kids borrowing to the hilt to buy and hedge exotic instruments. Then, as the credit concerns began to erode the value of those instruments, all of these funds began to try to unload the same types of instruments, causing a failure of markets for them. It's a sort of perfect storm for hedge fund mismanagement.

A few thoughts on the markets, risk, and fund management during a day in a week of yet more equity and debt market turmoil.

More to follow......

More On Female Business News Network Anchors: Who Really Likes Liz Claman?

Yesterday, I wrote about former CNBC anchor Liz Claman's much-desired departure from that network last month. I wrote, in part,

"I have found Claman to be ill-informed and of no particular added value to any business topic which she covered. Her interviews with people like Warren Buffett are notable for their cloying obsequiousness and adoring, softball questions. Following the Barbara Walters approach, she gets these plum interviews because her subjects know she will paint them in a soft, glowing light and never surprise them with any truly probing, potentially uncomfortable questions.

With Claman, you know she'll never ask the questions you'd ask if you had her subject on camera with you."

As is so typical with blogs, the heavy weight, more important posts rarely draw comments. But the fluffy ones do. For example, "Anonymous" (seems they usually are) wrote, in response to my post,

"Oh god, You're so effing in the minority here that it's not even funny. She had the #1 show on CNBC and judging by todays little tidbit in the NYDN, Looks like she has tons of offers on the table.....Hofefully she'll be on Fox Biz soon"

For clarification, Claman did not "have" a show on CNBC. She appeared with other anchors in the mid-morning slot. So it is difficult to understand how she could have had the "#1show" on the network.

But anonymous' comment about Claman's purported, rumored offers got me to thinking. With whom is Claman so popular? According to the blurb for which 'anonymous' provided a link, it is CEOs.

However, networks sell advertising on the basis of viewers, not CEO viewers, per se. Yes, I know CNBC likes to show ads with CEOs who watch their network. But that is not what pays the bills.

What's the likelihood that a network full of Claman-type interviewers could actually succeed? CNBC has Donnie Deutsch and Michael Eisner doing CEO interview shows. But not all day long.

Then there's the issue of how long such a rich diet of CEO interviews will last, before viewers realize that these have simply become well-orchestrated, safe publicity opportunities for the CEOs and other 'leaders' in question. This is my major bone of contention with Liz Claman as an interviewer. She just gushes over her subject, literally, and then lobs softball questions which smack of adoration and wonderment, rather than scepticism and objectivity.

Interestingly, nobody claims that Claman actually added value at a desk on air. Most of her appearances, as I recall, tended to be either in live interviews, or running taped interviews. For good measure, I followed the NYDN link (it's a daily updated page, so the Claman story is already gone), and the Claman paragraph stressed her popularity with CEOs because of her reputed feminine attractiveness.

Wonderful. Women try to be taken more seriously as business people, and we have people celebrating a plump, middle-aged woman for her physical features, overlooking her lack of intellect.

If loading up on this sort of 'talent' is what Fox is planning as major content for its business news channel, then I don't think they'll do very well. On the other hand, it's just possible that CNBC will become more attractive with the loss of its Wall Street Journal connection.

For example, Joe Kernen routinely cites Journal articles on the CNBC early morning program with Becky Quick. Since I watch the network primarily for breaking business news and market news, that works for me. They have occasional guests and hosts whom I respect, like Mike Holland, Brian Wesbury, or John Rutledge. But these are, frankly, exceptions among a parads of also-ran analysts and fund managers of whom you have never heard, prior to their 2 minutes of fame on CNBC.

Either way, it should be fun to watch the competition between Fox's new business channel, and CNBC. Who knows, maybe competition will result in one, or both, channels focusing on news and intelligent commentary, rather than glamour interviews with primping CEOs.

Belated NewsFlash: Liz Claman Departs CNBC...for Fox's Business Channel?

CNBC did not publicize Claman's departure last month, but I suddenly realized that I have not seen her massive, somewhat dim-witted presence on the network's midday programs for a while. At first, I chalked it up to her being on vacation. Now, after googling her name, I have learned that she left CNBC in July, amid rumors that she is going to be an on-air personality with the new, yet-to-be-unveiled Fox Business Channel.

Heaven help us, and Rupert Murdoch. Let's hope this is not a precursor of the kind of moves that Fox will be making in relation to its new cable business news channel. Murdoch didn't need to buy Dow-Jones for this.

I have found Claman to be ill-informed and of no particular added value to any business topic which she covered. Her interviews with people like Warren Buffett are notable for their cloying obsequiousness and adoring, softball questions. Following the Barbara Walters approach, she gets these plum interviews because her subjects know she will paint them in a soft, glowing light and never surprise them with any truly probing, potentially uncomfortable questions.

With Claman, you know she'll never ask the questions you'd ask if you had her subject on camera with you.

With the considerably more-talented female anchors available on CNBC- Becky Quick, Erin Burnett, Michelle Caruso-Cabrera- it's hard to believe that Fox would bother with Claman.

After my hopes have been raised by the promised arrival of a competitor to CNBC, I would truly be unhappy if watching the new business channel meant I had to tolerate seeing even more of Claman.

More on Risk: Details On The Recent Credit Market Turbulence

I had a chance to catch up on reading a lot of Wall Street Journal articles this weekend. Among the pieces on which I focused was one in this past Friday's edition concerning how a German bank, IKB, has crippled itself through injudicious involvement with sub-prime mortgage CDOs.

What amazes me is that so much of this is a rerun of the 1998 LTCM debacle. For instance, the German bank had been encouraged by its regulators to move out of basic corporate lending, its historical area of business, in order to diversify its revenue base. The result was for IKB to play 'investment manager,' creating two separate entities which issued commercial paper, collateralized by investments in CDOs containing, among other things, American sub-prime mortgages. According to the Journal article, the bank's commercial paper program recently won an award from one of that sector's organizations. Like LTCM's eventual demise, due to hedges involving equities, with which it was not historically experienced, IKB has been brought down by a foray into unfamiliar financial market instruments, as well.

Stepping back, however, there is absolutely no obvious economic value-added which IKB provided, or could have provided, to the buyers of its paper. What it was really doing was making a spread between its commercial paper, which enjoyed low rates typical of such instruments, while collecting higher rates on its riskier investments in CDOs.

Unfortunately, these guys didn't even do anything so esoteric as construct complex hedges between, say, equity and debt instruments. They simply got caught holding the risk of, well, riskier instruments, while having promised commercial paper returns which they suddenly could not pay, in light of the severe losses on their mortgage-underpinned CDO holdings.

In the US, the coverage late last week of various "quant," or quantitative hedge funds running into trouble again reminded, once more, of LTCM's troubles. As I discussed with a friend yesterday, it's almost an exact rerun of the Long Term Capital Management dissolution.

Whiz kids at the helm of trading desks and risk management functions assume that various correlations between instruments will always obtain, and that markets for all instruments always function smoothly.

In neither case is the contention true. Unusual debt instruments can simply become unsaleable at any price. Nobody wants the risk. Thus, losing positions cannot be unwound.

Perhaps the more worrisome part of this recent credit market debacle is how much of it seems to be a function of the compensation and promotion practices among elite financial service firms.

When frontline traders and their management reap tens of millions of dollars annually in compensation, they simply no longer really feel any risk from ruining their company, customers, or the financial system. How much trust can you really place in a person who risks your money, but keeps perhaps 90% of his own millions safely out of harms way. He's no longer managing in your interests, as if they were his.

And don't be fooled by the line that they, too, want their bonuses, etc. Just like overpaid CEOs who underperform, these traders and investment managers lose little, financially, if they become unemployed due to wrecking their firm.

Ego damage, yes. But someone like the recently-departed senior executive of Bear Stearns, Warren Spector, will hardly feel any change in his lifestyle due to current unemployment. No, he'll be more affected by the embarrassment of having lost his powerful job at Bear. But not by the loss of income.

This is critical, because we trust these people to manage other people's money with fiduciary care. But now we see they do not do this. The ultimate cost of failure to themselves, which is loss of customer assets and their own positions, is more than sustainable. The upside of taking so much risk is more money, in the form of bonuses and added compensation in subsequent years.

If it were my money, I would not commit substantial capital to any fund or strategy in which the manager was not required to have the bulk of his net worth also invested. Otherwise, it becomes worthwhile for the manager to take higher risks with my capital, on which he is paid for performing well. Losses only affect my capital. The manager doesn't have to return prior compensation.

Thus, it's my belief that until measures are taken to address this mismatch between trader and investment manager compensation and equity participation in their own activities, we will continue to see the type of problems we are witnessing in the buying, trading and holding of sub-prime mortgage-backed instruments for many decades to come.

Why I'm Sick of John Chambers, Cisco CEO

John Chambers has enjoyed considerable exposure, some might say over-exposure, this week.

First, he was the subject of a warm and fuzzy, fawning interview by The Wall Street Journal on Tuesday. Gliding over Cisco's meltdown during the tech bubble-bursting and subsequent disastrous performance, the Journal had the sense of an advertising-driven entity to stay away from even remotely being perceived as focusing on that period in the company's past.

Instead, it lionized Chambers and his firm for its many acquisitions and prior growth. Then, it allowed the Cisco CEO to claim that his firm was about to march into consumer electronics, showing everyone 'how it's done,' so to speak.

Chambers' 'five tips' for running a technology firm smack of managerial basics: catch market transitions in a timely manner; offer differentiated products in new markets; focus on customer needs and wants; have good leaders in your firm, and; innovate.

Gee, thanks John. I'd never had guessed at any of those key strengths of any successful growth firm.

But that's not the best of John Chambers this week.

I caught his appearance one morning on CNBC. As a CEO, the on-air-head anchors naturally expected Chambers to have credible answers on questions like the sub-prime mortgage market turmoil. So they asked him for his opinion.

To my horror, unlike President Bush, who deflected an economic question at his press conference this week with the clear notice that he is not a trained economist, Chambers went ahead and pompously pontificated on the condition of that highly esoteric debt market.

Thanks again, John. Why bother listening to observers with real market experience who might have informed insights on this recent area of financial concern? Instead, let's go ask someone from an entirely different sector.

I'm rapidly tiring of seeing Chambers pop up everywhere. With me, at least, his credibility and my respect for him took a big hit when he failed to simply pass on the sub-prime mortgage question, noting that he has absolutely no basis to make any informed remarks not available from any other observer also not active in that market.

For Cisco's shareholders' sakes, let's hope Chambers has better judgment running their firm than he does talking about management practicies and debt markets.

As the Yahoo-sourced chart nearby shows, while Cisco has outperformed the S&P over the past five years, this wasn't the case as recently as early last year. The firm's performance has been erratic, leveling off once again early this year, and sustaining a long period of decline during 2004 and 2005.

Risk Week: All Risks Are Not Alike- Lessons From Hershey Park

As this week has worn on, and I have written about risk each day, the US equity markets have exhibited incredible volatility, while probably ending today up as much as 1%. Our equity portfolio has demonstrated similar performance.

We're not down in the double digits of percentage return this week, or this month. We hold large-cap, S&P500 equities, and call options thereon.

We don't sell calls. We don't sell puts. We don't buy or sell on margin. We don't try to hedge different instruments, in hopes of taking advantage of relationships which are, in general, predictable, but perhaps not so during times of financial uncertainty. We buy no bundles of mixed securities, such as mortgage CDOs, or other CDOs, nor do we buy or sell them in pairs, to hedge their returns.

A few weeks ago, as I spent several days with my daughters at a well-known amusement park in the next state, I mused about how my behavior at that park was rather like the investment behaviors my partner and I evince in the equity markets.

Since we only deal in listed US equities, or call options for them, that means we eschew some very unpredictable instruments which lend themselves to pricing and demand irregularities with frightening frequency.

Similarly, I don't take my children to just any amusement park. Some are rather lax in their admissions security checks and general behavior requirements. Others are less well-known, and subject to my concerns about the safety of some of their rides.

For instance, my daughters and I love to ride roller coasters. We are addicted. Thus, we've spent at least a few days during each of the last few summers at Hershey Park. As I am being rocketed around one of the older, more exciting wooden coasters, I regularly consider how little would be left of all of us if the cars left the track. You basically have no chance of survival whatsoever. None.

Thus, while I engage in the, to some, risky behavior of riding roller coasters, I only do it at a park where I trust the management to operate totally safe roller coaster rides. I never worry about boarding any ride at Hershey. Between the park's long reputation for cleanliness and safety, and the related food operations of the parent, I am confident the company's management of the park brooks absolutely no lapses which could lead to any fatalities or serious injuries on the rides.

Each year, there's a story about someone dying while riding and, falling out of or from, some ride at some amusement park somewhere in the US. But never Hershey.

The lesson I draw from my amusement park behavior, and apply to my investment behavior, is that it is important to set hierarchical, conditional criteria for risk.

We don't invest in instruments other than large-cap, US equities, and the purchase of options thereon (calls in markets expected to remain strong, puts in markets expected to remain weak).

Having set that initial criterion, we remain invested through market turmoil such as these past few weeks. My partner and I monitor the conditions that affect the companies whose equities we may purchase, but we don't worry unnecessarily about the trouble other investors create for themselves through injudicious trading and investing in various esoteric instruments.

That is very germane to this week's market activity. Although some extremists, such as Jim Cramer or Gary Shilling, believe there is a global liquidity and capital contraction which is of systemic proportions, I do not share that view.

Global economic growth and corporate activity remain healthy and robust. Profits are up. Most financial instruments- equities, corporate debt, Treasuries- are in good shape.

The genesis of the current financial volatility and perceived liquidity problems lie primarily with those parties who have chosen to buy, hold, and/or depend upon other parties with positions in relatively high risk instruments involving sub-prime residential US mortgages.

Just a week ago, James Cayne, Chairman of Bear Stearns, got the denial ball rolling by alleging that this is the 'worst debt market in twenty years.'

Only if you happen to dabble significantly in the riskiest, least creditworthy, shallow and illiquid parts of it. Which Bear did.

By Tuesday of this week, other scorched trading and portfolio players, also guilty of expecting constant profit from sub-prime debt, echoed Cayne's claim that the market was unraveling, and, therefore, they had not done anything extreme, greedy or unwise. They were merely victims of a bad market.

Someone would have to fix that bad market. Oh, yes, and, in the process, bail out those who chose to play with that brand of fire labelled 'sub-prime.'

As the French swung into action yesterday, with Paribas' idiotic suspension of redemptions in several of its sub-prime-related funds, and the EuroBank loudly announced its provision of liquidity to their markets, the panic began. Cayne, Cramer & Co. had accomplished their objectives, by causing sufficient uncertainty that counterparties to known holders of sub-prime-related issues stampeded out of positions.

As my partner has pointed out, the actual expected loss on sub-prime mortgages, were they simply to be written off, is far, far less than the total amount of market value destruction seen over the past week in the global financial markets.

Over very, very short periods of time, like the past few weeks, the mass of mediocre, poorly-informed and -reasoning investors, analysts, money managers and pundits can cause temporary market behaviors to depart radically from what more reasoned, informed market participants believe is warranted.

As such, as we have seen recently, volatility can soar, and assets can appear to lose even their intrinsic values. But this is a purely short term effect when there is no serious, structural economic problem underpinning the behavior.

Right now, being in US large-cap equities and options has insulated our portfolio from egregiously magnified losses of those experienced in the S&P500. We still have risk exposure, but we feel it is far, far less than that of investors who have engaged in complex, hedged positions which rely on modeled behavior of prices for esoteric, thinly-traded debt instruments.

Risk Week: The Homebuilers Fiasco

I read a revealing piece in last weekend's Wall Street Journal, discussing what went wrong with homebuilders' plans to break free of their historic roller coaster attachment to the boom/bust of the housing cycle.

As with a related business, mortgage lending, the answer is absurdly simple. Homebuilders departed from their newly-avowed business model which had allowed them to prosper nationally in the modern age.

My own portfolio selections, gains, and losses, it turns out, remained, relative to the current environment, remarkably free of trouble. I got out well before the carnage. As I wrote in this post, just last March,

"Over the time period stretching from mid-2003 to mid-2006, my selection process had selected companies in these sectors which returned a total of 4.8%. By July of last year, however, the process had rinsed mortgage lending and homebuilding out of the portfolio."

Further reading of the Journal article reveals that these guys simply couldn't accept slowing growth. So, they did what financial executives nearly always do in a slowing market- they cut standards and stoked higher-risk growth. Hand in hand with the mortgage banking industry, the homebuilding executives thought that that, as so many before them, could repeal the laws of Schumpeterian dynamics, and continue to grow their revenues and unit volume forever. Soon, these companies began to resume practices they swore off some years ago, including buying large amounts of land, instead of optioning it, as they claimed they had, prudently, now learned to do.

And now, big surprise, the homebuilders- KB Homes, Lennar, Beazer, etc., are paying the price. As the Yahoo-chart nearby shows, these homebuilders all peaked in mid-2005, and have continued sliding every since. Even so, a few are still above the S&P's return for the entire period, if not consistently.

But that minor amount of outperformance is probably not going to remain for very long, given the current environment.

When you study this chart closely, the magnitude of the homebuilders' losses in shareholder value are stunning. From a high of as much as 400%, they have mostly plummeted to 100% or less, in just two years.

That's the price of departing from a disciplined business model, refusing to accept the natural occurrence of the rise and fall of demand in any sector, and managing a firm as if growth will continue unabated for years.

It never works that way. Never has. Never will.

Risk Week: Bear Stearns, Jim Cayne & Warren Spector

Last weekend's Wall Street Journal edition carried a rather detailed article on the people and actions that led brokerage firm Bear Stearns to its current, sub-prime mortgage fueled debacle. A debacle that has now claimed one casualty, board member and head of stock and bond trading, Warren Spector. And may yet claim another, Chairman James Cayne, contrary to his rather boastful statement that he intends to remain until 2011.

Basically, Cayne and Spector screwed up and lost significant amounts of shareholder value, owing to their failure to properly oversee risk management among Bear's positions in various esoteric debt instruments.

Bear Stearns deserves to be in trouble. From just the cursory details in the Journal piece, you can see Spector's rise as a fast gun trader. The type of swaggering trader who demands ever more lush and powerful packages, in order not to bolt to a larger firm, like Goldman, or some hedge fund. In his case, Spector happened to share an interest with the current Chairman. They both play bridge, and Spector was a phenom as a youth. Cayne recognized his name.

As my partner mentioned at lunch today, wasps like Cayne, at Wall Street firms like Bear, are more clubby and parochial than people might imagine. Having passed muster as a bridge maven, it appears that Cayne essentially gave Spector a pass on any more supervision.

Thus, Spector was given a board seat at Bear at age 30. Shortly thereafter, apparently after elbowing a rival off the path upward, the command of Bear's equity and fixed income trading functions. Last year, Spector was paid some $33MM by Bear.

It's important to note how such large compensation packages affect the behavior of management at such a firm. Neither Cayne, nor Spector, was going to go homeless if whatever their equity interest in the firm became worthless. Even the lack of many more years of such compensation isn't exactly becoming poor.

So, if anyone thinks that financial consequences would ever figure in supplying some sense of risk awareness and prudence to either Cayne or Spector, think again. Folks at that level are motivated more by power and prestige than by money. The former are provided by others, as a function of staying in power, while the latter becomes a non-motivator pretty quickly at those sums.

Thus, we find both Cayne and Spector, laughably, attending a bridge tournament during a key week in July, when the fortunes of their firm were souring. You cannot make this stuff up.

It's debatable whether Spector, or anyone else, can do much about Bear's position. Let me make some conjectures.

First, the problems stem from rather exotic debt instruments which are not always traded. See this post , from yesterday, for some more details on how this works. Perhaps some forms of credit derivatives are also involved.

How do you price instruments which are either seldom traded, individually tailored, over the counter, and/or based upon exotics? Well, without much confidence is the answer.

As a one-time partner of mine, B, who built a well-known Street mortgage business, used to tell me,

"A model can tell me what something was worth yesterday, or may be worth tomorrow. But the only way I know what it is worth today is to take a piece and offer it, and see what the bid is."

Just so. And very scary, since if the bid is much lower than the carried value by the firm, the difference in value must be marked down.

Now, if these instruments were hedged, with credible counterparties, then one reasons that the damage would be contained, right? For limiting upside profit, a downside loss could be minimized.

What do you want to bet very few of Bear's positions were hedged? Because, after all, limiting profits limits bonus pools and, therefore bonuses. And who wants that? The firm pays out bonuses from those profits. It never allocates the losses to the traders.

With such a handsome asymmetric payoff matrix, why would the traders or their managers hedge much of the risk? Besides, the models probably assumed they could simply sell problem instruments when needed, per my earlier post.

So, it's not hard to imagine Bear having held, unknown to the senior managers who didn't really want to, or know how to, ask many piercing questions, that, in mutual funds and/or on proprietary trading desks, there has been substantial, unhedged exposure to some thinly-traded, esoteric debt.

That Cayne would so callously and dangerously declare the current debt markets to be the 'worst in 20 years,' is a measure of the depth of Bear's desperation and situation. By attempting to make the system and market the problem, he hopes to deflect observers from the truth- that Bear got into this mess on its own.

Fortunately, quite a few pundits, and Ben Bernanke, have vocally disagreed with Cayne's view, since his over the top comments in last week's conference call.

As Herb Greenberg, of Marketwatch, noted, this is one case where the retail investor dodged the bullet, because the class of instrument which has disintegrated is too complex and inaccessible for most of them. The institutions which have been brought down or damaged- mortgage companies, fund managers, brokerages- all knew what they were doing.

Typically, every decade has its financial debacle. It usually features young, inexperienced traders and risk managers who believe they have everything under control. More senior managers, with prior experience during financial market meltdowns or major problems, are typically further from detailed knowledge of the risk management and positions, and better insulated, financially, from damage, should the firm go under.

Bear's senior executives, Cayne and Spector, deserve to lose their jobs. Bear, as a firm, probably deserves to be bought or acquired by a better firm. In the final analysis, the company finally seems to have run afoul of its buccaneering attitude and less-than-adequate risk management, losing

As the nearby, Yahoo-sourced chart displays, Bear has lost considerable value this year. More than two-thirds of its returns for the prior two years.

Management like this deserves to be replaced. But in a firm with a culture like Bear's, that may not be sufficient. The whole firm may need to go down.

Rupert Murdoch's Big Opportunity

If you need to see the size of the opportunity that now awaits Rupert Murdoch and his new acquisition, the Wall Street Journal, look no further than this afternoon's Fed meeting watch on CNBC.

Here we are, amidst a turbulent credit market that is spooking the equity markets. There's a tension between bailing out institutions that made bad decisions in credit markets, and holding the lid on inflation.

So, who does CNBC have on their Fed watch segment? John Rutledge? Larry Kudlow? Mike Holland? Any of the former Fed Governors who appear from time to time?

No.

They have the Marx Brothers of finance- Jim(my) Cramer, Steve Leisman, and Ron Insana.

Cramer is, as I wrote here recently, an unabashed shill for his trading desk friends on the Street. Leisman is the networks uncredentialed, nonsensical, self-impressed 'senior economics reporter.' He is regularly bested by their Chicago on-air correspondent, the excitable but wise Rick Santelli.

Finally, we have Ron Insana. A former CNBC correspondent and anchor of no particular talent who managed to lose at least one prime-time afternoon slot due to his lack of presence and knowledge. Now, we are told, he is a guest commentator, and managing partner of Insana Capital Partners.

Oh. How impressive.

Does anybody else but CNBC know this guy at all?

So, for one of the most anticipated Fed meetings in memory, we have three clowns moderated by the earnest, but underappreciated Erin Burnett. More farce than analysis or sense.

For Murdoch, constructing a network to put CNBC out of business should be like shooting fish in a barrel.

Recruit the better anchors away- Kernen, Quick, and Burnett. Use the Wall Street Journal to fuel content. And add distinguished guest commentators, making sure they are available for breaking news events, like today.

Simple enough. And it should help send GE's stock further down under Immelt's lackluster stewardship, as even the media group loses yet another opportunity.

Risk Week: When Is A Market Not A Market?

As I devote this week's posts to the topics of risk, and risk management, I want to discuss the question,

"When is a market not a market?"


There are two fundamental assumptions which, when they fail, effectively turn a market into something that is not a market- and does not function like a market. Those two assumptions are: that buyers and sellers always exist for each other, and that pricing is continuous.


These failed in 1987, according to a then-friend of mine who was a very successful asset manager at a major firm. They failed three times in early 1987, on the way up, when the market was peaking, and fills took place at prices higher than those thought to be the execution price. As he wryly noted, nobody complained at that time.

Then, in October of that year, they failed again, this time on the way down. Way down.

People traded, not knowing for days what the actual price at which they sold was. And prices didn't move in small increments, as specialists deserted their functions.


Prices skipped downward, discontinuously.


Further, in panics, markets fail in terms of liquidity. There are not buyers and sellers present to 'make' the market. Again, specialists in equities step back. And in debt markets, bids simply vanish.


The whiz kids of today don't recall LTCM in 1998, much less the crash of 1987. They do not realize that, in a crisis, a panic, the "market," as we conceive of it, vanishes.

Bids fail to materialize. Prices do not move continuously, especially for esoteric, non-listed instruments.

This is, in my opinion, key. So much of the trouble invariably begins with thinly-traded instruments and/or derivatives thereof. One-off CMOs, CDOs, their derivatives, derivatives based upon some proprietary index.

It seems that many trading desks, risk managers, and hedge fund managers either were unaware of, or forgot these phenomena. When markets stop being markets, and become something else, all hell has effectively broken loose in the OTC market where so many esoterics trade, as well as in the more thinly traded listed instruments.

Happy to book profits on originating, distributing and/or trading these esoterics, Wall Street firms suddenly realize how risky they can be at times of lessened liquidity.

In my opinion, this is where a number of interacting phenomena combine to cause major problems.

Few traders remain traders into their forties. Thus, most on a desk at any given time may have no more than ten years' experience. Risk managers are likely similar. Promotions for both tend to lead them off the floor, into senior management, or into other firms, perhaps at hedge funds.

Thus, with each new crisis, the frontline troops are largely untested, and the experienced managers are slower to see the new problem unfold, and are often unfamiliar with the details of the source of the latest debacle. Thus, when all is well on the way 'up,' managers don't think to ask or check that a desk trading mortgage CDOs is in a position to be passively hedged, in the event of a meltdown, so that losses are minimized without the need to trade through non-market periods in which bids vanish or skip around.

Besides, hedging limits profits. Who wants that? It puts a lid on bonuses, doesn't it?

Fuggggetaboutit!

And there you have your new financial instrument crisis. The new whiz kid traders, risk and fund managers think they have it all controlled via quantitative programs. But they fail to account for the inability to even trade a portfolio during the time when asset values are plummeting, if there is a recent market value at all.

And this is, in my opinion, how and why we repeat these types of instrument-based financial market failures every decade. It simply doesn't pay for the adults to bother building in safeguards because, as the Wall Street Journal noted in an article lately, bonuses are short term, but the risks held in portfolio are longer term.

When individuals are paid upwards of $3-4MM annually, the loss of net worth due to the decline of their firm's stock's value is a lot less painful than most people realize. Coming atop a cushion of tens of millions of past compensation, it simply isn't a sufficient incentive to curb current excesses- ever.

Chrysler & Bob Nardelli

I would be remiss if I did not comment on today's announcement that Home Depot's ex-CEO, Bob Nardelli, has been named CEO of Chrysler, now a holding of Cerebrus, the private equity group.

There really isn't all that much to say about the move. Oh, there are the obvious aspects.

Having drawn the ire of many shareholders through his overpaid failure to earn respectable returns at Home Depot, being CEO for a small group of private owners removes that problem this time.

But looking more deeply, one wonders why Cerebrus would choose a cost-cutter to save a firm whose major problem is developing, building and selling cars people will actually pay list to buy. Plus, they've given the sack to at least one Chrysler executive, and a former Cerebrus advisor on automotive units.

Since I don't believe Cerebrus made a good deal buying Chrysler to begin with, putting Nardelli in charge simply adds to my scepticism about this situation.

Many people, including some pundits, believe that, as the Wall Street Journal cited today, Ford's Alan Mullaly and, now, Chrysler's Nardelli will, together, bring a radical new perspective to union negotiations, and magically eliminate the two firms' cost disadvantages relative to firms like Toyota.

Let's just say, I remain to be convinced that; a) this will happen, and b) it will matter in the long run.

Risk Week: Jim Cramer Shills for Hedge Funds

In view of the salient events of the last few weeks in the credit markets, and their overwhelming effects on the equity markets, I'm making this week's posts all about risk.

Yes, it's "risk week." I will be writing posts about various aspects of the recent activities in the debt and equity markets, and risk, and its management.

To begin my posts, I want to discuss Jim Cramer's outrageous comments last week on CNBC while speaking one afternoon (Thursday?) with Erin Burnett.

He set himself up as a sort of God of the markets, claiming various Wall Street trading desk personnel were beseeching him to tell Ben Bernanke how bad the credit situation is. Cramer alleged that these traders told him,

'You're the only one they'll listen to. You can get through to them....'


Nice try, Jim. But you're just a shill for your trading desk and hedge fund friends. They are using you the same way you used to use CNBC and The Wall Street Journal when you managed a hedge fund, as you have admitted.

What is going on now is not a general credit market meltdown. And in no way is it remotely as bad as Bear Stearns Chairman, Jim Cayne, alleged, saying it is the worst credit market in 20 years.

All that is happening is that some investment banks and hedge funds have made poor risk management and investment decisions. They hold more sub-prime mortgage paper than is prudent, if holding any at all is, at this point. These institutions would love to have the market bail them out. Rather than admit they have made costly mistakes, they would prefer that others believe, instead, that the credit markets are in crisis.

Thus, as Cramer was shilling the other day, Ben Bernanke must cut rates. Damn inflation, let's rescue some overpaid, underperforming traders and fund managers!

There is no crisis. What there is, is a case of some greedy, opportunistic, short-sighted managers at some firms being caught with heavy losses on bad investments.

It pains me to see CNBC allow Cramer to openly shill for his friends, and other industry insiders. At least this morning, several commentators directly contradicted Cramer, though not naming him specifically. They simply reiterated my position, that this is not a credit market crisis, it's a problem for some firms.

What most people fail to grasp is that these traders and fund managers will do anything to escape the losses they now face for injudicious decisions. If crying "fire" in a market, and getting others to stampede and believe the market is in crisis, so be it. So long as it leads to the Fed cutting rates, pushing debt prices up, then these traders and hedge fund managers will be relieved of some of their losses. And can rapidly dump their trash onto the market before others catch on.

The truth is, credit market problems primarily lie with a sub-species of the collateralized mortgage obligations market. Not corporate debt, or Treasuries. Not equities. It's a weakness confined to those players who knowingly bought sub-prime mortgages, or sub-prime-based paper, knowing the greater risk these mortgages bore.

I don't think it merits a general hand-wringing over the credit, or equity markets. And it certainly does not merit Jim Cramer anointing himself God of the market, and imploring Ben Bernanke to quit doing his job as Fed Chairman, and just loosen the monetary spigots to bail out some overpaid Wall Street traders, fund and risk managers.

Tomorrow: when a market is not a market, and why that surprised this generation's risk management whiz kids on Wall Street.

On Marketing

Wednesday's Wall Street Journal contained a review of the book "The Marketing Mavens," by Noel Capon. Mr. Capon, it is noted, is a professor at the Columbia Business School.

If this is the extent of new marketing discoveries at Columbia, they are in trouble.

According to the review, Capon led a team on a four year study

"to examine companies across 25 industries, interviewing 57 executives from an array of concerns."

The book alleges to provide "the lessons of the long-term winners." Nowhere, though, does the review cite what constituted "winners" according to Capon.

Before I reveal Capon's list of five "imperatives," let me recite another list.

Back in 1976, over thirty years ago, in a marketing course I took from Dr. David Lambert at Saint Louis University, he taught us the five bases for successful segmentation of markets:

1. Segments must have differing behavior, in order to have the behavior exploited through segmentation

2. The segments must be identifiable.
3. The segments must be specifically reachable, or targetable.
4. The segments must be of sufficient size to merit segmentation.
5. The segments must be such that serving them uniquely is profitable.

Now to Mr. Capon's imperatives, as reported in the book review in the Journal:

1. "picking markets that matter"
2. "pick the market segments where they can deliver the best product"
3. "securing a 'differential advantage' over competitors"
4. "adjust systems to better serve customers"
5. "measuring what matters"

Maybe it's just me, but I'm not just unimpressed with Capon's list. I find it, at best, derivative of the basic truths about market segmentation that I was taught, as an undergraduate, thirty years ago.

Capon's first imperative echoes Lambert's fourth basis of segmentation. His second, which closely resembles his third, is really just a no-brainer about business in general, and product development/management in general. There's no direct relation between the segmentation bases and Capon's fourth or fifth imperatives.

Having the rare combination of undergraduate and graduate degrees in marketing, I've probably sat through more hours of marketing instruction, by very capable professors, than most business graduates, and anybody I have personally yet met. For me, the most basic facet of marketing is segmentation.

Segmentation, as exploited by the University of Pennsylvania's pioneering, and the nation's first, marketing department, under genius Wroe Alderson, is a direct application of the microeconomic theory of segmenting buyers according to their price inelasticity behaviors. Observing the opportunity to discriminate, profitably, on price, and then provide other bases (product features, delivery, or promotional messages) on which to justify the price differences, is marketing's true core operational mission.

Of course, as Stanton wrote in his classic introductory marketing text, seen from a larger perspective, marketing is dedicated to satisfying consumer needs, over the long term, profitably.

Identifying and satisfying those needs leads, obviously, to segmentation, and, thus, the five bases.

When I reflect on that verity, Capon's work seems superfluous. So much neo-marketing fluff.

At root, marketing, even explicitly and appropriately consumer/customer-centric marketing, begins with segmentation. From this, all other marketing practices and knowledge flows.

To even attempt to speak of marketing fundamentals, and skirt the centrality of segmentation, is, I believe, to mark oneself as sadly, fatally misinformed.

Beyond his somewhat off-the-mark ideas on marketing, Capon, according to the article, chooses some examples that ought to raise eyebrows. Among them are Charles Schwab, Pfizer, and Target. The review doesn't provide details as to when in their life cycles Capon chose to study each company, but the first two are most assuredly not 'winners' on the basis of consistently superior total returns.

I personally respect and laud Target's marketing savvy, but that hasn't made it a consistently superior total return performer, yet, either.

What I conclude from the review of Mr. Capon's book is yet another academic conducting a dubiously-designed study, in order to publish a book and cash in on the resultant consulting business he hopes will follow.

I'm skipping this book. You should, too, now that you know Dave Lambert's five bases of successful market segmentation.

CNBC's Erroneous Focus on "The Trade"

As the equity index volatility of the past few weeks continues, it makes the prospect of buying or selling equities fraught with concern that the market price is not truly reflective of long term factors.

Rather, the price at which one might sell an equity could be heavily influenced by temporary forces or misconceptions.

As such, it's caused me to reflect on something I see quite a bit these days on the cable business news network, CNBC. It seems that every day, some of the anchors and/or on-air staff will bark at a guest,

'so, if that's true, what's the trade?'

Or a correspondent will breathlessly describe some equity's price movement in terms of 'the trade' between it and something else.

This is a mistake. It's not about the trade. Here's why.

Unless you know what someone already holds in their portfolio, describing 'the trade' is a meaningless term. It is a mistaken focus on 'the trade,' rather than relative buying or selling opportunities.

For example, suppose you and I each hold a single equity. I hold a technology-oriented company's stock, while you hold the stock of a durable good manufacturer.

We are sitting together, watching CNBC, when a reporter announces a significant rise in the price of oil. The on-air anchor then turns to a guest and excitedly asks,

"so, what's the trade here, Ron?"

Well, Ron can't know what's in either of our portfolios. So Ron can only say, univocally for all viewers, something like,

"I can't say what 'trade' to make, Dylan, because I don't know each viewer's portfolio composition. However, given the reporter's news, I would say that this makes energy stocks more attractive, relative to other things consumers might buy. So several sectors may now be less attractive, such as consumer discretionary items, luxuries, durables, etc. However, I don't think it will affect business technology spending."

But "Ron" never actually says something like that. Instead, there will be some platitude about selling this and buying that.

It's just typical business cable "news" network entertainment nonsense.

Last week, I believe, I saw a really excellent few seconds of commentary from CNBC's morning guest host, Liz Ann Sonders, Chief Investment Strategist for Charles Schwab & Co. She basically made light of the current equities volatility, and called attention to the real investment needs and objectives of Schwab's retail base of customers. Sonders noted that, for the average retail investor, or any investor with a long time horizon, this recent spate of market turbulence and volatility are no basis to "trade" anything.

Rather, she argued for simply continuing with existing investment strategies, and ignoring temporary, emotionally-based pricing dislocations and hysteria-based volatility.

I think this is very wise. Volatility is no reason for trading, per se, for most investors. Perhaps for those investment bank and hedge fund trading desks for whom this is their business. But not longer-term investors.

Temporary valuations driven by fears involving sub-prime mortgages, counterparty risks in credit derivatives, and overall debt liquidity, are hardly the stuff on which to base long term investment approaches. These influences on equity prices will be volatile and uncertain during their duration.

Certainly, these factors cannot be the basis for someone in the business media to solemnly announce 'the trade' which is now compelling. At best, their exhortations are simply silly. At worst, they can cause real damage for the unwise, who are not well-advised or knowledgeable as to what, if anything, they should remove from their portfolio, in order to buy the hyped equity.

For investors, trading is simply the means by which our strategies are implemented. We trade when our investment processes indicate to own less of some equities, and more of others. We don't trade simply for the sake of trading.

We invest.

Microsoft's Latest Attempt at Resurrection: Craig Mundie's Mandate

A very recent Wall Street Journal article focused on Craig Mundie, the man who is being touted as 'Bill Gates' replacement.' Mundie is the new chief of strategy and research at Microsoft.

I wrote several posts, here, here and here, among others, about Microsoft's dilemma, and a potential solution. The last of the three, and its predecessor a few days earlier in November, 2005, contain the seeds of my ultimate recommendation and prophesy for Microsoft.

Simply put, as good a guy as Mundie probably is, he can't and won't personally, single-handedly overcome:

- the wooden-headed, arrogant and wealthy Steve Ballmer's insensitivity to Microsoft's shareholders

- the vast, entrenched, far-flung bureaucracy and operational mindset at Microsoft, which has been built over two decades of prior success

- a company so large that it simply will never be able to match the speed and innovation of smaller startups in any area in which Microsoft chooses to try to 'lead' from a technological base

- the apparent trusim that technology firms, as technology firms, simply do not have successful second acts. Ever.

As I read the Journal article, I was struck by how very much like the old AT&T, at which I plied my trade in the 1970s and '80s, Microsoft now is. So large that the same solutions are developed in isolation, multiple times throughout the firm. A single leader is annointed to fix the problem and shake things up, but without sufficient authority.

Time and again in the article, Mundie exhorted some or other staffer to go see another, kindred group, meet with the senior executive of some similar activity, or build stronger ties to produce groups.

The trouble is, it matters to people who gets credit for solutions. Mundie seems oblivious to how the groups in power will respond to being presented with 'solutions' by smaller research units from far away locations. The integration of the various ideas and solutions will not be seamless, if it happens at all.

So long as Microsoft tries to use its existing structure to be something it hasn't been before, it will fail. As I wrote nearly two years ago, what Microsoft needs to do is think and behave like a venture capitalist, and spin out various smaller entities to work on the areas in which it wishes to lead. By retaining a stake in the firms, seats on their boards, Microsoft, the parent, will share in the innovation-based value that these startups will create. In time, these startups could become the next Googles, etc.

But so long as senior Microsoft executives respond to Mundie's efforts with comments like Tom Gibbons, VP for various non-computer software efforts,

"I need to think of this as a completely new effort,"

in response to Mundie's stimuli involving mulicore processors, I think Microsoft is doomed to remain a large, hulking, mediocre giant whose best days of consistently superior total return performance are way, way behind it.

One talented, even motivated executive like Craig Mundie just cannot overwhelm the weight of factors arrayed against him at Microsoft, no matter how correct Mundie's insights and actions are.

Bancroft Family Reveals True Whorish Capitlistic Values

Today's Wall Street Journal, and CNBC, reported on the final stages of the Bancroft family's sale of Dow Jones to Rupert Murdoch's News Corporation.

What is delicious irony, of course, is that, after all the Bancroft crowing and public fretting about 'editorial independence,' the deal's closing is now dependent upon them extracting a sort of modern "greenmail" from Murdoch.

To wit, some of the Bancrofts are demanding reimbursement for legal and advisory fees connected with the entire negotiation process. This, they argue, is in lieu of a simply higher price for their weightier, on a voting basis, and, thus, more valuable shares.

As my partner noted to me, in an email containing the initial inklings of this on Friday, it demonstrates that, in the end, the Bancrofts are shameless capitalistic whores, just as many decry Rupert Murdoch to be. It wasn't simply a matter of protecting the Journal's editorial sanctity that would lead to the deal's closing.

Oh no. That was just a first step. The real action comes now that the family is seeking to extract the maximum price they believe Murdoch will tolerate paying for their publicly-listed, but, ultimately, family-controlled company.

I posted on this topic at the time of Murdoch's bid, here, back in May. Then, the Bancroft family enlisted various greybeards, such as Peter Kahn, a former Journal executive, to publicly fend off Murdoch. In the ensuing months. they've looked high and low for other alternatives. However, as I wrote then, the truth is, print-only companies are simply too small, in an economically efficient sense, to survive in today's media world.

Murdoch is the best fit for the Dow Jones Corporation media assets. Others share his vision for how to use them, but only Murdoch actually has the goods. As for retaining a stake in the entity, as one interloper suggested, the family members who want to participate in future growth of the brand under Murdoch can simply by News Corp stock.

But the real story now is how the Bancrofts are making use of the two-class stock they created when Dow Jones went public, to extract maximum gains only for themselves. Personally, I have no pity for the non-family shareholders. Despite what some, like CNBC's guest host this morning, Ron Insana, may say about family shareholders not being entitled to their gains because they simply "inherited" the shares, other shareholders bought the stock knowing full well that they could not vote a controlling interest, even as a united class.

Thus, they knew that they always faced the prospect of the Bancrofts screwing them in order to cut a better deal for their controlling shares. And that is exactly what is happening now.

By demanding that the advisory fees they incurred during the sales process be paid by Murdoch, some Bancrofts are, in effect, receiving higher prices for their shares than other owners are. We used to call this "greenmail," back in the 1980s, when people like Carl Icahn accepted higher prices directly from management in order to repurchase his shares of a takeover target.

Now, however, the Bancrofts are using the tactic in reverse. In order to takeover Dow Jones, Murdoch must pay greenmail.

No doubt, if we were to search back through the sainted editorial pages of the WSJ back in the 1980s, we'd find sanctimonious pieces by the Journal staff decrying the practice of paying greenmail, or otherwise treating shareholders of the same company differentially.

All of which goes to show, in the end, it's all about capitalism, capital, and the money. No shame in that. Things generally go better when we are honest about our motives and keep financial activity in its realm, and charity or "public interest" elsewhere.

Obviously, in the end, the Bancrofts believe this, and are no different than the man who runs the company to which they are selling theirs.

Microsoft's Xbox 360 Dilemma

The Wall Street Journal ran an interesting piece earlier this month, sourced from breakingviews.com.

Essentially, the article contended that Microsoft's latest troubles with its gaming unit's product should spell the end for the product group. At least under Microsoft's aegis.

I could not agree more, and have written as much last spring (2006). In this post, I suggested the following,

"My friend S, a consultant, was discussing corporate performance with me recently. While debating the recent fortunes of tech companies such as Google, Intel, and Microsoft, she challenged me to articulate what I would to fix what ails the last one. I had opined that Microsoft is, essentially, finished as a company capable of generating consistently superior returns, in part, as I have written recently, because of its chairman's excessive wealth. By the way, according to S, my estimate of Gates' net worth may have been light by as much as 50% or so. He apparently was worth some $50B as recently as 6 months ago, not the $25B I thought.

In any case, I said that the first, and, for a while, only thing I would do at Microsoft would be to essentially execute the threatened anti-trust remedy of the Netscape case- split the company into three: an applications software company, an operating systems company, and an internet-related company."

The recent Journal article also advocates spinning off Microsoft's gaming unit. It notes that the Xbox group accounts for only 10% of the company's revenues, yet has become a drain on profits, as sales of the gaming consoles have failed to meet expectations.

As I have written before, having too much financial cushion, and a complicated internal capital allocation process, tends to make units of conglomerates like Microsoft less competitive in the marketplace. They aren't as committed to "do or die" innovation and product success, because, regardless of the group's performance, they will still get paid.

Trouble is, the online gaming business is now a bare-knuckles, innovative slugfest among Nintendo, Sony and Microsoft. There's no room for a half-hearted entrant to dominate the sector.

Between the recent Xbox recall, and its already-slow sales start, I would agree that it is time for the software giant to cut this entity loose to sink or swim on its own.

It isn't doing shareholders much good, and CEO Ballmer still has his hands full with the other two major divisions- applications software and operating systems. Neither of which is yet on track to return Microsoft to its glory days of consistently superior total return performances.