....it should be realized that merely maintaining the present relatively high rate of return may well prove more difficult than was improvement from the very low levels of return which prevailed throughout most of the 1960’s.
-- Warren Buffett, Berkshire-Hathaway Annual Report, 1971.
Everyone who writes about finance knows that selling short is risky because there's no limit to how much you can lose. But this is because people who write about finance rarely think like value investors. Consider: the stock is at $10, you think it's worth $5, so you sell it short with 4% of your portfolio, expecting to make 50%. Over the next month, the stock rises by $5, to $15. Now it's (a little bit more than) 6% of your portfolio. Bad news? Possibly, but now the expected profit is 67% ($10/$15, instead of $5/$10), and perhaps the odds of realizing that profit are higher as the stock gets more egregiously overpriced.
I think that, contrary to convention, short-selling is what I think of as a pure value trade -- a trade which, once you make it, fluctuations in market price cause the same change in portfolio allocation that you'd make anyway.
Unfortunately, the only other pure value trade I can think of is the currency-standardization trade. If you expect that A is a better currency than B, and thus that people will standardize on A, every time A rises relative to B it becomes a better standard than B. This is probably why gold bugs sound the way they did in 1962 (read Barrons from that time -- a good business school library should have it -- and you'll find the same kind of arguments you hear today).
As the gold thing should illustrate, there are many more pure trades outside of the value school. For example, venture capitalist and global macro expect Peter Thiel seems to be talking about the same thing in this essay. What he ignores is that most all-or-nothing bets have a time limit, and that people who bet on the current bubble being right are, in general, poor to the extent that they make this bet. Or put another way: Wilbur Ross could invest a month's worth of the dividends, management fees, and interest he's getting on his steel, coal, and textile holdings, and he'd have a bigger bankroll for betting on the Singularity than the average venture capitalist. But if Thiel has picked the right bubble, he's making a great pure trade on it.
Momentum investing consists of mostly pure trades: if it doubles, buy it, if it doubles again, allocate twice as much of your portfolio to it (done!). Macro investors make those trades, too -- a thesis like "Money is flowing into Singapore" is more or less identical to "Buy financial assets in Singapore while they appreciate, and sell if they drop."
What's odd is that investors shy away from these simple trades. The daily turnover makes it clear that investors are more concerned with what Coca-Cola will make next quarter than with what they can make over a century and a half. I suspect that investors hate these trades because they require so much conviction: when you leave everything after your decision up to the market, you're showing a lot of faith in that decision.
The average investor will accept a lower return, if it includes ample opportunities for second-guessing.
The price decline of thinkorswim Group (SWIM -- InvestTools until a few months ago; they're in the "Investor Education" -- high-priced trading seminars -- business) convinced me to look over the company's history, and the first thing I did was examine their earliest available annual report, and the first thing I noticed there was that InvestTools traded over the counter, and was the product of a merger between two other OTC stocks, each of which had declined about 95% in the prior year. So it looks like the usual OTC hocus-pocus (with which I'm familiar only because about 1% of OTC stocks are legitimate companies run by people too ornery for Sarbanes-Oxley). The difference: less than a decade later, this company was worth over $1 billion.
Like many OTC companies, InvestTools' new subsidiaries were also involved in some kind of penny-stock scam, in this case involving a brokerage (known as "World Trade Financial" until some time in 2001, when it hastily turned into "Amber Securities"). This company lives on only in the old SEC filings of InvestTools (unless this is the same group under the old name), but it should worry investors that within the last decade, the company they still value at half a billion dollars was involved in such behavior. Perhaps there's a simple misunderstanding. But I don't see that kind of history with firms of a similar size, even those that were once traded OTC. In fact, a company like Ash Grove Cement (one of the aforementioned 1%) has about the same market cap as SWIM, but doesn't have any of the reputation issues even though it trades on the least-regulated exchange there is.
Investors considering thinkorswim due to the low P/E, high ROE, amazing growth rate, etc., are advised to read over the company's first annual report. It definitely tells you where they're coming from, and probably tells you where they're going.
Congressman Nick Rahall demands that oil companies "use it, or lose it": he wants them to forfeit any oil lease they aren't using, and not to be awarded any new leases.
Is there some kind of standardized test that only admits people to the House if they show economic dyslexia? This idea is ridiculously stupid. Example: let's say Exxon has a lease that is, currently, just-barely-economical; they can extract oil for $125/barrel (including overhead, depreciation, etc). But they're also aware that new technologies they're prototyping now will allow them to extract it for $50/barrel in five years.
Normally, they would do the sane thing and wait -- they own the lease, but the sensible thing to do from the global economy's perspective is to exploit it when it's maximally profitable, not the second they own it. With this bill, they'd be drilling and extracting (and polluting, and moving more capital from non-energy to energy investment, hurting the rest of the economy) in order to do the right thing at the wrong time. They might even realize that drilling is unprofitable now, but will be profitable in the future -- they could end up pumping oil, then dumping it somewhere because it's not worth selling, solely so they can keep control of the assets they own long enough to use some of them sensibly.
The kicker: many people are angry about the fact that oil has suddenly gone way up in price. Economic theorists say that this shouldn't happen, because if oil is expected to go up in price, oil companies will just slow down their drilling -- if their oil-in-the-ground appreciates at 10% each year, it's like a high-yield bank account. But of course if enough of them do that, current oil prices rise(supply has dropped) and future prices drop (supply is higher) until oil is ready to appreciate at a rate that makes companis indifferent between extraction-cost-now-oil-later and oil-now.
There are ways to mess this relationship up. One is to give people a reason to think that they won't control their oil in the future (so it's better to pump now and take the money than to wait for more money they might not get). This is what happens to Russia and Nigeria. Many commentators seem to think that the pressure to show high quarterly profits is equivalent -- that somehow, these companies are controlled by sinister executives who take advantage of their economically uninformed shareholders by producing high short-term profits but sacrificing long-term growth.
Perhaps. But I can't help but notice that the oil industry is run out of Houston when prices are low, but run by Washington when prices are high. And somehow, executives with twenty-year tenure over immortal corporations have a longer-term outlook than politicians up for reelection every few years. We now have a system in which oil is a business when the oil business is unprofitable, but oil is a populist piggybank when we need the industry most. This is the worst imaginable way to run things.
According to Wikipedia, Rahall's sister is paid $15,000 a month by Qatar. Rahall is a big fan of Qatar, incidentally. Although he wins in a landslide every race, some may be interested in the campaign site of Rahall's opponent, Marty Gearheart. There is a 'donate' button.
Zac Bissonnette, reader and blogger, disagrees with my assessment of Adams Golf. With the caveat that Zac has clearly been following the stock longer than I have, and done more research, I'd like to present and address his claims.
The comment about bad management is mystifying -- do you remember what Adams was 5 years ago? On an operational front -- in terms of rebuilding the company -- Chip Brewer has done an amazing job.
Whether you start out losing money or making money, "good management" is incompatible with investing large sums in the business without corresponding growth in sales and profits. Corresponding doesn't mean positive -- it means in excess of (at worst) the increases in capital, and (at best) what's available elsewhere. A manager who makes 10% on capital, and asks for more money so he can make 9% on a larger capital base, is not doing his job: he's siphoning money away from higher-return enterprises. In this case, Chip may be a great operator. He may be the kind of guy who can turn a business that loses 10% on capital into a business that earns 5%. But a good manager should know not to allocate money for poor returns.
Your comment that "their business model is to hope that their Chinese partner doesn't hire an American salesman." is misinformed.Adams designs (Check out the R&D organization) and assembles the clubs. They purchase component parts from Chinese manufacturers. This is what EVERYONE does.
This is a fair point, so I'd like to research it more. It's fine to turn commodity inventory into a branded product, if that's what they're doing. But it's a little odd to rely so heavily on a single supplier. There aren't many business that turn undifferentiated inputs into competitive outputs, but which deal with larger sellers than buyers. The only examples I can think of are companies that buy from local monopolies -- e.g. all the homebuilders have to buy their gravel from the local gravel company (transporting it isn't worth it) so they get 100% of their supply (for that product) from one seller, and sell to many buyers.
Has anyone looked at the returns on capital for gravel companies versus homebuilders? The gravel business is incredible. If I had to pick an automated trading strategy to retire on, it would be: buy and hold index funds, and every time a gravel or aggregates company trades at less than tangible book, buy it until it's 10% of the portfolio and hold forever.
Adams has a history of profitability (That could change this year because of increased marketing expenses) and has continued to strengthen its brands -- number 1 iron set at retail, number 1 hybrid on all the tours.I talked to one securities analyst recognized as the expert on golf stocks and he told me that if Adams wanted to put itself up for sale, he could "put together a deal in a week."
I should hope so. As we seem to agree, this is a company that needs selling. A smart buyer could probably dump most of that excess inventory, and cut SG&A, and end up with something earning a little more free cash flow on a lot less investment. That would be a great move. If I saw evidence that management was moving in that direction, I'd change my view of the company. But it's all too easy to buy one of these now, and realize in ten years that earnings have increased slower than inflation, that all the extra cash is going back into that super-slow compound growth, and that the only exciting moments in the company's life are when it has an inventory writedown, a customer blowup, or its huge overseas supplier decides to squeeze a little more.
One more thing: it's important to take into account the seasonality in Adams' business: the vast majority of sales come in Q1 and Q2, and then the receivables convert to cash in Q3 and Q4 and the cycle starts again as the company builds up inventory: the end of the first quarter is the company's low-point for cash/balance sheet quality, and then it strengthens over the course of the year.
I was doing year over year comparisons to get around the seasonality issue.
One the most recent conference call, I (and someone else) asked about the increase in receivables/inventory: the mgmt, which is extremely non-promotional so I doubt they would bother lying, said it had to do with production delays and late shipping on the new XTD stuff: shipped later in the quarter, so receivables collect later etc.
A very sharp finance professor I talked to a while ago pointed out that most corporate fraud doesn't start as a way to show huge growth -- it's usually a way for a company to maintain its growth rate when it starts seeing diminishing returns. I'd add that often, the problem isn't fraud, but gambling. When they realize that their business can't get the returns they want from management as usual, they bulk up inventory, stuff the channel, and hope that the market turns around before the whole thing falls apart. Perhaps the good folks at Adams Golf really are expanding at a breakneck pace. Perhaps they are cautious and non-promotional, causing this growth to show up in their demand for capital rather than their ability to produce free cash flow.
But that's too much of a qualitative 'perhaps' for me. Management has turned the company around, from a money-loser to a value-destroyer. There's no shame in running a bad business well. But there's no money in it, either.
From the first time I read Security Analysis
So when I look at the recent financial statements of Adam's Golf (freshly-listed on the Nasdaq, ADFG), I recognize the kind of company that, as recently as a year ago, I would have seen as a screaming bargain. Their current assets are about $30 million each of inventories and receivables, along with about $1 million in cash. Their current liabilities total $20 million, so this (profitable) company's $36 million market cap puts it at a 10% discount to the value of assets that are, in accounting theory, convertible to cash within a year. A one-year 11% CD with a net income attached doesn't sound like a bad deal.
But looking over their history reveals that this company is a mess: over the last five years, sales have not quite doubled, but inventory has risen from $9.13 million to $28.75 million, and receivables are up from $8.55 million to $18.01 million. So it looks like they have to grow their capital base faster than their earnings, which should lead to perpetual disappointment from stockholders, along with the occasionally lurch in profit thanks to an obsolescence writedown or a bankrupt customer. Their cash flow statement confirms this: their net income melts away into higher working capital, so even though the rest of the cash-flow statement doesn't show anything, the business is barely able to hold their cash on hand stable while keeping up their growth.
And get this:
A significant portion of our inventory purchases are from one supplier in China; we purchased approximately 46% and 62% of our total inventory purchased for the years ended December 31, 2007 and 2006, respectively, from this one Chinese supplier. This supplier and many other industry suppliers are located in China. We do not anticipate any changes in the relationships with its suppliers; however, if such change were to occur, we have alternative sources available.
That's right: their business model is to hope that their Chinese partner doesn't hire an American salesman. These guys are extracting a gross margin of 43% for having a few friends among end retailers. I'm betting that this unnamed supplier could find a salesman who wants less than a 43% commission.
If this were a letter attached to a 13-D, I might include a few suggestions:
There might be a good company hiding in the mess that is Adams Golf. If there is, it's probably too small to be public. If there isn't, nobody is likely to take Adams private. It must hurt shareholders to sell their stock at four times last year's earnings, and at a discount to net current assets besides. But I fully sympathize with the sellers who have knocked the company's value down by 33% in the three months it's traded on the Nasdaq. I don't know how cheap the company deserves to be, but it looks like management is gradually chipping away at the company's business value, and raising the risk the company faces at the same time. The small chance of better management is not worth the risk that, five years from now, the company will once again be selling twice as much, and hauling around four times as much in current assets to do so. This is no way to run a business.
[1] A little of this is because Schoenberg's biography treats accounting as a very dramatic subject. Perhaps that's because Geneen's biography is mostly about accounting until the very end, when he's mixed up in some nasty bribery scandals. So Schoenberg has to treat the overhaul of depreciation schedules or the revamping of inventory monitoring as some kind of high heroics. The shareholders at Jones & Laughlin, Raytheon, and ITT certainly could have considered Geneen a hero for his work at those companies.
I recently found a copy of this biography of Robert Maxwell
The fictional portrayal falls flat -- they were English-speaking media barons who made most of their money in acquisitions, so it sounds like they'd often bump into each other. But besides a bidding war or two, and the coincident near-collapses of their media empires in the early 90's, they rarely crossed paths.
But what's interesting about Maxwell is that he's completely misunderstood. The usual narrative is that Maxwell was simply a fraud. He bought companies with money he didn't have, took from them money he didn't own, and would have kept it up had his crimes not been exposed, leading to his suicide. Actually, he was a complex sort of fraud: he started his career money-poor but asset-rich, thanks to his extensive contacts in postwar Germany and the USSR. Most of his early business deals arbitraged this: he bought scientific books from German publishers who had to have an English contact to stay in business, he traded up to a British wholesaler, and after that company fell apart he used his remaining assets as a basis for a publishing and education conglomerate.
Maxwell tended to buy companies on the cheap because they were poorly managed, poorly capitalized, and about to go under. It's no accident, then, that his operations often lost money. Like Templeton, he bought when there was blood on the streets, and like Templeton he was occasionally bloodied himself.
What's surprising, then, is how Maxwell's empire collapsed. He ran his public and private companies in parallel, and occasionally made deals between them to keep everything stable. What ruined him wasn't fraud -- it was hubris. When shares of his public company, Maxwell Communications, started dropping, he mortgaged them to buy more; when he ran out of collateral, he started selling his private assets to put more money into the public stock. As his company continued to lose value, he used up all of his collateral, fled the country, and was found dead (circumstances say suicide, autopsy says stroke, conspiracy theorists blame the KGB or Mossad) a few days later.
Maxwell's juggling of public and private partnerships is reminiscent of Enron: some Enron executives used the partnerships to extract money from the company, but they also used partnerships collateralized with Enron stock to keep the company's earnings high. Unlike Maxwell, it took a huge staff of accountants inside the company and out to keep things running -- amazingly, Maxwell handled a similar structure all on his own. Like Enron, what brought him down wasn't that he'd overstated earnings, but that he had borrowed too much on the expectation that his stock would always trade at what it was worth, rather than what the market worryed itself into believing. Even though Maxwell lied, it's hard to see him as a crook: what ruined him was that he believed too strongly that he was doing the right thing all along.
Katherine Burton offers a fair warning to investors in concentrated hedge funds: a fund with fewer holdings will have more volatility.
Her star example is Edward Lampert's ESL, which is, indeed, down 27% from last year. Now, if Lampert's investors are leveraged 3:1 against their investment in the fund, this is, indeed, very bad news. Of course, if they borrowed to invest in the fund before last year, they've long since solidified their financial situation thanks to his 30% annual returns. Burton apparently believes that if Lampert would only stick to his top 50 stocks rather than his top 5, he'd have survived the recent rout. True, but it ignores the fact that even Lampert would have trouble showing such great returns from 1988 to 2006 if he'd divided his resources so thinly (that's not even taking into account ESL's incredibly rigorous due diligence. By the time they actually buy a stock, they probably know more about the company than the CEO).
Burton also cites the case of SRM Global, down 70% thanks to concentrated bets in Countrywide and Northern Rock, among others. That's truly damaging, but: surely Burton is aware that Countrywide and Northern Rock each owned hugely diversified portfolios consisting of thousands of different mortgages and mortgage-backed securities. If diversification is such a panacea, why did SRM do so badly diversifying by proxy? And was most of Countrywide owned by concentrated portfolios -- or were most of the losses out-of-the-headlines declines due to money blindly allocated to the financial sector rather than carefully invested in a single business?
Careful thought will show that while Lampert's portfolio may be concentrated, it isn't unusually so: large mutual funds and hedge funds with thousand-stock rosters of holdings are clearly not analyzing each company individually, so they must be purchasing stocks in order to execute a strategy (e.g. 'Buy energy stocks as long as the dollar is dropping and Americans insist on commuting by car,' or 'Expect companies' valuations to converge on the industry average'). Is a portfolio based on four or five of these theses, executed through trading hundreds of stocks, really less concentrated than a Lampert-style list of half a dozen individual businesses with individual reasons to excel? Perhaps from one day to the next, the five-thesis manager will have more steady returns than the five-stock guy. And in a terrible year, someone who owns a thousand average stocks will be closer to the median return than someone with a few extraordinary holdings. But over a lifetime, there is almost certainly an inverse correlation between the quality of one's decisions and the number of decisions made.
Burton should know: the next few years may be boring years for a journalist who writes mostly about hedge funds. But Burton's name wouldn't be recognizable if she just wrote a little bit about everything. The author of this should know better.
Michael Lewis has discovered Meredith Whitney, so it's time to address the phenomenon: she is not a great analyst. She is not an especially good analyst. She has made good calls with bad reasoning, so I suspect that her status is mostly due to luck. She's not a leader -- she's a mascot.
Highlights from the article:
It all started back on Oct. 31, 2007, when she published her now-legendary report on Citigroup Inc. In it, she pointed out that the company's dividend now exceeded its profits -- the bank was handing money back to its investors faster than it was taking it in from its customers.The U.S.'s biggest bank was being managed to ensure only its bankruptcy. Citigroup would need either to raise capital, sell assets or slash its dividend -- possibly all three.
Brilliant! Their earnings, which dropped due to writeoffs, were lower than their dividend! Ensuring bankruptcy! Oddly, I've seen several companies that pay more in dividends than what they earn, and which don't seem to be collapsing -- they seem to be winding down, or maintaining a dividend that reflects their long-term earning power rather than their short-term results. People used to admire AT&T because they had the same dividend throughout the Depression ($9/share, even though their earnings collapsed from $15/share to $6/share).
Even more strangely, Lewis suggests that they would have to sell assets to deal with this problem. For someone who worked at a large investment bank, he doesn't seem to understand how banks work. Citi earns a high return because they have lots of assets -- they borrow at one rate, lend at another, and return a fraction of the difference to shareholders in order to compensate them for not being a priority in the event of a liquidation. If the company wants higher earnings, they need to go for more assets.
Whitney now says ``that call was absolutely straightforward, the easiest call I've ever made.'' But at the time, none of her fellow analysts was saying anything like it.
It's easy, and nobody else is doing it. Vote of confidence, or a good reason to consider whether it's really so smart in the first place?
Parsing possible explanations for her success, Lewis offers this:
Working for a smaller firm, and largely unnoticed, she had nothing to lose from making wild, negative predictions. If she was wrong, no one would pay her any attention; if she was right, she'd be famous....
The trouble with this explanation is that Whitney has had a bit too much good luck to be merely lucky. Thrust into the limelight by Citigroup's collapse, she's moved on to helping other banks collapse, too.
Lewis is also ignorant of how other bubbles form. In 1999, he could have written that the success of Internet stocks had to be real -- after all, Yahoo! and AOL could have been a fluke, but Pets.com and Webvan also had huge valuations, so there must have been something besides luck.
Of course she wasn't just lucky. Once she had a reputation, her predictions became self-fulfilling prophecies. Even a 5% chance of ending a quarter with investors asking "How could you have held X when the most admired analyst on the street said it was going under?" is too much.
Lewis also revises history:
On Oct. 31, 2007, everyone else was still more or less thinking of these firms as they had since at least the early 1980s, when they became masters of the universe. Since then the markets haven't seriously questioned whether the firms at the heart of capitalism actually knew what they were doing with capital.
This graph seems to show that people were talking about such issues months earlier, and that Whitney didn't make much of difference.
And that turns out to be his argument. That Meredith Whitney was the first person to understand that tangible book value doesn't mean the same thing as book value, and that in a crisis, a large bank can't be liquidated for their last reported shareholder's equity. I thought that was understood since the beginning of financial markets; I thought people had long been aware that banks get lax -- in their lending and their accounting -- during booms, and that crises are necessary to keep this from getting out of hand; I thought the possibility of a recession was factored into every bank's price. I also thought Lewis was an informed observer who could tell the difference between talent and hype -- but I guess that went too far.
Instead of getting primary and main election donations, politicians could bet a prearranged fraction of their donations on their own nomination. An interesting feature is that long-shots get a huge funding boost (if Mike Huckabee had invested 25% of his funds into his own nomination contract at an average of $.05, his post-primary fund would be 500% of the original sum he raised).
Nassim Nicholas Taleb runs a portfolio that makes outsize bets on low-probability events. This is a good way to be absolutely right and never make any money from it. The most recent specific article I can find is from 2005; it claims that he
is betting that the price of oil, now at $61 a barrel, will be at either $10 or $400 in three years. He admits that he does not know which one it will be, but he believes it's possible that it will reach either extreme. Since most traders don't think such extremes are possible, he can buy options ... that would profit from either scenario for a cheap price
The problem is, of course, that he paid cash up front in exchange for a promise that in the event of unprecedented economic upheaval, someone will give him substantially more cash back. What he's really doing is making a loan that the other party will only have to pay if it gets severely traumatized by the market. Six months ago, my instinct would be to wonder if he bought credit derivatives to account for this risk -- now I'm pretty sure that would be doubling down.
This is actually fairly similar to my dispute with the investment strategy of "Mencius Moldbug", who advocates investing in GoldMoney, GLD, and the like, but not in physical gold (too expensive) or gold futures (could be invalidated in the event of a crash). I suspect that if you rank political instability on a scale of 1 to 10 (where gold prices are something like 10 to the power of the ranking), gold contracts are invalidated at about 5.5, GoldMoney is shut down at about 5.7, and physical gold gets physically confiscated at maybe 5.8. So there's a very narrow window in which this is a good trade, after which you would have been better off accumulating directly usable goods and political influence.
More sensible: a 'portfolio insurance' system, in which you buy gold futures, roll the profits over into gold coins, and periodically sell those coins to buy canned food and shotguns.
(As far as objections to the gold standard itself, Nick Szabo's blog post covers about the same territory as an email I sent to Mr. Moldbug, but with more examples and less theoretical handwaving).
Let's say a smart, avaricious, amoral person wound up as chairman of a major investment bank. Let's say that on his first day at work, his CFO carefully explains that the company has made some obscene arcane bet on the correlation between Thai mortgage refinancing and Idaho soybean plantings, which -- whoops! -- whiped out all the company's equity, and then some. The amoral chairman doesn't want to hurt his options, and figures this happened under his predecessor's watch, anyway. The question: given access to all the SIVs, VIEs, prop traders who can mark anything to market, and Level III assets -- how long can they keep up the appearance that everything is normal? I'd bet that the answer is 'at least a decade'. Jerome Kerviel was ahead by up to $2 billion for a while; if SocGen had been the company in question, how hard would it be to convert that massive fraud into earnings? Paying Jerome a $2 million bonus and sending him on his way would be more than enough, and there can't be just one Kerviel Cookie Jar waiting to get raided.
The odds of this situation being anything like true are probably tiny -- 1% or less. But the derivatives market is based on a chain of perfectly reliable counterparties -- when JPM makes a trade with MS, but cancels it out by talking to GS, and they hedge their bets with RBSGC, etc., etc., etc., the fact that one of those parties might be only 99% reliable can really foul things up, especially if you don't know which bank it is. If the derivative market becomes a derivative-and-credit-to-the-nth market, it would be as jarring as when the market in US government debt turned from a pure interest rates game to a rates and ratings problem.
I'm in the middle of Thomas Schelling's The Strategy of Conflict, a collection of essays on Game Theory. One thing he points out is that negotiators can get better results if they have less freedom: if you're buying a house and you would be willing to pay $500,000, but have signed some sort of binding pledge not to pay more than $400,000, you're in a great bargaining position (as long as your binding pledge puts you somewhere above the minimum price at which the other party sells).[1]
What I wonder about is why this isn't more popular. Imagine if a buyout shop took control of some union-dominated company in a debt-finance acquisition, and explained to the negotiators that because of the interest payments on debt, the company would have to cut labor costs 20% or go under. Suddenly, by weakening their capital structure, they've strengthened their bargaining position. Of course, the benefit here goes straight to the former shareholders, rather than the new owners. One possibility would be a situation in which the new owners bid, say, $1 billion for a company they own 20% of, but finance that transaction mostly with debt. They only get a small fraction of the total benefit, but they do benefit, and someone owes them a favor. My question is:
a) Why is this not the most popular justification and strategy for LBOs -- that by depriving companies of capital, they force unions to capitulate to any reasonable demand?
or
b) Is this how people made money borrowing at double-digit rates to pay a 30% premium for an assortment of companies in declining businesses? Hm.
[1] Schelling uses this example, but his book was written in the 60's, so the prices he uses are $16,000 and $20,000. Even if he ended up paying the $20K, I sure hope for his sake that he got the house.
It occurs to me that the same people who said capitalism was exploitative are the ones who push universities to divest their assets in South Africa (during Apartheid), Israel, and the like. If they really think capitalism is oppressive and unfair, shouldn't they demand that Harvard invest all of its endowment in oppressive countries?
A SocGen trader making less than 100,000 Euros a year dreamed big and bet bigger, and now SocGen has announced a loss of $7 billion on his unauthorized trades. I have a question: has anyone, ever, issued a press release like this: "A rogue trader at BancCo has been fired for exceeding his position size limits. He made the firm $100 million last quarter, and is the only reason they beat their estimates."
It reminds me of a point about sexual harassment: that nobody has ever been prosecuted when it turned out that his advances were wanted, after all. There should be a term for doing something wrong on average that doesn't get you punished if you're lucky enough to accidentally benefit the party you'd usually harm. For now, I'm calling them Victimish Crimes.
It's probably bond trading 101 that if a country's capital disappears into a mushroom cloud, that country's bonds will drop in value. This is not necessarily true: distressed-debt traders are buying North Korean bonds (defaulted in 1972, price at 32 cents on the dollar). This seems to be a case in which the probability of repayment is so low that the only thing they're trading on is volatility: North Korea is not just poor -- it's stable -- so a bull market in their bonds either indicates that they're expected to get closer to South Korea or that they're expected to get closer to the kind of chaos that would allow South Korea (or China, or Russia, or an internal Junta) to swoop in and reform things.
I'm a proponent of prediction markets. It seems obvious to me that if you want to know what smart people know, the way to do it is to pay them in proportion to their ability to make good predictions. We already do this in an ad hoc sense -- people who make the right investments and career choices make more money -- but formalizing it can't hurt. Most of the people who discuss this seem opposed to prediction markets, though. Fortunately, I can usually address their claims on my terms:
That covers it, I think. On the other hand: Daniel Dennett can explain Christianity as a Darwinian phenomenon involving the cost of acquiring new information versus mimicking people around you. His opponents can explain him as a religious phenomenon involving the necessity of doubt to make faith meaningful, or the temptations of a materialist outlook. In other words, I'm sure there's an anti-PM system of thought in which my examples are nonsense. I just have no idea what it might be: in every example, I've explained how a market skeptic who really believes in market skepticism can make money at the expense of radical, fundamentalist free-market demagogues like me. Is there a counterargument?
[1] The Al Gore arbitrage mentioned in that article is over: whoever shorted the Gore-President and bought the Gore-Nomination made a low-risk profit.
... if they charge passengers per mile but reimburse them per minute.
Drivers get more reckless when they have to wear seatbelts, because they feel safer. Depending on which data you use, the resulting change in total accidents either underwhelms or swamps the safety effects of seatbelts. This works the other way, too: on icy roads, drivers slow down and drive cautiously, drastically reducing fatalities. This leads to an obvious conclusion: the way to make driving safer is not to mandate safe behavior, but to mandate behavior that feels as unsafe as possible compared to how safe it is. If people think that driving with an eyepatch makes them 300% more likely to get in an accident, but it really only makes them 10% more likely, mandating eyepatches makes driving much safer.
Now, consider: people don't judge lawmakers based on how effective laws are, but on how effective they seem. So lawmakers have no reason to pass a law that, as far as their constituents know, makes driving 300% more fatal. In fact, they have exactly the opposite incentive: to pass the laws that appear the safest, but that cause more accidents so there's a further need for safety-generating legislation.
Public elections are perfectly designed to produce what is literally the worst law imaginable. QED.
Today I walked past the Bear Stearns headquarters, and noticed that they have a gaudy Christmas wreath in the lobby. I'm wondering how to interpret this indicator, which is more fine-grained and timely than the Beige Book. My guess is that it's positive: it means they can afford to have a minion put up the wreath without really thinking that this is not the thing to do after losing a few billion dollars on mortgages. Or it's negative: some slightly higher-up Bear Stearns executive has nothing better to do than make lobby-decorating decisions. And since the wreath is still up, both theses are valid if inverted: are they too poor to pay someone to take it down, or too busy to get around to it? Econometrics is a tough subject.
In other news, Barnes & Noble has hired a greeter for their Fifth Avenue location. Is it a bullish indicator that a major player in a highly competitive industry can afford that kind of frivolous expense -- or should I read a recession into the fact that Manhattanites are being treated like Wal-Mart shoppers?
A few months ago, financial writers started muttering about how most hedge funds were just looking for clever ways to sell puts. Put-selling is a great strategy if you're paid on performance and don't care about ethics, because, done right, it means you'll make more money with lower risk for a while, until you blow up. The math is pretty simple: out-of-the-money options expire worthless most of the time, and occasionally pay off massively. A put-selling strategy could be calibrated so it returned 15% a year, guaranteed, unless there was a March 2000 or 9/11 or Summer '02 or August '07, in which case it would lose a very lumpy 50%. A great deal for the manager making 2% of assets and 20% of profits, because he's earning roughly 5% on assets most years, and giving nothing back when he blows up.
But not all hedge funds behave that way -- a good quant fund might just be a way to sell expensive puts, which would have the same performance characteristics with higher peaks and shallower valleys (this seems to describe quant funds pretty well). And hedge funds aren't the only ones playing that game. Thus, I present the world, in options trades:
Buying calls: Artists, musicians, entrepreneurs, venture capitalists, and trendsetters whose trends don't always catch on. Anyone who is trying to do something useful and original, and is probably going to fail. Basically, the Bohemians.
Selling calls: Critics, media distributors, intellectual property trolls, heirs, heiresses, and anyone trading on influence over talent. Anyone who is extracting rents from a dying business or a diminishing capital base. In short, the Establishment.
Buying puts: Macro fund managers, survivalists, and basically nobody else. Oh, yeah: Goldman Sachs. Summary: misanthropes. Won't be invited to any parties, but every so often they're the only ones who can afford any parties at all.
Selling puts: Banks, quants, closet index-fund managers, anyone with a get-rich-quick scheme that works. But these guys aren't even a small fraction of the story: there's one entity that seems to sell very low-risk insurance to anyone who asks -- it's willing to bail out people who build houses in the paths of hurricanes, people who buy houses for twice what they're worth, people who make the loans to buy those houses, people who build terrible cars, people who make the expensive steel that goes into less terrible cars, and anyone who has lost a job or lived long enough to quit without saving up the money to do so. And, oddly enough, it never sells puts for cash when it can just sell them for votes.
Why do American voters have so many choices? The statistician and economist Harold Hotelling claimed that everyone has an incentive to make their products undifferentiated, and this applies quite nicely to politicians. Consider: the average voter seems to want the government to pay for a certain fraction of all health care. Let's say the average voter wants that fraction to be 30%. You might expect politicians to be scattered -- with Kucinich types advocating 99%, Paul-ish ones pushing for 0%, and a cluster of mainstream Democrats at 35% with a cluster of mainstream Republicans at 25%. But every politician has to be aware that if he's the most moderate, he'll capture the most moderate votes -- and if support for different levels of health care spending is distributed normally, the marginal benefit of moderation goes up the more of if you offer. So cynical politicians should all be exactly moderate, and differentiate themselves only with rhetoric.
The rhetorical differences are wider than the policy differences, but it's still amazing that, in 2008, an American voter will probably be able to vote for either leaving Iraq soon or leaving it a very long time from now -- whereas Hotelling might expect voters to decide between, say, leaving a month before the average voter wants to, and leaving a month later.
Why do voters have so many choices?
But the last is just too weird to contemplate.
Pablo Escobar was once worth $9 billion.
Carlos Lehder was worth up to $2.5 billion.
These numbers sound like liquid net worths, because cartels usually don't release their numbers, and nobody's quite sure what the P/E ratio ought to be. Illegal drugs are a product with: 1) a very high markup, 2) a tendency to be produced by monopolies, and 3) very high risk of arrest or murder for sellers. It seems to me that this guarantees that a few people in the drug trade will simply have more money than anyone could possibly spend, and they won't pay taxes on it.
Consider Manhattan in 1985, borrowing liberally from Brett Easton Ellis
Either a) he invests in more coke-producing capacity (but only if that raises net profits, which just means deferring the question), b) he holds on to cash, which keeps bills out of circulation and fractionally lowers the money supply, making net lenders richer and net borrowers poorer, or c) he invests that money, turning consumption in Manhattan into capital everywhere else.
The answer is clear: if the government wants to increase our savings rate, the first thing they need to do is increase the number of Masters of the Universe (unfortunately, we may already be at capacity). The second thing the government needs to do is more stringently enforce laws against using cocaine, without trying to lower the demand (seems we're already doing that, too). And finally, if none of that works, the cheapest way to increase global savings rates is to subsidize the next Pablo Escobar.
Jesse Jackson has an editorial ($) in the Wall Street Journal calling for a "Marshall Plan" to pay people to occupy homes they can't afford. His plan:
It's time for another U.S. government-sponsored Marshall Plan. But instead of reconstructing Europe after World War II, today's Marshall Plan for mortgages would restore homeowners' and investors' confidence and dreams.We already have a model for such a plan. It has been used successfully several times since the Great Depression, and has always worked. That model is the Reconstruction Finance Corporation. During the Depression, President Hoover used the independent government agency to provide $2 billion in aid to state and local governments, and for loans to banks, railroads and other businesses. Subsequently, President Roosevelt used it to finance the most creative aspects of his New Deal.
That's right! The new economic policies that, for some reason, coincided with the longest and most severe economic contraction in US history are precisely what we need right now!
The RFC helped to restore business prosperity by financing building programs for highways and other infrastructure, and for reorganizing the banks. It founded Fannie Mae and its government-insured home mortgages, and provided funds for rural electrification efforts. And practically all of the nearly $10 billion in loans made by the RFC were repaid to the U.S. Treasury -- with interest.
Hm! Sounds like a good deal -- making loans, and getting money back with interest. In fact, it's a suspiciously good deal -- if it's so profitable, shouldn't we let the private sector do it? And if it isn't profitable, why disguise the real cost by making low-return loans when you can just admit it upfront with a giant subsidy?
Since then the RFC has helped our farmers and, during the 1990s, a similar agency -- the Reconstruction Trust Corporation -- rescued failing savings and loans. If we can save the S&Ls, we certainly can save homeowners with subprime mortgages. And whatever you call the revived agency, whether its middle name is Finance, Trust or even Mortgage, it is needed to rescue those Americans steered into subprime, adjustable-rate mortgages, often laced with hidden fees they never knew about.
A fee isn't "hidden" if it's spelled out in a contract someone didn't read. Some of these mortgages were fraudulent, of course, but it's redundant to create a new government agency to deal with fraud -- we already have one, which we call "the judicial branch." A real "hidden fee" would be, for example, an ex post facto tax on not patronizing Jesse Jackson's friends.
We must move immediately to adopt this Marshall Plan for mortgages or face the prospect of entire neighborhoods and communities becoming depressed and potentially abandoned.
Unlikely, to say the least. Jackson's political beliefs notwithstanding, the mortgage crisis is not just a sinister plot by right-wing meanies to steal houses from poor people.
Our leaders must not fail us. On Monday, thousands of Americans, including business leaders, mayors and others, are expected to march on Wall Street and in cities across the country to urge the government to take the right steps immediately to solve this economic emergency that touches everyone.
I hope they get the right address this time. Their last protest was at Goldman Sachs, which is massively short subprime mortgages. In other words, to express their rage at subprime lenders, Jackson's friends and associates gathered up their ire and picket signs -- and marched on the world's largest subprime borrower.
I finally read this week's Becker/Posner piece on carbon offsets, and I must admit that I'm unimpressed: Becker and Posner both believe that offsets will fail because they just fund projects that would happen anyway. So a company that plans on planting an acre of trees, for example, will first find someone will to pay them for the carbon those tree would produce, and only then to plant them. Two obvious solutions present themselves:
How do you summarized Paul Krugman's article on structured finance? By saying "Paul Krugman wrote an article on structured finance. It's a delightful gem of unreason; Krugman admits that he doesn't understand the subprime market or these new investment products, but also notes that they're proof that his political prejudices are right.
The test of a theory isn't "Upon hearing new information, can you construct a plausible narrative that includes your theory and the new information?" It's "what did your theory predict?" My theory predicts that, in the future, Krugman's articles will note that good consequences are caused by the people he likes, bad consequences are caused by the people he hates, and that his rhetoric remain in the blissful nirvana of having nothing to prove and nothing to say.
When the first history of the subprime mess is written, it will relegate C-BASS to a footnote, but eventually, we'll see it as iconic -- the WebVan of 2007. The brief history is this: the company was set up to help MGIC and Radian securitize some of their assets. C-BASS did about as well as you'd expect for a while, because the loan-and-mortgage slicing-and-dicing business was doing very well, indeed. And then a few structured products fell apart, and there really wasn't a market for C-BASS's assets (which put it in roughly the same position as a bank that has accidentally foreclosed on every single borrower -- in a new business they didn't understand). C-BASS managed to scuttle a merger between its parents, since neither side could figure out which was more to blame for the disaster.
And now, the latest: in February, C-BASS bid way, way above the market price for Fieldstone, a company in the mortgage origination business. Now, in November, Fieldstone is bankrupt.
In just a few years, C-BASS has ruined two parent companies and one subsidiary, costing the financial markets many times its own net worth in lower asset values. I'm impressed
Suppose a gang of Radicals for Capitalism
A few specific proposals they might endorse:
I'm almost afraid to add
