Straight-talk on FAS 157: Blackstone and their Banker Buddies Have it Wrong

There have been some rumblings over the past several months about accounting rules being a key contributor to the banking sector meltdown, and I've let it slide. But now that  Steve Schwartzman and Tony James of Blackstone have publicly stated their views that FAS 157 - or Fair Value Measurement rules in normal-speak - is perhaps even dangerous, I have to put my blogging hiatus to the side. Because this view is so myopic, slanted and not acknowledging of the complexity of the issue that some additional (and more detailed) perspective is warranted.

I've always felt that primary responsibility of bank leadership was to maximize return while managing risk to an acceptable level, and in a financial firm this really comes down to the concept of gap management (the difference between the duration of assets and liabilities, or the net interest rate sensitivity of the firm). Before the rates thrifts could pay for deposits was de-regulated, they had a wonderful business of lending long at comparatively high rates (principally in residential mortgages) and borrowing at comparatively low rates (via core deposits). Because rates were undifferentiated core deposits were very "sticky," as there wasn't a price motive to switch from one thrift to another. Therefore, the implied duration of its loan book was long while the implied duration of its core deposit base was long as well, giving them a matched book and a steady stream of earnings. Now this is a simplified view of things but you get the point. When this came to a screeching halt in 1982 and thrifts needed to compete more aggressively for both mortgage assets and deposits, that nicely managed gap widened dramatically. Assets were still long-dated, but lower yielding than before due to competition. Liabilities were now more expensive and of a much shorter duration, causing a massive funding mismatch that contributed to the S&L crisis of the late 1980's.

Why my little walk down memory lane? Because my thesis is that we are pretty much experiencing the same phenomenon today. Assets whose duration have unexpectedly lengthened due to lack of liquidity, while most banks have funded themselves in a seemingly opportunistic but highly risky way through repurchase agreements, asset-backed commercial paper and other short-term financing instruments. And when the music stops and investors stop wanting to lending short? The predictable cash crunch ensues. This is a classic failure of gap management, the key building block of running a successful financial firm. Some may throw up smoke and say "Well, the trading risks of investment banks are much more complicated than the simple mortgage loans of the 1980's. This is totally different."

Bull. Trading risk becomes liquidity risk when you can't trade. If you can't finance a book to take into account the vagaries of different market (read: liquidity) scenarios, then nothing else matters. Just ask Bear Stearns. So, if you are a prudent gap manager and operating in a FAS 157 world, what would you do? Do real stress-testing of liquidity scenarios and construct a capital structure that address much of the liquidity risk posed by non-standard assets. Because in an adverse scenario where liquidity dries up, there is a flight to quality and spreads blow out, the bank will experience a large mark-to-market gain on its liabilities, both avoiding a huge hit to equity and mitigating the need to run out and secure costly financing under highly adverse circumstances (like Citigroup, Merrill Lynch, Lehman, Washington Mutual and the rest of them). This could have prevented a lot of pain to a lot of shareholders. Sure, they might not have ridden as high during the up-market, but they would been more than compensated with downside protection. It's called volatility reduction. Or prudent gap management.

By way of background, let me share some of the Financial Accounting Standards Board's summary of what FAS 157 is intended to do:

The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability.

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This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability.

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This Statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine.

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This Statement clarifies that a fair value measurement for a liability reflects its nonperformance risk (the risk that the obligation will not be fulfilled). Because nonperformance risk includes the reporting entity’s credit risk, the reporting entity should consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value under other accounting pronouncements...

I think this stuff is pretty straightforward and reasonable but hey, that's just me. Messrs. Schwartzman and James, however, feel quite differently. From today's New York Times:

But Mr. Schwarzman is convinced that the rule — known as FAS 157 — is forcing bookkeepers to overstate the problems at the nation’s largest banks.

“From the C.E.O.’s I talk with,” Mr. Schwarzman said during an interview on Monday morning, “the rule is accentuating and amplifying potential losses. It’s a significant contributing factor.”

Some of his bigwig pals in finance believe that Wall Street is in much better shape than the balance sheets suggest, Mr. Schwarzman said. The president of Blackstone, Hamilton E. James, goes even further. FAS 157, he said, is not just misleading: “It’s dangerous.”

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The idea seems noble enough. The rule forces banks to mark to market, rather to some theoretical price calculated by a computer — a system often derided as “mark to make-believe.” (Occasionally, for certain types of assets, the rule allows for using a model — and yes, the potential for manipulation too.)

But here’s the problem: Sometimes, there is no market — not for toxic investments like collateralized debt obligations, or C.D.O.’s, filled with subprime mortgages. No one will touch this stuff. And if there is no market, FAS 157 says, a bank must mark the investment’s value down, possibly all the way to zero.

That partly explains why big banks had to write down countless billions in C.D.O. exposure. The losses are, at least in part, theoretical. Nonetheless, the banks, in response, are bringing down their leverage levels and running to the desert to raise additional capital, often at shareholders’ expense.

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Of course, Mr. Schwarzman’s theory only holds up if the underlying assets are really worth much more than anyone currently expects. And if they are so mispriced, why isn’t some vulture investor — or Mr. Schwarzman — buying up C.D.O.’s en masse?

For Mr. Schwartzman’s part, he says that the banks haven’t been willing to unload the investments at the distressed prices. Besides, the diligence required for most buyers is almost too complicated.

I think Steve and Tony are only looking at half the problem. In a mark-to-market world, you can't only look at the asset side, you need to look at the liability side as well. And, oh yes, there is also that niggling issue of liquidity. As Mr. Schwartzman says, "...the banks haven't been willing to unload (the) investments at distressed prices..." Well, a firm earns that right by having a capital structure and funding plan that can support a long-term hold strategy. Otherwise, they should suffer the vagaries of the market. But this is an issue simply not addressed by the bright men of Blackstone or their Wall Street buddies.

So why do risk managers and bank managements' so consistently make bad decisions? Probably because there is an over-reliance on measures that are seemingly quantifiable. They can measure delta. They can measure vega. They can measure theta. They can measure gamma (or at least they think they can). They can estimate credit loss ratios. But what about liquidity? When you are quantifying factor exposures, how exactly do you model liquidity as other risk factors change? It is a very, very hard question. Sometimes risk management requires judgment beyond computers, which is hopefully one of the biggest take-aways from the current credit melt-down. My sense is that there is currently a fear to manage without a machine telling you what to do. It is kind of like the drunk looking for his lost keys by the streetlight, simply because this is where he can see. But the likelihood of his keys being within the illumination of the streetlight is very, very low. Some of the best risk managers, guys like Gus Levy of Goldman Sachs and Ace Greenberg of Bear Stearns, didn't rely on computers but relied on instinct, savvy and experience. We need more of this. It's called leadership. Let's not cloud the issue. It's not about FAS 157 or any other accounting rule. It has been and always will be about management. 

Anschutz as Icarus: Flying too Close to the Sun

The variable prepaid forward contract, without question one of the most popular transactions on corporate and high net worth derivatives desks on Wall Street. Every firm has their own brand name for it, but the bottom line is always the same: helping a company or a wealthy individual protect the value of a concentrated stock position and generate liquidity from the position without paying taxes currently. In essence, getting all the benefits of a sale without the costs associated with a sale. An article in today's Wall Street Journal highlighted the structure and provided an example of its being pushed to the limit, so much so that the favorable tax treatment generally associated with the strategy is being challenged by the IRS. These strategies in other forms have not drawn the IRS's ire, but why?

First some historical perspective. In a perfect world, derivatives professionals and their clients would like to figure out how to sell an appreciated asset and not pay taxes - ever. Historically there has only been one foolproof way to accomplish this feat - by dying (with your heirs getting a stepped-up basis in the appreciated stock to fair market value at the time of death, enabling a sale without ever paying capital gains taxes on the position). Most clients and their advisers prefer a somewhat less draconian vehicle for accomplishing this, and the easy answer used to be the "short-against-the-box" trade. This involved simply borrowing stock against an appreciated stock position and selling it, posting the sale proceeds as collateral against the short position and perfectly hedging the value of the appreciated shares. This deal worked for a long time, until the IRS determined that if a transaction looked like a sale and smelled like a sale then it probably was a sale, and eliminated the tax deferral associated with the strategy. So smart derivatives practitioners then asked themselves the question - if a "short-against-the-box" transaction eliminated too much risk to warrant a tax deferral, then exactly how much risk needed to be taken in order to secure the more favorable treatment?

Financial engineering then gave us the variable prepaid forward and its variants (collectively 'VPF"). Essentially, you can think of a VPF as a kind of private mandatory convertible, similar to the instruments sold to raise capital for banks and corporations. Put another way, a client using a VPF to hedge a stock position is:

• Selling their stock forward (agreeing to sell at a future date for a pre-agreed upon price, generally 3 to 7 years foward);
• Buying a call option struck at the current stock price; and
• Selling a call option (or in some structures .833 of a call option) at 120% or more of the current stock price.

And once the hedge is put in place, the client can receive the present value of the future cash flows upfront, which is generally in the range of 80-85% of the current fair market value of the hedged position.The net effect of all this is to give the client significant liquidity, protect the full downside of the hedged position at the current stock price and to defer payment of capital gains taxes until the expiration of the hedge.

• Question: why does the IRS deem this not to be a constructive sale for tax purposes while the short-against-the-box is treated as a sale?
• Answer: because of the variability of future outcomes associated with the hedged position, the measure of which is the spread between the call option bought and the call option sold (in the above example a 100% call bought and a 120% call sold for a 20% spread) as well as the length of the hedge.

What are two ways to make the above hedge more "sale-like" and therefore blowing the tax deferral in the eyes of the IRS?

1. Make the call strikes closer, e.g., a 100% bought call and a 110% sold call; or
2. Make the maturity longer, e.g., 10 or more years.

The best measure of "stock-likeness" is embodied by the concept of delta. Per Wikipedia:

The delta measures the sensitivity to changes in the price of the underlying asset. The Δ of an instrument is the mathematical derivative of the option value V with respect to the underlyer's price.

Think of it this way: owning stock has a delta of +1. Selling stock has a delta of -1.  The hedge is the synthetic selling of stock. So if the delta of the hedge is too high (meaning the call spread is too tight or the maturity is too long), there won't be enough retained risk or variability of potential outcomes to cause the IRS to allow tax deferral. And while Congress hasn't enacted concrete rules that govern these strategies, the IRS has issued "private letter rulings" to law firms and banks on the topic that pretty much support what I've written above (or at least they did when I was in the business). But what was always an issue, a niggling little issue that sometimes found its way into certain of these hedging contracts, concerned the issue of stock borrow. And this is where the wealthy and generally fortunate Mr. Anschutz might be in a bit of trouble.

In order to execute one of these VPF deals, stock needs to be borrowed and sold to establish the short position. The Wall Street bank is the one who does this. But in the hedging contract, it has to be stated who bears the risk of a stock borrow being "called in" (meaning you've got to give the shares back to the stock lender and the transaction gets unwound). While there are lots of shades of gray (e.g., the stock can go "on special" and the borrow simply gets more expensive but doesn't go away, but someone has to incur the higher borrowing costs), someone is taking the borrow risk. So far we're ok as far as the IRS is concerned.

But where it used to be fuzzy prior to 2006 (but now is not) was when the Wall Street firm had the ability to borrow the shares held by the client in the event of a short squeeze or if there was not sufficient borrow available to get the hedge off in the first place. I looked at this feature many, many times and spent countless hours with counsel trying to get comfortable with this but never could. In the late 1990s/early 2000s during the Internet bubble, it was often very difficult to source enough borrow to execute a big hedge on a recently IPO-ed stock, and borrowing the client's shares would have been the ticket to millions in fees. But sadly, a prudent man's view of the facts and circumstances left these deals to be done by others or none at all. Don't shed too many tears, however: there were plenty of liquid stocks to hedge where this issue never came up, but in some cases it did and some decided to roll the dice.

Enter Mr. Anschutz. Now, according to the WSJ article, these transactions were entered into during 2000 and 2001. But they provided the counterparty, DLJ, with the ability to borrow the shares held by Mr. Anschutz. So think about this. Mr. A has shares. He posts them as collateral to DFJ for the hedging transaction. They sell those exact same shares as part of the hedge. Seems like a sale, right? This is the IRS position. The IRS formally shut the door on this type of deal back in 2006, a full 5-6 years after Mr. Anschutz put his hedges in place. Clearly his counsel will argue that such transactions should be grandfathered as they were entered into before the rules were clarified. But some of us saw these deals during the same time period and concluded that they were simply too dangerous. The benefit of an 8-year tax deferral like the one contemplated by Mr. Anschutz's hedges are very valuable. But the terms of his particular agreements are yet another example of something we see on Wall Street time and time again: flying too close to the sun.

 

Bank Holding Company Stockholders: Even Greater Dilution Awaits

During my years as a derivatives and capital structuring professional, I spent a lot of time working with my teams to develop versions of the "holy grail" - tax-deductible equity. In short, when corporations are seeking to raise funds, the goal is to receive equity credit from the rating agencies while incurring a financing cost more akin to debt. And this is nowhere more important than with regulated financial institutions, which have mandated minimum capital ratios which are heavily scrutinized by both regulators and the analyst community. Bank holding companies have been on the leading edge of so-called "hybrid" equity issuance, and have historically been among the largest issuers of such paper.

Without question, hybrid paper has created a form of both regulatory and economic arbitrage, where "equity" can be issued at debt rates. This has been courtesy of bank regulators, ratings agencies and the IRS, from whom opinions are sought to ensure the amount of equity credit received and the tax-deductibility of the structure. It could only be that such an arbitrage opportunity could exist when three different bodies are involved in the treatment of such instruments.

There is a limit to this nirvana, however: only so much of this paper can count as equity before the regulators and ratings agencies call bullshit. And if you believe the story line in a recent Wall Street Journal article - and I do - then this breaking point has pretty much been reached:

U.S. banks and brokers trying to raise capital with hybrid securities have turned to issuing the instruments so frequently they risk losing the securities' capital-raising benefits.

If the banks decide to sell more of these securities, which are a blend of equity and debt, they may not be considered capital by rating firms. That in turn could limit financial firms looking to raise more funds to bolster battered balance sheets.

The companies are then likely to tap other avenues that pose their own disadvantages, such as selling common stock -- which current shareholders wouldn't welcome.

The real issue here isn't that the banks are opportunistically trying to raise cheap capital and get equity credit, though this has been the "sale" from Wall Street firms to the banks during calmer times, but that banks need to raise equity, real equity - and fast. Damaged balance sheets face banks of all sizes across the U.S. the UK, and they either need to massively shrink their assets and de-lever (which causes a flood of paper to further depress asset prices), raise real equity capital or both. And it appears that the equity issuance side of the equation will become more costly, and greater numbers of these sales will be in the form of expensive and dilutive common stock. This is clearly not good for existing common stockholders, who will bear the brunt of this change in issuance strategy. Whether it is through public market issuance or via private sales akin to Washington Mutual's deal with TPG or the announced Bradford & Bingley transaction in the UK, common stockholders will be hurt - badly.

It brings me back to my early days at Citibank when Prince Al-Waleed spent a cool $590 million to buy up what turned out to be one of the best investments of all time (even in light of current problems). We have only witnessed the tip of the iceberg.

 

Yes Ben, the Dollar Does Matter

The weak dollar has been a source of much consternation, at least for me, over the past year. There are those who say "Who cares; a weak dollar helps exports," and "You need to keep pushing down interest rates until the economy recovers and we work through this crisis." My position has been pretty clear: a weak dollar is bad, not in and of itself, but because of the knock-on effects of such a policy. Why? Consider just a few reasons:

• The U.S. is a debtor nation. We rely on foreign governments to finance our deficits. If the value of those dollar-denominated holdings keep falling, at some point they will either stop buying or demand an increasingly high interest rate to offset currency losses;

• The U.S. financial system is in a badly weakened state. We need both onshore and offshore sources of capital to bolster bank balance sheets burdened with busted ABS and retained LBO loans. If foreign investors lack confidence in the dollar, this erects an extremely high barrier for investment.

• The U.S. imports a lot of stuff. Paying for this stuff with depreciated dollars means only one thing - rising prices. A weak dollar is fundamentally inflationary and something that could bring us back to a time we'd all rather forget - the 1970s.

But for most of the time I've been writing about my frustration with Fed policy, Mr. Bernanke has been turning a deaf ear to my pleas. But now it appears that we've reached a tipping point in Ben's mind, a point that has prompted him to sing a somewhat different song; here are his comments during yesterday's speech at the International Monetary Conference in Barcelona:

In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets.  The challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation.  We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations.  Over time, the Federal Reserve's commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy--including flexible markets and robust innovation and productivity--will be key factors ensuring that the dollar remains a strong and stable currency.

Price stability? Maximum sustainable employment? Flexible markets? Hmm, not sure we've done such a good job on these fronts. Productivity, yes - so far. Mr. Bernanke is focused on the right goals to be sure. It's just that it has taken him a while to get there. And now he has to follow through with actions to back up the words. Clearly in his calculus he viewed the need to push down rates regardless of the impact on the dollar as critical in order to help repair the broken U.S. credit markets. It is hard to fault him for his intentions, though one can argue that pain taken quickly and sharply is, in the long run, a better policy than death by a thousand cuts. And given that the impact of Fed policy has a lag associated with it, are inflationary forces already unleashed in the system too far advanced for tighter monetary policy to tame them? Are we destined to suffer higher prices and higher interest rates due to the Fed's slowness in reining in liquidity to stem a plunging dollar? This is the $64,000 question. And given the way things are looking, I'm not sure I want to know the answer.

Hedge Fund Fees and Liquidity - Setting it Straight

The current fallout associated with DB Zwirn is causing a renewed focus on both mark-to-market practices and, by association, pay-for-performance practices. The way it's being depicted in the media it's almost as if someone woke up and realized, "Hey, if hedge funds have illiquid investments kind of like private equity firms, then shouldn't they get paid like private equity firms (e.g., upon realization)?" 

I've been beating this drum for a long, long time, because if you've spent much time in the industry and have experience with both liquid and illiquid assets it becomes very clear, very quickly that there is an inherent conflict. How, exactly, can a manager justify a quarterly mark on a fundamentally illiquid position and deem it fair to get paid on an upward revision in value? You can't eat that revision, you can't monetize it, yet somehow you should get compensated for it? Interestingly, these are often the same managers who squawk about being judged on a quarterly basis when their strategy is fundamentally long-term. Why should one really be surprised about this asymmetry - heads I win, tails I don't lose. It is this ego and greed that drives many - but clearly not all - good hedge fund managers.

I actually think I wrote a pretty good post on this issue last year, with the following paragraphs being particularly relevant to the current media frenzy:

If positions are held for trading, meaning that short-term assets are being funded with short-term liabilities, then you've got to use either market prices or prices privately received from, say, five dealers, who are quoting based upon taking the bid (or at least the mid) side of the trade. And these are the prices that should be used for both NAV and performance fee calculations for funds, and carrying values for banks and other kinds of asset managers. Let me repeat: if the asset is a trading asset funded with short-term trading liabilities, then you need true marks. No marking to model. Period. Because as we all know, models don't begin to reflect the realities of financial distress, and are inevitably skewed in favor of the manager, if not intentionally then at least subliminally because managers, by definition, tend to love their positions.

Conversely, if positions are held for investment, it must be demonstrated that such investments are funded with liabilities of like or longer duration. This way, an investor can take comfort in knowing that while the values used might not be market-based, the manager can ride out adverse market conditions and not be forced to liquidate at the worst time. However, investment assets should not attract performance compensation until they are sold, and Management must provide clear documentation as to the process used to value these assets for NAV calculation purposes. This necessarily sets a higher return threshold for investment assets relative to trading assets, as should be the case: if one is giving up liquidity and the ability to collect quarterly performance compensation, then the expected return on these assets better be huge. This is where Management's view comes into play. This approach treats investment assets as if they were private equity in nature, being funded with long-term liabilities and attracting performance fees only when sold.

It all seems brutally straight-forward to me. It always has. But in an industry where the words "hedge fund" have come to mean a fairly standard set of terms and conditions - 2% management fee, 20% performance fee, fees paid quarterly - investors have gotten locked into a compensation paradigm that no longer fits portfolios that have become increasingly chocka-block with illiquid assets. Theoretically, in a perfect world, I'd argue that managers should get paid on positions as they get closed out, whether they are held for one day or five years. This eliminates the impact of marks on compensation, offers 100% transparency and truly aligns the motives of managers and investors. Sure, record keeping would suck, but this can be figured out. I'd be interested in the arguments contrary to this position, except those which say "The best managers simply won't accept this." Over time things can change but it depends upon investor resolve and insight, two things that have clearly been lacking in this latest wave of hedge fund melt-downs.

The Inevitable Growth of Derivatives Exchanges

The World Of Derivatives Has Changed

Derivatives exchanges for the trading, clearing and settlement of options and futures is nothing new; they've pretty much been a fact for over 30 years. And volume growth at these exchanges is exploding, regardless of the venue - ICE, ISE, NYMEX, CME, etc. They are all flourishing amidst rising market volatility and rising transaction volumes in general. That said, exchanges continue to miss an enormous part of the derivatives trading and hedging activity that happens in the over-the-counter (OTC) market. Back when I was a derivatives structurer and marketer, the OTC market was THE place for derivatives transactions, particularly in the fixed income, foreign exchange, credit and commodities markets. But today things have changed. The meteoric rise of the OTC credit derivatives market has caused many market watchers to question both the degree and extent of this largely unregulated activity, and recent crises that have involved credit default swaps (CDS) and the like are raising questions about issues of transparency, counterparty credit risk, broker/dealer market exposure and documentation.

Why OTC Markets are Still Enormous

Even in light of the clear benefits of exchanges - transparency, standardized documentation, centralized credit, clearing and settlement functions - the OTC markets have continued to thrive. But why?

• Customization: Whether for risk management or for speculation, the standardized (or lightly customizable) contracts offered by the listed markets simply don't meet the needs of many market participants. Whether for a corporation issuing a bond that wants to precisely hedge a recent issuance (e.g., by swapping a bond with a fixed coupon to floating rate), a project financing vehicle that needs to protect a series of highly variable and choppy cash flows or a speculator that wants to express a particular view through a basket of credit swaps and equity positions, the OTC market is able to address and and all requirements on a highly customized basis.

• Lack of transparency: Let's face it, banks want as little price discovery as possible because it leads to more generous pricing opportunities. Especially if a hedger or speculator wants to put on a non-standard position, banks stand to make the lion's share of their profits relative to facilitating large numbers of exchange-traded instruments with razor-thin margins. This is just reality.

• Potentially better terms: This transcends pricing, as bank counterparties may be easier on collateral requirements and credit terms than exchanges. It is in a bank's interest for derivative counterparties to honor their agreements over their life, and have been known to do unnatural things to keep a derivative counterparty alive for the duration of the agreement.

Rising Volumes Make All The Difference

When I marketed and structured derivative solutions customization was the key driver, as tailored solutions that better met a client's needs also provided the opportunity to make more money. It was effectively the synthesis of an investment banker and a Sales & Trading professional, offering strategies and counsel in order to deliver the right OTC or public capital markets solution. This was pretty cool. The transactions got papered right, the appropriate credit was approved and the necessary ISDA Master documentation was in place. But maybe I did 50 transactions a year. This is a very different situation than we have today where tens of thousands of credit derviative transactions and trillions of dollars of notional value get done annually.

Risks Of The OTC Documentation Blizzard

Further, prime brokers and their broker/dealers were nearly in crisis around undocumented trades, particulary in the 2004-06 time frame, so much so that the SEC had to step in to force banks operations areas to clean up their act - or else. Imagine a situation where a major institution fails with tens of billions of outstanding CDS' written on its bonds, and thousands of unconfirmed trades spinning a tangled web of relationships among investors, speculators and hedgers all over the world. It would be a bonanza for litigators but a nightmare for financial market participants and those for whom they manage money. Not a scenario I want to imagine.

Exchanges Are Designed To Help

So what is the answer? Getting the leading derivatives originators to agree on a standardized template for CDS trades, interest rate swaps and the other building blocks of the OTC market, and creating enough degrees of freedom in the contracts such that there is some ability to customize without losing the liquidity of the instruments. The central exchange function is simply so valuable in an a world of exploding volumes and numbers of counterparties, and can serve as a mechanism to ensure best practices with respect to transparency, credit provision and documentation. I am not one to bang the drum for excessive regulation, but by pushing as much trading volume onto exchanges as possible I believe the likelihood of market dislocations will be minimized and "unexpected" crises in the wake of credit and performance defaults will be substantially reduced.

The Inexorable Shift Towards Exchanges

I find it useful to think about ideas by stressing the extremes, e.g., how did things used to be and how might they look at infinity? And to me it is inevitable that, at infinity, almost all transactions will be done on exchanges. Why? The benefits simply outweigh the costs, and there are a number of catalysts in place to support this conclusion: increasingly global and liquid markets; inexorably rising transaction volumes; much larger credit exposures; the difficulties with counterparty credit review; increasingly intertwined financial systems; and the blizzard of paper required to trade OTC with more and more counterparties. Over time, the inefficiency of the OTC market will cause it to take a back seat to the exchanges, and this is a trend that will build momentum over time. Think about Toyota versus GM. Who could have imagined Toyota's success three decades ago? And now they are pulling away. This is how I think of the exchange model versus the OTC model. The changing of the guard is inevitable. Just wait and see.

On Spiritual Holiday

For whatever reason I'm just not in a writing mood these days. Very intense. Working on projects. Lots of deals. Helping portfolio companies. Busy with my family. L-A-S-E-R-F-O-C-U-S-E-D. For the first time in nearly two years my well is dry, my inspiration lost. Having not experienced this since becoming a blogger, it is kind of freaking me out. Am I letting down my readers? Do I really have nothing more to say? Am I brain dead? None of these are pleasant prospects. It used to be that every day I had 2-3 ideas I wanted to write about and just couldn't wait to sit down at the computer and type away. But that feeling is lost right now. And I am feeling somewhat guilty. And pretty sad about it.

That said, I am doing what I need to be doing, which is letting it flow - or not. I'm sure I'll get over my hump, but for now I am taking care of business. My business. And right now my business does not seem to include writing. I am sure my feelings are not unusual and that many of my blogging friends and colleagues have experienced something similar, but right now it seems like I am the only regular blogger in the world who isn't blogging regularly. And it feels like crap. Fred Wilson? Paul Kedrosky? Barry Ritholtz? Felix Salmon? Those guys are super-human. I am a mere mortal.

But not to worry, I'll be back. Oh, you betcha. I'll be back.

Does SPAC Really Spell SCAM?

To be clear, I don't see the SPAC industry itself as bad. Well, not too bad. What I do see, however, is an industry that might be moving towards a role that is neither good for SPAC investors nor consistent with an alignment of interests among private equity firms, SPAC sponsors and their investors. A good friend of mine got my thoughts flowing after forwarding me a recent article from Bloomberg:

May 16 (Bloomberg) -- Kohlberg & Co., Madison Dearborn Partners LLC and Kirtland Capital Partners have resorted to selling holdings to so-called blank-check companies, a path more private-equity firms may follow as other buyers remain scarce.

Leveraged buyout firms stepped up the pace of takeovers in the past five years, aiming to cut costs at businesses ranging from newsprint makers to crane purveyors and then sell them to the public. Now they're turning to special-purpose acquisition companies as demand for IPOs sinks to a three-year low and tight credit markets make it harder to borrow money to finance LBOs.

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While SPACs are flush with cash, the other buyers private- equity firms have traditionally relied on are unable or unwilling to invest, according to Steven Kaplan, a finance professor at the University of Chicago's business school.

``Buyout firms are selling into these situations where they can't go public by the normal route and there's no one to sell it to,'' Kaplan said.

So have SPACs become the buyer of last resort for those private equity-backed companies in need of liquidity? Probably not exactly what SPAC investors had in mind, unless the prices paid by the SPACs are cheap. The words "private equity" and "selling cheap" generally don't go hand-in-hand, so this recent phenomenon has caused my BS detector to emerge from its week-long slumber.

It kind of seems like a case of adverse selection; since institutional investors aren't eager to fund a current IPO calendar, perhaps retail investors can be tapped indirectly by selling these companies to SPACs? Maybe I'm just being cynical. But wait a minute, these deals are pretty good for those SPAC sponsors, right? They get a big chunk of equity for simply putting together the SPAC and are long a call option on, say, 20% of the business if a deal goes through. And these sponsors are under time pressure, because they've been sitting on a pile of cash and in need of a deal, or their money will be returned (less fees) to investors. So it is just this kind of a dynamic (a ready-to-deal private equity industry, closed IPO markets and SPAC sponsors in need of deploying cash - now) that makes me wonder: is something rotten going on here?

Consider the key constituencies and what they have to gain by the current PE portfolio company-to-SPAC deal cycle:

Private equity firms: They want liquidity and can't do so via an IPO. Sales to possible strategics are often harder to accomplish and result in lower sales proceeds, and sometimes come under regulatory scrutiny. SPACS offer ready pools of public markets liquidity, the incentive to get deals done, less price sensitivity and complexity than selling to a strategic buyer. Not bad. It's pretty clear why the private equity industry is heading in this direction given today's less-than-friendly market environment.

SPAC sponsors: They are all about getting a deal done, since the clock is always ticking on deploying their funds before they have to be returned to investors. Buying public companies is hard, because dealing with multiple shareholders, regulatory approvals and SEC red tape is a major hassle. Further, the risk of the deal not getting done is far higher than dealing with a single entity, e.g., a private equity firm. One could imagine a scenario where SPAC management might not sharpen its pencil to get a deal done at the right price, since the motivation to get a deal done is so great. And while the proposed acquisition has to be approved by 60% of SPAC shareholders, unless the deal is a dog on its face it is easy to imagine it getting through.

SPAC investors: The original investors, under the SPAC structure, pay a boatload of fees for the privilege of participating in the SPAC. And these fees don't get returned, even if the SPAC never does a deal. So there is a lot of motivation for investors to support the SPAC sponsor's proposed deal, since flushing 7% down the toilet is a hard thing to stomach. So even if the sponsors appear to be overpaying for a deal, unless the deal smells very, very bad it is pretty likely to get through.

So my word to SPAC investors is: be careful out there. First, does buying into a SPAC make sense in the first place? Second, are you better off voting down a deal, even if it means giving up the fees, in order to avoid an even worse outcome? Best advice: if you must invest in a SPAC, wait until after it has traded for a while and begins to trade at a discount to NAV. Then you won't have to shoulder the full weight of the upfront costs and are simply long a call option on the sponsor's ability to get a good deal done. And if they don't, you don't get burned. Today is a time for prudence; this is my Rx.

ADDENDUM - 5/18/2008

One of my readers sent me some additional information concerning SPACs that I wanted to share. As one who is not currently active in the SPAC marketplace, my perspective might be applicable to the industry of yesteryear (like buyers of convertible bonds, which is now dominated by vol arb players and less by long-term, fundamental investors). I appreciate the insight and knowledge shared by this individual. Thanks, Mark.

When the SPAC is originally funded, almost all the investors are hedge funds with absolutely zero intention of voting for the (eventual) acquisition. Instead, they buy the shares using leverage, then immediately strip off and sell their warrants and continue to collect interest on the (refundable) balance. By doing this, they guarantee themselves a very high (10%+) risk-free return. Once the target is identified, the SPAC management team then has to do a SECOND roadshow, in order to find "long-term" investors to buy the shares from the original SPAC investors. (Those original investors are generally highly cooperative in this process, because it greatly reduces the time it will take for them to get their money back, vs. waiting three years for the SPAC to dissolve, and then another four months for the escrow money to be returned to them.) So, anyone who buys into a SPAC up front really has nothing to worry about if they don't like the original acquisition, and anyone who does so later is doing it with his or her eyes "wide open."

The real problem with SPACs is that it can become a massive (and ultimately unsuccessful) time drain for their management teams, as it's so hard to get approval for whatever deal they line up. More and more frequently, those teams are now giving up big chunks of their equity to investors willing to come in (on the secondary market) and vote "yes"; at some point, it won't be worth the effort for a team to put one of these things together... In which case, they may have to go out and get real jobs!

Long PM Health/Short Tums

What do you get when you cross good, thematic long-term investors and stock pickers with quarterly or annual redemptions? Perverse decision-making and style drift. Or a portfolio manager with an ulcer. There is a fundamental mis-alignment of motives in the hedge fund business, and my guess is that it will push truly excellent investors into one of two camps:

1. Becoming "institutional," substantially growing assets, running an overly diversified portfolio in order to dampen volatility by pandering to institutional risk-aversion, and generating mediocre returns in the process; or
2. Becoming disenchanted with the focus on quarterly performance and forcing out most outside investors or imposing a super long-term lock-up which will likely have a similar effect.

I've spoken to several friends in the fundamental long/short business who are good, really good, and they all get stressed out and irritated by quarterly performance measurement because this is not their investment horizon. Many of the value-oriented funds I know will hold investments for years - whose value naturally oscillates due to both company-specific and market forces - but ultimately the thesis plays out over time. Their approach is more akin to Warren Buffet than it is Jim Simons, and turnover as a rule is quite low. Just look at Berkshire's stock price; it whipsaws around regardless of the rate at which book value compounds over time. Market sentiment, sector rotation and macroeconomic factors have dramatic effects upon stock prices over short time periods, which may have little to do with the intrinsic value of a business. Quarterly reporting and redemption horizons that are mismatched with investment holding periods exacerbate the problem and lead managers to consider portfolio management decisions that are suboptimal for maximizing long-term returns. Two excellent managers I can think of off the top of my head, David Tepper and John Zwaanstra, run very concentrated, volatile portfolios with dramatic swings in performance year-to-year. And their investors understand this and are willing to take the roller coaster ride. But they are rarities indeed.

So why has this pervasive asymmetry existed? Because hedge fund managers ask for it. If a manager wants a quarterly payout, they have to live by quarterly reporting and performance measurement. Period. And if they complain that their investment horizon is long-term and that they shouldn't be judged on short-term results, then they shouldn't get paid that way, either. In a perfect world, managers would collect fees to run the business and attract and retain talent (management fees), but would have both performance fees paid and lock-ups match their investment horizon. So, if a manager had a three-year investment horizon on their thematic portfolio, they should get paid on positions in the book on a rolling three year cycle. This would result in a true melding of the hedge fund and private equity models, where performance fees are paid upon realization, not on period mark-to-market values, and capital is committed for long time periods. The same thing can be said for quantitative managers: stat arbs and other high-frequency strategies with short-term signal horizons should get paid out quarterly - but they should have redemptions quarterly as well. This is akin to the CTA business, and quite frankly it makes a lot of sense.

I believe this is a sensible, rational, and fair way to align manager and investor interests and to let the long-term fundamental manager do what they do best - invest, not trade. People would once again get paid for alpha generation and not simply asset gathering, and portfolio managers would probably have far fewer ulcers. Long portfolio manager health, short Tums.

The KKR/SUNW Deal Telegraphed Today's PE Environment

The KKR/SUNW convertible preferred PIPEs deal, an oddity in the private equity world up to that point, in retrospect looks like the harbinger of things to come. When I wrote about the deal in March 2007, I saw the following as being the principal reasons for such an investment:

• KKR knows that deal sourcing is going to get increasingly difficult. They are seeking to build a track record in the PIPEs space and to gain experience with the management of these types of investments. This is very, very different than the stuff they're used to. And they are acutely aware of this. The hope is that by being successful and by working well with Managements and Boards of Directors, that they'll ensure a steady source of deal flow tomorrow and beyond.

• KKR knows that deal return risk is increasing. You know those Blackstone guys? They see the same thing. KKR's approach (though an IPO is possible) is to put less risky assets into their portfolios to prepare for rainy days ahead. From a portfolio management perspective, this is smart.

• KKR, besides putting on an implicit portfolio hedge by booking a convertible debt structure versus straight common equity, is putting on a management and performance fee hedge. If KKR is moving down the risk/return continuum by shooting for lower risk, 10-12% total returns versus higher risk, 30-40% total returns, they are betting that shellshocked investors won't be offended by paying premium fees for stable, low double-digit returns. And they're probably right.

• KKR knows that private equity is coming under increasingly regulatory and PR scrutiny, and wants to be the firm wearing the white hat. By supporting company management's in PIPE deals, they burnish their image as a concerned corporate citizen that is a supporter and not a raider of industry. No asset stripping. No debt-funded dividends 3 months after taking a company private. Only good, wholesome, long-term investment. This isn't your father's KKR, my friends.

And look at what we've been seeing recently. TPG/Washington Mutual. Corsair et al/National City. Couple this with Carlyle's David Rubenstein's recent thoughts on the matter:

The co-founder and chief executive of private equity giant Carlyle Group said on Monday that struggling financial institutions are the "single biggest opportunity" for investment in the U.S.

Speaking during a conference of the Society of Business Editors and Writers here, David Rubenstein said financial institutions have enormous balance sheet holes in them and the amount of capital that is needed is more than has been publicly announced. While large, big-name institutions have made headlines, he noted that there are many lesser-known financial institutions around the country that need help.

Please note that due to regulatory restrictions, these investments are, by necessity in most locales, minority shareholdings. So at the end of the day the deals will look a lot like the Washington Mutual and National City deals. Very un-private equity-like. Highly unlikely to generate the kinds of returns private equity investors have gotten accustomed to.

I recently posted about my fears that fund size is leading to bad risk/reward decision-making on the part of leading private equity firms, and the two bank deals mentioned above were the marquee examples in my post:

And I know that these private equity firms and the SWFs say that they are getting quality assets on the cheap. But I worry about the conflict between the ability and desire to write a big check and the best time to write such a check.

Because it seems to me that some funds are a little trigger-happy, pushing money out the door while they can in order to justify their existence and to spend time managing dollars instead of deploying them. And if I am right, this is a very worrisome trend, indeed.

Equity Private recently weighed in on the topic, arriving at a conclusion similar to mine, which is not entirely surprising since she and I tend to be pretty blunt, sarcastic, cynical and generally rational:

What do you do when your private equity returns are dwindling because you have billions of idle cash sitting around and no deals to invest in? Invest in public equities, of course. Well, "of course," is sort of strong, particularly when your core competency isn't public equity analysis.

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I would say I'd be selling my Blackstone shares, if I owned any. I'd say short Blackstone, but, well, it's probably a bit late for that.

Funny, yet accurate stuff. Bottom line, my thesis of thirteen months ago is playing out pretty much as expected. It should be a very interesting (read: crappy) few years for the private equity industry. Gigantic asset pools that need to be deployed. Broken credit markets making leverage prohibitively expensive or unavailable. Existing portfolio companies in dire need of fixing (read: de-levering). So what's a survival-oriented PE banker to do? Put tens of billions in lower risk, lower return deals in public companies, or to massively step-up the foreign investing activities which frequently have smaller ticket sizes. In short, those pension funds that have been the largest backers of the top PE firms are going to see their returns go down, down, down. There is nowhere else for them to go. Because I don't care how good a PE banker you are: you can't fight gravity.