Playing Chicken with Citigroup

What does "too big to fail" mean anymore? Bailing out equity-holders? Debt-holders? Depositors? Entrenched managements? Sovereign wealth funds and other large offshore investors? We need to define our terms and our goals and we need to get it right. And one of the most stunning case studies for what this means in a post-AIG bailout world may well be Citigroup.

Citigroup touches every part of the U.S. economy and many parts of foreign economies as well. An out-and-out failure of Citigroup would invariably cause ripple effects across the global financial landscape due to its labyrinthine counterparty risks, collateral held on behalf of others, worldwide branch network and panicked depositors. Rightly or wrongly, I assign a zero probability to Citigroup being forced to file Chapter 11, so then the question becomes: what does happen if it hits the wall a la Bear Stearns or Lehman Brothers?

Option 1: TARP-style bail-out

This would involve writing $25 billion checks on a quarterly basis for the foreseeable future.  There would be no end in sight since the amount of toxic waste residing on Citigroup's balance sheet (see Assets, Level 3) is in the tens of billions and currently unknown. Transparency is not yet at hand. This plan would protect equity-holders and debt-holders at the expense of the U.S. taxpayer and better-run competitors. It would also protect the investments of sovereign wealth funds and Prince al Waleed, two constituencies who would likely go ballistic if Citigroup's stock price went to zero. The political ramifications of such a move shouldn't be underestimated, yet the impact of irritating offshore investors now pales in comparison to best dealing with the global financial crisis. Sure, they hold a lot of U.S. Government debt, but right now that is perceived as the safest paper in town. That said, this plan reeks of moral hazard and burns the very people who have the most skin in the game: the average U.S. citizen.

Option 2: Good Bank/Bad Bank restructuring

This would entail a multi-step process that wipes out common stockholders, and potentially some preferred stockholders and debt holders as well:

1. Separate Citigroup's Level 3 and other illiquid financial assets ("Bad Assets") from the others ("Good Assets") ;
2. Sell the Bad Assets to a Treasury-controlled special-purpose vehicle ("SPV") at market value. The SPV would be owned by the U.S. taxpayers;
3. After receiving the cash proceeds of the sale, take the book loss and mark down the capital account. Use free cash to pay off creditors beginning at the top of the capital structure. Some creditors will be paid and other's won't. That is part and parcel of the risks of investing; and
4. Compute the amount of capital necessary to bring the Good Assets - now the Good Bank - into regulatory compliance under the BIS standards. Capital can be provided by either public or private sources. The Good Bank, now freed from balance sheet uncertainty and with an attractive global asset base, may be an appealing candidate for private equity investment. If not, the U.S. taxpayer - through the U.S Treasury - will make the necessary capital injection. It will get a good deal.

This solution avoids moral hazard, penalizes those who took risk with the hope of great reward, and provides the U.S. taxpayer with a fighting chance to earn a fair return on its investment. Further, the Good Bank will not be motivated to hoard capital, since its clean and transparent book will be adequately capitalized and without the embedded mega-disasters causing most banks on the planet to apply for TARP funds. Will common and preferred equity holders be irked? Yes. Big deal. They are at the bottom of the capital structure for a reason: trying to capture the benefits of a levered return. Sometimes leverage works against you, as it has across many large financial firms. And in those cases, you lose. This is one of those times.

Conclusion

The time has come to drop the arguments over mark-to-market accounting, FAS 157 and fairness. If you can't finance your book, you are dead. Period. This isn't about accounting; it's about survival. This is a plan U.S. citizens, Congress and global financial leaders should be able to get behind. And they should apply the same solution to their problems. Because once we have financial firms with transparent, clean, well-capitalized balance sheets, the motive to stockpile capital is gone. Then we can turn our attention to the real economy where things are just beginning to get bad. But one step at a time; we need to lay the foundation for capital formation as the real economy starts to heal, and it all begins with a healthy banking system.

Why Can't We Admit That...

...Citigroup, parent of the once-proud Citibank and Salomon Brothers, is bankrupt?

...larger venture firms are fair-weather friends and lack the staying power that their prodigious committed capital balances would indicate?

...venture capital and private equity Limited Partners got burned by the old maxims of the ratio of funded commitments to committed capital?

...venture capital is a cyclical business, and that a dedicated focus on any one stage will leave a firm exposed when the cycle shifts?

...the stock market will continue to go down, regardless of perceptions that "this quality stock is cheap" or "this is the buying opportunity of a lifetime?"

...Berkshire Hathaway is genuinely threatened by a potential run on its credit, due to contractual provisions in its derivatives agreements that could compel it to post more collateral at exactly the worst time?

...if we are even talking about Berkshire Hathaway being at risk, then ANY company is at risk of a run on its credit?

...as well-intentioned as those in our Government might be, that most have no idea of how to address the issues that threaten our national prosperity and well-being?

...any institution for which buying a bank is even remotely logical will do so to gain access to TARP funds, whether necessary or not?

...spending on infrastructure to get people back to work while re-building and upgrading essential services is a useful expenditure of taxpayer funds?

...everyone is scared, from the top 1% of the wealth pyramid down to those doing everything in their power simply to get by?

...there is a difference between being pragmatic and being pessimistic, and that what seems overly depressing and negative in most environments is merely pragmatic in today's historic down-cycle?

...there will always be trading strategies that outperform in a given market, and that while CTAs, trend-followers and long volatility strategies look terrific now they often look like crap in market upturns?

...B of A buying Merrill Lynch is beyond inane and that BAC shareholders should rebel and vote "no" on what will surely be a value-killer for their holdings?

...derivatives need to move to exchanges to ensure transparency, liquidity and collateral adequacy?

...financial company balance sheets need to be marked-to-market unless assets can be financed on a long-term basis?

...Jerry Yang killed his own company, having shifted from his appropriate role of Chief Yahoo to CEO and blowing firm strategy in the process?

...good seed stage investors need to do what they do best, assess and take risk, and put money to work at sick prices for businesses that can weather the economic storm for the next 18-24 months?

...we are all in this thing together, as cratering Asian and European economies decline in sympathy with the embattled U.S. markets?

...as long as we've got our health and love in our lives that the Sun will rise tomorrow and bring new opportunities and challanges that make us feel alive and vital?

Scanning the News: Tough Times Require Decisive Action

Though I get most of my in-depth commentary on business and technology from blogs, I augment that with mainstream news headlines and alerts. I often extract the implied sentiment of headlines to get a tone of the markets and the economy, and this becomes part of the prism through which I view news, events and my activities. Lately the headlines have been pretty grim, and increasingly so as the global financial crisis bleeds into the real economy. Normally I associate depressing headlines with a contrarian opportunity to act, but at this point I believe the headlines do not yet discount the difficulties we will encounter both economically and militarily over the next 12-24 months.

Consider the top Breaking News headlines from Bloomberg.com, 2:30pm Eastern yesterday afternoon:

Breaking News

•Paulson Clashes With Congress, Warns Against Using Bailout as a `Panacea'
•U.S. Producer Prices Plunge 2.8%, Most on Record, as Global Demand Shrinks
•Home Prices Tumble in 80% of U.S. Cities as Foreclosures Drive Down Values
•Stocks in U.S. Retreat; S&P 500 Index Falls Below Lowest Close Since 2003
•Berkshire Credit Risk on AAA-Rated Debt Soars in Sign of Investor Anxiety
•Falcone's Harbinger Capital Faces Potential $200 Million Loss on Navistar
•Bank of America's Lewis Says Merrill Takeover Is `On Track' as Shares Fall
•Senate's McConnell Calls for Expediting $25 Billion of Loans to Automakers
•Hijacked Saudi Tanker Anchored Off Somalia Coast; Rescue Attempt Unlikely

This is what I take away from these headlines:

Seeing the chinks in "Teflon Hank's" armor. Hank has made big mistakes with TARP. He had the wrong plan, communicated it poorly and, as a result, sharply undermined his own credibility with Congress and the American people. That said, he was in a difficult position, made decisions that I believe were done with the best of intentions and changed course when he realized he was wrong. And for this he deserves credit. However, now that he is no longer Teflon Hank, he has to work extra hard to educate Congress on how and when TARP funds should be used. He is being bombarded on all sides by special interests and getting pressure from every faction in Congress. Had he done a better job of planning and communication upfront it would be much easier to manage the current situation, but this not the way it played out. What should have been a surgical strike of deploying massive funds into key areas (e.g., cleaning up busted bank balance sheets a la Good Bank/Bad Bank and developing a sensible mortgage restructuring solution, NOT opening the U.S. taxpayer's checkbook to virtually any bank that wants a capital cushion, money that will sit idle and not be used for capital formation) will invariably turn into a free-for-all. I can feel my wallet getting lighter by the minute, which would be ok if I felt the funds were being spent in a prudent manner. Which I don't.

The real economy shouts "No Mas." Just as Roberto Duran uttered those fateful words, the massive drop in U.S. producer prices is saying the same thing. Cratering commodity prices - metals, oil, etc. - are simply an outgrowth of the global economic slow-down. While lower prices are good, the speed and depth of the drop only exacerbated current problems: all that new production capacity that came onstream to take advantage of high prices are being mothballed only months later. Higher cost structures in the face of a precipitous drop in demand equals producer losses for a long time. And the drops were are talking about are of historic proportions, meaning that the adjustment period for demand to catch up to production capacity is likely to take years, not months.

Falling real estate prices aren't limited to the "go-go" markets. With 80% of U.S. cities showing price declines, the real estate bust is far more pervasive than one might have imagined. And, of course, falling prices beget falling prices: vacant houses in foreclosure drive down the values of adjacent housing stock, which in turn places those houses at greater risk of foreclosure, and so on. Further, these problems are worsened by rising unemployment, falling wages and ever-rising healthcare costs. We are likely in the midst of a downward spiral that can only be braked by fixes in the real economy; restructuring mortgages is a drop in the bucket if unemployment approaches 10% and people can't make even reduced monthly payments. We've just seen the beginning of the story; how the rest plays out is a function of how our new President, in conjunction with other global leaders and Congress, work to get our economic engines running again.

The equity markets have created zero value over the past five years. Sure, there have been some IPOs (value in), secondary stock issuances (value in), stock buybacks (value out), dividends (value out) and compensation paid (value out), but the bottom line is that we have basically been treading water. And if you look back, you can make the argument that we've made little headway over the past decade. In addition to the adverse effects on people's savings and retirement accounts, it is very poor for consumer sentiment and people's attitudes in general. Why did I work so hard only to be back where I started? While the issue is certainly more complex, the headline is very corrosive to peoples' sense of worth, accomplishment and safety.

Even Warren Buffett isn't immune from the market's harsh judgment. First, it was his deeply-underwater preferred stock investments, most notably in Goldman Sachs. Now, the cost of protecting against Berkshire's credit has skyrocketed to a level more in line with BBB-rated companies, not the vaunted AAA that it currently holds. Fears are centered around the long-dated equity index put options it wrote beginning in 2005, on a notional amount of around $40 billion. In Warren's eyes he has secured almost $5 billion in option premium that he can use for acquisitions, stock buybacks, etc. In the market's eyes some believe Berkshire is going to have to come up with collateral for the decline in the short option position. Reality is, the only way Berkshire has to post is if its credit rating falls below a pre-determined level. As unlikely as this may seem, those in the credit derivatives markets are looking at Berkshire credit risk with a wary eye. Sentiment in this market is as volatile as the VIX: if the market continues to push against Berkshire's credit will a downgrade become a self-fulfilling prophecy?

Even the "do no wrong" hedge funds are getting crushed. Phil Falcone's Harbinger has been on a roll for several years, making him among the richest and most feared activist hedge fund managers on the planet. But lately things haven't been working out so well for Harbinger, with the Navistar loss only the latest among a sea of bad news. To be fair, Harbinger is doing better than many and long-term, Mr. Falcone's fund has been a super-performer. But like many things, people often get too much credit in good times and too much blame in bad, but hedge fund managers and their compensation models make it hard to feel bad for them when times get tough. This is the time to fix the compensation models such that payment horizon and investment horizon match. Medium and long-term investors like Mr. Falcone should secure long-term lock-up money in line with their strategies, but should only collect performance fees that match holding periods. Having activist and longer-term thematic investors getting paid quarterly makes no sense. The best-in-class like Harbinger should lead the way on a new compensation model to better align GPs and LPs. Now.

B of A and Merrill - the market says no. What once seemed like a steal now looks both pricey and risky. Mega-mergers almost ever work, especially when the cultures of the firms in question are so different. The equity markets have been properly cynical about the merger going through, even in the face of Ken Lewis's insistence that he is committed to the deal. The market is offering him an out - he should take it. The value destruction facing BAC shareholders is monumental: bad culture fit, fleeing brokers, significant potential losses looming in its mortgage and derivative books, etc.. This is the time to protect your shareholders and to focus on execution of the core business plan. Bolting Merrill Lynch onto B of A cannot be seen as core to B of A's business plan. It was a grasp at what seemed like a compelling opportunity. Only the equity markets didn't believe it made sense. And I don't, either.

Bail out the automakers - or else... This partially has to do with Mr. Paulson's loss of control over TARP. The lobbyists and spin-masters are out in force, and all eyes are focused on the auto industry. Yes, it's in turmoil. But the proposals on the table are perhaps worse than Mr. Paulson's injection of $25 billion into Citigroup before they cleaned up their on- and off-balance sheet liabilities. A campaign of fear is being spread by entrenched interests, who want to see the sector bailed out and for its life to be prolonged until - who knows. The U.S. auto industry as we know it is dead. It has to die. The issue of legacy retirement and health care costs absolutely has to be dealt with before putting in dime one. That said, the industry can be restructured and the productive capacity used for other pursuits. Large chunks of the auto parts industry can be sold to more efficient foreign automakers who are already big customers. Certain factories may be able to be sold as well. Other plants can be retro-fitted for other activities, perhaps relating to core infrastructure projects to create attractive jobs, many of which can go to current auto workers. It would be far cheaper to pay workers a living wage and to give them training while plants are being re-tooled for other activities than pouring $25 billion into a sector that will need similarly-sized injections every quarter until the U.S. Treasury is bankrupt. We need radical change and creative thinking, not the same linear, predictable, pork-barrel line of thought that is the norm for legacy unionized industries.

Global instability on the rise. The recent spate of hijackings is indicative of an already unstable world in need of cooperation and order. Somalia, Yemen, Pakistan and Afghanistan will continue to be threats to the U.S. and our allies without a multilateral effort to ferret out terrorists and break their lines of funding. This will require information and intelligence sharing, jointly funded and staffed, that illustrates an unprecedented level of multilateral support that eventually serves as a deterrent to bad actors. Hopefully our new Administration can move this initiative forward - and fast.

Times are difficult and are likely to get tougher, and there is a lot of work to do. But much of the work isn't a mystery - it just need to get done by people with brains, heart, courage and vision. This isn't a popularity contest; it's about serving our country. If today's global turmoil isn't enough of a call to action, then I don't know what it will take.

The Markets, Politics and Change

Throwing $25 billion at the U.S. auto sector is akin to the $25 billion thrown at Citigroup; money flushed down the toilet. With over $100 billion of legacy pension and health care costs, a lack of globally competitive, fuel efficient cars and bloated cost structures, the U.S. auto industry as we know it has to die. Putting politics aside, it is simply foolish to pander to the UAW and their lobbyists by trying to save an industry that can't be saved. Let's take this opportunity through the bankruptcy process to purge unnecessary costs, sell valued assets to the private sector and re-purpose a skilled labor force towards infrastructure projects that can benefit the economy. Obama needs to make a stand that he is up for doing right, not simply thanking those who donated huge dollars and expect repayment - fast.

Obama's biggest challenge will be Congress. If he has any hope of delivering on "Yes We Can" and being the President of a changed America, he will have to get tough with Pelosi, Reid and the other entrenched politicos. Both he and McCain are right; the old ways of doing things need to fall by the wayside. And long-time Congresspeople focused more on popularity with their constituents and getting re-elected than on doing what's right for the country will be the bane of Obama's existence. Real change has to come from real changed attitudes. Whether our new President will be successful using moral suasion, skillful negotiation or taking his position right to the American people when it comes to key issues in front of Congress remains to be seen. Regardless, getting Congress to do the right things in a non-partisan manner is Job #1 for Obama.

TARP sucks. While Treasury Secretary Paulson has faced tremendously difficult circumstances, he has lost the battle and is losing the war, on both economic and PR fronts. Tossing hundreds of billions into "functioning" institutions, some of which have lousy management and even worse balance sheets, reeks of moral hazard and a rip-off of the U.S. taxpayer. I remain convinced that there is only one answer to getting the financial sector going: cleaning it up and stimulating the economy. The cleaning up should be done by enforcing mark-to-market accounting rules, seeing which banks hit the wall, hiving off bad assets into a liquidating trust and recapitalizing and restaffing (at the top) the remaining Good Banks. You think mark-to-market rules are unfair? Too bad. If you can't finance all those Level 3 assets, mark them to market and shut up. But the $164,000 question: will these good banks lend? The will have the capital, the clean balance sheets and the charter to do so. They will no longer fear a liquidity crunch and a possible run as they did prior to being restructured and recapitalized. But they will need good opportunities to cause them to lend. Making banks (or GSE for that matter) lend is stupid and dangerous. Economic stimulus is the next piece of the puzzle. For another bold perspective, my friend David Leinweber and a colleague, Salman Khan, have devised a prescriptive for the banking sector dubbed the New American Bank Initiative (NABI).  While I think Dave and Sal have identified the right concepts and barriers to success inherent in the current bailout plan, I believe my approach is equally as effective and easier to implement. That said, I credit them with a very creative, throughtful, unorthodox approach to solving the problem.

For economic stimulus, Obama needs to to prioritize a dramatically simplified tax code and no tax increases - period. Taxing corporations is the same as taxing individuals; those who don't get this need to remember that corporations are nothing other than assemblages of individuals ultimately selling stuff to other assemblages of individuals. Once simplified, tax policy needs to be used for strategic objectives, such as substantial tax incentives for investing in alternative energy and other "green" technologies. We absolutely have to break our dependence on foreign oil, but at $60 a barrel (or perhaps lower if the global economy really hits the skids), heavy investment in alternative energy doesn't make economic sense. Too bad. We can't wait. We can also use tax policy to encourage capital investment in other industries, where lower costs can help justify projects and new hiring that otherwise would be delayed until better days. We are in crisis, and have a golden opportunity to fix our broken tax code once and for all. Tell the lobbyists to go to hell. The time has come for logic-based, common sense action.

Push technology and education like crazy. Even in the midst of crisis, we can't lose sight that, yes, the future will come and we need to be prepared. I love the National CTO idea. But this will be nothing other than window-dressing unless Obama can get Congress to fall in line. I'd love to know how technologically-literate our Congresspeople happen to be. My guess is they'd score pretty low on a Tech IQ test. This has to change. While technology isn't a panacea, it is an enabler that will be a critical element of both fixing our economy and our educational system - for the long term.

Support entrepreneurs of all stripes, particuarly through tax incentives (e.g., R&D tax credits that can be used to lower the effective purchase price of equipment). We are entering a period of years where the common homes for many really smart, lateral thinkers - consulting, investment banking, etc. - won't be available. We should encourage these people to start companies or to work at start-ups. I am convinced that some of the greatest ideas of a generation will emerge over the next five years, precisely because the risks of starting a business have fallen so far (both in terms of cost and work alternatives). It should be the new Administration's mission to make sure that this happens.

Citigroup is toast. Can we get our $25 billion back? That was one severely stupid investment. Thanks, Hank.

Don't get depressed; get mad, get even. Use that energy to come up with new ideas, but perhaps related to stuff that you understand really well. Leverage technology. I can't believe some of the ways people figure out to make money using the Internet. I wish I was so creative. You might be.

Help people. Even though we are in the early innings of the economic malaise I've already seen some pretty crazy stuff happen to really good people. Everybody needs help these days. Even if things feel really bad and scary, we've got to help each other. Continue to look outward. Friends, family, friends-of-friends. Emotional support. Commisseration. Networking assistance. Whatever. Be there for others. They'll be there for you.

Why I Left Seeking Alpha

I have allowed my content to be re-published on Seeking Alpha for a long time. Since I don't care about the money of blogging, I didn't get upset that they made money off my stuff (though I know several who get completely psychotic about this apparent unfairness). I always viewed it as a way to let more people who want to read about Wall Street, hedge funds, economics, technology, etc. find me. And that was ok - until now.

As I've become more broadly read both on Information Arbitrage and on Seeking Alpha, the number of comments I've received per post has risen dramatically. I recently started using Disqus for my blog comments and it has been a life-transforming experience. I love being able to respond directly to specific comments, and for others to continue to stay on a particular comment thread for as long as they want. I had no idea how emancipating such a change could be. The number of comments I receive has gone up a lot. And I've been more engaged in the dialogue since I can just check in, rip off some thoughts to a few commenters and move on.

Seeking Alpha has no such functionality. It is the old-style, newest-comment-on-the-bottom approach with no ability to insert onself in the midst of the dialogue. I didn't really care when I was receiving 2-4 comments per post, but as that number has climbed towards 20 and beyond it has become a problem. Further, the tone of the comments on Seeking Alpha are often pretty hostile, which really makes me want to call out specific people and give them a piece of my mind. But I can't do this because of their antiquated comment technology. So I decided to say goodbye.

I'd be interested to know if anyone really cares that I am no longer on SA. I'm still here. Where it all started.

The Pyramid Principle: Venture Investment in a Capital-Efficient World

Large venture firms are in trouble. The combination of too many dollars to deploy coupled with the rapidly declining costs of starting companies has largely rendered their models obsolete. While there are exceptions, e.g., Cleantech, most venture-stage companies require very little money to prove their viability, often less than $2 million (made up of an angel round or an angel plus a "light" Series A round from a small venture firm). So where does this leave the big firms running assets of, say $250 million and above? Either relegated to a dwindling number of later-stage deals where large amounts of capital are required or a concentration of capital-intensive sectors such as Cleantech and Biotech. As either a GP or an LP of these funds, this is not where I'd want to be.

But all is not lost for these funds, if they are willing to adapt and if their LPs are able to wake up and shake off their hidebound ways of thinking about venture investing. It will require a change in staffing, due diligence methods and capital allocation. Big stuff to be sure, but essential if the legacy leaders of venture want to stay relevant and on the cutting edge. The way forward is what I'm calling the Pyramid Principle. It contemplates a three-tiered approach to venture investing, but through a structure that is almost the inverse of what larger venture firms are doing today.

The base of the pyramid - where firms will spend the lion's share of their time - will be in true early-stage venture investment. It will involve leading rounds that are as small as $250,000 and up to $2 million. It will also include incubation, which will pair a small, high-performance, tightly-knit group of agile developers that can churn out rapid prototypes of entrepreneurs' ideas. The base is a bubbling cauldron of deals, experiments and innovation. Where will the ideas come from? Either internally by looking at gaps and trends across the investment portfolio, bringing on Entrepreneurs-in-Residence that have specific ideas they'd like to work on or by being approached by an entrepreneur with a compelling idea but would benefit from the structure of working within a venture firm. The goal of investments in the base is to assess viability, e.g., whether the product or platform can demonstrate commercial relevance and traction. I would expect the staffing of the base to be with wicked smart, young-ish entrepreneurs, who want to step back from working on a single idea and to develop their chops as investors. The more experienced venture professionals, the Mentors, could provide advice and counsel to these up-and-comers and, in the process, get mentored themselves in bleeding edge technologies, business models and development methods. Entrepreneurs would get carry for both bringing in deals and working with companies, and Mentors would get carry for bringing in deals, advising the Entrepreneurs and directly working with some of the young companies. Some companies out of the base will be sold early, generating super-high ROIs but not large absolute dollars. If it turns out that growth will either cost too much or take too long to achieve, then it might make sense to take the money and run. That will be ok under this model. It will require a culture that pushes rapid assessment and admission of mistakes, rewards innovation and compensates heavily for successes that can be broadly applied. Most large venture firms find this activity too time-consuming and capital inefficient to warrant much attention. In the future I believe that getting the base right will be the key to success in the large-scale venture field.

The middle of the pyramid - where less time but more capital will be deployed - will be in B-round  growth capital investments. These source of these growth-stage investments will largely emerge from the base, in companies that require $2-$5 million to aggressively go-to-market. Money will go towards bulked-up engineering and operations teams, key management roles and creation of a sales and account management infrastructure. This has been a very competitive stage in the venture world for the past 3-5 years, where plenty of funds are happy to write checks for $5 million to help a company grow. The problem is, there will be fewer of these companies requiring fewer dollars as bandwidth and storage costs approach zero, yet these larger VCs are traditionally reliant on these deals and even later-stage investments to put their bulging LP commitments to work. By cultivating and nurturing companies in the base, the new-age VC can hang onto their winners and build a strong stable of growth-stage companies in their portfolio.

The top of the pyramid - with a small number of deals consuming large amounts of capital - will be in C and D-round growth acceleration investments. These will be for those companies that are runaway successes which can benefit from large ($10-$100 million) investments to rapidly achieve scale and dominate the space. They will be graduates from the base and middle of the pyramid, and will have been nurtured from inception to explosion within the firm. These investments represent "venture firm nirvana" - winners that have been on the books from the beginning with the ability to put progressively larger dollars to work throughout its life cycle. This enables those C and D round returns to be augmented by cheap A and B round valuations, creating the optimal mix of ROI and capital consumption.

I imagine that making these changes will be very difficult for most large venture firms, as it requires an internal culture change and a different team coupled with an external shift in messaging. It may be that a number of brand-name VCs go into run-off mode, taking their chips off the table over time and focusing their efforts elsewhere. Perhaps some of these firms could segregate their businesses into a run-off book and a new fund, with the LP commitments at a fraction of their levels in the heyday. Maybe we'll see yesterday's $1 billion fund as today's $200 million fund, with a number of $75-$150 million funds started by the venture stars of the late 1990s/early 2000s. This would be a good thing for everybody except the old-line venture firm GPs, who will no longer be collecting management fees on mega-asset pools that are no longer necessary. That's ok; they'll get over it. But if the major VC players want to remain relevant and in the game, they will need to dramatically scale back assets and modify their approach to the investing business.

The Case for Derivatives

My recent post, in which I shared my experiences as a derivatives salesman, elicited very strong reactions both on this blog and on Seeking Alpha. Many of the comments equate derivatives with scandal, fraud and loss, which is an unfortunate by-product of their mis-application, lack of transparency and disclosure. The fact is, derivatives are powerful and valuable tools that, when used properly, can expand the value for all parties involved: the hedger, the speculator and the investor. And with standardized hedging instruments, a centralized clearinghouse for managing counterparty risk, accounting rules that support detailed disclosures and transparency and Boards of Directors that monitor their prudent use, derivatives will regain their rightful place in the capital markets - as a powerful tool for good.

Consider the hedger. It might be a corporation that has very cyclical cash flows, like a manufacturer of construction equipment. The manufacturer's cash flows will often rise and fall with GDP, giving it an asset duration that is short. As a result, the company would want a liability duration that is also short. But these companies often want long-term liquidity for investing in new plants, re-tooling of product lines and other capital-intensive activities, indicating that they'd want to issue long-term debt. But most companies that issue long-term debt can only do so by paying fixed rates, resulting in a liability duration that is long, much longer than its asset duration. The company, in this case, can secure long-term liquidity by issuing the long-term fixed rate bond, but can match liability duration with asset duration by swapping this bond back to floating. Assets and liabilities are matched, yet the manufacturer's long-term capital plans are secure. The fixed-to-floating swap is a key piece of the puzzle. This is a prudent hedger in action.

Consider the speculator. It could be a derivatives trading desk on Wall Street. It could be a hedge fund. They take the other side of the hedger's transaction, where they will receive fixed and pay floating, taking on a long duration exposure. They might do this because of a view on swap spreads, Fed policy, yield curve shape or any number of other variables. They could even hedge out part of the exposure and leave the rest open to express a view. Regardless, they provide liquidity to the hedger and make it possible for the manufacturer to see their total utility increase. To the hedger it no longer matters whether rates go up or down, because their asset and liability cash flows are highly correlated and, therefore, hedged. The speculator, meanwhile, sees their total utility increase as they are able to express a view using derivatives that they couldn't otherwise establish in the cash markets. Speculators, like short sellers, play a necessary role in the capital formation and allocation process.

Finally, consider the investor. They can sometimes use derivatives to establish positions in stocks more efficiently than they could in the cash markets, e.g., buying deep in-the-money calls instead of the the stock outright to secure upside participation with less cash required. They can also use derivatives to trade around positions and increase return while preserving the original investment thesis, e.g., selling out-of-the-money calls to collect income in flattish environments, or out-of-the-money puts to establish long positions at depressed price levels. Derivatives can also be used to generate cash against a long-term position, such as what Warren Buffett did by selling extremely long-dated put options against his cash portfolio.

And let me add a few words about credit derivatives. They are valuable tools for both managing risk and speculating on credits. Consider the bank, the hedger, that underwrites a loan to a corporation, and even after syndication still has a significant hold position in the credit. It may want to offload most if not all of this residual risk, and the most efficient way for doing so is often the credit derivatives market. By purchasing default protection on the name, it can effectively immunize the exposure posed by the cash loan. Conversely, the speculator can express a view on credit spreads and default probabilities by taking the other side of this trade, again providing liquidity to the hedger where no cash market alternative exists. The investor can use credit derivatives to hedge both its debt and equity exposures, buying downside protection that often costs far less than equity options (while bearing a measure of correlation risk). The lion's share of the problems we've seen in the credit derivatives arena are due to inappropriate mortgage-related transactions: an indictment of the entire industry is illogical, unfair and inconsistent with prudent use of the tools.

The point I made earlier still holds: pushing most of the OTC derivatives market to a central clearinghouse, together with common sense accounting rules and appropriate corporate governance will facilitate the safe and prudent use of derivatives. When used and monitored properly derivatives are financial assets, just like any other. Being scared and adopting a reactionary stance towards their use will only hurt the liquidity, efficiency and safety of the financial markets. It is so easy in times of crisis to throw the baby out with the bath water: this is one baby you want to be sure to wrap in a towel and keep safe.

Insights from a Derivatives Salesman

I spent over 10 years in derivatives, from 1993-2003. My role was a transactor in the Structuring and Origination part of the business, advising corporations on all manner of risk management strategies. During this time I saw the power - and the risks - of inappropriate derivatives transactions, either due to unnecessary complexity or blatant mis-application. The 1994 derivatives blow-ups of Proctor & Gamble, Gibson Greetings, Air Products and Orange County, the 1998 leveraged bets of LTCM and assorted scandals ranging from MG to Barings to various municipalities marked the ebbs and flows of the industry. I spent the better part of 1994-95 restructuring broken transactions and giving "best practices" presentations, only to see many of the same mistakes made again and again over the subsequent decade. I have seen the "it" asset class move from interest rates to equity to credit, and transaction volumes move from billions to many trillions. It is a new - and scary - world. My years in derivatives as a practitioner, and now as an observer, have taught me many things and clarified my view of how and where these instruments should be used. Bottom line: an exchange-based model is the way forward for the good of hedgers and speculators, promoting stability of the financial markets and protection of governments and taxpayers across the globe.

The OTC market was cool - for making money

I was a big proponent and beneficiary of the over-the-counter (OTC) derivatives market. Customized and client-specific, these transactions also meant something else: fat spreads. By the time the 1990s rolled around, spreads on vanilla derivative transactions collapsed rapidly and new entrants moved in and competition increased. Doing a vanilla fixed-to-floating swap off the back of a bond issuance or floating-to-fixed swap to lock-in the rate on a bank financing simply wasn't interesting - from a compensation perspective. Knock-ins, knock-outs, up-and-outs, down-and-ins, embedded bermuda swaptions, momentum caps, etc. all helped to differentiate solutions from competitors and preserve proprietary profits in trades. Volumes off the corporate desk simply weren't great enough to make a business solely on vanilla trades, and smart and creative derivative originators, structurers and traders found ways to "add value" through complexity. The question always was: does the structured solution better meet the client's needs than the vanilla option? It was our job to convince the client that this was, in fact, the case. And sometimes it was, but other times it wasn't. 

Bought and sold optionality - toxic or transient insurance

Trades ranged from those that substantially increased risk through complexity (such as the P&G swap, with an implied duration of 100+ years, which meant it was massively leveraged and hedging absolutely nothing) to those that decreased risk through complexity (such as vanilla swaps with embedded sold options that produced cost savings under a wide range of outcomes but whose protection would go away under large rate moves). The trades that increased risk had durations that far exceeded those of the hedged underlying, while those that decreased risk had durations that were less than those of the hedged underlying. Those that increased risk could blow up and generate eye-popping losses, while those that decreased risk had ugly mark-to-market values over their lives until the embedded optionality decayed over the swap's life. The bottom line, of course, is that nothing was free. Cost savings over a range of scenarios could rapidly be consumed by unexpected rate moves, but these were the bets made by corporate treasury departments every day and pushed by Wall Street derivatives professionals. And the compensation imperative was present in the corporations as well, where treasury departments were often treated as profit centers driven by money made on derivatives trades. So all that embedded optionality in swaps that reduced financing costs by 40 bps per annum - unless...? Corporate treasury staffers got paid on that this year, notwithstanding the fact that these trades could blow up in later years. This was a huge flaw in the corporate compensation model, a weakness that ended up generating billions of losses through inappropriate transactions done in the name of individual compensation. Sound familiar?

Educating clients - who only understood half the story

After the high-profile 1994 losses, banks became much more sensitive about client communication when it came to derivatives. At Citi, we had "client appropriateness" letters for each corporation that were signed by both the coverage banker and the derivative professional, which were updated every year. This was the bank's way of saying to the Fed: "If you come and audit us, we've already thought about which clients are suitable for certain kinds of derivative transactions." Further, we needed to document all client communications and to show sensitivity analyses for all transactions the clearly showed the downside scenarios, in order that the client could never come back and say "But you never told me this could happen." I always kept copious notes and detailed deal files, which were, in fact, reviewed by bank examiners on several occasions. They loved my files, because they were clear in both numbers and narrative. But at the end of the day, the examiners and certain less sophisticated clients had only a surface-level understanding of the solutions, and didn't really comprehend each piece of the structured solution but only the results of the bundled product. And in this era most clients weren't focused on mark-to-market issues as hedge accounting rules (FAS 133 - Accounting for Derivative Instruments and Hedging Activities) hadn't fully been enacted. As long as the trades were risk-reducing they were treated as hedges, and changes in swap value would be used to offset the change in value of the hedged underlying. Derivative pros made a lot of money in this era.

Rising commodization - and a push to other products and asset classes

By the late 1990s, the interest rate swap business became very uninteresting. FAS 133, which put a huge crimp in the structured swap business together with every bank on the planet opening a derivatives trading desk caused the brains to flee to more fertile pastures - equity and credit-related transactions. While the equity and credit derivative businesses existed in the mid-late 1990s, they really took off around the new millennium. And while many of the solutions had less pure math complexity than the interest rate transactions, they had plenty of accounting, tax, legal and regulatory details that created barriers to competition and offered opportunities for proprietary profits. Much larger, in fact, than those available during the halcyon days of the interest rate derivatives market of the 1990s. And while the equity derivatives market was huge - buyback-related transactions, private mandatory convertible instruments for monetizing large stakes in other companies, structured capital-raising transactions - it eventually was dwarfed by the credit derivatives market and its offshoots. As complex as the market was in the 1990s, it became orders of magnitude more complex - and large - in the 21st century.

Where do we go from here - lessons learned

The evolution of the derivatives markets over the past 20 years have made clear the power and danger of these instruments. They can mitigate and distribute risk, they can assist with corporate budgeting and planning and they can promote liquidity and efficiency of the cash markets. But the sheer size of the OTC markets and the interconnected web of transactions among global institutions has rendered the current model dangerous and almost impossible to monitor. And the financial markets crisis has laid bare these risks and de-bunked the traditional view that dispersion of risk is at any time and always a positive thing. In a vacuum, this statement is correct. But without an ability to trust counterparties and to understand where the exposures lie, fear can, and has, caused the markets to seize up. This couldn't happen in a world where the lion's share of the OTC derivatives market was pushed to exchanges, where simplicity, transparency and liquidity are paramount. Centralized clearinghouses for trading and margin management would have eliminated almost all the factors associated with the current financial crisis. The time for wide-spread commoditization is upon us. Based on experience, the give-up of customization is a small price to pay for price efficiency, liquidity and stability. Like most things, it's the 80/20 (or, in this case the 95/5) rule: getting the big things right provides the lion's share of the benefit. In an earlier time, when volumes were small and users were few, the OTC market was an essential element of the development and growth of the derivatives markets. But derivatives have become like air: they're everywhere. And in their current state, there is only one answer for how the derivatives market can safely promote its use and continued growth: exchanges.

Michigan Football and the U.S. Economy: Taking the Long View

Anybody who is a fan of Michigan football knows that this is perhaps our worst year - ever. No, even the losing 1967 squad makes the current crop look like the junior varsity. So after so many years of success why the trouble? In short, regime change. The powers that be decided that it was time for change, to leave the Pro-style, five step drop passing game and a between-the-tackles running game for the Spread, a rapid-fire, cutting, quick-strike offense that relies on a mobile quarterback, quick-footed linemen super-fast decision-making. The view of the Administration was that it was worth finding the right guy with the right system for the long-term, even if it meant a near-term setback. Seeing Michigan run the Spread is a strange thing. It just doesn't look right, at least not yet. When it was announced that a new leader was coming in, fully 18 scholarship players recruited by the last coach to fit in the prior system left. This created a skill vacuum that will take time to replace, as well as the time necessary to learn a completely new system. For those wanting current gratification, they will be sorely disappointed by Wolverine football for the foreseeable future. One year? Two years? Three years? Perhaps more. But notwithstanding the recent difficulties, Michigan has a tradition of winning. The institution and the community are supportive of the team; it is part of the cultural fabric of the school, and of the larger community. Make no mistake - with the benefit of time and support from the Administration, students, Alumni and the community, Michigan football will regain its winning ways.

I see a close analogy between Michigan's plight and that of the U.S. economy. Economic conditions haven't been this bad in decades, after an almost three-decade run of prosperity. The powers that be, namely, the voting-age citizens of the U.S., decided that it was time for change. We are clearly shifting to a new kind of regime, with the belief that it will be better for our country in the long run. And while there is uncertainty about a new leader, one quite different than those of the recent past, the voters spoke loud and clear. The staff surrounding the President will also change, creating a learning curve that requires time for getting fully productive. Given the economic perils facing those in the U.S. and abroad, dealing with change will be painful, the benefits of which may not be seen for several years. Those looking for a short-term fix will be out of luck, as the kinds of systemic changes required to regain our economic vitality take time to enact and an even longer perior to take effect. But make no mistake - with a definitive mandate from the American people and a supportive Congress, I think the odds are pretty good that the new President will succeed, with the help of time and an engaged and pragmatic legislative branch.

Sustainable success takes time. It is easy to get discouraged in the short-run, to want the losing (football games, stock prices, etc.) to stop and to feel better regardless of how it happens. If there is one thing that time has taught us, it is that quick fixes don't yield lasting benefits. There is always a price to pay, whether it is through recruiting violations (by attracting talent using illegal means) or inflationary monetary policies (by pushing short rates towards zero and flooding the market with liquidity). We need to adopt a calmer, more balanced, longer-term mindset towards problems, and to internalize a very simple credo: you don't get something for nothing. Whether the Lotto-based mentality prevalent across our society and in our Government can change is the real question.

Congratulations, Senator. Now the Real Work Begins.

Barack Obama's historic victory has given many in this country, and across the world, hope for a brighter future. But make no mistake; the President Elect is facing a global political and economic landscape more hostile and challenging than it has been in a generation. He has to lead with confidence and decisiveness, but with actions that are grounded in facts, common sense and broad-based support wherever possible. While it is tempting for him to completely distance himself from the policies and practices of the current administration, the fact is that abrupt shifts, if ill-considered, could do immense damage to the economy and the country at such a delicate time.

There are a few guiding principles I believe President Elect Obama should follow, some of which might not comport with Democratic dogma but which are necessary to deal with a perilous social and economic situation that could plague us for a decade - or more.

• Do not raise taxes. For anybody. Individuals. Corporations. Anybody. Period. We need economic stimulus. We need to encourage investment. We need people and companies to re-build over-leveraged balance sheets. Economic activity is going to slow, and the last thing individuals and corporations (which are simply an amalgam of individuals) need to be burdened with are higher taxes. If anything, tax rates should fall. Further, the tax code needs to be dramatically simplified. Complexity increases costs, and distorts the power of tax policy. Investment should be encouraged and rewarded. Rules should be very straightfoward and broadly applicable across industries to mitigate the effect of lobbyists and special interests.

• Do not allow "free riders." The way TARP funds are being disbursed, with a "come one, come all" spirit, is nothing but a squandering of U.S. taxpayer dollars. That money should be used to close weak firms, restructure ailing firms whose failure poses real systemic risks and increase deposit insurance thresholds. It should also be used to recapitalize critical institutions whose assets are marked-to-market, leaving a gap in regulatory capital levels that can be filled - temporarily - with TARP funds. TARP should be about building confidence in the U.S. banking system, not providing cheap capital for any bank that wants it.

• Insist on financial statement transparency and support a push towards exchanges. The integrity of financial statements needs to be unimpeachable. Problem is, with the incredible latitude provided by current accounting rules investors simply lack confidence in the veracity of bank income statements and balance sheets. And this says nothing about the trillions in off-balance sheet liabilities plaguing the system. Push for greater clarity and transparency in accounting rules, such that investors will once again be willing to buy the shares of our financial institutions and hold them for the long haul. This also speaks to the moving of over-the-counter derivatives obligations on to exchanges, to address both counterparty risk issues as well as valuation issues that have damaged our financial system.

• Be ready to invest in core infrastrucure. As the global deleveraging kicks in and economic activity slows down, millions of people - factor works, service professionals and the like - will be out of work. Unemployed people spend very little money. It is also true that this country's aging infrastructure has acted as a millstone around our necks, curtailing current growth while moving the obligation into the future. This culture of deferral of pain has to stop. Monies that would be spent providing capital to healthy banks and financing distant wars can be used to support state and federal projects to upgrade our airports, roads, ports and waterways. This is a real long-term investment with an attractive ROI. But our new President needs to rise to the challenge and work with both state and federal officals to prioritize projects and get them done quickly, efficiently and with the greatest bang for the buck.

• Support education at all levels. We need both a strong public school system as well as robust independent school alternatives. Local accountability. More flexible work rules. Merit-based promotions and raises. Better pay. Vouchers for those needing tuition assistance. We can't get this wrong, as we have done consistently during my lifetime. Our educational system is an embarrassment on a global scale. Smart, curious, confident, well-rounded citizens are what's going to make this country, and our world, strong. We are not doing our part. The President Elect needs to make this a very high priority.

• Fight against short-termism. This means making hard choices and tackling seemingly intractable problems. JFK had it right - "...what you can do for your country." What President Elect Obama can do for our country is to take the long view, to prioritize the most pressing immediate issues (e.g., economic weakness and credit crisis) but to make real progress on a few critical long-term problems (e.g., social security, health care costs, etc.). These steps will not be politically popular. But they will help get dialogues going around issues that most politicians are simply too scared to talk about. It's always about the next election cycle. Someone needs to stand up and say "NO." And that person can and should be Barak Obama. Right now.

• Re-establish U.S. credibility on the global stage. This doesn't mean being everybody's best friend, but it does mean regaining the respect of our allies and others as a smart, thoughtful, humane but strong people. And this perception will have to originate from our Commander-in-Chief. We need to be led not by gut but by reason, not by emotion but by thoughtfulness, not by unilateralism but by a desire to work and build like-minded coalitions wherever possible. The problems of today, both economic and political, are far too large for us to handle alone. We need our friends and allies, now more than ever.

President Elect Obama has his work cut out for him. His first term will be among the most challenging in the past 30 years. But what he will have is a clean slate, a fresh start, a chance to enact policies and to lead with a confidence and clarity that has been so lacking from our leaders this millennium. And he will have the support of the American people. He has a mandate to lead a people starving for leadership. His chances are few, the risks are great. But hopefully he will rise to greatness by focusing not on party but on all people, by shedding dogma and orthodoxy and making the hard decisions without bias or fear. This is a very special time in our country, which is unfortunately mixed with one of the most difficult and scary times in recent memory. I am confident that we, as citizens of the U.S., can help the new President achieve greatness. And we will all be the better for it.