"Implicit" Hedge Fund Regulation: Moving in the Right Direction

Today's article in the Financial Times chronicling concerns over hedge fund collateral has only reinforced a theme that I've pounded on for the past six months: HEDGE FUNDS ARE ALREADY REGULATED. Why this realization is only now coming to the fore in mainstream media and, potentially, in our regulatory bodies is beyond me, but thankfully it seems to be here. Now this is an issue worth thinking about. And it is properly being addressed to the banks and prime brokers extending credit to hedge funds, in their capacity as entities regulated by the Federal Reserve and the OCC.

US, UK and European regulators have expressed concern in recent meetings that investment banks may be allowing hedge funds to increase their borrowing capacity using collateral that could lose its value rapidly in a financial crisis.

The regulators have asked banking executives in the meetings on Wall Street to detail exactly how they use portfolio netting, a practice that allows hedge funds to use relatively illiquid securities such as credit default and total return swaps as collateral to reduce overall margin requirements.

The fear among some regulators and outside observers is that in a big market dislocation the funds might be unable to sell those securities, increasing the likelihood of widespread defaults.

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One Wall Street executive acknowledged that regulators had a "legitimate concern" that such agreements might not be enforceable in the face of a hedge fund collapse. However, he did not believe regulators would find that banks were taking on excessive risk.

The questions are part of a broad new effort by the New York Federal Reserve, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the UK's Financial Services Authority and European regulatory bodies to understand better how much exposure large banks have to hedge funds and whether that could present a significant risk to the financial system in the event of a market disruption.

So far, detailed discussions have been held with a group of five of the largest Wall Street securities firms that some time ago agreed to volunteer for a "consolidated supervised entities programme". Members of the programme are among the most active in lending to hedge funds.

Officials have found that some firms have been extending credit on less liquid instruments but relatively little credit is being extended under these circumstances - and at higher cost to borrowers, regulators say.

This is great stuff. This is the way it should work. Regulators spending time interviewing the market participants in order to gain a deep understanding of the issues. They then develop cooperative relationships with the top players in the market in order to standardize data collection, have early visibility into trends across the industry, and have a direct line into senior management should urgent questions or concerns arise. This is a process for intelligent, fact-based oversight outside the reach of political agendas and perverse motives. What a breath of fresh air.

And the issue they've targeted, the appropriateness of collateral practices, seems particulary timely in light of the frothy markets and ever-tightening credit spreads (the FT is on a roll - they also had a story on this today). The credit markets appear priced for perfection, and we know what happens when most large players are caught leaning one way: inevitable pain and suffering ensues. Selling premium seems like a good way to generate returns; I mean, the real economy is strong, earnings are strong, corporate balance sheets are healthy (except those that have been LBO-ed in the private equity frenzy), so what could go wrong? Oh, I don't know, maybe Iran, Iraq, terrorism, return of Russian stateism, and about 300 other things? Naaaaah. And this same motivation is what can drive, shall we say, more liberal collateral lending practices in the prime brokerage community? This would seem to be a logical extension of tightness in the credit derivatives market, but somehow I'm not getting this vibe. Banks have gotten much, much smarter in the wake of LTCM and other hedge fund meltdowns. Risk controls have, in fact, gotten much more sophisticated and robust. This doesn't mean that someone won't drop a several hundred large in some purportedly 10-sigma outcome (ha!), but I really don't think that banks are going hog wild lending to hedge funds. The risk/return is just not skewed in their favor by making stupid loans with crappy collateral. They don't have to do this to mint money. I mean, they've still got stock lending, right?

Anyway, I am just happy to see the bodies that should be doing the overseeing actually doing it without the assistance of Congress or like bodies in the UK. Let's hope this favorable trend continues for the good of the hedge fund community, the financial markets and investors everywhere.

Wallstrip Post #2: Me on Wallstrip!

Yes, it's true. The lovely Lindsay and the entire Wallstrip gang came into Monitor110 and checked us out. I speak about Monitor110, our pending launch, search technology and my blogging at Information Arbitrage. I gotta tell you, it was a lot of fun. But after seeing myself on the small silver screen I am now clear as to why some are on TV/video and others are not. Let's just say I'm no Howard. After seeing Jack-in-the-Box yesterday, it is clear I need more bling!

Wallstrip Post #1: Jack-in-the-Box Rocks!

As some of you know, I've been a regular contributor to Wallstrip since its inception. I think Howard Lindzon, Jeff Marks, Adam Eland and yes, the fetching Lindsay Campbell, have done an absolutely phenomenal job bringing both intelligence and humor to investing. But I have to say that they have really outdone themselves this time with their show on JBX - Jack-in-the-Box. For those of you SNL groupies out there, you might find the production reminiscent of a certain episode with Justin Timberlake that aired during the holiday season. If you're not sitting down please do so now, click on the show link, and get ready to split a gut. It is truly that funny. And have a nice day. You'll thank me later.

"Intentional Programming?" How About "Intentional Search?"

I really enjoyed Jason Pontin's article in today's New York Times concerning Charles Simonyi's venture, Intentional Programming. I certainly knew of Mr. Simonyi's exploits as a programmer, both at Xerox PARC and later at Microsoft, but knew little of his current focus. A focus which I happen to think is both tremendously brilliant and sorely needed - that of making programming easier, less costly and more intuitive.

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Charles Simonyi, the chief executive of Intentional Software, a start-up in Bellevue, Wash., believes that there is another way. He wants to overthrow conventional coding for something he calls “intentional programming,” in which programmers would talk to machines as little as possible. Instead, they would concentrate on capturing the intentions of computer users.

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The method begins with the intentions of the people inside an organization who know what a program should do. Mr. Simonyi calls these people “domain experts,” and he expects them to work with programmers to list all the concepts the software must possess.

The concepts are then translated into a higher-level representation of the software’s functions called the domain code, using a tool called the domain workbench.

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Thus, programmers and domain experts can fiddle with whatever projections they prefer, editing and re-editing until both parties are happy. Only then is the resulting domain code fed to another program called a generator that manufactures the actual target code that a computer can compile and run. If the software still doesn’t do what its users want, the programmers can blithely discard the target code and resume working on the domain workbench with the domain experts.

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Intentional programming has three great advantages: The people who design a program are the ones who understand the task that needs to be automated; that design can be manipulated simply and directly, rather than by rewriting arcane computer code; and human programmers do not generate the final software code, thus reducing bugs and other errors.

Wow. Cool stuff. Is it just me or could this article have been written about vertical search?

• The system is set up to know what you are thinking - sounds like a vertically-focused search algorithm.


• Capturing "intention" via domain experts - sort of like using domain experts to train machine learning/AI-based intelligent search tools.


• Programmers and domain experts can "fiddle" - kind of like tinkering with term weightings, etc., with easy adjustments that can be made on the fly.

I can't get over the similarities between the two problems. The goals are similar. The language is similar. The requirements are similar. Maybe those of you who are real techies (unlike myself) got this analogy right off the bat, but I was struck by the revelation. And presumably the problems are equally as complex and multi-dimensional. Mr. Simonyi has been at it for quite some time, as have we at my company. It is a sacred mission for him as it is for us. And we will both win. I'm sure of it.

Banking vs. Trading - Breaking into Wall Street

I get a decent amount of email from readers who ask my opinion on various issues (poor, misguided souls), and one recent note hit on a theme that has been the source of many inquiries over the past six months - "Where should I start - banking or trading?" Some of the text from this catalytic email is as follows:

I've read your blogs on how to succeed on Wall St. and also S&T vs IB and have found them incredibly informative for someone in my situation. I noticed that you've worked both in IB and in trading (and apparently all the shades in between). Ironically, I'm facing the decision of choosing between trading and IB right now; with an engineering undergrad, I have concerns that choosing trading would pigeon-hole me fairly quickly into that area. While trading is certainly something I want to do right now, I see myself doing something more along the capital market side of things 7 or so years from now.

I guess I'm asking, given the stigma and the attitudes of these two fields, how hard was it for you to personally move across the gradient? Without much experience in this area, I would don't really want to force myself into anyone area but on the other hand, I think I could really enjoy doing trading for a few years.

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Great question. To which I provided the following answer:

 

I’d say, in general, that it is hard if not impossible to move from banking into trading, whereas the converse is not necessarily true. While I did “this” (banking into trading) let me be clear: I have never actually traded. I have run massive groups of traders and run large books of risk, but this is not trading. I was a trading manager. Do I wish I had actually traded at some point? Yes. But once I was a successful banker and derivatives pro was this ever going to happen? No. So I’d say that if you’ve got the fire in your belly to give trading a shot, do it first. Also, if you are worried about the “pigeon-holed” element, go into a trading discipline that is at the intersection of trading and corporate finance, like credit derivatives. This requires understanding companies as well as markets, so it is kind of a cool area. FX trading, conversely, prepares you for nothing beyond FX trading, except maybe FX structuring. The more commodity-like the underlying asset, the less relevant the trading skills into value-added disciplines. At the more complicated end of the continuum you’ve got credit derivatives, mortgage-backed securites, etc. whereas at the other end you’ve got FX trading, futures/bond/swap traders, etc. So these are my thoughts. Hopefully they are useful. Hmmm, I may write a post about this.

After re-reading my answer, I'm sticking to it. If you are smart, hungry, quantitative and have the chance and desire to trade early in your career, take it. I'd argue that it is much harder to take this up later in life, particularly after you've become successful in other high-paying disciplines that don't train you to trade, ergo, you'd come in as a shoe-shiner on a desk (if they'd even have you) and take a 97% pay cut for the privilege. It just doesn't happen. And you know what, if you don't go for it early on you'll end up like me, as someone who will never know if he could trade and was too chicken to find out. And this sucks. Also, if you've never traded, whether fair or not, your credibility as a trading manager, regardless of your success in related areas (say, complex derivatives structuring and M&A, not that this is personal) will always be in question. Again, sucks. So this is a post about satisfaction and long-term happiness, not pure cash. Which is always the right way to think about stuff.

The other point is that if you do have the sense that capital markets, financial structuring or M&A might be areas of future interest, do pursue trading opportunities in more complex, less commodity-like asset classes like credit derivatives and mortgage-backed securities. In these areas you really need to understand the documents, the companies, credit, structuring, etc., not just the markets. You become conversant in issues of law, finance, capital structure, bankruptcy, rating agencies, and other non-trivial areas that prepare you for a career in banking later on. Besides, these are areas that will require smart people and not just machines for quite some time, whereas humans in the more commodity-like areas are rapidly being displaced by machines. And it wouldn't be fun to be replaced by a machine.

Anyway, this is my advice to young people after searching my soul in the wake of my Wall Street career. It was great and fun, don't get me wrong. But I will always be missing that little piece of the puzzle that says "I've traded." And my asshole trading friends from the Street will always have this over me!

Power to the People: China and the Internet

While social commentary in China, either via public demonstrations or offline media, is still heavily controlled by the Communist Party, there is one place where it is alive and well:  on the Chinese bulletin boards. And it is a force best given its due by those who are the target of its ire, as the power of the Chinese Internet community to shape offline public opinion is, well, quite significant. This is a phenomenon that was most recently chronicled by The Economist in a story concerning Starbucks and its presence inside the Forbidden City:

IF THE strength of Chinese nationalism were to be gauged by its expression on the internet, it would seem a powerful force indeed. A blog posting a couple of weeks back complaining about a Starbucks branch in the Forbidden City, an ancient imperial palace in the centre of Beijing, has triggered a torrent of online criticism against the American firm and those who allowed it to open there.

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Why should Starbucks, or the Forbidden City's management, pay attention to online chatter? The answer is that, in a country where the media are fettered by Communist Party censorship, and public protest of any kind is discouraged by the authorities, the internet plays an unusually prominent role as a barometer of public opinion.

Even senior officials say they pay attention to it. Online protests sometimes appear to influence party policy. Four years ago the government revised its vagrancy laws, after heated online debate about the fatal beating of a university graduate held in jail for lacking correct identification papers.

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Starbucks may yet weather this storm, as it did a smaller one soon after opening the Forbidden City outlet. At that time it removed some signage, to answer complaints that it was not blending in. Its small shop is now hard to spot. Better that than the fate of KFC, the seller of Kentucky Fried Chicken, which was obliged to close an outlet in a park north of the Forbidden City four years ago when the government feared for the garden’s “imperial style.”

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This is just a small example of the power of the BBS denizens who have shown their displeasure with both local and foreign companies. A stark example of this was in the case of Avon, which in mid-2005 was given the ability to engage in direct selling following a 1998 government ban. Avon responded to this news by immediately creating a massive 3,000-strong direct sales force, and sharply limiting support to the Chinese distributors that had helped it grow during its successful expansion in the late 1990s/early 2000s. Further, the financial markets expected Avon's metoric growth in the emerging markets to move forward unabated, a significant component of which was its continued success in China. Following its ham-handed transition from distributor-based to direct selling, the Chinese BBS was afire with complaints over Avon's handling of its distributors, 74% of which demanded inventory refunds. This fury was then picked up in local print media, and there was even a picture of an enraged distributor pointing his finger in the nose of the head of Avon China. Needless to say, this was not good news for Avon.

But believe it or not, this story was not picked up in Western media until after Avon released its earnings over two months later. And guess what - they whiffed. Terribly. And why did they whiff? Because sales in China had fallen 16% in the wake of channel conflict. All you needed to do was connect-the-dots. The "smoking gun" was out there to be seen. So I guess there are two key take-aways: (1) don't think that China is some repressed society without an outlet for expression. It has an outlet, and it's called the BBS; and (2) what happens in the East can effect the West, and for some reason it often takes a long time for relevant information to find its way over here. Unless you have the right tools. Remember the adage "Think Global/Act Local" - whoever said it was right.

Proxy Voting and Economic Ownership: Getting the Big Things Right

Paul Atkins, a commissioner at the SEC, is in a snit over the potential influence of hedge funds in the wake of proxy voting reform. This was chronicled in an article in today's Financial Times:

Short-termist activist hedge funds could gain undue influence on companies' boards as a result of expected new rules allowing shareholders to vote on company directors, Paul Atkins, a commissioner at the Securities and Exchange Commission has warned.

In a speech to company directors and corporate governance experts on Monday night, Mr Atkins said giving investors greater say on the composition of boards could have the unintended consequence of increasing the power of hedge funds.

He said hedge funds' ability to borrow and short-stock before crucial corporate meetings and use financial derivatives to own shares without having an economic interest in the company could lead to the appointment of "special interest directors".

"What if a shareholder who participates by voting at a meeting holds no economic interest or possibly a negative interest in the corporation?" Mr Atkins said at the Corporate Directors' Forum in San Diego, California.

"Who is making the nominations and what are the interests and the conflicts involved?"

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The SEC is expected to revisit the issue in coming weeks, four years after an earlier attempt to allow such access failed. The subject is part of growing calls by investors for greater influence on corporate governance matters after the scandals of the past few years.

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Opponents of such access, chiefly the Business Roundtable and US Chamber of Commerce, have long argued that opening up the proxy for voting purposes could allow companies to be "hijacked" by special interests - usually a reference to unions and environmental activists.

But Mr Atkins said the increasing role of hedge funds and other activist investors in pushing for change to underperforming companies, or influencing the outcome of takeovers, means any debate should now also include the role of such interests.

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"As the financial markets are moving towards instruments where you can artificially boost your shareholding it is important to have disclosure, and a system that shouldn't be able to be gamed by people who have marginal economic interest," Mr Atkins told the Financial Times.

Quite frankly, Mr. Atkins, I agree with you. It is great that the SEC has finally reached the level of sophistication where an issue this subtle - voting power vs. economic ownership - is in the minds of its commissioners (though, to be fair, this issue was first flagged in Europe. Those European derivative shops were ahead of the game, let me tell you). The concept of the bifurcation of vote and value has long been a bedrock in the fields of taxation and partnership structuring, not to mention in the dual class shareholding structures so prevalent in the media business. But let's not confuse the issue of proxy voting reform with the particular issue you raised. They should be dealt with separately and in a focused manner.

There is no question that proxy voting needs a face-lift and that entrenched Managements and Boards of Directors need the bejeezus scared out of them (if not appropriate checks-and-balances) to do what they are, in fact, hired to do. If I read of one more example of a stupid, irresponsible Board or of a self-serving, self-aggrandizing, shareholder-unfriendly CEO I seriously might barf. The necessity of reform is simply a fact, regardless of the cronies populating the Business Roundtable and US Chamber of Commerce who are against such changes. All I have to say to them is - grow up and lose that sense of entitlement. Hijacking by special interests? You've got to be kidding me. This isn't a movie, guys. This is life. Get on the clue bus, ok? It's leaving the terminal as we speak.

Now the issue raised by Mr. Atkins is legitimate, to be sure. Anyone who has been hanging around M&A, derivatives or prime brokerage knows of the ability to split off voting power from economic value, which can be used to great effect during hotly contested corporate fisticuffs.  And I've got to say it does seem somewhat unethical (if not illegal) to wield voting power in the absence of economic interest or, more precisely, to use disproportionate voting power to impact a substantially smaller economic interest. It doesn't cost that much to buy votes, and if it can be used to sharply increase the odds of maximizing value on a position without risking a like amount of capital that is pretty cool. But is it fair, and does it go against the very principles or one share/one vote, when the shares and votes cease to be inextricably linked? I am neither an ethicist nor a moralist, but I can certainly appreciate the objections to this type of financial engineering.

In sum, two thumbs-up for proxy reform as well as a review of the voting power vs. economic ownership issue. These are the kinds of substantive, non-trivial discussions I like to see being had by the SEC. Let's hope they can stay on track and get the big things right. Because it is easy to get tangled up in the details.

ADDENDUM: Today's Wall Street Journal has a big article on this very issue. It raises a lot of the same points noted in my post, as well as providing some examples of when these tactics were used to sway outcomes.

Sell-Side Analysts and Option Expenses: Is There Anybody Out There?

I've commented quite a bit lately on the topic of sell-side research, its plight and its problems. Unfortunately, many of the problems it faces it brings upon itself, as highlighted in Herb Greenberg's interesting piece in Saturday's Wall Street Journal titled "How Expensing for Options Throws Analysts Off Course." Before I dig right in, I'd like to tell you what I'd expect from sell-side analysts (or analysts of any stripe, to be truthful):

1. Honesty;
2. Intellect;
3. Analytical rigor;
4. Critical, independent thinking; and
5. A digestable, informative work product; that gives me
6. A reason for me to read their stuff

I mean come on, is this really too much to ask? I've known and worked with many sell-side analysts in my career, almost all of whom have been good, caring people. But the problem is that many missed several key items on the list above, with numbers 3 and 4 the most frequently omitted. Analytical rigor and critical thinking? Shouldn't these be the two bedrocks of investment research, regardless of whether or not one is talking buy- or sell-side, retail- or institutional-oriented, etc.? Am I missing something here? I think not. And there are structural issues for why these problems have become embedded in the [sometimes] dysfunctional Wall Street architecture, i.e., analysts covering too many companies, being forced to release work product too frequently, pressure from clients and bankers to emphasize the positive and downplay the negative, etc. But the bottom line is that research is and should be treated as a profession with the same degree of standards expected from other professions, i.e., law, accounting, medicine, etc. And in the absence of this recognition of research as a profession, it will be frought with inconsistency, conflict and bias.

Anyway, so what of Herb Greenberg's article? The bottom line is that earnings estimates reported to the biggest aggregrators and distributors of such things are not prepared in a similar manner, because not all analysts taken option expenses into account in their estimates.

One tried and true way to analyze a company is to compare its value with its peers. When it comes to tech and biotech, more than any other industry groups, you're on your own -- especially if you're relying on the most widely used consensus earnings forecasts.

Earnings per share estimates for many companies simply aren't created equal, largely because of the uneven treatment of options expensing by analysts. While it has been a full year since new accounting rules required companies to include options expenses in earnings, there is no such standard for analysts or companies that compile estimates.

That can lead to confusion and even misleading valuations, especially for investors who don't pay attention to the details or, worse yet, who use computers to pick stocks based exclusively on the numbers. "Consensus EPS estimates do not provide an apples-to-apples comparison among large-cap technology stocks," writes Sanford C. Bernstein analyst A.M. Sacconaghi Jr., in a recent report.

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The trouble comes when analysts, for whatever reason, don't include options expenses in their primary earnings estimate. Their numbers are then compiled -- and consensus is created -- by three companies: Thomson Corp.'s Thomson Financial, Reuters Group PLC's Reuters Estimates and Zacks Investment Research. Zacks, which claims to have created the industry nearly three decades ago, is the only one whose consensus always includes options expenses, even if it means manually figuring it out; as of the third quarter, it had to do that for 300 of the 4,500 companies in its database. Reuters Estimates and Thomson Financial base their consensus on majority rule. "We need to conform to market standard," says Ashwani Kaul, senior research analyst for Reuters Estimates.

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And that's where this story gets weird. Only a handful of brokerage firms, including Bear Stearns; Bank of America Corp.; Goldman Sachs Group Inc.; and Sanford C. Bernstein, a unit of AllianceBernstein LP, require analysts to include options expenses in estimates that are picked up by Thomson Financial, Reuters and Zacks.

Why don't all of them? Good question -- and viewing earnings any other way is puzzling even to the CFA Institute, which charters analysts. "Our view is that options are a form of compensation," says Rebecca McEnally, a spokeswoman for the institute's Centre for Financial Market Integrity. "And the fair value of options expense should be treated as any expense in the forecast. To fail to do so is to underreport expenses and overreport the earnings." If that's the case, then why are we having this discussion?

I've got to say that Ms. McEnally's sentiments perfectly reflect my own. As a person who was a derivatives transactor and ran derivatives teams, and spent a tremendous amount of time working with large corporations on strategies for managing their option costs, the avoidance of these costs when modeling earnings estimates borders on malpractice. If the companies themselves acknowledge that options represent a real cost to shareholders, and any credible academic in the fields of financial engineering or corporate finance echo the same, then what exactly is the analyst community doing? What are they thinking? Is it laziness? Is it unwillingness to adjust complicated historical models to take into account such valuation effects? Is it the uncertainty of the assumptions underlying option valuation? It could be any or all of these reasons, but frankly I don't care. It is the analyst's job to make assumptions, state them clearly, argue their position and make a recommendation. And sticking one's head in the sand or simply ignoring a complicated, hard-to-quantify issue is not part of the job description.

This is a serious issue. If sell-side analysts want to prove their worth and solidify their role as a key part of the buy-side investment process, they've got to up their game, up their rigor, up their critical thinking and internalize their position as a professional. Otherwise, the marginalization of their historic role will continue unabated.

 

SAC Rips It In 2006: I Told You So!

Remember in mid-September, when Stevie Cohen was the subject of a big story in the Wall Street Journal in which he was practically pessimistic about the likelihood of putting up big returns given the increasingly crowded and competitive environment? I posted on this two days later, in which I basically said: this is a load of crap. Steve and his team at SAC are a bunch of forward-looking rock stars with great brains, great technology and the resources and vision necessary to stay a step ahead. Don't believe me? Here are excerpts of what I wrote on September 18th, 2006:

This does not sound like a multi-billionaire running an eleven figure sum for some of the most powerful investors in the world. Where's the hubris? What has changed? Is he right that the easy money has been made and it will be tougher sledding from this point forward?

I'm not buying any of this. SAC and its team is way, way too smart to be pigeon-holed by a single strategy. If there is too much money chasing too few ideas, invariably there is a lot of dumb money out there that can be exploited by someone smarter and more experienced. I mean, come on, he is up 18% YTD on a big, big number. That is pretty good based upon the stats I've seen.

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Given the trend towards more and better data and information being put out there on the Internet, it will be those with the vision, the brains and the tools to take advantage of this alternative data set that will establish a true edge on the competition. Again, SAC is a very forward-looking organization with the resources and trading acumen necessary to exploit the massive opportunity for discovery that is the Internet, so I am also certain that they will lever their expertise into this area as well.

So, from my vantage point things don't seem so bad for Stevie. Maybe he is showing his soft side so we'll all get complacent and he'll clean our clocks! That seems far more likely than the defeatist attitude on display in the WSJ article.

So now the numbers are in: Stevie and Co. put up 34% (on $10+ very, very large) during 2006 vs. 12%-14% for most of the hedge fund indexes.  So who was right - me or Stevie? Answer? ME! But he's taking home 10 figures and I'm taking home - well, let's just leave it there. I appreciated his humility and willingness to let us all inside the tent a bit, but at the end of the day he is a smart, resourceful, competitive performer at the top of his game, and there is no doubt in my mind that he is ultimately confident in his ability to find new and improved ways to make money, regardless of the environment (and regardless of what he says). Thought he shaded it during his interview, I called bullshit. Hooray for me. And hooray for him.

 

Valuing Apple Inc: Pricing the "Jobs Put Option"

Overview

Today's article in Bloomberg got me thinking about how investors are dealing with the uncertainty surrounding Steve Jobs, namely the possibility of his removal in the wake of the options backdating scandal.  However, I think this mis-characterizes the true underlying fear investors have (and which is the real risk facing the stock): the negative impact on Apple's share price given Job's departure, regardless of reason. It just happens that the backdating scandal is currently in the forefront of most investors' minds, yet this is a man that has fought cancer, and faces that same risks that any of us do who buy insurance to protect our families and loved ones given an unexpected adverse event. Yet I'm not confident that this is how investors are valuing Apple's shares, and pricing in the array of risks facing Jobs (and, therefore, Apple investors) in an insurance oriented, value-weighted, probabilistic manner.

Apple's shares have behaved like a yo-yo as different interpretations of the SEC and DoJ's likely actions concerning Job's role in options backdating have come to light:

Jan. 17 (Bloomberg) -- Apple Inc. may find its most valuable asset is something it can't protect through patents or secrecy: Chief Executive Officer Steve Jobs.         

If Jobs were to leave, shares of the Cupertino, California- based company might drop 25 percent or more, analysts say. That would erase about $20 billion in Apple's market value.                

``It would be a disaster,'' said Gene Munster, an analyst with Piper Jaffray & Cos. in Minneapolis, who's had an ``outperform'' rating on Apple's shares since June 2004. ``He would be almost impossible to replace.''         

The computer maker's dependence on its CEO was illustrated the last week of December, when the stock dropped as much as 5.8 percent after the Recorder, a San Francisco-based legal publication, reported Apple had faked documents to backdate stock options.                 

On Dec. 29, the company said its own investigation, led by Apple director and former U.S. Vice President Al Gore, cleared Jobs of any wrongdoing. That eased concern Jobs may have to step down and sent the shares up 4.9 percent.   

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When "analysts" say the shares might lose $20 billion in value, how are they quantifying this amount? Are the oscillations of Apple's share price when each piece of news concerning the options investigation come to light reflective of shifting probabilities of his ouster, or something on a more visceral level? I don't know. But I'd certainly like to know.

Analysis

As an ex-derivatives guy, it seems to me that the rational investor would value Apple's shares in the following fashion:

Fair Market Value of Common Shares (Apple) = PVFCF (Apple) - Put (Impact of Jobs' departure)

And to value the "Jobs Put" correctly, one needs to consider the following three factors. And this analysis needs to be run for each of the different risks that could give rise to Jobs leaving Apple's helm:

1. The timing of an adverse outcome
2. The likelihood of an adverse outcome
3. The negative payoff associated with an adverse outcome

These are all complex issues, but the negative payoff is certainly the most difficult to quantify. How much of Jobs' DNA has been embedded in the organization? How deep is the creative bench at Apple? What is the real value of his PR glamour status? How long would it take for his departure to impact the fundamentals of the stock? Is he the single most valuable executive in the U.S. today? All hard yet critical questions to consider when seeking to quantify the absolute impact of his not being the CEO of Apple. But, of course, this number needs be discounted by the probability of his not being CEO together with the timing of when this outcome might occur. What the rational investor should probably do is construct a matrix of possible scenarios by flexing factors 1-3 above, and build a range of values for the Jobs Put that is netted against Apple's discounted free cash flow projections.

Conclusion

The Apple situation is very interesting. I'm not sure I can think of another firm whose share price is so inextricably tied to its CEO, a person whom is facing an array of serious risks that could be of great consequence to the firm. And it is precisely because of this unique dynamic that Apple's share price subjects itself well to an options pricing framework, essentially bifurcating the value of the firm into two distinct pieces: Apple (with Jobs) - Apple (without Jobs) = Value of Jobs Put, or by shifting terms;

Apple (without Jobs) = Apple (with Jobs) - Value of Jobs Put

Whether Apple investors are aware of it or not, they are short an option - a big, valuable put option, which they should be attempting to value. If not, may the force be with them. And be careful out there.