Thinking Deep Thoughts About Sony's Strategy

Sony's strategy has perplexed me for some time. Long-time hardware and engineering excellence, progressively (IMHO) getting farther and farther away from the customer. Net result: problems creating products that enough people actually want given the costs of producing them. Further, I've been tremendously cynical about the whole "window into the living room" strategy as an explanation for a high price point, where a gaming console is being positioned as a multimedia player. Do gamers really want to pay for multimedia? I'm not so sure.

Anyway, a few things have prompted me to re-assess my thinking. Firstly, it looks like Sony might be willing to scale down and focus, as illustrated by its considering the sale of a part of its animation studio and digital effects company. Companies like Sony usually collect properties like these as trophies, regardless of whether or not they make sense from an ROI perspective. Because vertical integration has always been favored, as well as having a broad, horizontal set of product offerings. So Sony's willingness to reduce its commitment to these ancillary businesses is both very unexpected and extremely encouraging from an investor perspective, at least to me.

Another point I'd like to raise was tabled by my friend Tristan. We have both been watching the console wars unfold for some time, and our thinking has evolved along somewhat different paths. His angle is that Sony's PS3 strategy is all about the Blu-ray player, and that its economic model will ultimately be built around licensing revenue from the studios, not gaming revenue or console sales, as Blu-ray wins the format war against HD-DVD. My perspective is more that if someone wants to buy a Blu-ray player they'll buy a Blu-ray player, and if Sony wants that Blu-ray player to be the PS3 then they need to seriously revamp their messaging. The pitch I get is that PS3 is a powerful, leading-edge gaming console with killer graphics, and, oh, by the way, it is also a Blu-ray player. This just isn't going to move the metal, as currently weak PS3 sales attest. Now I'm not disputing the fact that PS3 may well be a cost-effective Blu-ray player right now, but just how many people want this player today? And if, in fact, Blu-ray does turn out to be the dominant nextgen digital video format, is PS3 going to be well-positioned to garner these sales? I'm not that confident.

Though I'm not a marketing guru, the mixed messages Sony is sending towards the PS3 can't be good. It's confusing. And further, if Blu-ray is the winner, won't lower-cost Blu-ray players come to the fore simply because they won't incorporate the components necessary for a high-end gaming console? I'm just not buying this angle. Maybe I'm just too wedded to my bearish view on PS3 as a platform, but I don't think so. Gaming consoles are sold to gamers. Video players are sold to those who want to watch videos. And until Sony (and Microsoft, for that matter) figure this out, there is going to be a lot of shattered dreams and unrealized expectations. And it's just not fair. Especially to those working in the gaming business and doing great stuff.
 

The Internet: Offering Insight by Giving Voice

Yesterday I wrote a fairly detailed, research-oriented post on gaming. Now I'm looking for nuggets all the time, and occasionally I find one that reminds me why watching for what comes across the Internet is so interesting, and potentially so important. And this example, believe it or not, has to do with the Nintendo Wii. The source: a guy who works in Target actually stocking the units in the store. He might have a pretty interesting perspective at a grass roots level, no?

From allgames.com 10/28/2007, Wii Shortage is Nintendo Bull Shit:

Here's the deal I work at Target in electronics at night unloading trucks, which means that I see all the new product we get in before they're released. Last night (10/27/07) I was doing my job and found that we had received 7 boxes of Wiis and in each box are 3 of the system. I thought to myself well this is rare and quickly put them in the back room because we do not put consoles out the day I was working, (this is dumb I know but this is not the first dumb thing I have come across since working there that made no sense.) well as I go to put them on the shelf of the electronics room I look around for a place to put them and as I 'm doing this I look up on a very high shelf. Now what do you think I saw, well is was none other then more boxes of Wiis looking down at me (totaling 48 with the others I had just received) and as I saw them I thought we have never had this many in store in a month's time and Target is not even the a major benefactor of game sells so we do not supply much.

I don't know just thought it was interesting that there are so many of this "hard to find" system in a back room of a Target in South Jersey 2 weeks+ from Black Friday.....

Now this is just one's guys view in one store of one retailer, but it is kind of interesting. But wait, as I've discussed on many occasions, it is sometimes the comments that are even more interesting than the posts themselves. Here is a comment from the aforementioned post:

Actually I've been reading this... not sure if it's true or not... but the Wii is now easy to find in Japan. It's finally sticking around store shelves so Nintendo has been shifting some of their supplies over to the US because in the US it's still selling like crazy so you may see more Wiis on store shelves for the holidays then ever before but still with that said they believe that it's still going to sell out which is why they upped their projected sales for March 2008 to 17.5 Million.

Another things to consider is that the amount of consoles that get shipped weekly is 100,000 to all major retailers. Microsoft bumped their amount to 120,000 because when the 360 was launched it was a hard find like the Wii up until March. The Wii has already sold 12,000,000+ in less than 12 months so they have been selling practically a million consoles a month so they have upped the amount more than 200% and with this increase it's still selling like crazy.

The shift from Japan to US may put more Wiis on stores shelves in US but with the amount of Wiis being sold in the US it doesn't seem to want to die down which is why I think Reggie thinks there will be a shortage.

Again, just one data point, not something that in and of itself is going to cause you to go out and either go long or short NTDOY. But it is an interesting factoid that can play a part in building your investment mosaic. The Internet never ceases to amaze me. A guy unloading trucks at Target blogging about his experiences? He gets a voice, we get some insight. Sounds like a fair trade.

A (Brief) Review of the Gaming Landscape

In case you're not in the mood to read this post, let me give you the punch line: Nintendo has disrupted the console gaming industry, the responses to which are just now being fully revealed by Microsoft and Sony. And it isn't pretty. This is not to say, however, that Halo 3 hasn't given the Xbox 360 platform a kick in the butt. It has. But hit games are like hit movies - they are hard to come by. And now that we are in the third phase of the Halo sequel, what is the next smash hit in the Xbox 360 pipeline? Because, my friends, the hits business, whether in music, movies or games, is a tough road for building a long-term, broad-based business franchise. And discount rate at which one present values such uncertain long-term cash flows is very, very high.

In any event, you can read more about the impact of the strong Halo 3 launch on Microsoft's Home & Entertainment (H&E) division performance at ARS Technica 10/26/2007. Read some of the comments; there is more than a dose of cynicism related to Microsoft's booking its $1 billion+ in costs for the extended warranty program in the prior fiscal year, giving them a nice clean slate on which to report attractive future period earnings. I'm not saying that anything untoward is going on, but the latitude that exists in financial reporting makes the analysts' job that much harder. Should such costs be spread out of the time period when the services are being delivered, i.e., the period of the extended warranty? You be the judge.

Turning to Sony, one might say that PS3 is in the process of being "Dreamcasted" by Nintendo. Technical achievements are pretty meaningless if people don't care, and I'm sorry, but PS2, the last-gen Sony console, is far hotter than its next-gen brethren.  From PS^3 10/24/2007:

The latest BAFTA games award ceremony took place last night, probably to the familiar tune of large amounts of drunken revelry and self-congratulations with much fun being had by all. In short, here’s what happened: Nintendo pwned. Well, Wii Sports pwned, to be precise; it scooped up every award from best casual game to best multiplayer game to best game I would marry to my sister.

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Nonetheless, there is something for Sony fans to be upbeat about – PlayStation did manage come away with several awards anyway: Okami won Artistic Achievement and Original Score, while God of War II won Story & Character and Technical Achievement.

Funny thing is though, these aren’t really Sony’s latest blockbusting’, eye-poppin’ titles. Instead they’re now decidedly old school, being for the PS2. That points (yet again) at a glaring hole in both the PS3 line-up and the idiocy of removing backwards compatibility from the current 40GB models. Those old games still make money, are still very good and apparently still win awards. People want them, occasionally more than all that poorly built high definition crap that keeps being shovelled at us.

Right. PS2 is still pretty hot, while PS3 is, well, not. Now consider what came out of a discussion between my friend, N'Gai Croal of LevelUp, and Sony Computer Entertainment America CEO Jack Tretton 10/18/2004:

From Washington, D.C. to Foster City, California, the word of the day is, apparently, "relevant." An embattled President Bush used the R-word yesterday morning during a press conference to explain why he decided to veto a children's health insurance bill supported by both Republicans and Democrats. That's why it echoed in our minds during a conversation yesterday afternoon with Sony Computer Entertainment America CEO Jack Tretton, wherein he used the word "relevant" ten times in just 12 minutes while referring to the similarly besieged Playstation 3 and its predecessor. Was this a confident recitation of the facts or merely a wishful talking point? We'll let you be the judge. But based on what our sources are telling us, if the PS3 had a power animal, the September sales gap between the Sony's flagship console and those of its two competitors would see the PS3 represented by a duck—one as lame as the current occupant of the Oval Office.

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In determining which were the key features that had to stay and which were the ones that could be allowed to go, what was the thinking specifically on backwards compatibility?

The big difference between backwards compatibility on our machine and some of our competitors, you're talking about a machine in the PlayStation 2 that remains incredibly relevant, has a 120 million unit installed base, is going to go on and sell an additional 10 million units of hardware this year. We're the only company that has two relevant consoles, and we feel that the PS2 remains incredibly relevant and remains supported in the PlayStation 2 itself. In the face of our competition, those machines don't exist anymore at retail, so the only way you're going to be able to support that platform or play that platform is through backwards compatibility. We've chosen to focus on PlayStation 2 through PlayStation 2, and focus on Playstation 3 as part of the future and the PS3 software experience.

Did Jack just learn the word "relevant" and is so excited that he has to use it in any and every context possible? Why can't he just say "We are protecting our cash cow called PS2 while the market (hopefully) catches up with our whiz-bang multimedia player called PS3?" Because that would make Sony look like it failed at PS3, something into which they've got way too much money and way too much ego invested. I recently wrote about this issue of backward compatibility, so I don't need to belabor the point, except to say that Management's rationale for why it has been stripped out is a bunch of malarkey. But anyway...

Happy birthday, PS2. Are you 1, are you 2, are you 3... I'm 7! And even at the ripe old age of seven, you are still kicking a** and taking names. From Destructoid 10/25/2007:

I'm thinking that Sony is not only celebrating an old friend, but also quietly hoping to conjure up images of its future. After all, it was not all that long ago that Sony wasn't feasting on humble pie, and we were all madly in love with everything they threw at us. Things might look a little dim for them right now, but a turnaround is anything but inconceivable.

As the Xbox 360 continues to struggle with hardware failures (warranty or not), Sony has the perfect platform in which to make their rise back to the top complete. They've already taken steps to make the PS3 more affordable. Now they need to throw everything at their disposal towards helping (nurturing relationships) developers give us the newest batch of memorable games to brag about at the next birthday party.

You've got to look at some of the statistics provided by Sony in that post. The PS2 numbers are truly mind-boggling. Problem is, is this a sign of strength or merely a sign that the PS3 is just not making it? Hmm... Dean Takahashi drew some interesting conclusions from September's NPD numbers, with stunningly bad news for Sony. From the Mercury News 10/19/2007:

One piece of news that came out this week was that Sony pleaded with third-party developers not to abandon its struggling platform. That change in attitude is a marked difference compared to the arrogance of past years. The argument is that the PS 3 will show its strength as developers learn how to make games for it. But developers know they can staff four or five Wii teams with the same number of people it takes to make one PS 3 game. We may have a glut of Wii games soon, but that’s not as bad as not having enough games on the PS 3.

I made the development cost argument about a year ago, and it has played out pretty much as expected since then. And even the positive arguments that are out there for Sony are simply weak, weak, weak. Targeting moms with a low-cost media center? Huh? From Joystiq 10/22/007:

"I had written off Sony's PlayStation 3 game console as a flop, but it may be time to reconsider," opines Seattle Times columnist Brier Dudley, suggesting that the PlayStation 3 digital media center might defuse (and diffuse, as it were) the bomb in his mind. In his article, Dudley points to all the pieces as they drop into place: a $399 price point, an impending firmware update to improve the system's music streaming interface, a torrent of downloadable content on the PlayStation Network and the increased appearance of the PS3 in the home entertainment section of stores.

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Unfortunately, this proposition hinges on several other technological factors. Does mom have an HDTV? Can she tell the difference between a Blu-ray and a DVD? With the latter format still effortlessly bulldozing HD-DVD's and Blu-ray's minute battlefield, it seems too early to play the "It plays HD movies!" card as a means of broadening the audience. If Halo 3 and Wii Sports are any indication, games are still the most effective console salesmen. Is exchanging third place in one market (where moms are already spoken for) for a number one spot in a niche really the solution?

Duh. If I've said it once I've said it 10 times, people buy consoles to - yes - play games. All that other stuff may be welcome to some, but for many all it does is result in a high-priced, over-powered gaming console.

And what of our friends at Microsoft? They're upping their bets across the board, whether it's buying aQuantive for $6 billion, buying a 1.6% stake in Facebook at a $15 billion pre-, etc. And they did just report blow-out earnings, driven largely by their desktop franchise. As it relates to Xbox 360, once one moves beyond Halo 3 things aren't so rosy. They are trying to re-engage the casual gamer, after a failed attempt around a year ago in the wake of the Viva Pinata launch that was given the short shrift by their own marketing team. From Destructoid 10/15/2007:

Viva Piñata is a game that many people adore and yet it didn't do very well at all. According to Rare's James Thomas, Gears of War and Microsoft's marketing strategy are to blame. The two titles were set to be big Christmas releases, but while Gears was promoted out of the arse, there was sadly no room in the budget to give Viva Piñata the exposure Rare felt it needed.

Most interestingly I think from our point of view, it was interesting to see how the marketing budget was split last Christmas, because obviously everyone knew that Microsoft were publishing Gears of War and Viva Piñata. Yet, so much of the money went towards Gears of War, which is going to sell millions anyway. It was a bit of like, "What about the other franchise?" I think we got left in the wake somewhat.

Of course, Microsoft is now keen to get its hands on some of Nintendo's 'casual' market (as stupid as that buzzword is) and will surely do a lot better in the future, but there's no denying that with more promotion of the Xbox 360's less gritty titles, it could shed that irksome 'shooter box' stigma a lot faster.

I think, however, the biggest irony is that whenever I play Gears of War online, one of the most popular juvenile insults heard is "Go play Viva Piñata." It would seem that the game does get all the promotion it deserves ... from the very game that took its marketing budget.

But at the end of the day, does Microsoft have a chance in hell of successfully courting the casual gamer? Cynicism abounds, especially in the wake of Microsoft's latest attempt at broadening its appeal, the Xbox 360 Arcade system. From The Digital Gamer 10/23/2007:

Last winter, Microsoft attempted to court The Casuals with Viva Piñata, a game that was too cutesy for adults, but too complex for kids and anyone else new to videogames. As a result, and despite being really good, Viva Piñata failed to generate any kind of mass pre-teen/casual migration to Xbox 360.

Today’s announcements represent Microsoft’s second, concerted, annual attempt to muscle in on Wii’s lucrative monopoly over casual gamers.

This effort still feels too little, too late though. An entry level hardware specification and DLC tailored for kids doesn't fix the parent-intimidating back catalogue of hardcore games, or the intricacies of the (relatively) complex hardware – the Xbox 360 proposition is still far-removed from the plug and play immediacy and budget-priced novelty that Wii delivers so well. And the promise of any amount of digital content lying beyond a perceived iron wall of connectivity issues isn’t going to change that for the masses.

All righty, then.  How now, Nintendo? Pretty good. Pretty, pretty good. First of all, consider this little factoid from dsfanboy 10/22/2007:

You know, we never thought about this ourselves, but the ratio of people to DSes in Japan is pretty amazing. With an estimated 127,433,494 people living in Japan and 18.11 million units sold in the country, it comes to about 1 DS unit for every 7 people. If you want to go by a different figure, VGChartz has the handheld selling 19.72 million in the area, bringing that figure down to 6.4.

When you break the numbers down to something more personal like this, it really makes the weight of the sales figures that much more significant, wouldn't you agree?

Now we all kind of knew this, but seeing such a figure in black and white is pretty crazy, eh? And then there is all the excitement around Wii Fit, all primed for mega-release. From Wiifanboy 10/23/2007:

It's been a while since we've seen anything on Wii Fit, but Dengeki Online has an update that includes several screens, a shot of the boxed set, and a video preview of the fitness title. The Japanese release date is getting closer and closer, and we can't wait to gauge public reaction to the title. Critically, of course, the nongame continues to be lauded; Popular Mechanics recently named it one of the top ten "gadgets" of 2007, and it's not even out yet!

Wow. But core to Nintendo's success is getting developers to write for its DS and Wii platforms, and this "sharing of the wealth" is being felt all across the gaming industry. Consider Ubisoft's blow-out first-half numbers. From GameDaily BIZ 10/23/2007:

Yves Guillemot, CEO of Ubisoft commented, "Ubisoft has turned in a very solid first-half showing and has continued to win market share on new-generation consoles. For the first nine months of the 2007 calendar year Ubisoft was ranked as the leading independent publisher for the Nintendo DS, as well as number 2 on Wii, number 3 for the PlayStation 3 system and PSP system and number 4 for the Xbox 360 system. The strong sales performance and our positioning on high gross margin consoles has led to a sharp profitability improvement for the first half of 2007-08.

The success of the DS and Wii platforms becomes a self-fulfilling prophecy, as a virtuous cycle of strong unit sales (and orders-of-magnitude lower development costs than for the competing platforms) fuels developer interest which creates a better game library which drives additional unit sales, etc. Nintendo is right in the middle of this mutually beneficial dynamic, and it is hard to see this success abating any time soon. And with success comes strength and confidence, and Nintendo is starting to consider changing the playbook on the release calendar. From Eurogamer 10/24/2007:

Nintendo of America's outgoing vice president of marketing says that the company is "starting to look at the annual calendar differently" in terms of release date timing, rather than just stuffing everything in Q4.

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"The first two quarters of the year tend to be more quiet. But now we've seen some evidence of sales in that period.

"Other than the holiday quarter, I think the traditional way of viewing it is not necessarily a slam dunk. I think a really good product can be a slam dunk any time of the year."

Asked to explain the change, Kaplan suggested that it was down to the Wii and DS systems' ability to act as "a quick hit of entertainment", whereas traditional system which might be more suitable when "kids and families can spend more time playing or during holidays".

And not wanting to get completely stomped by the Wii/DS phenomenon, Microsoft and Sony are certainly not standing still. They are trying to engage - and now. From the Financial Times 10/18/2007:

Sony announced a $399 PlayStation 3 for the US on Wednesday while Microsoft confirmed that it would launch a new $279 version of its Xbox 360.

The moves increased price competition with the Nintendo Wii in time for the crucial holiday season sales period.

The Wii remains the cheapest of the next-generation consoles at $250.

But Microsoft signalled that its Xbox 360 Arcade would be challenging the Wii for the new audience that Nintendo was bringing to gaming.

“Arcade becomes [for us] the ability to bring in a new set of audiences. They’re probably a little bit more casually focused, they’re looking for a new family experience or they’re more price focused,” Robbie Bach, head of Microsoft’s Entertainment and Devices division, told the Financial Times.

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The $399 PS3, available on November 2, costs $100 less than Sony’s cheapest stand-alone Blu-ray player.

Jack Tretton, president of Sony Computer Entertainment America, said: “If consumers buy it as a Blu-ray player, they will find other uses for it; this is a great multimedia machine.”

He announced that Sony was also cutting the price of its premium 80Gb PS3 by $100 to $499.

So they're trying, as one would expect. Problem is, the fundamental issues still remain. Sony thinks it is selling a multimedia player that is going to find broad appeal among non-hard core gamers. Microsoft thinks that Arcade will be its answer to the Wii and will engage the casual gamer. Time will tell, but both the Internet conversation and my own sense after reading the gaming tea-leaves for the past 15 months make this a hard, hard sell. Make no mistake - Nintendo is leading the gaming discussion right now, the discussion that is trying to engage a much broader array of potential users than ever before. And the industry's only real response to the carnage it has wrought since its launch - a 7 year-old platform called the PS2. It's catch-up time, folks. And the latest offerings clearly aren't cutting it. So you're cutting price to stay in the game. But price alone does not sell a platform to the casual gamer. Fun does.

Ann Arbor: My Kind of Town

A few weeks back, my family made its annual pilgrimage to Ann Arbor for a football game, hanging out around campus, eating at our favorite local places (Zingermans' and Cottage Inn, in particular. Missed Pizza Bob's this go round) and doing a little boozin' and movin' (sans kids) at the Blind Pig. Good times. I think my boys actually want to move to Ann Arbor, loving fall at U of M (my favorite season) and all that comes with it. The leaves were beautiful, the air crisp and clean and the campus bustling and full of energy. And then, of course, there was the trip to the Big House. We saw the Wolverines dominate the Purdue Boilermakers, which was a beautiful thing as Michigan seeks to recover from its two disappointing losses at the beginning of the season. Maybe someday Carin and I will go back as adjunct professors for a term and take in Ann Arbor life as adults. Maybe...

Anyway, here are a few pics from our trip that capture the essence of the Ehrenberg's Ann Arbor experience:

The Ehrenberg men on Hoover walking to the Big House

Andrew and Ethan loving the game (with Daddy intently focused on the field)

Chad Henne leading the charge

The boys playing football in the diag after the game

The family in the wake of a stylin' Zingermans' breakfast

Now I've written before about the unique institution known as Zingermans': in short, it represents a seemingly unattainable combination of excellence in product, service, as an employer and as a citizen of the Ann Arbor community and the world at large. It is truly remarkable, and I have long had the utmost respect for its founders and all who are associated with its success and mission. So while we were at the store on Kingsley, I spied one of the founders, Ari Weinzweig, and decided to say hi. Ari is, as far as I'm concerned, "The Oracle of Ann Arbor." Some may trek to Nebraska to see Warren; I choose a shorter jaunt to see Ari. We had a great conversation that has continued via email, and my amazement with Ari and what he and his partners have built over the last 25 years continues to grow. This was one new element of my Ann Arbor visit that was truly special.

I am looking forward to not one but two trips to A-squared next year, one for my wife's 20 year college reunion (no kids) and our annual trip with the boys. Win or lose on the gridiron (though wins are clearly preferable), I can't wait.

On NPR Talking Subprime: What I Didn't Get to Say

So I had a little cameo today on NPR's On Point program titled The Mortgage Bailout Debate. On the air at the same time as me were Robert Shiller (Yale, author of Irrational Exuberance, you know the guy) and Robert Kuttner of The American Prospect. Two very smart guys. The tone of the discussion swayed from "How could those bankers have gotten paid millions of dollars only to get bailed out; how come the heads of the Wall Street firms haven't lost their jobs?" to "There are some fundamental flaws in our regulatory system that need to be addressed." Clearly a mix of populist rhetoric and economic substance, which I guess is necessary to both engage listeners and further the learning process. But I'd like to say what I would have liked to have said if I had more time to spar with the Bobs on-air.

First, let's take a step back. What were some of the forces that gave rise to the subprime mess in the first place? Here is my own short list (in no particular order):

1. Cheap debt a/k/a accomodative Fed policy
2. Abundant investor liquidity
3. Lack of sensible know-your-customer standards in mortgage origination
4. CDO investors who didn't do their homework and/or relied on rating agencies
5. Bank investors who didn't do their homework and understand the potential impact of off-balance sheet vehicles
6. Rating agencies lack of experience in dealing with CDO credits of such complexity
7. Poor accounting rule-making

Now if you look at this list and then say 'How many of these problems did Wall Street create?", my answer would be "precious few." What Wall Street is exceptionally good at is taking advantage of the rules. They make sure they know the rules very, very well, better than any other constituency on the planet. Then they innovate, develop, structure and sell based upon delivering customers (be they issuers or investors) value in a form that enables them to make money. Risk sharing and mitigation. New asset classes for investment. Greater liquidity. These are all good things. Say what you want about Wall Street, but one thing I haven't heard in the sea of criticisms of late are the words "illegal" or "fraud." That's because they did nothing wrong. They did what the current screwed-up regulatory construct (hello, Congress?) and the markets (hello, What me Worry? investors?) allowed them to do. So take a look in the mirror before throwing stones, all ye critics. Because odds are that you play a part in this crisis as well.

Mr. Kuttner made the comment that "SIVs were new and invented by Citigroup, I think." Wrong. SIVs and their intended use has been around in a variety of forms for decades. Operating leases, sale/leasebacks, asset defeasance transactions - these are all geared around keeping assets off the balance sheet. Thing is, analysts (at least those who are sentient beings) know this, and good ones properly capitalize these off-balance sheet exposures effectively undo this accounting imagery in their models. Investors should be doing this as well, and if they don't, too bad. Problem is when investors who are stewards of mutual funds, pension funds and other fiduciary vehicles do dumb things it is everyone who suffers. Not just Wall Street. Main Street.

Mr. Shiller made a point I agree with very strongly, that our fractured, decentralized regulatory infrastructure is woefully inadequate given the rapidly increasing scale, complexity and globalization of our financial markets. We do need a single set of rules for areas where market inefficiencies necessitate regulation, and one which both Bobs mentioned and which I agree with relates to underwriting standards. I am personally less concerned with the standards themselves than I am the "Know your customer" concept that already exists at retail brokerages both outside and inside Wall Street firms. This same concept needs to be enforced on mortgage originators, in order that customers will only be shown products that are appropriate given their income, job stability, etc., because it is clear that there were widespread abuses of people originating paper that never should have been written in the first place. And coordination of regulation between states and the Federal government is critical for clarity, which will make regulation easier and facilitate innovation.

So if you were to draw a picture of the problem with arrows and a big SIV in the middle, you've got loans in on the left, some good, some bad, into the SIV, and then CDO paper out. Retail investors need better protection on the left, in my opinion via know-your-customer and product appropriateness standards. CDO investors, many of whom relied on ratings agencies to make their purchases, need the confidence to be able to trust the integrity of the agencies and the quality of their analytical work. Right now, both issues are in question. That said, investors need to do their homework, over and above an implicit "seal of approval" from the rating agencies. And none of this addresses the accounting rules, which still enable off-balance sheet structures that defy both economics and logic. That is a post for another day.

I am glad these issues are being hashed out in public. I just wish that they were more dispassionate in their approach, leave the populist rhetoric to the side and to focus on the underlying problems that need to be fixed. Because there is a whole lot of fixing to do, and griping about Wall Street salaries is not going to get us there.   

Missing the Boat on the M-LEC Issue

We have witnessed a tremendous backlash against the M-LEC, Super SIV or whatever other name you choose to call the pooled securitization vehicle proposed by several banks and supported by Mr. Paulson and the US Treasury. While articles in the New York Times, Financial Times and the Wall Street Journal have all raised concerns over its likelihood of success, the motivations behind its creation and concerns over "moral hazard," two particularly snarky pieces showed up this weekend penned by Mr. Ben Stein (NYT) and Mr. Alan Abelson (Barron's) that warrant comment.

Let me be clear: I see neither a moral hazard nor a pending bailout in the form of the M-LEC; what I see is something more akin to the "Good Bank/Bad Bank" restructurings of the 1980s, where discrete pools of good loans were hived off of the bad to protect the good from being subject to perverse behaviors arising from the bad. This doesn't mean that the bad somehow get wiped away, forgiven, eliminated or anything of the sort. What it does mean is pools that, in aggregate, are being penalized for the credit features of a portion of its assets are able to access cost-effective financing for those assets that warrant it. The others, well, they need to be worked out. This isn't crazy stuff. It's just sound finance. Not voodoo financial engineering. Not some super complex derivative strategy. At its core it is pretty basic stuff.

One can use either the Good Bank/Bad Bank analogy or even the tracking stock/spin-off analogy, where the value of a mis-priced component of a group of assets is allowed to trade at its own level, bolstering the value of the combined group. Either way, Messrs. Paulson and Steel are not out to try and pull the wool over investors eyes, bail out Wall Street or anything like that. They are merely helping to problem-solve at a time when, let's face it, the problems are both large and stark. And they happen to be two very seasoned market participants who get it, and can certainly add to the collective gray matter required to address the pain that we'll all inevitably incur.

Now, the first cynic at the table is Mr. Stein from today's NYT:

Now, the ultimate Wall Street player and insider, Henry M. Paulson Jr., the Treasury secretary, has bestirred himself to take serious notice of the credit problems faced by some very big lenders. He wants to create a bailout fund in which banks that still appear sound buy some of the debt of the troubled players like Citigroup.

THE deal, as far as I can tell, is that they buy the most secure levels of debt that Citigroup and others own, get large fees and allow Citigroup and the others to keep the debts off their balance sheets. But there are at least two giant issues here.

One is that it’s a bit too predictable that Mr. Paulson would basically pooh-pooh the subprime problems until major Wall Street powers got in trouble and then — presto! — swing into action. It might have been inspiring had he stepped up to the plate when smaller players like home buyers were getting burned, but that’s not really his style.

The other is that it’s hard to see what good the maneuver would do. Suppose Citigroup or some other lender has a perfectly good loan to sell. Why does Citigroup need a big Treasury-sponsored organization to sell it? They can sell it to anyone right now. The problem is with the questionable loans. And they seemingly are not part of the plan from the Treasury.

I don't know if Ben is running for office, but it sure sounds like it. I think his characterization of Mr. Paulson's motivations make for good copy but are too inane for words. Right, he is bailing out his Wall Street buddies. Mr. Stein, while you don't make much of this subprime mess most of us do, and the credit markets are gradually waking up to the longer-term risks posed by the credit crunch, and the amount it effects Wall Street relative to Main Street is trifling. So if Mr. Paulson really wants to help his Wall Street pals there are easier ways to do it (like to whisper in the ear of Mr. Bernanke - if someone wants to see a possible moral hazard in action look at Fed policy). And as it relates to the argument that Citi and others could just sell the well-performing loans, this structure provides a single, ready buyer, a buyer who is only going to buy if the price makes sense. No firm planning to be involved with the M-LEC structure is charitable by nature, and unless the deal makes sense they won't participate. So I'm not really sure what to make of your argument except to say that it is expedient if not entirely possessing teeth. So your entire bailout line of discussion to me is, in fact, a red herring, and a convenient vehicle for you to vent your spleen about what really irks you: that the Government should stay out of all this stuff, period. Now if that is what you had written I'd have taken you more seriously, but as you didn't, well, I don't.

And now, from Mr. Stein's bosom buddy, Mr. Abelson from this weekend's Barron's:

Happily, we have in the person of Henry Paulson a Treasury Secretary who has a keen grasp of how the financial world works, who understands how crucial bankers and brokers are to the comfort and well-being of this rich nation. He is able to make that judgment because so many of them are his bosom buddies, one of his treasured legacies from the many years he spent laboring in the vineyards of Wall Street.

Carpers and cynics who never met a payroll and, indeed, likely never did an honest day's work (you know the types as well as we do: politicians, journalists, that sort of lowlife) may snarl all they like about crony capitalism and worse. But decent, compassionate folk can only cheer the speed with which Mr. Paulson whistled up a $100 billion bail-out for a posse of banks that found themselves stuck on a sandbar when the sea of liquidity they have been so happily splashing about in suddenly went bone dry.

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Enter Mr. Paulson, who put the arm on a number of major banks, even some that had no exposure to SIVs, to set up a fund with the real catchy name of the Master Liquidity Enhancement Conduit to help out the needy banks by buying securities from them, presumably at a discount. The obvious intention is to reassure the world that everything's hunky-dory and keep the banks, poor sensitive creatures, from having to show those squishy assets on their balance sheets.

Our considered view is that the supposed bail-out is a typical bit of Washington flash: all show and no substance. For a second, more tempered, opinion we turned to Punk Ziegel's savvy bank analyst, Richard Bove. He calls it "a horrible idea" that "would do nothing to solve any subprime-debt questions, mortgage issues, bad bank-loan problems etc... It would not bail out any bad loans from anyone, anywhere...It will not solve the liquidity problems where the SIVs need the most help and it will not reduce the debt problems facing the economy."

Again with the snarky sarcasm? Ben and Alan must have gone bowling late last week and decided to pile on Mr. Paulson this weekend. Again, reference to a bail-out. Where? The M-LEC is a market-based vehicle being assembled by financially motivated participants, none of whom is the US Treasury. So this jargon is simply inaccurate and muckraking, at best. And as for the balance sheet argument, if analysts are too dumb to take into account the impact of off-balance sheet assets, be they SIVs, asset defeasance transactions, operating leases, etc., then they deserved to fired. Balance sheet footnotes, my friends. Sure, one can argue over the accounting rules, but any bank analyst worth their weight in dog-sh@t knows of these deals and their true economic effects. That said, I think Mr. Bove's questions are more to the point. There is no question that the M-LEC solves no bad loan issues on day 1. If anything, it provides some financing to buy time, but how much value this really conveys is a mystery to all. And he is also correct that the detritus is incredibly hard to finance, and will weigh on balance sheets likely for quite some time. Some may well have to be sold at huge losses, others will be worked out, while some others may recover as market conditions improve. That said, it is a big unknown.

I think the real question is if the M-LEC has enough positives to make it worthwhile relative to the unknowns. As it introduces friction, it costs money to assemble for participating firms, especially those selling assets into the vehicle. And as noted above, it doesn't directly solve any fundamental credit problems. But it does create a ready market for high-quality SIV assets, in size, that streamlines the operational process of generating liquidity relative to selling discrete assets to many, many buyers. And it does provide an opportunity for market conditions to improve, possibly enabling some of the currently distressed paper to recover. And the part that doesn't, the banks will take some lumps. Lumps that they deserve to take. So net net, it might be worth a go. And it certainly doesn't have all of the negative connotations or motivations put forth by Messrs. Stein and Abelson. I don't know what someone put in their Wheaties this weekend, but keep it out of my bowl, ok?

 

Getting Good Documents Early On: Money Well-Spent

As an active early-stage investor and a long-time Wall Street denizen, I appreciate the value of a well-done set of documents. And while I also appreciate the desire to keep non-operating costs low, especially in the early days of a start-up, I believe it is critically important not to short-change the legal formation and fund-raising framework for a young company. And I am saying this from the perspective of the entrepreneurs and early investors, who are inevitably the ones who get jammed when things don't go as planned. Let me offer a few cautionary tales for those who may thing "Oh, we'll figure out the legal stuff later. Let's get the money in the door and build this thing. Nothing bad will happen."

Well, what about your IP? And I'm not talking about patents here, I'm talking about most young companies earliest and most valuable source of IP - its people. When people leave, they take tremendous IP with them, and unless these employees have proprietary information and inventions agreements that clearly establish IP ownership for the company, and have fair and reasonable non-competition and non-solicitation clauses, their departure can do real and lasting damage to the company and its investors. Not that their mere leaving won't hurt, but it will pale in comparison to the pain should they decide to start up a related business on someone else's dime when they developed this IP at your company. This would suck. And yet it happens.

And what about something like, say, the ability of an investor to sell and/or transfer their shares without the consent of the company? And what if the person or entity to whom the shares are transfered elects to compete with the company in which they own shares? Again, not a pretty picture, and one that could have been avoided with a right of first refusal clause, pretty standard stuff in basic, well-constructed financing documents.

So my point isn't that sometimes an entrepreneur gets the short end of the stick in document negotiations, but that they can be beaten with the stick if they don't put decent documents in place right up front. So even if it costs $20k to get a quality set of docs from a well-respected law firm, it may well save many multiples of this down the road when it comes time to do another financing, do an offering, sell the company, etc., because quality investors won't stand for weak, crappy papers. That dog just doesn't hunt. Life is too short to be futzing around with litigation and stress related to poor early organization. Raise enough money to do it right - and get on with creating the business you've envisioned and disrupting an industry. Because that is what it's all about.

Early Observations of Web 2.0

The Web 2.0 Summit has gotten big. Really big. So big that is almost unmanageable. That said, I think it is both a necessary and a positive thing for the technology and media investment/entrepreneur/networking scenes, as there is nothing quite like it out there. At the end of the day it is probably 90% networking and 10% new information. Bottom line, it is most assuredly worth it.

Aside from some great meetings with friends and contacts old and new, the person whose Web 2.0 talk was most impressive thus far was Evan Williams' of Twitter (and Blogger and Odeo). By a long shot. Now I am not a user of Twitter and I don't really care much about the application, but I couldn't have been more impressed with Evan's vision, candor and brilliance in communicating a profound but difficult message: how to get more from less. And as one who both invests in and is actively involved in running technology companies, I can tell you how hard it is to do what Evan has done.

It is and has always been all about the user experience, and getting the right balance of ease-of-use and functionality is an art that has eluded me thus far. The siren song of added functionality is very, very seductive, until you realize that the value of the added functionality may be far exceeded by the degradation of the user experience and the added cost of developing and implementing the functionality.
Seems simple, right? Wrong. Especially when you are emotionally involved in a product or project and you want it to be the best it can be.

But when is just ok is good enough, simply because the value proposition is heavily skewed towards ease-of-use and not features?  Look at Twitter. It is incredibly simple to use and has a sparse interface. Kind of like Google. Evan mentioned other examples as well of companies that have introduced constraints into their decision-making in order to bring the user experience to the forefront. It is the opposite of getting wrapped up in the "science project" that burns tons of cash, frays nerves of employees and investors alike and often leads to a product that is too complex for the market.

If all product development organizations, in both start-ups and established companies could internalize Evan's words we'd probably save billions of dollars and better deliver to the end users what they want: things that work. Simply. Easily. It is a solemn goal. And one to which all companies with human end-users should strive.

Out of the Crisis: SIVs, Big Banks, the US Treasury, LTCM and "Moral Hazard"

Question: what is going on here? Answer: the US Government, all branches of government, are afraid. Very afraid. The mortgage bubble is clearly much worse than was initially anticipated, and it was thought to be pretty bad at the outset. So what we have now is a Treasury Department, led by ex-Wall Street legend and "free-market pragmatist" (my phrase) Hank Paulson, that is seeking to mitigate the effects of private sector mistakes through public sector influence. And the stakes couldn't be higher, namely our economic and social well-being, especially in light of the intertwined nature of the financial meltdown bridging Wall Street (mortgage-backed securities and other less liquid assets) and Main Street (homeowners and consumers). And Hank & Co. just can't sit idly by and watch this slow-motion train wreck pick up speed - or can they?

Question: Is US Treasury intervention crossing into the realm of "Moral Hazard?" Answer: no.

Wikipedia describes moral hazard as it relates to finance as:

Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.

In my opinion, this is not what's going on here. There is no "bail-out," just as there was no bail-out in the midst of LTCM. In that case, the Treasury Department and the Federal Reserve played active roles in bringing key constituencies to the table. These constituencies were able to act in a coordinated manner to stave-off systemic risk. This seems to be exactly the role being played by Treasury in the subprime mess. Sure, they are urging the mega SIV issuers and others to create a new vehicle that will kick start the asset-backed CP market, but there is neither an implicit nor an explicit US Government guarantee. From the New York Times 10/15/2007:

The plan announced Monday involves no money from taxpayers, and it was negotiated primarily between the banks themselves. But it highlighted Mr. Paulson’s growing effort to marry two competing goals of the Bush administration: to stabilize the battered markets for mortgages and housing, but to avoid a government bailout that might encourage investors to take even bigger risks in the future — what economists call “moral hazard.”

“I have no interest in bailing out lenders or property speculators,” Mr. Paulson plans to say, according to an advance text of a speech he will deliver on Tuesday. “Still, we must recognize the very real harm to families affected by the housing downturn.”

This is far different, IMHO, than the very real moral hazard involved with FNMA and FHLMC, where these quasi-governmental agencies have been allowed to grow well beyond their original charter due to politics and the implicit Government subsidy. This is not Hank's gig. Hank is a free-marketeer, but also understands that sometimes markets fail, and isn't going to abdicate responsibility for some ideological purpose when he can facilitate a recovery through moral suasion, not moral hazard. He is smart and he is right. From the Wall Street Journal 10/16/2007:

In his first public comments on the plan, Treasury Secretary Henry Paulson said the huge, bank-affiliated funds that were kept off-balance sheet and that owned assets backed by shaky mortgages and other securities suffered from a lack of transparency and that regulators may need to step in to avoid future problems. "The regulators didn't have clear enough visibility with what was going on in terms of these off-balance-sheet SIVs," Mr. Paulson said to reporters after an event at the University of Texas at Austin.

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Some have criticized the Treasury for essentially helping big banks avoid the financial pain associated with risky bets that didn't pan out. The reaction in Washington, though, was more muted. Democrats sought to use the Treasury's willingness to get involved to bolster their demands that the Bush administration do more to help homeowners who are also suffering from the subprime downturn.

Question: Are the big banks in trouble? Answer: Some of them, to be sure.

Citigroup has taken a beating lately, and for good reason. Management instability. Poor transparency. Weak risk management. And a giant hole in its balance sheet due to a concentration of illiquid assets. As to the raison d'etre behind the super-SIV program, also from the WSJ:

They expressed hopes that the plan, announced as expected yesterday by the banks, would help jump-start the commercial-paper market, which provides financing for things including mortgages and big investment projects but has been struggling since late July. The fund would issue short-term notes to investors and use the proceeds to buy securities from specialized funds, known as structured investment vehicles, or SIVs, that are being forced to wind down their businesses.

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In the short term, Treasury officials said the financial markets were in danger of a large-scale dumping of assets by the banks, which would have hurt capital markets and potentially spilled over to the broader economy. To avoid that, Treasury stepped in to facilitate discussions among the banks for a private-sector solution, which culminated in the creation of a fund to buy SIV assets.

Question: What is this plan really going to do for the big SIV banks? Answer: generate liquidity for the good while warehousing the truly distressed, where the value of buying time is uncertain.

This vehicle, the Master-Liquidity Enhancement Conduit, or M-LEC, is not designed to hold a bunch of garbage, but only the highest-quality components of existing SIVs. From the WSJ:

According to people familiar with the plan, though, the price of admission for SIVs will be high. SIVs will only be allowed to sell assets rated AA or better and likely will be unable to sell collateralized debt obligations -- pools of debt repackaged into slices with different levels of risk and return -- backed by subprime assets. In addition, the SIVs will have to pay a fee to the super conduit and accept a discount in the price of the securities they are selling. In return for that discount, the SIVs will receive notes in the "junior" layer in the conduit -- which will take the first hit if losses are incurred.

So, what the M-LEC is really doing is generating liquidity against a higher quality pool of assets, leaving behind... the dreck. It is like a keeping well over a $100 billion of illiquid toxic waste in the current SIVs and using the better, more marketable stuff to generate liquidity. I guess the ultimate question is how much value there is in the stuff left behind, and how much of a hole will be blown in bank balance sheets if many of these residual SIV interests crap out. That said, the M-LEC structure does buy time for the markets to become more orderly, for some liquidity to creep back in, and for a near-term crisis to be averted. But it doesn't change the fact that lots of really bad loans were made, and lots of securities were sold backed by these really bad loans, and real investors and real people will incur over $100 billion of real losses when the dust settles, even in the best of circumstances. And it is going to be the magnitude of the losses, where these losses reside and how they are absorbed that will ultimately determine the damage to both Wall Street and Main Street communities.

Bottom line: there is major ugliness out there, and the US Treasury can only do so much. But they are trying. It is only with the passage of time that we'll know the full extent of the damage, but I think we can all say with confidence that this will rank as one of the worst credit meltdowns in history.

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NB: the title is a reference to and in honor of W. Edwards Deming, one of the true geniuses in the fields of process engineering and organizational management. He was all about a very simple yet powerful concept: reducing the variability of outcomes as a measure of quality. He generally applied this in the context of manufacturing businesses, but his genius is applicable to service-oriented businesses - including Wall Street and asset management businesses - as well. If only some of those market participants had internalized his teachings, maybe some of today's problems could have been averted. Just maybe.

Securities Pricing: A Proposal for a New Paradigm

The issue of securities pricing for purposes of portfolio valuation is now front-page news (see last Friday's Wall Street Journal, for starters), seemingly every day. And with good reason: it gets to the very root of the trust relationship that (should) exist between portfolio managers and their investors, as well as the integrity of financial reporting. Oh, yes, and the implications for investors are literally in the trillions of dollars, when one takes into account management and performance fees (hedge funds and long-only funds) and stock market valuation (banks, investment banks, insurance companies and publicly-traded asset managers).

With all that is at stake, wouldn't you think that the framework used to address this issue would be pretty objective and well-known by all? Well, if you thought that, you'd be pretty disappointed. The procedures for marking books are almost as varied today as when I started in the derivatives business in the early 1990s, when one could (and did) get incredibly creative when it came to marking incredibly complex books of correlation risk that lacked any kind of liquidity. Bottom line: the issue is the same today as it has been for decades, with little in the way of improvement. Why? Because it has to do with one thing and one thing only: P&L and compensation. Because this is what makes the markets go around.

So if you'd indulge me for just a minute, I'd like to step away from the issues of P&L and compensation and to try and think about this issue rationally and pragmatically, and from the perspective of an investor. As an investor, what do I really care about?

1. That the financial statements reflect both value and intention;
2. That the financial statements truly represent Management's view of the business; and
3. That, where possible, market-based pricing is used for financial reporting purposes.

As a pragmatist and as an investor, I know that market-based prices for all securities are sometimes either impossible or not reflective of true prices if my manager had to move the entire position. So assuming that I am using market prices in circumstances where they are available, what about the rest of my positions? I'd say that I'd want to know if the positions are held for trading (short-term) or investment (long-term). This gets to the issue of intention.

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

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

Therefore, a well-balanced manager would likely have a book largely made up of trading assets, with a lesser amount of extremely high-conviction investment assets that represent call options in a book of less volatile, lower expected-value constituents. So I am advocating a hybrid hedge fund/private equity valuation model to address the issues that have dominated the headlines since the subprime crisis broke out, but have really existed for decades. From my perspective liquidity has always been the litmus test for managers; if you want to have a bunch of illiquid assets, then you should be able to support them with appropriate duration financing and defer performance fee gratification until performance has been proven. Otherwise, get those marks, guys. And if they suck, which they invariably will, too bad. You can't have everything. But investors need some stability, reason and fairness in financial reporting. I believe that if my approach had been used starting early this year, we might have seen problems emerging far earlier then we did.

James Wolfensohn Visiting JP Morgan? Hmmm...

This usually isn't my thing, the non data-driven rumor thing, but given all the hubbub around Citi and Chuck Prince what could I do? A friend of mine told me that they saw none other than Mr. James Wolfensohn strolling into JP Morgan just a short while ago. Maybe he's just making a deposit. Um, probably not.

Let's not forget that Mr. Wolfensohn is Chairman of Citi International's Advisory Board, as well as a Senior Advisor to Citi itself, so maybe, just maybe, there is something more substantive going on. Further, did you know that JPM's stock price performance has kicked Citi's butt over the past five years, by a factor of 3? Is James there to discuss jump-starting Citi's growth by purchasing some of JPM's global banking operations, or perhaps generating some cash and slimming down the Citi colossus by offloading some overseas assets to its better-performing global competitor?

You be the judge. But with all the heat Prince is taking for Citi's performance, and in light of the recent reorganization, investors and clamoring for him to do something. And maybe Mr. Wolfensohn's visit is part of the something.

What is Chuck Prince Doing? I Never Know What He's Doing...

Sorry, a little Wedding Crashers reference. But truly, what IS he doing? He is running a $240 billion (market cap) global financial colossus, and he is treating his organization chart as if it's his own personal plaything. When I eyed tonight's Wall Street Journal story I was simply awe-struck.

The personnel moves were announced as part of a new corporate structure in which Citigroup will merge its investment-banking operations and its alternative-investments businesses. The combined unit will be run by Vikram Pandit, a former Morgan Stanley executive who joined Citigroup earlier this year when the bank bought his Old Lane hedge fund. Initially viewed as a potential successor to Mr. Prince, Mr. Pandit will now rise another step up Citigroup's hierarchy just months after joining the bank.

Vik to run both alternative investments and banking? How does that go together?

Meanwhile, Thomas Maheras, who has been co-head of investment banking with responsibility for capital markets and trading, is leaving the company. Mr. Maheras also had been considered a potential successor to Mr. Prince and is highly regarded with the ranks of the bank.

The well-regarded Tom Maheras and Randy Barker (mentioned later in the article) shunted to the side? It was not that long ago that Tom was the "golden boy" - how do you go from that to dog-crap in such a short span of time? This just isn't natural.

Under the new structure, Mr. Pandit is rising above veteran banker Michael Klein and James Forese, who will jointly run the investment-banking business, and John Havens, who will run the alternative-investments business.

And what about Michael Klein and Jim Forese? Are they just going to say "Hey, Vik, great to have you as my new boss!" This is Wall Street, Chuck. People have egos, believe it or not. These are top guys, real deal guys, and you've treated them like - well, if I'm them I'm not sticking around too long. Don't get me wrong - I'm not against bruising egos here and there for the greater good, but is this really the greater good? It seems as if maybe, must maybe, you are trying to accomplish a few things in one fell swoop:

• Scapegoat a few guys for having their privates in a vise due to aggressive P&L targets, taking on too much risk and losing some money when everybody on the Street did, guys who have been making the firm lots of money and building businesses for a long, long time;

• Assert your leadership via the old Al Haig routine - "I am in charge." Yeah, I know. So was the captain of the Titanic; and

• Set up Vik for the inevitable CEO succession which was telegraphed when you paid the largest executive search fee in history, around $800 million, to buy Old Lane essentially for Vik, John and an ok, mid-sized hedge fund.

This whole move makes me think of George Steinbrenner's recent ultimatum to Joe Torre delivered via the press: "(You're) the highest paid manager in the game; if (you) don't win this series then maybe (you) shouldn't be working here." Ugh. I understand that the other Prince (the Saudi Prince) was supportive of Chuck's move; maybe he is looking for something, anything, to propel Citi's share price higher. But as an outsider who used to be an insider, this does not look good.

Leveraging the Internet for Idea Generation: Only the Creative Need Apply

I have long marveled at the power of the Internet for idea generation. In fact, much of my writing has been in this vein. But what I haven't really discussed is how the 'Net can also be used to design new products and services, and I am proud to announce that one of my portfolio companies is doing just that.

Clear Asset Management, the algorithmic asset management firm and creator of innovative ETF products, has launched a contest involving three schools (Columbia, Lehigh and NYU) and Facebook. The goal: come up with creative, high-value ideas for new ETFs products. The prize: $4,000 cash, a paid internship at Clear and the chance to attend the bell-ringing ceremony at the exchange when the winning ETF is launched. There are other cool things for runners up, honorable mention, etc., but I'm focused on the brass ring. There are many more details at the Facebook page and any and all interested parties should check it out. I'm sorry, but this whole idea is cool. Pretty, pretty cool.

It just makes so much sense; I'm only sorry it wasn't my idea. And this is just the first of many contests Clear is planning to run, which will continue to leverage both online (Facebook, Clear Indexes website) and offline (schools excited to participate) distribution channels. Why not? Get access to some great R&D by tapping into thousands of bright, creative, ambitious financial thinkers who would love nothing better then to see their ideas come to life, get a few bucks, an internship and a great resume-builder to boot? It's all good. And it taps into the long-tail of financial engineers lurking in dorm rooms, home offices and garages everywhere. It's like Mechanical Turk for financial engineering. I love it. I'll report back on how it goes, but I am highly confident that the idea is a winner.

Windows XP SP3: An Upgraded XP or "Vista Lite?"

As a follow on to last week's Vista retrospective, a few more interesting data points on Microsoft's OS strategy. From Slashdot 10/07/2007, Windows XP SP3 Build 3205 Released w/New Features:

Windows XP SP3 build 3205 is the first official & authorized release of the next Windows XP service pack; and has been made available to testers as a part of the Windows Server 2008/Windows Vista SP1 beta program. NeoSmart Technologies has the run-down on the included 1,073 patches/hotfixes including security updates. Contrary to popular belief, Windows XP SP3 does ship with new features/components, most of which have been backported from Windows Vista. Some included features: 'New Windows Product Activation model: no need to enter product key during setup. Network Access Protection modules and policies have been brought to XP after being one of the more-well-received features in Windows Vista. New Microsoft Kernel Mode Cryptographic Module - the Windows XP SP3 kernel now includes an entire module that provides easy access to multiple cryptographic algorithms and is available for use in kernel-mode drivers and services. New "Black Hole Router" detection - Windows XP SP3 can detect and protect against rogue routers that are discarding data.

And a few little tidbits from Engadget 10/09/2007:

It looks like Vista isn't the only OS Microsoft is working to improve, with the folks at Neosmart now reporting that a beta of Windows XP SP3 Build 3205 has been sent out to a select group of testers.

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All this, of course, follows the recent extension of XP sales until June of 2008, so it certainly seems that there's quite a bit of life left in the venerable OS that many are still clinging on to.

We know from earlier posts that both corporate IT departments and individuals are having a hard time reconciling the "benefits" of Vista versus XP, leading many to delay or outright reject deploying Vista in its current form. Well, the individual perspective was certainly driven home to Steve Ballmer at a Gartner symposium yesterday. From Computerworld 10/10/2007:

"I'm one of those early adopters of Vista," said Yvonne Genovese, an analyst who was interviewing Ballmer along with fellow analyst David Smith on stage at a conference forum. "My daughter comes in one day and says, 'Hey Mom, my friend has Vista, and it has these neat little things called gadgets -- I need those.'"

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She went on to explain that she installed Vista for her daughter -- and two days later went right back to using the XP operating system. "It's safe, it works, all the hardware is fine, and everything is great," she said of XP.

Genovese also argued that her experience with Vista is broadly shared: "What we're seeing and what we're hearing from users is a very similar thing. It's difficult to implement. What should we be seeing that we're not seeing?"

Strategically, Microsoft's moves seem consistent with those of Sony concerning its decision to cut backward compatibility out of PS3.  Except instead of dumbing-down Vista (it is already dumb enough), they are enhancing XP. Bottom line, both strategies are geared towards protecting legacy franchises for products that work (either because of features, price or both), and buying time for new products to get the kinks hammered out before severing the umbilical cord. Like Sony, Microsoft's move is economically rational IMHO, even if it is in response to a flawed strategy around Vista. What remains to be seen is if Vista ultimately has legs, and if corporations and individuals alike will move on from XP fast enough to keep Vista alive. Should be an interesting year for the folks from Redmond.

PS3 and Backwards Compatibility: The Analysts are Missing It

My friend Rob and I talk a lot about gaming in general, and gaming analysts in particular. Frequently, we can't quite understand how they approach problems or arrive at conclusions, probably because they are mired in cranking out reports and not spending enough time thinking about the big picture. And this was never more clear than in an article that ran in today's GameDailyBIZ concerning the issue of the PS3s lack of backwards compatibility. The analysts conclusion: since much has been made over the PS3s high price point, and since stripping out this functionality saves between $30-$50 per unit, a cost reduction is clearly more important than offering this feature. Voila! Instant Wall Street group-think.

In short, my pal and I believe this thinking is, well, quite stoned, and evidence of thinking deep, deep inside the box and neither looking at the facts nor Sony's true economic motivation. But hey, this is only the view of a couple of stupid non-gaming analysts.

First, some excerpts from the article:

So the question must be asked: Considering the pure dominance of the PS2 and the millions of gamers who may want the ability to play PS2 games on the PS3 should they ever purchase the console when it comes down in price, is Sony shooting itself in the foot?

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"Cost is hard to gauge, probably $30 - $50 per unit," Wedbush Morgan Securities' Michael Pachter said. "I thought lack of backward compatibility would hurt the Xbox [360], but it really didn't. My guess is that Sony has addressed the concerns of those who care about backward compatibility with all of the boxes sold to date, and that they will continue to offer the 80GB model if anybody feels that they need backward compatibility. So it's not fatal."

It's not an ideal solution, but something had to be done. "It's about cost reduction, but also getting people to focus on PS3 games. End of the day, they need to do something, and this was probably a compromise between costs and price cuts," UBS analyst Ben Schachter said.

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For Cole, the bigger issue for Sony and its consumers remains the price barrier and the losses piling up in Sony's gaming division. "For me the big problem with the PS3 is high price. The problem is bringing the price down means bleeding a lot of money per unit. You lower the price $100 and you are losing $100 million for every million units sold. To me I just can't imagine many consumers stumbling over backwards compatibility. But I can imagine a whole bunch stumbling over price," he said.

Colin Sebastian, an analyst at Lazard Capital Markets, agrees wholeheartedly. "It appears that pricing is becoming more of a priority, which makes sense given where the PS3 is selling in terms of market share. I don't believe removing backwards compatibility is a huge deal, considering that most people who want to play PS2 games will continue to do so on their PS2s," he said.

So, a question arises, say, like why Sony wouldn't make the PS3 backwards compatible. There has been tons of talk about the PS3 being priced too high. "Let's see, it costs money to make the PS3 backwards compatible, the price of the console is too high...I've got it, they're going to strip out the functionality and reduce the price. That's surely the answer." There is only one answer for such narrow-minded thinking: the recency effect.

The recency effect, in psychology, is a cognitive bias that results from disproportionate salience of recent stimuli or observations. People tend to recall items that were at the end on a list rather than items that were in the middle on a list. For example, if a driver sees an equal total number of red cars as blue cars during a long journey, but there happens to be a glut of red cars at the end of the journey, he or she is likely to conclude that there were more red cars than blue cars throughout the drive.

Right. Since high price is the proximate problem, any action Sony takes will be perceived as trying to address this issue. My view: WRONG.  Consider this explanation. PS2 is kicking PS3s ass, both in terms of hardware and software sales. And not by a narrow margin, mind you. Consider these figures from VGChartz:

                                                       PS2                                PS3

Hardware (13 wks)                        746,341                        502,730

Weekly avg                                        57k                                39k

Software (13 wks)                         3,969,654                2,721,050

So, if I'm Sony, am I worried about people focusing on the PS3, or not cannibalizing my far more profitable cash cow, the PS2?   Come on, guys. The answer is right in front of you. Sony is actually being economically rational for a change. The last thing they want is for PS2 console sales to slow to a trickle, sales that attract a far greater margin than PS3. Further, they are selling many more PS2 titles than PS3. And Sony is enjoying that nice license stream off of PS2 games. So bottom line, they are using PS2s profits to subsidize PS3s losses to offset a slower-then-expected adoption cycle. And they are making the bet that the PS3 has the technology and will have the game library to overtake Xbox 360 and the Wii over the long haul, ergo their 10 year console life cycle positioning.

It all makes perfect sense, doesn't it? But again, my pal and I aren't Wall Street analysts. And just maybe that's a good thing.