Did I Just See a Dead Cat Bounce?

Sorry to be a party pooper, but I don't buy the sustainability of the recent market rally. 500+ points in two days? Give me a break. Market prognostication is not one of my specialties but I simply have to speak. It doesn't take a rocket scientist or the Amazing Kreskin to see that things suck out there. In the real economy. Being excited about lower rates is only part of the equation. Sure, you are discounting back future cash flows at lower rates and therefore increasing the present value, but what exactly are you present valuing? I'll tell you what - lower future cash flows. So many market participants get all excited about the prospect of the Fed dropping rates, but I think a few questions need to be asked:

1. Why are they dropping rates, and what are they seeing that we aren't;
2. Does the Fed really have the power to stimulate growth simply by monkeying with the short end of the yield curve; and
3. What are the knock-on effects of the Fed lowering rates that could work against a rosy outcome, i.e., a weaker dollar that chokes off domestic demand and causes long-term rates to rise?

I personally don't like the answer to any of these questions right now. The Fed is scared, that's for sure. They see the dislocation in the credit market persisting, and perhaps getting worse. All we need is the failure of a single monoline insurer or (another) 10-figure write-down by a major bank to toss the financial markets into a complete panic, which would be good for precisely nobody (except perhaps Bill Ackman, Jim Chanos and a few others). So in light of these risks, they may well tilt towards an accomodative stance. However, if they do this, will this really stimulate growth in the real economy and meaningfully loosen up tight credit markets? Debatable. There are likely more direct steps they could take to provide banks and other financial intermediaries with the liquidity to bridge the gap and to address the tightness in the mortgage markets, steps that maybe wouldn't have such an adverse effect upon the dollar. And what if they continue to push down short term rates, and the real economy doesn't react as hoped? In the absence of real growth and in light of lower rates, the dollar will fall further, only exacerbating an already difficult situation. This could have the effect of causing foreign capital to flee and long rates to rise, making it more costly for firms to raise stable, long-term capital (not to mention the US Government).

So market rallies are great, and I am an optimistic person in general, but the trading action of the last few days doesn't fool me. I just saw a dead cat bounce. And it will soon fall back to earth.

WSJ Re: Merrill Lynch: Authority in Mainstream Media Takes a Hit

One of the big knocks on the blogosphere as a source of news and insight is that the content created is often of questionable authority. From whom are these views coming, anyway? Given this, how can the reader assign much weight to what is written? Sure, there are a handful of "cross-over" content creators who pen for alternative media outlets but are really mainstream writers in bloggers' clothing, but they are in the minority. Authority is the bugaboo of the blogging world. But this is clearly not a problem in the world of mainstream media (MSM) because of the editorial review process and the standards to which content creators are held, right? WRONG.

Consider a little snafu over at the Wall Street Journal. Felix Salmon pointed out today that the WSJ just corrected a front-page story from three weeks ago that showed their reporting to be something other than rigorous, balanced and professional. Consider this lead in from the original WSJ story dated 11/3/2007:

Deals With Hedge Funds
May Be Helping Merrill
Delay Mortgage Losses

By SUSAN PULLIAM
November 2, 2007; Page A1

Merrill Lynch & Co., in a bid to slash its exposure to risky mortgage-backed securities, has engaged in deals with hedge funds that may have been designed to delay the day of reckoning on losses, people close to the situation said.

The transactions are among the issues likely to be examined by the Securities and Exchange Commission. The SEC is looking into how the Wall Street firm has been valuing, or "marking," its mortgage securities and how it has disclosed its positions to investors, a person familiar with the probe said. Regulators are scrutinizing whether Merrill knew its mortgage-related problem was bigger than what it indicated to investors throughout the summer.

In one deal, a hedge fund bought $1 billion in commercial paper issued by a Merrill-related entity containing mortgages, a person close to the situation said. In exchange, the hedge fund had the right to sell back the commercial paper to Merrill itself after one year for a guaranteed minimum return, this person said.

********************

That was then, this is now. The correction to the story above, dated 11/26/2007:

ON NOV. 2, the Journal published a page-one article on Merrill Lynch & Co. that was based on incorrect information that the firm had engaged in off-balance-sheet deals with hedge funds in a possible bid to delay the recognition of losses connected to the firm's mortgage-securities exposure. In fact, Merrill proposed a deal with a hedge fund involving $1 billion in commercial paper issued by a Merrill-related entity containing mortgage securities. In exchange, the hedge fund would have had the right to sell the mortgage securities back to Merrill after one year for a guaranteed minimum return. However, Merrill didn't complete the deal after the firm's finance department determined it didn't meet proper accounting criteria. In addition, Merrill says it has accounted properly for all its transactions with hedge funds.

Now when I read something in the WSJ, I have come to believe that the story is truthful, well-researched and generally relevant. So when I cite the WSJ as a source in posts that I write I view it, from a factual perspective, to be correct. Well, I had given the WSJ my trust when I wrote the following post, only to be proven wrong and made to look like a jackass:

The Root Cause of Today's Market Turmoil?: It's a Matter of Trust

Trust in our government. Trust in our financial institutions. Trust in those who play the role of "trusted adviser," regardless of whether or not they are considered fiduciaries by law. After taking a big step back and asking the question "Why are the markets trading so poorly, and why are financial institutions in particular getting crushed?" the answer boiled down to one word: trust. Or the lack thereof, as seems to be the case today.

The last few days the buzz has been about Merrill Lynch, and the possibility that they've been trying to engage in cosmetic balance sheet transactions to make things look better than they really are. From today's Wall Street Journal:

Merrill Lynch & Co., in a bid to slash its exposure to risky mortgage-backed securities, has engaged in deals with hedge funds that may have been designed to delay the day of reckoning on losses, people close to the situation said.

********************

In one deal, a hedge fund bought $1 billion in commercial paper issued by a Merrill-related entity containing mortgages, a person close to the situation said. In exchange, the hedge fund had the right to sell back the commercial paper to Merrill itself after one year for a guaranteed minimum return, this person said.

While the Merrill-related entity's assets and liabilities weren't on Merrill's own balance sheet, Merrill might have been required to take a write-down if the entity was unable to sell the commercial paper to other investors and suffered losses, the person said. The deal delayed that risk for a year, the person said.

In a statement, a Merrill Lynch spokeswoman said, "We don't comment on specific transactions and we are confident in the appropriateness of our marks."

Whoa. Now as one who has trafficked in the world of structured transactions for the bulk of my career, I can tell you that this type of "creative balance sheet management" has been going on for decades. No joke. And in the wake of Enron, things were supposed to have changed, where "sham" transactions (those without true economic substance, or where the transfer of risk didn't truly take place) were supposed to go the way of the buggy whip. Well think again, friends. There is a fine line between risk retention and true risk reduction, and if what's described in the WSJ is true, these deals are all about balance sheet presentation and have nothing to do with risk reduction. And FYI, Merrill Lynch shareholders, your firm is paying money, your money, to effect this optical illusion. So not only is there a breach of trust, you are paying for it, too.

Breach of trust? Tell me about it. I'm pissed. Really, really pissed. I had the title right but the subject wrong: Media: It's a Matter of Trust. And my trust and those of millions of others has been breached. The New York Times had their own problems with the Jayson Blair fiasco, and many other breaches across mainstream media have recently come to light. So the next time someone from MSM blathers on about how the user-generated content is a bunch of garbage and that MSM is the only source of truthful and authoritative news and events, I'm going to pull up this post on my Blackberry and promptly say "SHUT UP."

Did Breakingviews.com Forget Corporate Finance 101?

So I'm minding my own business, reading the weekend edition of the Wall Street Journal when it hit me: someone clearly skipped out on Corporate Finance 101. It brought back a rush of memories that are truly priceless. Consider the following story:

Buyout Shops' Dull Edge

Is the buyout industry losing its deal-making edge? A tussle for high-end furniture and knickknack retailer Restoration Hardware may pose an answer. Buyout firm Catterton Partners offered to buy Restoration for $366 million earlier this month. Now, it may face a rival bid from Sears Holdings.

Before the credit crunch hit, strategic buyers such as Sears found themselves at a disadvantage relative to private-equity firms. Fast forward to today: Catterton's weighted-average cost of capital in this deal will be much higher than Sears's.

In addition to Catterton injecting its own equity, four public shareholders will roll their existing shares into the new leveraged entity. All told, equity will make up 70% of Restoration's capital structure -- well more than the 30% that characterized precrunch deals. So the deal's after-tax cost of capital will be 16%, assuming the equity investors expect a return of 20% a year.

Sears has a net debt-to-cash-flow ratio of less than one. It could raise debt to buy Restoration or use some of its cash. Either way, its cost of equity -- the upper limit on its overall cost of capital -- isn't much above 10%. This means Sears could offer a much higher price. The deal looks like another good illustration of just how critical a component cheap debt was to private equity's golden age.

Whoa. Using the way one finances an asset to determine the intrinsic value of that asset? I don't think so. Now, for those with a taste for history, see if you can remember this one: The Coca-Cola Corporation and Columbia Pictures. Coca-Cola bought Columbia in 1982, which led to a very stormy relationship over the ensuing years. After much strategic and financial engineering, Columbia was finally purchased by Sony in 1989. Many thought that Coca-Cola paid an absurd price for Columbia back in 1982, with one significant driver of over-valuation: using its AAA-credit rating and low cost of equity as inputs to the cost of capital with which to discount back Columbia's volatile cash flows. This yielded a very high NPV, as the discount rate did not reflect the riskiness of the cash flows being purchased but the riskiness of the entity doing the purchasing. Is this any way to value a business? Of course not. The way a deal is financed should not impact the value of the operating business. The value of financial engineering and leverage is a separate potential source of value (and risk) that needs to be considered separately. This was one of the case studies I learned as a young banker of how not to value a company.

So here we are 25 years later reading a story that is basically making the Coca-Cola argument: since Sears has a lower cost of capital than a private equity shop, it should be able to pay a higher price for the business. NO. NO. NO. Please, no. Deals are hard enough when you pay a theoretically fair price for the business then when you grossly overpay since you didn't use sound corporate finance principles when valuing its cash flows. I wouldn't have expected to see this kind of weak financial analysis in the Wall Street Journal. Tsk, tsk.

Asymmetric Incentives: Investors and Boards Take Heed

The issue of executive compensation has been "hot" for quite some time, and it has only gotten hotter given the massive losses sustained on Wall Street and certain segments of the hedge fund industry. There is plain outrage that certain members of senior management get to keep tens of millions in pay even in the wake of tens of billions in lost shareholder value. It is hard to reconcile such asymmetries, yet the problem is rooted in the structure of the compensation culture that has emerged across Corporate America and the burgeoning hedge fund industry. I personally am less irked by the numbers themselves than the mis-aligned incentives that have contributed to today's market crisis (as well as poor corporate performance). And it is unclear how this issue will be rectified in a rational manner, as populist rhetoric takes hold and deflects the analysis from the question of "how" to pay instead of the "how much" to pay. But one thing is for sure: there is a problem. And it needs to be addressed now.

James Surowiecki penned a recent piece in the New Yorker that did a good job outlining some of the complexities of executive compensation, and the skewed incentives that Boards and investors may be giving their charges in the name of building shareholder value. He also expanded the analysis to cover hedge fund managers, and the asymmetric risk/return profile they see under the standard 2/20 fee structure:

The havoc on Wall Street following the collapse of the subprime-mortgage market boils down to a simple truth: for years, lots of very smart people took lots of very foolish risks, betting borrowed billions on dubious mortgage derivatives, and eventually the odds caught up with them. But behind that simple truth is a more surprising one: the financial whizzes made bad decisions in part because that’s what they were paid to do.

Mr. Surowiecki, as usual, breaks down the fundamentals with great clarity. An interesting feature of his analysis is the fact that the very properties of hedge fund returns are in line with the compensation culture that has emerged. For instance, overall hedge fund returns tend to be negatively skewed and exhibit high kurtosis. In english, this means that when something big happens to impact overall returns it tends to be negative, and it tends to be very, very negative. This is similar to the properties of an out-of-the-money put selling strategy, where a premium seller will outperform over a wide range of outcomes until - oops - the sold puts move into the money and causes exponential losses over short time periods. The funny thing is that prior to the blow-up, the put seller a/k/a the hedge fund industry, exhibits returns that are both better and less volatile than the broad market. Whoo hoo! Unfortunately, it is just this that lulls investors into a kind of complacency that makes for a rude awakening when things go south. Mr. Surowiecki goes a little far when raising the issue of how the manager of a poorly performing fund below its high water mark can simply shut down and start again. The reality is that not every manager has this luxury and it certainly isn't near the top of a manager's play book when thinking of how to deal with a period of weak performance. But overall, his analysis of manager motivation given the prevailing incentive fee structure is pretty accurate.

Mr. Surowiecki's discussion with respect to corporate executives gets very interesting when he cites a recent study on the use of stock options and its impact on company performance:

Not surprisingly, a recent study of almost a thousand companies by the management professors W. Gerard Sanders and Donald Hambrick found that C.E.O.s whose compensation was made up mostly of stock options tended to “swing for the fences,” making investments and acquisitions that were riskier than those made by other executives. As a result, the performance of the companies run by the risk-takers was far more volatile, and not for the good of the companies: the risky strategies were more likely to end in a big failure than a big gain. Generous options grants may also encourage fraud; the business professors Jared Harris and Philip Bromiley, who have made a study of hundreds of firms forced to restate earnings after accounting irregularities, found that companies that paid out most of their compensation in stock options were far more likely to end up restating earnings. And, as with hedge funds, the perverse effects of performance pay are exacerbated by the fact that big bonuses are often based on short-term performance.

The results of this study are pretty intuitive. And you know what is really interesting? If an analysis of hedge fund returns (and manager motivation) yields a profile that looks like a sold put option, an analysis of corporate manager motivation creates a profile more akin to a bought call option. Except in this case, the option is not bought by the manager but granted to him/her by the Board of Directors. Free optionality - it is the holy grail. The corporate manager's risk/reward prism is, in effect, the converse of the hedge fund manager's prism. The hedge fund manager wants to merely outperform with a high degree of certainty over the intermediate term, in order to "demonstrate" superior investment results, grow assets, capture ever-larger management and performance fees and accrue great wealth. If things go wrong after that, you have a hedge fund manager with egg on its face but a large bankroll. Now consider the corporate manager. Their motivation is to take risk. Big, big risk in order to shoot the moon and get the stock price to rocket upward. Small amounts of outperformance aren't going to yield the types of market returns that get corporate Masters of the Universe excited. Lights out, leave your competitors in the dust-type performance will, however. And these are the types of gambles they are financially motivated to pursue. One thing is for certain; if you give highly intelligent, highly motivated, wealth-seeking individuals skewed incentives, they will push this skewness to the limit. And this is the real Achilles' heel of mega-stock option grants that reward corporate managers for absolute stock price movements.

There have been periodic attempts to change the structure of executive option grants. Some companies have tried to structure "outperformance grants," where the payoff was linked to the difference between company performance and a broad market index like the S&P. Others have sought to try and isolate outperformance between a company and its publicly-traded competitors. Each of these approaches has conceptual appeal but generally have failed in the marketplace. Either too difficult to administer, too unattractive for manager prospects or too unusual relative to the vanilla options used by competing companies.

But my biggest issue is that stock price performance - especially short-term performance -  in a vacuum doesn't begin to measure the effectiveness or long-term worth of a senior executive. How about building a new product pipeline? Employee morale? Talent management? Recruitment? Investor relations? Relations with all key stakeholders? The list goes on. Until compensation plans become more robust, and more focused on the real, sustainable, long-term value brought to the company and its stakeholders by senior executives we'll get the problems of mis-aligned motives we've witnessed since the advent of large stock option grants. But both investors and their Boards need to acknowledge this need or nothing will change. And change is what's needed. Right. Now.

Hacking Webkinz: What's Up With That?

My family just had dinner with some close friends of ours, celebrating our pre-Thanksgiving Wednesday ritual at our favorite neighborhood Japanese restaurant. Two 40-something couples hanging out, getting a little head on, with four beautiful kids joking around, playing 20 Questions and Mad Libs. A pair of 10 and 7 year olds, one boys and the other girls, reveling in their shared history and interests. All was good. Except one thing. The little girl discovered today that her entire Webkinz room had been cleaned out. Totally cyber hacked. This little girl had spent months painstakingly playing games, earning points and furnishing and decorating her room, and identifying with all she had put in to her little project. It was all her own. And she was proud of it.

Needless to say, when she came home and logged on and found out that she had been robbed, she was pretty hysterical. I've got to tell you, I've had stuff taken a few times in my day and I've felt pretty angry and violated myself. And I was far older than 7 when both thefts occurred. So this little girl feels violated, unempowered and helpless. Her mom, who is quite computer-savvy, logs right on to Webkins to find out how to deal with the situation. The first thing she reads when clicking on Customer Support and Has Something Gone Missing is this:

The only way an item can go missing is if someone knows your username and password (or Secret Code) and has accessed your account. If someone has removed or sold an item, it cannot be reinstated. Please change your password by clicking on the “Login” button on the menu to your left (or go to the Webkinz World homepage and click “Login”). Click “Change my Password.” You’ll be able to create a new password. Please remember to make it something easy for you to remember but difficult for others to guess.

Now that's a pretty confident statement: "The only way an item can go missing is if someone knows your username and password (or Secret Code) and has accessed your account." I don't think Google, Microsoft or Yahoo! make such declarations. Based upon my experience with the Internet and on Wall Street, if one were to interpret such a statement as a Service Level Agreement it would mean 100% assurance, no deviation. This clearly is nonsensical, as no service provider on the planet can guarantee such performance. But somehow Webkins feels they can. And even with such an astounding level of confidence, it is really hard to get hold of them. No easy way to drop Customer Support an email. No seamless way to share concerns and issues. This is not the way it should work. If you claim a 100% service level one of two things needs to be happening, either:

1. Perfection, no variation; or
2. Ready, willing and able service representatives to address issues in real-time.

Since neither of these appear to be present in this situation, I'm frankly confused. How does a little girl get satisfaction from having been robbed? It doesn't appear that Webkins has either anticipated such a circumstance or gives a sh*t. I'd be really interested to know their stance on these issues. Because I'm not happy. And neither is my 7 year old friend.

 

From the Mailbag: Who Will Lead the Next Wave of Financial Innovation?

Future leadership in financial innovation; this is the question du jour:

I'd love to get your take on where the next generation of financial innovation will come from as well as on your view of the trading world and where it's heading.

Will it be the big firms, the Wall Street behemoths and multi-strategy hedge fund complexes?  Or perhaps the small, nimble and creative start-ups and spin-outs? Where will innovation best be nurtured and developed in tomorrow's investment landscape? In order to answer this question, I think we need to consider some of the trends taking place across the investment business.

The re-shaping of the asset management business is a mega-trend that has permeated this blog since the beginning, and was the topic of one of my very first blog posts. My view has long been that the alternative investment business will look increasingly like a barbell, with multi-strategy mega firms running tens of billions in assets and small single-strategy firms running a few billion or less. The middle will be squeezed, as the resources necessary to expand into new strategies and compete globally are too great while the ability to generate alpha relative to smaller, nimbler firms is too difficult. The middle is not a good place to be, and will become increasingly more hostile as the institutional high-end of the market solidifies while the organic low-end of the market is a bubbling cauldron of alpha-generating success stories mixed together with value-destroying failures.

Turning to the issue of innovation, I think it needs to be bucketed into two groups:

1. Idea innovation; and
2. Technology innovation.

Idea innovation is not reliant on massive amounts of silicon, and is largely a function of intellectual capital. The goal here is alpha, or risk-adjusted out-performance. It could be a new capital structure arbitrage strategy. It might be an attractive investment approach in an emerging market. It could be a better researched idea and a more profitable trade than perceived by the investment community. Idea innovation could spring from either large or small firms, depending upon the nature of the innovation. If the source of value requires taking a position in Sri Lanka relative to South Africa and calls for extensive bottoms-up research, then a small firm is unlikely to have the bandwidth and resources necessary to implement such an global strategy. However, if the approach is a new way to structure PIPEs deals that puts the investor on a more profitable risk-adjusted frontier and creates cheap optionality, then a small firm could be the source of such local innovation. 

Technology innovation involves creating an edge through bandwidth, processing power, execution speed and intelligent algorithms. This is generally the province of larger firms, be they hedge funds or Wall Street prop desks. Plain and simple, this stuff is expensive. Being the next Jim Simons or David Shaw requires big cash, and few outside of the mega quants or Wall Street have the knowledge and resources to engage in this arms race. Enough said.

Elements of idea innovation have and always will be open to the small dreamers. The barriers to entry are brains, hard work, vision, some luck and a few bucks. Idea innovation that requires global reach and presence, however, will be hard for the smaller funds to realize. Technology innovation is now a game of the big and the rich, and those lacking a significant bankroll need not apply. And I'm not talking about renting processing power and storage on Amazon's EC and S3 - I'm talking about boxes near the exchanges and the latest on-ramps to the silicon highway. We now have a stratified market where innovation is heavily skewed to the biggest, best funded and most powerful hedge fund and Wall Street players. The chance still exists for the small players to innovate and make it happen, but the odds are becoming longer every year.

Looking Overseas for a U.S. Financial Sector Bail-Out: It'll Cost You

There were two stories this weekend that solidified what I already knew:

1. The Fed is between a rock and a hard place with respect to interest rate policy; and
2. Overseas investors are being viewed as a possible savior to buy up depressed U.S.-dollar assets.

Problem is, with 1 above being the case due to a still-growing economy together with a plummeting dollar, a banking sector in disarray and locked-up credit markets, 2 is looking less likely unless the terms are substantially more attractive than they've been during the first three quarters of 2007. Consider this article from Saturday's New York Times (I have bolded certain key themes):

A Federal Reserve governor (Randall S. Kroszner) said yesterday that another interest rate cut would probably offer few additional benefits to the economy, a hint that the central bank plans to hold rates steady at its meeting next month.

********************
Mr. Kroszner warned that the housing recession was likely to worsen and predicted weaker home sales and a cutback in consumer spending as mortgage rates rise and foreclosures increase. But he said he expected the economy “to return to its longer-run sustainable rate” after a difficult few months. “Conditions for subprime borrowers will get worse before they get better,” he said.

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The bank’s statement (in October) at the time suggested a reluctance to ease rates further. In his remarks, Mr. Kroszner warned against a series of consecutive rate cuts, suggesting such a move could set off inflation. “All else equal, each successive action in the same direction tends to lower the incremental benefits and to raise the incremental costs of additional actions,” he said.

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The weak dollar has kept domestic business activity growing as foreign demand increases, but the report suggested companies are taking a more conservative stance, lowering inventories in anticipation of a spending slowdown.

“Exports can only take you so far,” said Joshua Shapiro, chief United States economist at MFR, a research firm. “I think we’re starting to see the evidence pile up of the effects of weaker domestic demand.” He added, “There doesn’t seem to be much reason for optimism, with housing continuing to decline.”

The themes in this article represent the two-sided nature of the Fed's dilemma. Housing is likely to worsen, mortgage rates rise and foreclosures increase yet the economy will "return to its longer-run sustainable rate" after only a few months? Huh? And even in the face of such weakness a series of consecutive rate cuts are viewed by the Fed as inflationary? But the export-driven growth in the face of the weak dollar is likely to abate and falling domestic demand come to the fore? What is the prudent man supposed to believe? The credit crunch and banking sector instability is clearly a prime driver of this Catch-22, but it is what it is: the Fed is stuck with poor, blunt weapons and little understanding of the true nature of the enemy.

And given the U.S.'s debtor status to the world and trillions of dollars in wealth stored up by sovereign wealth funds, they will come to our aid and bolster our ailing financial services sector and scoop up bargains in distressed debt and other asset classes, right? Well, maybe... My friend Thorold Barker over at the Financial Times penned an interesting piece this weekend on this very issue:

As the credit crunch saps liquidity from a number of traditional finance sources, the sovereign funds provide an interesting alternative for some US companies.

The idea of deep-pocketed overseas investors, who want to diversify their governments' holdings, is beguiling. Sovereign funds tend to be stable investors, who should not be too panicked about short-term share price volatility. So far, they have not tended to demand active board roles, in contrast to more aggressive hedge funds or private equity firms.

********************

Financial stocks could well prove to be a classic value trap for the unwary. But the likelihood of a big firm being forced to raise capital will increase if credit markets remain dislocated. And that could offer the bargain of the decade for sovereign funds, or others, willing to step up at short notice.

The trouble is, financial companies should not assume sovereign funds will provide easy cash on demand. The Chinese government is already red-faced due to the falling value of its Blackstone investment.

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Now, any sovereign wealth fund tempted to open its wallet for a struggling financial company that actually needs money is likely to drive a much harder bargain.

I think Thorold is quite right that sovereign funds now find themselves in the enviable position of having lots of investable cash at a time when relative bargains might become available. And given the scarcity value of their liquidity and the rough shape of many U.S. financial firms, they will likely demand far more onerous terms than they've gotten previously. That said, I think there is another massive point of negotiating leverage for these sovereign funds: the weak dollar. These funds are looking more and more to non-U.S. and Western European investments for better growth dynamics and appreciating currencies. Why put more assets in the U.S. when the sinkhole of banking sector losses is not yet quantifiable and domestic demand is poised to fall? Neither of these trends speaks well to the status of the U.S. dollar.

In order to attract this offshore capital long-term Treasury rates will have to rise to keep our bulging deficits financed, and private sector deals will have to be done on terms far more advantageous to foreign investors than six months ago. It is what it is. If you run large deficits, have weak accounting rules and governance practices and investors lose faith in your currency you get what we have today: a meaningful risk of stagflation, a hole out of which we'll be digging for years.

Some Straight Talk on "Liquidity Puts"

"Liquidity puts" - yet another new and ominous sounding term for something that has been in existence for a long, long time. The term is defined in an 11/13/3007 article in Fortune as follows:

What Citi did a couple of years ago was insert a put type of option into otherwise conventional CDOs that were backed by subprime mortgages and sold to such entities as funds set up by Wall Street firms. The put allowed any buyer of these CDOs who ran into financing problems to sell them back - at original value - to Citi. The likelihood of the put being exercised, however, was regarded as extremely remote because the CDOs were structured to be high-grade entities called "super-senior."

Have you ever heard the term "recourse?" It is a fairly simple concept that has been around over six centuries, and is directly related to the aforementioned liquidity puts. The Merriam-Webster definition of recourse is as follows: 

Main Entry:

re·course

Pronunciation:

      \ˈrē-ˌkȯrs, ri-ˈ\    

Function:

noun

Etymology:

Middle English recours, from Anglo-French recurs, from Late Latin recursus, from Latin, act of running back, from recurrere to run back — more at recur

Date:

14th century 

1 a: a turning to someone or something for help or protection <settled the matter without recourse to law> b: a source of help or strength : resort <had no recourse left>2: the right to demand payment from the maker or endorser of a negotiable instrument (as a check)

Turning to someone for help or protection? A source of help or strength? Sure sounds like a liquidity put to me. The interesting thing about recourse, however, is that it is generally believed that assets need to remain on-balance sheet if they are subject to its occurrence. Because, as a matter of fact, one does not know if and when those assets may be coming back to you, and should be accounted for in a conservative manner. This then raises the issue of securitization in general, and whether or not many of these vehicles should be off-balance sheet at all. A little blurb on securitization from Wikipedia raises the issue as well (the bolding is my own):

Securitization occurs when a company groups together assets or receivables and sells them in units to the market through a trust. Any asset with a cashflow can be securitized. The cash flows from these receivables are used to pay the holders of these units. Companies often do this in order to remove these assets from their balance sheets and monetize an asset. Although these assets are "removed" from the balance sheet and are supposed to be the responsibility of the trust, that does not end the company's involvement. Often the company maintains a special interest in the trust which is called an "interest only strip" or "first loss piece". Any payments from the trust must be made to regular investors in precedence to this interest. This protects investors from a degree of risk, making the securitization more attractive. The aforementioned brings into question whether the assets are truly off balance sheet given the company's exposure to losses on this interest.

This is the issue in a nutshell. Liquidity puts and its variants are strewn across the entire securitization landscape and have been for a few decades, and any investor that buys and sells the shares of financial institutions without understanding this concept is in for a lot of pain. The likelihood of incurring this pain has always been there, it is only that today's markets being as they are that the fat tail of the distribution has finally come along to swat ignorant investors (and their unfortunate clients) in their pocketbooks. But don't sit there and tell me that these risks are new, special and different. They're not. It is only that certain investors have been awakened from their heavenly slumbers by a heaping dose of reality. And whose fault is that? If you want to play in the world of complex instruments read the documents. Very. Carefully. Don't rely on the rating agencies - they won't save you. And don't count on clear and useful accounting rules or detailed company disclosures to bail you out. You've got only your own brains, perspective and diligence to count on. And if any of these three are lacking - look out.

 

From the Mailbag: Blogging 101 - Building Readership

Building awareness of your blog. A very interesting issue with both spiritual and technical elements. I know some who really couldn't care less how broadly their blog is read. I know others who want their blogs to be among the best read on the planet, and take steps to make this happen. And yet others, like me, fall somewhere in between. It is a very personal issue and one that requires a bit of discussion around the "why" before launching in to the "how." The question as posed by a recent IA reader is as follows:

"...may I ask you to consider posting on your own blog about how you built your readership, what worked and didn't work etc.  Of course quality content comes first, but how important, bluntly, was self marketing?"

As it relates to the "why," I write in a certain way that attracts a certain kind of reader. Not the kind who is going to live on my site watching what I post 5-10 times a day, but one who checks their RSS reader every day or two and says "Oh, Roger has written something new. Let me check it out because he usually has something interesting to say." They know it will take more than 30 seconds to read, is generally around a topical issue concerning Wall Street, finance or technology and will have some hard-hitting, unambiguous commentary from someone who (often?) knows what he's talking about. Almost by definition, mine isn't a blog that will be near the top of any kind of ranking. I came late to blogging (less than a year and a half), am not from the VC/tech/entrepreneur/online world and don't write for daily market watchers or trading types. I write about stuff I think is important and where I feel I can constructively add to the conversation taking place in both online and offline media. Period. And this works for me. My goal was to be well-read, well-respected and to be an important part of the discussions that intersect with my interests, abilities and experiences. And I think I have done that pretty well. Approximately 3500 subscribers, 30-40k uniques a month, a link roll that I am proud of. I'm making it happen my way.

As to the "how," the question my reader posed, I will share what I did to build my online presence, but of course it will only directly apply to those who share my goals. I can offer some suggestions for those who want to be near the top of Technorati/Alexa rankings, but since I really don't care about this my advice will be half-hearted and likely not the best. I will also take as a given what my reader said, that content quality needs to be high. This is the ticket to play the game (at least the way I play it).

#1: Tell your friends. I emailed a bunch of friends across the domains I planned to write about (namely, Wall Street and technology) to tell them of my blog. I also sent an email to my LinkedIn network announcing my new endeavor. This was a useful way to get the ball rolling.

#2: Track your traffic, subscribers and inbound links upfront. I use StatCounter, FeedBurner and Technorati to follow my traffic, feeds and links in order that I can understand my readership. I started this at the very beginning of my blogging. This has helped me discover people interested in my blog and to track those who link to my content. I will sometimes reach out to these people to establish a relationship.

#3: Reach out to those who share a similar perspective or world-view online. I quickly identified a group of bloggers who wrote about some of the same topics I did, and personally reached out to them. For me this included Paul Kedrosky, Trader Mike and Howard Lindzon, all of whom are now friends and colleagues. I found a group of intelligent, thoughtful, web-savvy people who really helped me build awareness and provide advice. I often became part of their blogrolls and this helped to build my early online footprint.

#4: Reach out to those who share a similar perspective or world-view offline. As I built credibility and a following online and I then sought to leverage this offline. This included writers from the Wall Street Journal, the Financial Times, the New York Times and Barron's. Some of this attention came to me and some I went out and got myself. I emailed top writers at publications I respected and got a dialog going. It is absolutely amazing how receptive these writers were to being contacted. It was then that I saw first-hand the blurring between traditional and new media. They were interested in getting the best ideas and insights wherever they be found, and are no longer bound by conventional offline sources.

#5: Write frequently enough to be relevant and keep people interested. Unless you already have a large following and have down-shifted to a less-frequent publishing cycle, you've got to write several times a week, at least. Those who want big followings will have to publish several times a day in areas that attract this kind of readership, e.g., the stock market and investing, but to simply build a core following you probably need to write at least four times a week. And this is a good routine to get into, anyway.

#6: Write about the occasional non-core topic that is "buzzy" and by all means be provocative. I like the business of gaming. Gaming happens to have a very wide, active and passionate following on the Internet. It is also a very different online following then, say, those interested in Wall Street and investing. When I started writing about gaming from a different perspective than most bloggers and took some very aggressive stances I got picked up. A lot. It also helped me make connections across the gaming community that has resulted in new friends, new perspectives and a new pocket of readers. This is key to building a growing readership base; identifying new groups that find your blog a "must read."

#7: Build relationships with bloggers who aggregate content and have a wide reach. Every domain has "nodes," people who run sites that publish top links in a specific area of interest. If you can show them that you write consistently good content they will sometimes link to you, which can expose you to an entirely new set of readers and cause a permanent increase in your traffic.

#8: Build relationships, all the time. This isn't really another "to do" but simply an amplification of what is obvious from above.

Success (as defined by awareness from those whom you care about) online, as in life, is all about relationships and making connections. If you are a good and worthwhile person and have something to say, and if this is reflected in your writing, you have the ability to be successful online. All it takes is passion, focus, finding your own voice and some of the basic steps outlined above. Do these steps constitute personal promotion or marketing? Sure. But this is no different than they way we develop relationships, establish networks and build reputation in life. But once you have been online for a while and established a good reputation, you can take it wherever you want it to go. The only limit is your imagination and effort.

John Thain: The Right Man for Merrill. Can We Clone Him?

Big news. Huge news. Good for Merrill investors and even better news for Merrill employees, IMHO. Stan O'Neal clearly had to go, having lost the trust of both employees and the investment community. Further, it was never clear that Stan was the right cultural fit to be the CEO of Merrill, being a pretty brusque, harsh sort, not exactly the kind of guy who would endear himself to its massive and powerful brokerage arm. While he spent a stint running the private client group, most of his career was in the realm of leveraged finance and capital markets. It is a rare manager in these areas that can balance transactional DNA with relationship DNA, both of which are extremely important in running a firm of Merrill's scale and complexity.

It is hard to understand the root cause behind Merrill's staggering losses. Was it simply overly-aggressive risk-taking while playing catch-up to Goldman? Was it a conscious decision to swing for the fences in an effort to collect massive current compensation (like the $48 million Mr. O'Neal collected in 2006) and if the bet didn't work out, oh, well, too bad? Or was it a function of a breakdown in risk management and controls? This is a topic for another day, but is was clearly a result of short-term thinking that led Merrill down a path that will cost the firm at least $10 billion, and maybe much more.

So what does John Thain bring to the party? John is clearly a more cerebral kind of guy, a consensus-builder with a strong analytical bent. He has experience at the top of one of the most successful financial enterprises the world has ever known, Goldman Sachs, a firm with a culture of collaboration, long-term thinking and investing in people. He has experience running a big cooperative, the NYSE, that he led through a public offering and a merger. These are large, complex firms with vast constituencies, far more numerous and complex than those making up Merrill Lynch. There aren't too many executives in today's financial services industry with his experience base and youth, and this is a big, big problem. Is he up to the challenge of righting Merrill, securing the confidence of employees up and down the hierarchy as well as the investment community? Absolutely. But what about Citigroup? Bear Stearns? UBS? And the list goes on.

Institutional investors should demand far better succession planning and talent management at the largest financial institutions, many of which have either been run as fiefdoms or with revolving doors that have provided little management continuity and consistency in strategy. This absolutely has to change. The stakes are simply too high. With the largest financial firms controlling tens of trillions of dollars in assets and being counterparty to hundreds of trillions of dollars of financial transactions, depth of leadership is critical. No, it is necessary. And it is up to us, the investors, to force the issue. And for Boards of Directors to heed our call.

A Prescriptive for Today's Volatile Markets

We need to get full and truthful disclosures from our public companies. Period. Remember my post discussing the underpinnings of today's market turmoil? Investors everywhere are on edge. Debt. Equity. Structured products. It doesn't matter. There is no place to hide. The VIX has skyrocketed, and one need not be a market technician to both see and feel the intra-day volatility taking place. One can say that the market is overreacting on both the upside and the downside, but I think it is important to take a step back and ask - why? 

I have written a lot lately about the importance of good financial disclosures as a vehicle for building investor confidence and stabilizing the markets, but I think even I may have understated the magnitude of its impact. If investors are waiting for the other shoe to drop, waiting for that next unexpected write-off, that next accounting scandal, what do you think happens when even a whiff of such an event gets leaked into the market? Investors react quickly and violently, especially in the face of imperfect information. This is a major source of volatility at a time when information is extremely imperfect - one might even say crappy - and is further leveraged by a growing interdependence among companies, countries and markets.

An article in today's MarketWatch discussed the possibility of financial institutions marking everything to market and getting all the bad news out at once, in an effort to rebuild confidence in their financial disclosures and prospects. Dramatic, yes, but provocative and worthy of discussion:

A couple of analysts I spoke to said that the best thing financial firms can do to rebuild confidence is to look at every asset on the balance sheet and mark it to market. If it can't be sold or if its value is unclear, it should be written off. That write-off should be a one-time event.

           

"They need to be as straightforward as possible about what their credit risks are," O'Shaughnessy (Patrick, analyst at Morningstar) said. "What's really killing them and killing investors is the uncertainty that surrounds it. Nobody's sure if the write-down is going to be $500 million to $1 billion or more."

           

O'Shaughnessy doesn't recommend that everything be written to zero, but underestimating risk is what initially got these firms in a bind. Erring by being overly conservative may cause some short-term anguish with investors, who could see some eye-popping numbers. For instance, what if the $45 billion in total write-downs is only half, or a quarter, of the final amount, as Deutsche Bank analyst Michael Mayo suggested Monday?

           

But a tough line on marking to market would lessen the likelihood of dragging down the industry and the economy this winter, and it leaves open the possibility that the market may revive and those securities might actually produce a dividend down the road.

Blythe Masters, a long-time credit derivatives pro at JP Morgan and now global head of currencies and commodities, had some interesting advice for her Wall Street peers:

"We need to raise the game and acknowledge our weaknesses," Masters told attendees of the Securities Industry and Financial Markets Association's annual meeting, adding that in the credit crunch, "we are experiencing a crisis of unprecedented proportions" that will "damage the economy."

Geez, Blythe is starting to sound like me. This is good for the industry - if her words are heeded. Corporations and managements everywhere have an aversion to pain, and this aversion is an adaptive response if, say, you are running from a predator. Unfortunately, this hard-wired dislike of facing into ugliness is something that causes crises to drag on for way, way too long, and we run the risk of having this exact thing happen if managements and their Boards don't have a come-to-Jesus moment - and soon.

John Authers, one of my favorite writers at the Financial Times, had a piece in today's paper that discussed today's market volatility but from a different perspective, one driven more by another quant meltdown than investor psychology:

Have the quants had another accident? Or have many people, operating in separate markets, independently decided to take profits at the same time? Or has a dose of risk aversion suddenly grasped almost everyone in the world markets?

The answer to all three is probably 'Yes'. And whatever the most important driver, there is a palpable sense of deepening gloom over the world's economic prospects and the chances for financials to muddle through the credit crisis.

********************

As for the role of quantitative funds, bizarre moves in US equities are redolent of the week in August when the largest names in the sector dropped by a third. Perverse effects can be caused when several quant funds, which tend to use similar models, pile in and out of the same stock at once.

Last week's sudden fall in tech stocks, which had strongly outperformed the market, certainly had that look about it.

Intraday trading patterns also had a crazy look. No news, or sudden change of Mr Market's heart, lay behind the 1.8 per cent fall of the S&P 500 in the last 38 minutes of trading on Friday, according to Bloomberg data. More likely, the move was dictated by shifts in the trading books of quant funds.

I see what John is saying, and believe me, few people have a greater appreciation for the impact of stat arb funds than myself. That said, based on anecdotal evidence of investors with whom I've spoken coupled with the intuition of market psychology and trading in an information vacuum that I've explained above, I think John's argument tells only part of the story. It may well be that quants are having the effect of increasing the amplitude of the waves due to crowded trades, but I believe the trend ball is getting rolled more by market psychology than automated trading.

Now if investors had the confidence that what was coming out of corporate PR departments was the truth, the whole truth and nothing but the truth (and not until the next time they release a new version of the truth), I believe the amplitude of the ups and downs we've witnessed would be muted. Why? Because trading would be based on fundamentals, not on persistent uncertainty. And if one adjusts cash flow discount rates to take into account these extreme uncertainties, models become very, very sensitive to changes in perception. And these perceptions, given the lack of investor confidence in the information they're receiving, are changing literally by the minute. This is no way to run an organized, orderly market. Things have got to change, and corporate managements and their Boards hold the keys.

Rapid Consolidation of Private Exchanges: Innovation Speeding Collaboration

The private exchange wave. It was kicked off by Goldman Sachs through its flotation of Oaktree on GSTrUE. It was then joined by a few individual firms, and finally by a consortium of Wall Street behemoths called Opus-5. And now they are joining together to support a common platform, Nasdaq's Portal system. From today's Wall Street Journal:

A dozen Wall Street firms have decided to drop their competing trading systems for the unregistered securities known as 144a offerings and cooperate on a single platform operated by Nasdaq Stock Market Inc.

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In recent months, investment banks built competing off-exchange markets for these 144a transactions, or sales of securities from companies that seek to raise money without the scrutiny and regulatory burdens of going public. The sales are open only to large, qualified investors, such as mutual funds and hedge funds. The systems ranged from Goldman Sachs Group Inc.'s GS TrUE to Opus 5, from an alliance of eight big investment banks.

********************

By using a single system operated by Nasdaq, investors in these instruments will congregate at the same site, which should result in a more-liquid market. Although making the market more transparent will result in lower trading profits for investment banks, increased volume is expected to offset smaller trading spreads.

This move is both highly rational and entirely expected, as a series of fragmented exchanges would be highly inefficient and bound to consolidate over time. I made this observation around six months ago as the private exchange wave was just getting started. From IA 05/19/2007:

If GSTrUE is successful, as I expect it will be, is there any doubt that Morgan Stanley and the like are close behind? And with the great leap forward in low latency trading technology, what is stopping a flow aggregator like Nasdaq or any ECN from pooling the deals originated on these private exchanges and enabling them to be traded more broadly? In fact, I am almost certain that this is how it will play out.

By doing this with Nasdaq, the group is getting institutional credibility, the imprimatur of a public exchange and access to a larger pool of liquidity. And it plays on the growing theme of high-quality, institutional issuers avoiding the US public markets in order to raise capital without the hassle of Sarbox. Today's WSJ article raised the shocking statistics about the extent of private issuance, the same theme I had written about in May's post:

The 144a market is enormous -- last year, the total capital raised through such deals was greater than the amount raised on the American Stock Exchange, the Nasdaq and the New York Stock Exchange combined, according to Nasdaq. The unregistered 144a securities are limited to qualified buyers because the companies don't have to follow Sarbanes-Oxley reporting requirements or GAAP accounting standards.

Here were my key take-aways from that post:

So, to recap, if:

• You have a massive pool of institutional liqudity in need of high-quality product; AND

• You have a sea of high-quality companies that would like liquidity but are put off by the regulatory demands of going public in the U.S.; AND

• You have innovative investment banks structuring these early deals between high-quality issuers and high-quality, leading-edge investors willing to buy a new and untested product; AND

• You have ECNs with capacity that can pool flow across these private exchanges and centralize trading, clearing and settlement in order to broadly and efficiently distribute product; THEN

• You get a withering U.S. new issues market that will slowly and inexorably die on the vine.

I think this is the way things are turning out. The only thing I find shocking is the speed with which fierce competitors have banded together to do the right thing for issuers and investors alike. Sometimes the private sector can, all on its own, get to the right answer, and fast. And this is clearly one of those times.

A Layperson's Primer to the U.S. Economic Crisis

I am neither a great economist nor a great markets thinker. I am, however, one who has spent over 20 years in or around the markets and have a pretty intuitive sense (IMHO) of what's going on. There is a lot of noise out there, and I'd like to try and bring a little intuition to today's landscape and to shine a light on the trade-offs our policy-makers face as we try and navigate out of the current mess. I will use the credit crisis as the launching point, raise some of the ripple effects of this contagion and ponder the dilemma faced by the Treasury, the Federal Reserve, Congress and propose steps we might take to improve our prospects.

1. The Credit Crisis

Background: The break-down of the credit markets has triggered fear and uncertainty across financial markets the world over. The crisis has triggered a profound liquidity crunch not just among vehicles supporting mortgage debt, but across a wide array of asset classes. And this has been reflected in the trading of asset-backed securities derivatives like the ABX, and the fact that supposedly "super senior" securities are trading at 80 cents on the dollar (does super senior really mean, like, BB?). And the impact is felt not only in the realm of liquidity, but in the area of financial statement integrity. Where do all of these assets live? And what about some of the more complex derivatives supporting them? We know that Wall Street firms are holding lots of this paper. How are these assets being accounted for? If one really marks their books to market and adjusts for the "Tier 3" mark-to-model securities, is Wall Street effectively bankrupt? Inquiring minds want to know. 

Impact: Mortgage lenders are scared and many aren't lending at fair and logical rates to even prime borrowers. Favorable debt markets that supported the multi-year spate of private equity buyouts has ground to a halt. Stocks across the global financial services industry have been hit hard, as announced bad news, anticipated bad news and uncertainty create an environment of pure fear. The US Fed has dropped rates to inject liquidity into the system, even in the face of an historically weak dollar and an economy that is at or near full employment and growing at above-trend rates. This has raised the issue of "moral hazard" and concerns that the Fed and Treasury are synthetically engineering a bailout of the banking sector. The crisis has also had a dramatic effect on both investors' and consumers' mind-sets, raising questions about the integrity and security of our financial institutions and related markets and the quality of the current accounting regime. This has shaken consumer confidence and created an environment of mistrust, uncertainty and volatility. The Fed, Treasury and accounting policy-makers are, in short, between a rock and a hard place.

2. The Dollar

Background: The US is the debtor to the world, and the problem has only gotten worse. Hundreds of billions spent on unproductive activities in Iraq coupled with a lack of faith in the fiscal prudence of the current US Administration has placed downward pressure on the greenback. This pressure has only accelerated in the wake of the credit crisis, as the integrity of US dollar assets has been questioned as well as the likelihood that the Fed will continue to walk rates down until the liquidity crunch abates. This makes holding US dollar assets increasingly unattractive on both absolute and relative bases, and when taken together with the uncertainty concerning US war spending, Fed policy and fiscal responsibility, it just doesn't provide an investor, be they domestic or foreign, with much incentive to go long the dollar.

Impact: A plunging dollar makes imports increasingly costly to the US consumer, putting upward pressure on retail prices and downward pressure on retail demand. This has the effect of putting the brakes on  the retail component of GDP growth. It also makes it less likely that the persistent and rising US deficits will continue to be willingly sopped up by foreign central banks, causing interest rates on longer-dated securities used to fund our deficits to rise. This will, in turn, cost the US taxpayer more to simply fund the current level of indebtedness, not to mention the likely increases arising from continued war spending and entitlement programs. And higher rates on longer-dated instruments will also make private sector capital projects more costly to fund, placing a further damper on business spending that will cyclically wane in the face of weakening consumer demand. None of this is good for the US's near-term GDP prospects, yet this weakness is happening just as inflationary pressures are building in the system.

3. The Price of Energy

Background: Oil prices are near their all-time inflation-adjusted high, causing prices at the pump to elicit "sticker shock" from the historically spoiled US consumer (as prices in Europe and other parts of the world often include an energy tax, rendering prices often 2x or more than those in the US). With China and India (but China in particular) taking up an increasing share of global oil production, demand-driven inflation is likely to be with us for a long, long time.

Impact: This is yet another inflationary pressure, and in a sense almost immunizes the effects of a Fed easing. While the US economy is becoming progressively less dependent on oil as a percentage of total output, it is still a big number and has a material effect on both retail prices and consumer psychology. Even with tremendous investment in alternative energy, the impact of these news technologies is unlikely to have a marked effect on our oil consumption any time soon. US consumers are loathe to give stuff up, but if retail energy prices remain at their historically high levels or move even higher it will cast a pall upon our growth prospects (particularly durable goods) while possibly catalyzing inflation. A bad ingredient in an already troubled stew.

A Summary

I am not one to use terms like "perfect storm" or "six-sigma events" or anything like that (since I think - sorry, I KNOW - the reality of fat tails and non-normally distributed risks), but it is pretty amazing that today's credit crisis is happening in the wake of some stuff that is totally unrelated to it but sharply impacted by it. Runaway Chinese growth and its insatiable demand for oil is not a driver of our credit crisis, nor is our war in Iraq. However, when you overlay the credit crisis on top of these two things it highlights the interconnectedness of today's flat world. Yes, China growth and war in the Middle East does impact the credit crisis, putting our policy-makers in an almost impossible spot. Focus on stable prices, protect the dollar and avoid the temptation to lower rates and let the credit markets roil as they must? Ok. But the short-term pain is simply neither socially nor politically feasible. We can argue all day as to whether or not this is right, but I am a pragmatist and I know that wasting my breath in this area is fruitless.

The Fed will do what it thinks it can do to dampen the impact of the locked-up credit markets, but the reality is that its power just ain't what it used to be. Regardless of what they do there's going to be lots and lots of pain felt by many, both inside and outside the US. We are at a time when trust in our Government, our financial institutions and our markets are at a generational low, yet we need this trust now more than ever. How else are we going to navigate an environment of forced low short-term rates, rising long-term rates, falling GDP prospects, a historically weak dollar and inflationary pressures all rolled into one? Poor navigation will lead us right into the dreaded place we found ourselves in during the latter part of the 1970's - stagflation. In short, hell on earth.

A Prescriptive

If one takes as a given that the Fed will lower rates as need be to inject liquidity into the system, what is to be done about today's confluence of adverse events? Well, here are a few ideas. I know I said I was pragmatic, but allow me to venture a bit into fantasy land. Because without a little fantasy, what would life be like, anyway?

• Stop the war. The economic destruction of the war can't be overstated. It is diverting hundreds of billions of dollars to unproductive uses, crowding out private sector investment and placing upward pressure on long-term interest rates that will have an increasingly material effect as the dollar continues its descent. The issue is social, psychological and economic. And there is no clear end in sight. The mere drawing of a line in the sand with clear time lines (and, therefore, knowable economic impacts) will have an immediate and positive effect on the markets.

• Stop stupid spending (over and above the dollars spent on the war). For some reason profligate spending has peaked during an Administration that ran on a platform of small, fiscally restrained government. Anyway, there is enough pork tossed around to feed several countries. All worthless spending needs to stop. There are plenty of productive areas in which these dollars could be diverted, be they science and math education, creating the proper incentives to fix the health care and social security systems, supporting immigration of talented and motivated individuals wanting to settle in the US, investments in alternative energy technologies, etc. The list goes on and on. And cutting or neglecting this stuff while investing in a war is just plain stupidity.

• Keep taxes low and encourage investment. David Malpass of Bear Stearns wrote a very good piece in Saturday's Wall Street Journal addressing this very issue. He provided a lot of interesting history but his punch line, creating certainty regarding low future tax rates and employing policies to make investments in dollar assets attractive, is right on target. His article specifically addressed the issue of how to stem the seemingly endless decline of the dollar, and is one of the key planks in my platform of helping extricate ourselves from our current economic plight (blight?).

• Fix the health care system - now. And while I'm on my fantasy kick - how about social security as well. While the three items above are really important and will have a very real impact on the markets, psychology and possibly even the dollar, health care and social security are the two biggest long-term challenges facing our citizenry. Talk about crowding out private sector investment and placing upward pressure on long-term rates! The trillions of IOUs and squandered resources will kill us if failure to address the first three prescriptives don't. In addition to neither being a great economist nor a great thinker I am certainly not a politician, great or otherwise, so I'll leave this issue right here. But I do know that someone, somehow, sometime soon is going to have to sacrifice their popularity and launch a full-out assault against these issues. Otherwise, we're just screwing our children. And I love my children. More than anything.

Hopefully this stitching together of seemingly disparate issues into a common fabric has been helpful. I'd love nothing more than to see a few (or more) of the prescriptives followed in an effort to get us out of this mess. Hopefully someone out there is listening. Hopefully.

Launching the Super SIV - Getting the Big Things Right

Call it an 80% solution. Call it what you will. Getting a pooled liquidity vehicle up and running - now - is far more important than waiting for consensus via "group grope" and maybe never getting it off the ground. The intended benefits of the Super SIV (or M-LEC) are pretty straightforward, but the optimization process that was being used to try and elicit support for the vehicle just wasn't working. The sheer scale and complexity of the monster vehicle was causing a form of "analysis paralysis," with each and every constituency weighing in as to what they needed in order to participate. Instead, and likely with the prodding of Treasury, they settled on a more simple, straight-forward answer in order to get moving and to begin enjoying some of the benefits of its operation. From today's New York Times:

The country’s three biggest banks have reached agreement on the structure of a backup fund of at least $75 billion to help stabilize credit markets, a person involved in the discussions said yesterday, ending nearly two months of complicated negotiations against a worsening economic backdrop.   

Officials from Bank of America, Citigroup and JPMorgan Chase reached agreement late Friday, settling on a more simplified structure than had been proposed, said this person, granted anonymity because he was not authorized to talk for the group.

In all of the comments and sound bites around the Super SIV vehicle, Treasury Secretary Paulson's messaging has evolved to sound a lot like, well, mine. From today's NYT:

Now, Henry M. Paulson Jr., the Treasury secretary, is describing the proposal’s benefits as helping “at the margin.” In an interview on Thursday, before the latest agreement was made, he acknowledged that the proposed backup fund would not rescue troubled SIVs, only lead to a longer and more orderly demise.

“This is something that is not a savior,” Mr. Paulson said, noting that he expected the fund to begin operating by the end of the year. “Anything at the margin that will speed up liquidity is worth trying.”

The fund’s organizers say it is intended to avoid a severe credit market disruption. The hope is that it will allow time for asset prices to recover, although most market analysts call that improbable. More likely, it will discourage SIVs from dumping their holdings all at once, causing securities prices to plummet.

Right. Not a panacea. Ultimate benefits uncertain. But certainly worth a try. Anything at this point that can enhance liquidity is a good thing, an important thing. This is a blurb from a post I wrote about a month ago:

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.

And this is from a post I wrote about three weeks ago:

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.

Now is a time for action. The reality is that the interconnect nature of our Wall Street and Main Street communities makes the fortunes of banks vitally important to the fortunes of all our citizenry. And while Mr. Market will ultimately determine the value of these and all other financial assets out there, a structure that helps ease the tightness of today's credit markets can only inure to the benefit of us all.

Sweet Validation of My Views on PS2

I discovered this gaming blogger Bruce - he's really smart, cerebral and experienced. But most importantly, it seems that he and I are on the same wavelength as it relates to Sony's PS2 strategy. And he really knows gaming. I just kind of know the Internet and finance. So I'm feeling pretty good about this.

His most recent post, titled PS makeover,  goes into some of the details of Sony's new version of the PS2 being released in Japan:

Sony Japan are to start selling a new version of the PS2 (the SCPH-90000) in Japan later this year which will then be rolled out to other markets in the new year. Initially it will be at the same price as the old model. This is pretty much what Sony did with the original playstation.

The reason for this is very simple, despite being 7 years old and with over 120 million sold, the PS2 still has a few years to go (three, maybe four). By re-engineering it to be cheaper to manufacture Sony will make more profit on every unit sold to help support the cash hole that is the PS3. Also it gives them more headroom to sell at lower prices, especially in emerging markets like India and China. And especially to compete with the Nintendo Wii.

Uh, yeah! Kind of like what I said at the beginning of October:

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.

And Bruce goes on to talk about how the PS2 has lots of life-cycle left, is easier to develop for than the PS3 and stands to make people lots of money during the latter phase of its life:

It is amazing that so many developers gave up on the PS2 two years ago. Then it had at least 5 years production life left in it as well as that massive installed user base. It is now well known by development staff with lots of proven tools available. So it is very easy to develop for, unlike the PS3. There is a lot of money to be made in the second half of a console lifecycle.

Bruce also has a really good post from mid-October discussing transitioning from one platform to another. Those interested in such dynamics should check it out. Bruce is a lucid thinker and a good writer. I am glad my friend Rob turned me on to him. I can never get enough of smart people with domain knowledge. This is why the Internet rocks.

A Question to Investors: Who is Failing Us?

I am beyond sick of reading about the sub-prime mortgage mess, "hidden" losses emerging from Wall Street balance sheets and CEOs being ousted for poor risk management. We find ourselves with a market environment that is very uncertain, so much so that every day seems to bring a new revelation about loss