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.