Considering Blackstone, One Year Later

Amidst the detritus of today's broken markets, I felt compelled to look back and review some of my thoughts around the Blackstone IPO. Why? Because I had thought their filing had pretty much signaled a  frothy equity market, and certainly a top for the private equity business, due both to the "perfect" environment for raising debt capital (e.g., savvy, opportunistic issuers coupled with liquidity-rich, brain-dead investors) and that some of the smartest money in the business wanted to take chips off the table and raise permanent capital. And were willing to take this step even in the face of much criticism and consternation from their LPs and others. Cries of hypocrisy came from every direction. But still Mr. Schwartzman pressed on.

Here is an extract from a post I had written 3/17/2007 titled Blackstone Going Public? Watch Your Wallet, Brothas:

But really, what does this mean? Mostly that Steve is calling the top. Not an absolute market top, but a valuation top for his firm. Why?

• PE is just getting so big. Too big. Too much liquidity. At some point in the not-too-distant future returns will degrade. He knows this. He is sitting the catbird's seat. He's smart. We're dumb. He's the deci-billionaire, remember?
• "The real and perceived growth of the Blackstone business will slow, so let's monetize it while we can extract the momentum from the market (read: dummies like us), right? And besides, guys, it's mostly my money, anyway."
• The public scrutiny of PE returns, its place in the market, and its adverse PR will only intensify. There is a real issue with the tax treatment of management fees - logic and reason implies that this may well change. Why not monetize these on a capital gains-tax rather than a ordinary income-tax basis? This is worth billions of capitalized market value.
• That whole issue of Steve's saying for the last 20 years "Being public sucks because of costs, complexity, scrutiny, etc." applies to everybody but him because, hey, now we're talking about his money and he wants it - now.

Looking back, I'd say that I was pretty much spot on from a motivation perspective. I expanded on this thought process in an editorial I penned for the Financial Times that was published 3/27/2007 titled Why the Blackstone Offer May Signify a Bubble:

My assessment is that we are in a private equity bubble of sorts. However, it is not one that has ghastly implications for the overall market but, instead, will have negative outcomes for those invested in private equity funds - and certainly for those buying into the public shares of private equity management companies such as Blackstone.

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

As long as the debt markets co-operate, all is well. But when debt investors wake up to the fact that they are systematically underpricing risk, the highly leveraged deal structures simply will not work. Deals will still get done because private equity firms need to deploy their capital to build franchises and justify their fees but leverage ratios will fall and returns will decline. Bad for the overall market? Not really, because competition for doing deals in general will remain strong owing to liquidity considerations. But bad for private equity investors? Certainly, and now there will be one more constituency at the table: investors in the public equity of these private equity firms. Here is the rub.

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

Mr Schwarzman knows this full well, as do his colleagues at Kohlberg Kravis Roberts, Texas Pacific Group, Apollo and others thinking about following in Blackstone's footsteps. They understand that the risk/reward calculus of the private equity business (largely being borne by debt holders in today's frothy environment) could shift rapidly, closing a historically attractive window for them to monetise their franchises. They see the private equity bubble and want to extract value before it pops. But where does that leave the rest of us? Unhappy, indeed.

Let's take a quick look at the data:

GSPC S&P 500 Index

3/17/2007 (date of my first post):       1386.95

6/22/2007 (date of BX IPO):                1502.56 (+8.3% from 3/17 post)

3/28/2008 (last close):                        1315.22 (-5.2% from post, -12.5% since BX IPO)

BX

IPO price:                                           $31.00

6/22/2007 close:                                $35.06 (+13.1% from IPO price)

3/28/2008 close:                                $15.28 (-56.4% from first day close)

I think we can all look back at the Blackstone IPO as one of the definitive signs of the troubles yet to come. Mr. Schwartzman and his PE colleagues all saw the same thing, the possibility of a sea change in the debt and equity markets, but only he had the guts and the intestinal fortitude to get a deal done - fast. And his decisiveness certainly paid off in spades - for Blackstone insiders, that is. In the future we should be more aware of the signs the top tier of "Money People" are sending us. Because it was all right there for us to consider. But few people wanted to believe the end was near. Sadly, this is a fixture of the human condition, particularly as it relates to investing.

Taking a Multi-strategy Approach to Alternative Investment

When it comes to corporate strategy, I have long been in favor of more focused, single-purpose enterprises than those which take a conglomerate approach. The reason: I find the benefits of centralized management largely illusory and only introduce friction to the operation of a portfolio of businesses. Sure, there might be cost savings both in financing and materials purchases through conglomeration, but in my book these benefits are generally outweighed by lack of focus and bureaucracy. For every GE, Danaher and Berkshire Hathaway there are literally hundreds of businesses whose diversification efforts failed and destroyed shareholder value. Give me a bunch of good, focused businesses with great management and I'll do my own diversification.

This contrasts with my view of investing.  Focusing on a single asset class, regardless of how expert the manager may be, exposes the investor to either poor returns with low uncertainty (e.g., investing in Treasuries) or unacceptably volatile and lumpy returns (e.g., investing in commodities or the emerging markets). This is clear. But what about when a particular manager seeks to invest across an array of strategies, much as a conglomerate invests in a group of different businesses? Does the same "friction" argument hold that renders the multi-strategy business structure so unappealing? Done well, I think not.

The difference between a conglomerate manager and a multi-strategy hedge fund manager is clear to me, but there are some caveats. Few conglomerate managers have an intimate understanding of all their business lines, and certainly not to the depth of those managing single-purpose businesses. Balancing the administrative benefits of conglomeration with the costs of bureaucracy and foregone entrepreneurship within the individual businesses is an extremely difficult and complex dance. Conversely, an investment manager who uses their expertise to employ a range of strategies (say, long/short equity, distressed and convertible arbitrage) gains the benefits of opportunism without the costs of straying from their core competency (in, say, deep fundamental analysis).

I think the argument breaks down when managers go outside their skill sets, trying to operate like a multi-strategy when their team lacks the skills and experiences necessary to do so. So multi-strategy approaches that offer diversification and flexibility without the give-up in quality are particularly well-suited to the currently challenging and uncertain market environment. In fact, I'm not sure I can think of an environment where this approach is less appealing than a single-strategy model. Top alternative investment asset allocators (think pensions and endowments) may argue that they prefer single-strategy funds, and want the ability to allocate among the strategies employed by multi-strategy funds (as in the example above, they'd want to invest in best-of-breed long/short equity, distressed and convertible arbitrage managers separately). But this approach doesn't take into account a two important points: the ability of a top manager who is living the markets every day to make superior asset allocation decisions, and the benefits of learning that are available across a multi-strategy team. These are two powerful sources of value that are not available to the asset allocator with single-strategy funds.

But the perils of growth need to managed very carefully. As a multi-strategy fund grow, there may be times when it makes sense to run it as a portfolio of strategies (much like DB Advisors, Millennium and the like), giving the manager the ability to asset allocate based upon market conditions while providing the individual teams with more closely aligned motives than what existed in the massive single-team, multi-strategy approach. These are hard businesses to manage but with the right culture and incentive systems it can be done. But with the promise of attractive risk-adjusted returns across a wide range of investment environments, the trouble is worth it.

Valuation, Frayed Nerves and Liquidity

Needless to say, we are in chaotic times. Balance sheet values are being questioned in portfolios across all industries and geographies. The banking sector, if not being brought to its knees, has been substantially weakened due to massive write-downs. Some have called for suspension of mark-to-market accounting practices, implying that it will somehow slow the downward spiral of asset values and market prices. Others feel strongly that this would be a big mistake, and that carrying values need to fall to their market clearing level, at which point liquidity will once again enter the market. My issue is that I'm not sure either of these camps are really answering the fundamental question: what is a balance sheet supposed to tell me about a business? Value today? Value as a going concern? And what if the value today impacts the ability to operate as a going concern?

Accounting practice has gotten it largely right from my standpoint as it relates to balance sheet classification. Short-term assets are those that are likely to convert to cash within a prescribed period of time. These assets have generally been carried at market value, subject to volatility and vagaries of market prices. Long-term assets are not expected to convert to cash within the prescribed period, and are therefore subject to "lower of cost or market" (LOCOM) treatment, with an adjustment for "permanent impairment." The concept here is that the asset should be carried conservatively, and that LOCOM does a good job of enforcing that intention. The problems, as we have seen over the past six months, are two-fold:

1. What if short-term assets don't have readily observable market prices?
2. What if long-term assets don't have readily observable market prices?

If short-term, supposedly near-cash assets don't have market prices because liquidity is poor and price discovery is almost non-existent, they need to be marked down to whatever level clears the market - period. And no funny business with trying to reclassify them as long-term assets, because that's cheating. One could supposedly make an argument for reclassification if they had both sufficient funding and the intention of holding onto the securities for the long term, but it would be a very, very difficult analysis to test the veracity of these claims. Absent such a bold move, the assets have to be marked down. Way down, to market clearing levels in private transactions. No questions asked.

I think the question as it relates to long-term assets is harder. However I think the definitive test for whether or not the asset needs to be marked down is a function of one thing: liquidity. If a firm has the financial wherewithall to finance its long-term book for an indefinite period of time, and if it is difficult to ascertain whether permanent impairment has, in fact, occurred, then I think there is a strong argument for carrying the assets at cost. But, and it is a big BUT, only if the two conditions I've stipulated hold. If not, then they are, in fact, short-term assets by virtue of their inability to be financed over a long time period. But I'd also make the point that footnote disclosure - very clear and transparent disclosure - should be provided to offer investors insight into the potential divergence between carrying value and market value. But for the company that doesn't need to sell the assets to continue as a going concern,  and if they can argue that permanent impairment hasn't occurred, then the fluctuations in market value are simply moot.

The issue with today's financial meltdown is clearly one of liquidity and leverage. If the banks and investment banks thought the paper they held was good and felt the value was there, then ok. Except for one key point. By being leveraged to the eyeballs and practicing exceedingly poor gap management (the spread between the duration of assets and liabilities, where most money is made investing in long-term assets and funding them on a short-term basis), they've put themselves in the position of having to mark-to-market their troubled portfolios pursuant to the guidelines above. Because the magnitude of these portfolios are such that they can't assure the markets that they can be carried indefinitely. They can't. And it has put banks globally into a painful Catch-22. Sell the assets, lock-in their losses, substantially shrink their businesses and raise billions in new capital to reload. Or try and hold on to their assets, and play a game of chicken with governments and the financial markets. Neither picture is particularly pretty, but this is where we are.

So the answer of which accounting regime is appropriate isn't really the question. It is which fits the dynamic nature of the financial institutions business, where the management of assets and liabilities are inextricably mixed. And at a time when distressed, illiquid assets are being met by hostile capital markets, pretty much everything should be marked-to-market if logical and rational accounting principles hold. It is a sad state of affairs but here is where we are. 

(Dis)continuous Time Finance

I grew up in a time when markets were considered to be "continuous." Portfolio insurance. Robert Merton's 1987 treatise Continuous-Time Finance. Liquidity was presumed to be available. And while markets could and did gap due to an event, new information, etc., it could and would clear with transactions taking place at the new level. The financial markets, through price discovery in the presence of liquidity, conveyed valuable information that could be used for both security selection and asset allocation. The field of financial economics, as such, was predicated upon the existence of bids and offers and, therefore, liquidity. And this phenomenon was assumed to persist across time. 

But this is not the world I observe today; quite the contrary. Price movements are not only discontinuous, but the notion of liquidity across time as traditionally assumed simply does not exist. Something has happened to rock the prevailing academic paradigm. Have the experiences of the past six months essentially blown a hole through the heart of modern financial theory?

This line of thought was spurred by my friend and mentor Bill Janeway. He is working on a project with colleagues at Cambridge that delve deeply into the issue I am going to tangentially speak of. I personally can't wait for their study to be released. But in the meantime, consider what Merton said back in 1957 as it relates to capital markets:

The conscious motivation for creating a capital market is to provide the means for financial transactions. However, an objective consequence of this action is to produce a flow of information that is essential for all agents' decision-making, including that of those agents who only rarely transact in the market.

You see, the problem is that without transactions it is hard to get information, and without information it is hard for people to transact. We are caught in this Catch-22, the Fed's prescription for which is injecting hundreds of billions of dollars into the financial system. And while this creates money, it does not necessarily create liquidity in the instruments for which no bids are available. Why? Because potential investors are sorely lacking information, either intrinsic to the securities or extrinsic in the form of observable market prices. This is partly due to the complexity of the instruments in question, the structured asset-backed market and related derivatives. And while this problem is not intractable, it is easy to imagine that getting sufficient information to make educated bids will take quite some time.

Another problem is that an element of liquidity was predicated upon the faith and belief in the ratings system. A AAA-rated security was available for purchase by trillions of investment dollars, AA-rated fewer trillions, A-rated hundreds of billions, and so on. But now that we've seen tens of billions of AAA-rated securities marked like junk, the very foundations of the institutional investment model have been shaken. Trust has been shattered. No trust, no liquidity. This partly explains the strength of the rally in U.S. Treasuries, even in the face of a sharply declining dollar. Most investors aren't looking to a rating agency for comfort that the U.S. Treasury will make good (no chuckles, please), ergo, the trust issue is moot and liquidity in Treasuries is plentiful. But we can't and don't live in a riskless world. The problem is that too many investors and market intermediaries thought we did. This was telegraphed by the historically low levels of volatility during the latter part of 2006 and into early 2007.

Today we live in a world fraught with risks that we barely understand, risks that modern financial theory doesn't have great answers for. A new model is needed that incorporates the effects of discontinuity as an outgrowth of, among other things:

• Complexity - structured securities, derivative instruments;

• Interdependency - widely disseminated holdings that can pollute portfolios globally, hundreds of trillions in counterparty exposures;

• Intermediary errors  - ratings that don't reflect the risks, financial institutions with weak control environments and poor risk management practices; and

• Bad actors - originators, underwriters, traders and managers with mis-aligned motives.

We have seen examples of each of these in the past six months, seeming "black swans" that don't appear so unusual any more. It's not that these risks didn't exist before. It is that their confluence when experienced over a short period of time yielded results that were unforeseen to many. Our models and academic frameworks needs to be robust enough to handle these occurrences and to provide a model for maintaining liquidity, price discovery and information dissemination. Based upon today's market action we've got a long way to go.

Responses to my "Interesting Conversations" Post

Thanks for all the amazing and timely responses to yesterday's post. Please, keep them coming. As I am in the middle of moving it will take me a little while to get back to you, but rest assured that I will. Thanks again.

From Analysis to Experience: I'm Apple-fying

In my post about moving I left out one important detail: myself and my entire family are shifting from PC to Apple. We've been living in transition for a few years so we held off on making a platform switch, and I wanted to integrate changing computer and music environments until we moved into our new place. And tomorrow is the day.

We're getting an iMac with a giant screen for family use in the kitchen. MacBooks for my wife and boys. A MacPRO for my office and a MacBook Air for travel. An AppleTV for the family room. An Apple Time Capsule and AirPort Extreme for storage. We've gotten a taste of Apple as my older son got a MacBook last year, and I've seen first-hand how incredibly easy it is to operate in an Apple environment. I've spent so much time analyzing Apple from a competitive perspective that it's hard to believe I haven't been a user. But now I'm converting talk into action. I am totally pumped.

I am also excited to really begin using some of the cool applications that have come out since we moved into our temporary digs, like Rhapsody and Sonus. While I know some stuff about edgy consumer technology (a lot of it learned from reading blogs, with perhaps Fred being my principle teacher), my home environment has been decidedly 20th century. As I get to use all this fun stuff, experiment and try new things, I'll be sure to report back on my experiences.

Interesting Conversations Wanted

I am in the process of codifying thoughts around a potential fund. The fund will be equity long/short, with the ability to invest a portion of its assets in illiquids: early and mid-stage VC and private equity. It will have a TMT (technology, media and telecom) emphasis, but be able to deploy capital in other verticals on an opportunistic basis. As noted previously, we will work to develop a research edge through the use of advanced textual analytics and other data aggregation and filtering techniques. These insights will inform both public and private market investments. Further, a reflexive relationship will exist between insights gleaned from private investing (how public company products and markets may be disrupted) and public investing (how private companies and technologies can help address gaps in public company business lines and products).  It will also employ macro hedging techniques to mitigate market exposures in order to isolate the effects of security selection.

So my interest is in speaking with experienced buy-side analysts, especially those focused on TMT, who have an interest in this approach and are eager to brainstorm about it. Please shoot me a note at roger@iacapitalpartners.com should you wish to chat. Fun stuff.

Dealing With HazMats Can Be Dangerous

Total capitulation. The Fed caved. Per the Wall Street Journal:

J.P. Morgan Chase & Co. has agreed to quintuple the price it will pay for Bear Stearns Cos. to $10 a share, hoping to stem criticism that the banking giant was getting too sweet a deal to snap up the ailing investment bank.

The company will also buy 95 million new shares of Bear, giving it a 39.5% stake in the company and a big leg up in getting shareholder approval to approve the takeover. The purchase is slated to close by April 8.

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

Other terms of the new deal are different than the original pact, including the role of the Federal Reserve, which played a critical role in the week-old deal. Among other things, J.P. Morgan will bear the first $1 billion of any losses in financing for Bear's less-liquid assets, such as mortgage securities, with the Fed being responsible for the other $29 billion.

Sure, I get what's going on here. The Fed is trying to show that moral hazard doesn't exist here due to the shifting of $1 billion in first-loss to JP Morgan. But the point is, they caved. They've (the Fed and Bear Stearns Board) tried as much as possible to hand the company on a silver platter to JPM in order to avert another shareholder uprising. But if I'm a shareholder and am feeling enlivened and validated by the Fed's behavior, why not hold out for more? I mean, the Fed is apparently in the deal-making business; why not try and cut yet a better deal? Sure, that avenue is largely forestalled by the 39.5% share sale, but hey, get organized, get all the employees, Joe Lewis, Bill Miller and the other brutalized institutional investors to "just say no." Since we now know that hardball works with the Fed, this chink in their armor can be exploited for fun and profit. What a sorry state of affairs.

The Fed: On the Cusp of Moral Hazard

The front page headline in this morning's New York Times: JP Morgan in Negotiations to Raise Bear Stearns Bid. Un-freaking believable.

Dear readers, if my initial analysis of the JPM/BSC situation was wrong, mea culpa. But my analysis was predicated upon one key assumption: that the Fed is not populated by a bunch of morons. If they go back at this point and re-trade the deal, they will look like a bunch of wimpy, pencil-pushing bureaucrats stumbling right into the minefield of moral hazard. From Wikipedia:

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions. For example, an individual with insurance against automobile theft may be less vigilant about locking his car, because the negative consequences of automobile theft are (partially) borne by the insurance company.

Bottom line: BSC would be in Chapter 11 if not for the Fed's intervention. One can argue whether this was a mistake or not, but they elected to take draconian and immediate action to stave off what they perceived to be a clear and present systemic risk. In light of this fact, the equity was worth precisely zero at that time. BSC was dead firm walking. Nobody would trade with it. Employees were gearing up to flee. Its asset value would have rapidly eroded as values predicated upon firm reputation and people would have vanished in thin air. And this process would have happened in real time, if not for the Fed's intervention.

Fast forward to today. You've got a bunch of shell-shocked employees with lots of stock, Bill Miller, Joe Lewis and some other sad people and institutions who bought in at prices above $100. You've also got debt holders who'd rather buy deal insurance by accumulative votes to protect their claims. But you know what - sorry. To all of them. Because conveying the equity holders any value at this point is simply writing a check, courtesy of the U.S. taxpayer. This sets an awful precedent that the Fed won't soon live down, to the detriment of both the U.S. taxpayer and the financial markets in general. Because if they cave and toss BSC shareholders a bone, they'll be committing one of the most egregious kinds of moral hazard out there: the kind that didn't need to be, if they'd just stiffen their resolve and push on through.

The Art of War a/k/a Competing on Wall Street

Three articles caught my eye over the weekend that touch on a common theme: how Wall Street functions (or doesn't function). In a nutshell, there are bits of interesting insight, wishful thinking and the usual conspiracy theories flying around. So what else is new?

1. It's Hard to Thaw a Frozen Market by Tyler Cowen in today's New York Times. Mr. Cowen is a smart guy. I've met him a few times and he is definitely on the ball. His article raises some essential points to deeply understanding today's locked markets and why they've become such a huge problem:

To understand the depths of the current crisis, let’s go back to an apparently unrelated episode in economic thought: the socialist calculation debate. Starting in the 1920s, Ludwig von Mises, the leader of the so-called Austrian School of Economics, charged that socialism was unable to engage in rational economic calculation. Without market prices, he reasoned, no one knows how much economic resources are worth.

The subsequent poor performance of planned economies bore out his point. For instance, the Soviet Union did a poor job of producing consumer goods and developing innovative industries. In the absence of well-functioning markets for capital goods, these mistakes festered, rather than being rectified by the independent judgments of individual entrepreneurs.

The irony is that the supercharged capital markets of the American economy are now — at least temporarily — in a somewhat comparable position. Starting in August, many asset markets lost their liquidity, as trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities has virtually vanished.

Market prices have been drained of their informational value and thus don’t much reflect the “wisdom of crowds,” as they would under normal circumstances. Investors are instead flocking to the safest of assets, like Treasury bills.

This last paragraph is a particularly important observation. I've been asked many times about "wisdom of crowds" and how they reconcile with company valuation, and my answer has always been "look at the stock price." Well, to Mr. Cowen's point, that isn't so helpful across a wide swath of the market right now. In the absence of a broad and deep market with a wide array of participants, price discovery is difficult if not impossible. Next, Mr. Cowen shines a light on why this problem is so acute for our financial institutions, and the answer, not surprisingly, is leverage:

This gridlock is especially harmful because leverage is so high, and financial institutions are so interconnected through swaps and loans. Institutions that rely so heavily on debt are precarious and need up-to-date information about valuations. When they don’t have it, markets freeze up. This is what has taken policymakers by surprise and turned a real estate crash into a much bigger financial problem.

The issue of leverage and interdependency is one about which I've written many times. This substantially ups the ante for all market participants, the Fed included. And the current gridlock and lack of real price discovery (given the absence of transactions) does not reflect well on the U.S. markets. And whether prices need to plummet to get activity going again or the Fed's massive liquidity party catalyzes a thaw in the markets, somethings got to give. Because the status quo reflects the utter non-functioning of a significant part of the U.S. financial markets.

2. Dimon Requests Freeze On Hiring Bear Advisers in yesterday's Wall Street Journal. Now I have quite a bit of respect for Jamie Dimon and how he's steered JP Morgan Chase, but this is mamby-pamby nonsense. This was part of the deal, Jamie. You got what you perceived to be a sweetheart but there were going to be some headaches.

Mr. Dimon is "basically saying, 'We're trying to help the system [with the Fed-backed takeover], and you're taking advantage of our gracious action. All is fair in love and war, but this is not a usual merger situation,' " said David Hendler, an analyst at CreditSights, a stock-research firm in New York.

Puh-leeze. This is no different than any other merger situation. Except that you've been given a $30 billion make-whole courtesy of the Fed and a few valuable options in the event you don't like how things are playing out (buying 20% at $2, option on the building). Part of what constitutes what I call "hard book value" is the ability to retain current staff and preserve franchise value within the key business units. This was a risk you supposedly priced in to the deal. And now you are asking your Wall Street brethren to back off because you want time to sign your own guys? Speed was a precursor to getting the package you got from the Fed, Jamie. You don't get to pick and choose what happens quickly and what happens slowly. If you are worried about losing key staff, sign them up. Now. Work 24/7, whatever it takes. But don't ask your pals to lay down their arms. You know the game. Play it right and play it fair. And no whining, please.

3. Making Sense of a Scared New World by Ben Stein in today's New York Times. I'd really like to see Nassim Taleb take a crack at de-bunking Mr. Stein's missive today. His logic is weak and pathetic even by Mr. Stein's not-so-lofty standards. Mr. Taleb would have a field day. One brief persual of The Black Swan is all one needs to understand why Mr. Stein's piece is intellectually bankrupt . This is the crux of Mr. Stein's argument that hedge funds are evil villains that have caused a goodly part of the current financial crisis:

The new part is the hedge funds and the changing of Wall Street from a financing entity to a market manipulation entity. The new part is hedge funds with (supposedly) $1.5 trillion in capital, immense hedge funds within banks and investment banks. The new part is that they have so much money and so much selling power that they can do what capitalists really want and love to do: to make money not by betting on the markets, but by controlling the markets, by putting so much sell side (and occasionally buy side) firepower in play that they know they will move the markets. This takes all that annoying uncertainty out of it.

The task of the hedge funds is to find a weak spot in the market, and to put so much pressure on it that they can move it down, scare other players into selling (with the endless help of guileless journalists), wreak havoc with the markets’ indexes and then create that much more selling. Once the process starts rolling, it’s shooting fish in a barrel.

Making money by controlling the markets, huh? Hey now, Ben. Never really thought about it like that. I've always thought that markets generally reflected the value of a security, with the actual trading level oscillating around intrinsic value over time. But what you are implying is that hedge funds can push so hard in one direction as to bring a firm to its knees that doesn't fundamentally deserve to be there.

Consider this, Mr. Stein. What about George Soros, the Bank of England (BoE) and "Black Wednesday" in 1992? Mr. Soros couldn't unilaterally cause the pound to pull out of the ERM if it wasn't fundamentally mispriced. Sure, he pushed, and the market went with him because his actions reflected the true underlying value of the currency. Did the BoE deserve for this to happen? Yes. The ERM was a charade.

Did Bear Stearns deserve its fate, given how it was being managed, investor concerns about its portfolio risks and its liquidity profile? Yes. Was this due to those mean hedge funds ganging up and pushing it to the brink? No way. If the value was there buyers would have stepped in and pushed in the other direction, getting a mispriced security for cheap. But that's not what happened.

What about MBIA and Ambac? Bill Ackman of Pershing Square has been on a 5+ year jihad against the companies and the space in general, arguing that the business model was fundamentally flawed and the companies effectively bankrupt. He had to hold his short for a long time before it eventually paid off, and it paid off huge. If he and his peers were so powerful they would have driven the stock into the ground back in 2002-03. It didn't happen. Why? Because his hedge fund brethren and other institutional investors weren't convinced until the past year, when the stock began to tank and its problems fully came to light. People acting in their own self-interest. This is what makes markets function.

You see, Ben, there are two sides of a market that is functioning, the buy side and the sell side. Those on the sell side win if they sell at prices above what the franchise is truly worth. And in the case of Bear Stearns, as with most other financial institutions, there is a massive difference between short-term "give me my money now" value and long-term "let the value of my franchise play out" value. But the key thing for a financial institution, as with any bettor, is to have a bankroll large enough to let it live beyond the short-term. And in the case of Bear Stearns and perhaps some others, they didn't size their bets properly (in light of their leverage) and keep a sufficient amount of liquidity on hand. Is it the hedge fund industry's problem that they happened to recognize this and lean against its stock price? No. It was highly rational and it ended up doing what was perhaps necessary: getting a new group of better-qualified people to run the business. Because incumbent management had been doing a really, really bad job.

Next time, Ben, when you feel the urge to let conspiracy theories get the better of you, take a deep breath, drink some calming herbal tea and perhaps go for a run. Because you need to get out and see the real world. Because the world you are writing about exists only in your head.