Startup Depression? Nah.

Jason's missive notwithstanding, I'm seeing something distinctly different. Sure, its harder to raise money. Sure, the osmotic effect of bad feelings in the public markets and the job market challenge one's optimism and perspective. But net net, opportunities abound, the same if not better opportunities then before the financial markets started to melt down. The crisis forces the survivors to place an even greater emphasis on efficiency, customer intimacy, value creation and relevance. Historical ways of doing business are being challenged by new ways of accessing content, the push towards open-source solutions, the different ways in which influence is created and disseminated and the high-value goods and services being created and delivered from low-cost, offshore sources. In today's world you are either moving forward or moving backward - stasis is not an option. Inertia is death. And it is at this intersection of creativity, intensity, customer knowledge and cost efficiency where start-ups can step into the breach. And they are.

The entrepreneurs I see every week are filled with energy, passion, good ideas and a laser focus on keeping costs low, not because the environment sucks but because they know this is they way it should be done. Develop a prototype. Put it in front of users/customers. Set a product development road map based on modest resource assumptions, rapid product iterations, intensive user feedback and a financing goal 12-18 months out. From this comes milestones that can be used for product planning, staffing, going-to-market and financing. Pretty similar, in fact, to the 10 points Jason raises in his post. His points are all really good points. But I don't see them as points related to today's environment. I see them as they way entrepreneurs should be establishing and running their businesses, all the time.

Fred also penned a very interesting and valuable take on Jason's post, a portion of which I'm sharing below:

So if you run or work in a startup company that is backed by well established venture capital firms, take a brief sigh of relief and then immediately get working on the "leaner, focused, profitable" mantra and drive toward those goals relentlessly.

If, on the other hand, you are just starting a company, or have angels backing you, or are backed by first time venture firms that are not funded by traditional sources, then I think you've got a bigger problem on your hands. It's not an impossible problem to solve, but you have to start thinking about how you are going to get where you want to go without venture funding.

I say that because in down market cycles, it's the seed and startup stage investing that dries up first. It happens every time. Seed/startup investing is most profitable early in a venture cycle and late stage investing is most profitable late in a venture cycle. It makes sense if you think of venture capital as a cyclical business and it is very cyclical. Early in a cycle you want to back young companies at bargain prices and enjoy the demand for those companies as the cycle takes hold. Late in a cycle you want to back established companies that need a "last round" to get to breakeven and you can get that at a bargain price compared to what others paid before you. I've been in the venture capital business since 1986 (that was a down cycle) and I've seen this happen at least three times, probably four times now.

There's another important reason why seed and startup investing dries up in down cycles. Venture firms don't need to spend as much time on their existing portfolio companies when things are going well. A rising market hides a lot of problems. But when things go south, they tend to become inwardly focused. I believe we are headed into a period where venture firms will spend more time on their existing portfolio and less time adding new names to it.

Now Fred has seen a lot more of this than I have, and I agree completely with what he's saying. New start-ups shouldn't be focused on getting that institutional round done because the bid may simply not exist. But I also think that the angel and seed stage investment community is far more developed and far deeper than it was even back in 2001-03. There are groups of ex-Googlers, DoubleClickers, and many other savvy entrepreneurs that enjoyed successful exits that are putting money to work in early-stage deals, and these groups have deep pockets, are real value-added, and can help down-cycle start-ups with both revenue generation and strategies for surviving another VC nuclear winter. While not exactly like a classic VC, they can bring many of the same benefits to the table with a greater appetite for risk. 

So am I saying "it's different this time?" I suppose I am. I'm not sure how many people like me were around doing deals 6-8 years ago, but I can say for sure that there are a lot more of me now then there were only four short years ago. And these people know that risk-adjusted returns on seed stage investing are very attractive, and that valuations will become increasingly rational as the sources of liquidity dry up. We're not going anywhere. And as long as that's the case, excellent start-up prospects will continue to get funded and grow, even in today's hostile environment. So don't get too depressed, because the strong will continue to get funded, survive and thrive. And the weak? Well, it will be a quicker and less painful death, and that is a good thing, too.

Why Have Things Gone So Wrong?

Lack of transparency. Intellectual dis-honesty. Failure to read the pulse of the nation. In my adult life I have never seen a backlash so powerful or so well-timed as this. The voting public called bull#$%& on Hank Paulson, the President, Congress, Ben Bernanke, and anyone else associated with the current proposal, right in the midst of an election year. It could have been so easy. See problem. Identify key elements of problem. Quantify magnitude of problem. Develop plan to address problem in conjunction with needs of key constituencies. Clearly and thoughtfully articulate the plan to solve the problem. Put plan on floor of Congress. Pass plan. Implement. Repeat if necessary. But this is not how it came to pass.

I have been a Paulson supporter since his appointment. But he has bungled the handling of the bailout worse than an intellectual midget. This is one circumstance where IQ points, hubris and ego served as a barrier to success. He was so convinced of his righteousness and correctness that he didn't listen. During an election year. In the midst of one of the most severe financial crises this country has ever faced. He simply missed the boat. He didn't have a read on the pulse of the country. And it cost his bill passing Congress. And perhaps his job as well.

I said it at the beginning of the crisis and I'll say it again: the voters, the people paying for the plan, need to trust its makers and need transparency for that trust to be cemented in their minds. Seems obvious. Seems fair. But this is not the way Secretary Paulson or his pals read the situation. They wanted supreme powers. They wanted to avoid judicial review. They wanted to steer clear of compensation caps. They couldn't have been more wrong, either on the issues in a vacuum or in light of the needs and desires of their constituents. Market Value. Repeat after me - M A R K E T V A L U E. This is what can and should be paid for liquifying toxic balance sheets. Not a penny more. The mere fact that Mr. Paulson has been fighting against this tooth and nail has only destroyed his credibility as a bright, pragmatic thinker, a leader that can get us out of this mess. Instead, he reads as a pandering ex-Wall Street executive, a man more concerned with preserving the status quo than helping usher the financial markets into a new, more customer-focused and risk-managed phase. This is a world that can still be profitable and create value for customers, employees and shareholders alike, but perhaps at a lower level and with more stable returns. Not a bad thing. And just maybe a really good thing. But this is not what lies deep within Mr. Paulson's heart. The days of yesteryear are what he still pines for.

If Secretary Paulson can't adjust his thinking, and put transparency and clarity first, he should step down and make room for someone who can. At this point the job is less about rocket science and more about doing the right thing for those to whom much wrong has been done - the U.S. taxpayer. They are going to get us out of this and they are the ones who should benefit. Unfortunately Mr. Paulson hasn't seen it this way so far. Hopefully, he'll be able to set his ego and personal interests aside and use his substantial intellect and aptitude for good.

What is Hank Thinking?

It's only Monday morning and two items have already hit my BS detector:

1. The ability of the SEC to suspend mark-to-market accounting rules on a case-by-base basis. From today's New York Times:

While the bill does not drop the accounting rule that requires banks to report on the market value of their assets — a rule that some banks believe has forced them to report excessive losses — it gives the S.E.C. permission to suspend the rule for any individual company if it thinks that is in the public’s interest. That is likely to lead to intensive lobbying of the commission.

2. Citigroup's acquisition of Wachovia assets with the FDIC's assistance. From this AM's Wall Street Journal:

"The FDIC has agreed to provide loss protection in connection with approximately $312 billion of mortgage-related and other Wachovia assets," Citigroup said in a statement.

The Federal Reserve and Treasury Department were also part of the effort, another sign of how proactive the government has been in preventing ailing financial firms from failing and instead pushing for stronger firms to acquire some assets of the weaker companies.

I am a detailed-oriented transparency junkie who believes that aligned motives are always essential for success. Unfortunately, these three elements of goodness are not present here.

Suspending MTM accounting. I know, let's commit $700 billion to doing the right thing and undermine the entire program by sewing seeds of doubt. There is absolutely no reason, logical or otherwise, for why the Government would fund or buy assets at prices other than at market clearing levels. Because you can't fake solvency. As I've stated, ad nauseum, long-term asset values are meaningless unless you have the capital structure to hold it for the long term. And, sadly, it is all too clear that few institutions have a liability structure that matches their asset duration. If you make your bed you should lie in it, which means moving busted assets off the balance sheet, cheaply, at market value, and filling in the capital gap with a senior convertible instrument that sits above current debt and equity holders. Net net, the same liquidity profile as if Hank bought the assets at carrying value (a fiction, to be sure) but with a shift in economic ownership from current debt and equity holders to the U.S. taxpayer. Seems fair and proper given that it is our money doing the propping up. I am just aghast at the insistence of keeping such a conflict-laden provision in the bailout bill. This isn't a feature of a Splurge - it is out and out theft. For the sake of credibility and integrity of the entire program, this little tidbit has got to go. Otherwise, there will always be questions of who got a sweetheart deal. And Secretary Paulson doesn't want that as part of his legacy, does he?

Helping Citigroup buy Wachovia. So let me get this straight; we (the collective We) and providing a subsidy to Citigroup to better manage the assets of Wachovia than if Wachovia itself were buttressed through the new program? It seems to me that the decision should turn, first and foremost, on the strength and credibility of management. Are we really comfortable that Citigroup's management, which has made perhaps one good decision in the last five years (raising $50 billion - and fast), has the wherewithall to manage this even larger Goliath? What evidence have we seen that this might be the case? Now, if you told me that Wells Fargo was the buyer, I might feel differently. But this seems like the case of consolidating a bunch of crappy assets under a decidedly mediocre management team in order to claim a win for the current Administration and the U.S. taxpayer. Bull*@%^. All we're doing is potentially upping the cost of a subsequent bailout instead of taking care of Wachovia cleanly and in a straight-forward manner - now. Why make the hard choices now when you can punt for another day? It feels like Social Security all over again.

Snatching defeat from the jaws of victory. Nice job, guys. Let's hope there is some more astute decision-making as this bailout takes hold. Because so far, I am anything but impressed.

Don't Bail out Wall Street; Re-invigorate Main Street

Needless to say, Messrs. Paulson and Bernanke's $700 billion rescue package has ruffled a few feathers on Wall Street, Main Street, and the Legislative and Executive branches of the U.S. Government. Some say "Do it now or else we'll have financial calamity." Others say "$700 billion to bail out Wall Street? They're the ones that got us into this mess in the first place." Emotions are running high and, I'm afraid, many people are losing sight of the main point: frozen credit markets inhibit small and large businesses from borrowing money, people of all economic strata from buying apartments and houses, and those in financial distress owing to inappropriate mortgages from refinancing. Commerce has slowed due to massive uncertainty and the ripple effects of the credit crisis throughout the U.S. economy. This is not (or, more properly stated, SHOULD not be) about Wall Street, it is about Main Street, and the average, hard-working citizen's ability to live their life without economic fear not of their own doing.

"Bailout" is clearly a pejorative term and has been bandied about when referencing the "recommended" solution to the current crisis. What I have in mind is not a bailout, per se, because its effects aren't bailing out those institutions and executives that screwed up. It is a loan. A loan with interest that gets repaid over time. With equity kickers. The U.S. taxpayers will own a loan plus warrants, and in exchange will get a credit system that can once again function and support both business and personal economic growth. But the key is in the design. A design, as I've stated previously, that takes troubled securities from troubled institutions at market value, buys senior convertible securities (senior to existing debt and common stockholders) to bring capital ratios up to compliant levels, works to restructure and simplify personal mortgage loans that enable credit-worthy borrowers to remain in their homes and works out the securities purchased over time. My vision is not a transfer payment to Wall Street, but a vehicle for re-energizing and re-invigorating Main Street.

A very bright and thoughtful man, Tom Evslin, wrote a post where he has changed his position on the bailout concept. I've read Tom for quite some time and he is very cerebral and intelligent, and if he has something to say I listen. That said, I disagree with his post and his reasoning, because I think he's missed the gravity of the current situation and its close linkage with Main Street. There are elements of his plan, however, with which I passionately agree, though don't believe they can be dealt with at the current time. I've copied the text of his post here and I've made my own comments in bold.

I've been wrong to advocate hedging the bailout bill with conditions; we should just say "NO".

We can take a fraction of the $700 billion dollars we save and use it for specific anti-recession measures. Let's start rebuilding our power grid; fix some bridges; maybe even help some homeowners with their mortgages where warranted. But no bailout for Wall Street; none.

The plan, well-structured, wouldn't be a bailout of Wall Street as discussed above. The mortgage assistance piece is part and parcel of a sensible package in any event. I fully agree with the infrastructure spend; I've written about it at length. I just think we shouldn't be bundling this until we've fixed our current financial plight.

If we say "yes" to the bailout bill, the Dow will go up. Great time to sell your stocks because we will have damaged the economy and our competitiveness for a long time to come.

Stocks going up is neither here nor there to the logic of the plan. Credit markets need to unlock. Commerce needs to take place. Mortgages and business loans need to be issued. This may, in fact, cause the market to go up. But it may not. The short-term uncertainty about prospects for the dollar, the possible rise in oil and other commodity prices might place a damper on the euphoria. But bottom line, it isn't the point.

If we say "no" to the bailout bill, the Dow will plummet – for a while. Big deal; that's what the Dow does; it'll create a buying opportunity.

Maybe, maybe not. There are too many degrees of freedom to confidently project the intermediate-term prospects for U.S. equities.

If we say "yes" to the bailout bill, the dollar will plummet. That $700 billion to bailout the world's financial institutions comes from printing more dollars and devaluing every dollar already in existence. A plummeting dollar means higher imported energy costs. That really hurts Main Street, the real economy, and national security.

This may happen. But, as with the uncertainty surrounding equities, it may not. A poorly-designed plan that looks and smells like a Wall Street bailout will invariably cause the dollar to tank and Tom's worst fears to play out. But if designed well, where the U.S. taxpayer is monetizing the liquidity option and holding an attractive ROI piece of paper, and the credit markets do once again begin to operate as they should, the dollar could potentially go up as expectations of future growth outweigh the near-term creation of dollars.

If we say "no" to the bailout bill, investors like Warren Buffet and Bank of America will continue to pick up assets from distressed banks cheaply. More power to them; they can deal with the problem of overpaid executives. They are showing us the right way out of this mess.

This really hasn't happened. The kinds of assets causing the greatest problems simply aren't moving, and haven't moved for months. This is the whole point of putting this plan together in the first place. In fact, here is the extract of a comment I wrote tonight about a recent post:

Chip, that is one awesome comment. You raise a great point. But here is my retort. if, in fact, these mortgage securities are so terrific, or at least appreciably better than the current bid, and there is hundreds of billions of liquidity sloshing around SWFs, Berkshire Hathaway, private equity firms, distressed hedge funds, etc., then why aren't they buying these securities up by the truckload? The system should be self-equilibrating if the securities get too cheap, yet somehow there just isn't a bid. This can't fully be explained by firm capital structure, which means something else is at play. Like the securities really are CRAP. Lone Star only took these off Merrill's hands at $.22 on the dollar, and required Merrill to provide $5 billion of seller financing. Something is amiss, and it happens to be on both sides of the balance sheet. A highly leveraged, short-duration capital structure supporting illiquid, crappy assets means only one thing: you're going bust.

Normally The Wall Street Journal would have been against the bailout on economic terms and The New York Times against it on populist terms. Apparently our two great national newspapers are too much the hometown newspapers of New York City to see straight. When you look out the windows of their editorial offices, you're more likely to see out-of-work bankers and empty restaurants than people struggling to pay for gas and home heating oil – or to keep their small businesses running or stay in their homes. So we have to do without their leadership on this issue.

Yikes! Your looking for leadership from them? Come on, Tom. It's not about being populist, it's about being political. I think they see both sides of the coin, for what it's worth. Not that it matters, however.

Fortunately three out of the four candidates in the Presidential sweepstakes are senators; they have to vote on the bill (unless it dies in committee). My vote for President is up for grabs. If there were contested house or senate races in Vermont, my vote for them would be up for grabs as well.

The upcoming election gives us a chance to save ourselves from the horrendous mistake this bailout bill would be. Don't wait for the pollsters to call; write your senators and congressperson today.

A bad bill would be bad. A good bill would be good. I think what I'm suggesting is good. Not bad.

Bottom line, I think the system would remain too jammed for too long simply letting things play out on their own. Now I am a free markets guy. I grew up in the markets. Love the markets. Believe in the markets. But this market is badly broken, and it needs a bridge loan to begin the healing process. And this can and must be structured in a manner that achieves the objectives without unfair and inappropriate bailouts. The devil is in the details. But to toss aside the call for action is, in my opinion, playing a dangerous and unnecessary game.

NB: My friend and sharp financial thinker Paul Kedrosky has raised many good issues on this topic. Please do check out his thread on the topic.

And on the Lighter Side of Things...

I need a little break from writing about such heavy topics such as billions for bailouts, bumbling bureaucrats and balance-sheet blow-ups. So here a few topics on the lighter side of life.

Congratulations to the Soren, Howard and the StockTwits team on closing its angel round. I am very excited to be working with these guys, along with my Betaworks friends Andrew Weissman and John Borthwick and my MyTrade (now thinkorswim) pals Andy and Landon Swan. Simple. Elegant. Lightweight. Yet powerful. I've never been quite so close to a consumer-facing Web 2.0 application, so I am super excited to be learning from such successful entrepreneurs and investors and hopefully adding some value along the way.

Congratulations to Alan Levy, founder of BlogTalkRadio, on his massive lead in the Silicon Alley 100 voting. I am both an investor in and Board Member of BTR, and have seen Alan's passion and brains first-hand. In short, he is a force of nature. Alan's rock-star status pales in comparison to my lowly 72 ranking. He's the real deal. I guess our relative rankings prove that those who can't do - invest (I know that doesn't apply to many but it certainly does to me).

Congratulations to the entire Silicon Alley ecosystem. Even in the face of an absolutely horrendous financial environment, I continue to see plenty of interesting and worthwhile business plans sponsored by bright, passionate, hard-driving entrepreneurs. Regardless of what is happening on Wall Street, I can't help but feel that Silicon Alley's momentum simply can't be stopped. There are too many industries to disrupt and fix, too many ads to serve, too many trends to be spotted. And it's all happening right here. In NYC, baby. Even if Yankee Stadium is dead and gone Silicon Alley is just getting started.

That's all for now. I feel much better.

Transparency on Trial: The Shift Towards Exchange-Traded Derivatives

Of all the lessons to be learned in the wake of the global financial crisis, I believe lesson #1 has to be:

PORTFOLIO TRANSPARENCY IS ESSENTIAL; NOT OPTIONAL.

Part of this has to do with enforcing more stringent disclosure rules, and consistently applying mark-to-market rules across portfolios and firms. But the other part is more structural. The worldwide financial services boom of the past 20 years has largely happened off-balance sheet, in the realm of the over-the-counter (OTC) derivatives market. When we talk of bank, investment bank and insurance company balance sheets in the hundred of billions of dollars, with a few firms having broken the trillion-dollar mark, these amounts pale in comparison to the tens (hundreds?) of trillions of notional value of outstanding OTC derivative contracts. Nouriel Roubini talks about the "shadow banking system;" the real shadow banking system is the OTC derivatives market, greater in scope than anything we could have imagined a mere two decades ago, creating risks and opportunities of a mind-boggling scale.

The key question is to be answered is:

Do we really have a firm grip on the exposures arising from these opaque agreements, and understand how these contracts lead to a deeply interconnected (and, therefore, highly correlated) financial system that can collapse if only one link in the chain gets broken?

Sadly, if the events of the past few weeks are any indication, the answer to this question is certainly not.

I spent some time thinking about this in June 2007, when I was concerned about the true amount of risk embedded within dealer trading books:

Wall Street risk management practices and infrastructures have been substantially upgraded over the past 10 years, partly due to the fact that risk manager compensation levels have shot up as its importance in the money-making process (either by protecting against financial loss or guarding against the "headline risk" of a blow-up) has become apparent. And this is completely appropriate, and more so due to the skyrocketing OTC derivatives volumes churning through the system. The question is: what is the true extent of the residual exposures being borne by the Wall Street dealer community, and how is revenue being recognized relative to the ongoing exposures carried in dealer trading books?  VaR won't tell you. These numbers simply aren't available. This is just something to keep an eye on as more and more asset hedgers look to buy optionality. Because someone will be booking these hedges. And they will be in sizes far in excess of those available through the listed markets. Which leaves the dealer community. Hmmm...

One of my key concerns then was the lack of depth of the listed derivatives markets, and that the bulk of risk management activities would happen in the shadows off dealer OTC desks. I'd say that prediction has pretty much come to pass.

This past May I thought more concretely about the importance of a deeper, more fully-developed exchange-traded derivatives market to deal with issues of transparency, rising trading volumes, exploding credit exposures and non-standardized documentation:

I find it useful to think about ideas by stressing the extremes, e.g., how did things used to be and how might they look at infinity? And to me it is inevitable that, at infinity, almost all transactions will be done on exchanges. Why? The benefits simply outweigh the costs, and there are a number of catalysts in place to support this conclusion: increasingly global and liquid markets; inexorably rising transaction volumes; much larger credit exposures; the difficulties with counterparty credit review; increasingly intertwined financial systems; and the blizzard of paper required to trade OTC with more and more counterparties. Over time, the inefficiency of the OTC market will cause it to take a back seat to the exchanges, and this is a trend that will build momentum over time. Think about Toyota versus GM. Who could have imagined Toyota's success three decades ago? And now they are pulling away. This is how I think of the exchange model versus the OTC model. The changing of the guard is inevitable. Just wait and see.

What I said in May is even more true today, and the reasons I cited for why a move towards listed derivative exchanges has to happen has been validated by the financial melt-down. Would AIG have gone down as it did if its derivatives book was largely executed on an exchange, with full transparency and price discovery? I doubt it. If exchanges were the central clearing-houses for derivatives transactions, would we be worrying so much about counterparty exposures and the interconnectedness of these exposures? No. Opponents to this plan will say "we'll lose the ability to customize our contracts." In a 100% exchange-traded world, yes. But there are two valid responses: (1) almost all complex risks can be decomposed into an array of simple and straight-forward risks that can largely be hedged; and (2) if not, OTC contracts can still get done, just with a far higher degree of disclosure and transparency than has been required previously. I'm not suggesting that all derivatives transactions either should or can be moved to exchanges; but I'd wager that at least 80-90% of current OTC volumes can.

This means that global exchanges have a massive opportunity in tomorrow's world, where derivatives trading dwarfs listed and OTC stock trading volumes. This also means that investors and other consumers of financial statements will have much greater clarity on this off-balance sheet exposure, and the risks that have exponentially risen every year since the mid-1980s but with little transparency as to its amount, character and counterparty concentration. Given the re-engineering of our financial system in light of the current criris, now is the right time to shine a bright light on this critical issue and to effect change. This is one trade where nearly everyone wins.

On Bank Holding Companies and Bailouts

BHC or Bust

The news that Goldman Sachs and Morgan Stanley are in the process of becoming Bank Holding Companies (BHCs) doesn't come as a complete surprise. If these firms were to remain independent, they had to radically reposition their balance sheets by bolstering capital and lengthening debt maturities. Further, the trend towards greater transparency is already afoot, so the kinds of disclosures required under the BHC Act were in the offing, anyway. Finally, by become a BHC you have access to the Fed window, access of some consequence given today's tumultuous market conditions. So by becoming a Bank (with a capital B) in the regulatory sense of the word, Goldman and Morgan Stanley are choosing life, with the chance of remaining independent. The question is - what kind of a life will it be?

One of the best things about being a Bank is the ability to take deposits. Few things are better in liability-land than core deposits, that sticky, low-cost source of financing that makes every other industry drool. Having deposits as part of the capital structure means that unless you screw things up pretty badly, you've got a stable, long-term source of funds to help support investment activities. But I have two questions when thinking about the former Houses of Goldman and Morgan Stanley becoming banks:

1. Are they really going to take in core deposits and run branch networks?; and
2. If so, is the FDIC (and, by extension, taxpayers) on the hook if the banking side of the house blows up?

Is the Glass (Steagall) Half Full or Half Empty?

In the topsy-turvy world of bailouts and rule changes, are the principles of Glass-Steagall gone forever? Is the FDIC effectively backstopping trading activities? If so, this is both wrong and terribly dangerous, yet another way of privatizing gains and socializing losses. If this is path the Fed, Treasury and Congress want to take (by having former bulge-bracket firms become BHCs), then I'd recommend very clear fire-walls between the banking and trading and deposit-taking sides of the house. If stock and bond holders buy paper in the Bank, and if trading does badly, they should suffer - not the taxpayer. Otherwise, we'll just be perpetuating the asymmetry between private investors and the U.S. taxpayer (heads I win, tails you lose).

But what of the "new" Goldman and Morgan Stanley's business activities? The cost of capital just skyrocketed because of forced de-leveraging, and by now becoming BHCs this deleveraging is a permanent state of affairs. They need to be much more capital efficient and to focus on high-margin businesses. Asset Management. Private wealth management. M&A advisory. Restructuring advisory. Trading portfolios that are highly diversified with buckets of orthogonal risk. Otherwise, these firms will establish an entirely new - and lower - level of base-line Returns on Equity, and will begin to trade at multiples of book that are more bank-like. Question is, will this business mix restructuring lead to a place that is less attractive to top performers? Will top traders want to live inside this kind of institution instead of hedge funds? Will advisory pros rather be at this kind of firm or at a Greenhill, Lazard, Evercore, or one of a scad of new vertically-focused boutiques? As noted previously, I believe we will have a small number of global capital markets behemoths that will run the capital formation process for the largest companies (as an oligopoly), and a large number of boutiques focusing on advisory services, private placements, alternative investment management and perhaps the high end of private wealth management. Will Goldman and Morgan Stanley make the jump to behemoth (with a more stable, longer duration capital structure to support such a business) or pull back on focus more intensively on high fee-generating, less capital intensive businesses? I'm guessing they'll go for being a behemoth but it is not clear that this is ultimately best for shareholders.

Bailout 2.0 - Just Give me your Tired, Your Weary...

And what about the bailout plan? Without question, the pure 1980s RTC structure was easier to implement because the Government simply took over the assets and liabilities of failing firms and worked them out. But in a regime where this is not viewed as desirable from a regulatory perspective, complexity needs to be dealt with fairly and with an eye towards the ultimate goal: getting the wheels of the credit markets going again and enabling mortgage debtors who are able to pay a restructured obligation to stay in their homes. Mechanically, I see it happening as follows:

• The Government-sponsored bailout vehicle (Principal Loan Origination Program, or PLOP in my vernacular) sets parameters around pools of assets it is willing to purchase. This approach is similar to a bid sheet in a program trade - tell me the characteristics of the portfolio, and I will make you a price. This is an efficient way to get bids and offers on a hetergeneous pool of assets. This will likely include illiquid mortgage securities, leveraged lending commitments and derivatives held by troubled firms.

• PLOP collects offers, and either starts from the bottom and buys them up or sets a single clearing price that is paid to all parties. This will ensure transparency and fairness; the after-tax difference between the PLOP price and the carrying value will be a direct reduction of book value.

• The gap between post-sale book value and regulatory capital requirements will either be sourced privately or through the PLOP. If through the PLOP, it will be in the form of a convertible debt instrument or debt + warrants senior to both debt and equity holders. This reflects the fact that taxpayers are giving this firm life, and should benefit from its rebirth after being recapitalized.

• The PLOP will work out troubled assets over time, and will eventually float the equity participations it receives in the firms it has bridged.

One thing is for certain: the Wall Street tomorrow will look very different than the Wall Street of today. A handful of global giants. A large number of profitable, focused specialty boutiques. Quite similar to the trend in the hedge fund industry. The barbell is the shape du jour. Very big and quite small. Both can and must exist. But the middle, once again, will get squeezed.

Note:

A more thorough and cogent take on the mortgage piece is provided by John Hussman. It is definitely worth a read.

 

Paying for the Bailout: In Defense of the U.S. Taxpayer

Avoiding "Free Riders"

Exactly how the U.S. Government will pay for bolstering the calcified credit system is still up for grabs. But there is one thing for sure: if the Executive and Legislative branches are concerned with ethics, morality, and the well-being of the everyman, they will think long and hard about the details of how capital will be provided. Because based upon Friday's market action, investors are expecting a bailout of institutions deemed "too big to fail," with benefits flowing directly to those firms' equity holders instead of the U.S. taxpayer who is providing the funds. This is clearly at odds with free market principles, as the common stockholders become "free riders." Does this need to be in order to stave off financial catastrophe? I'd say not. And whoever says this is the case has something to gain, like being bailed out from poor investment decisions. Those at Treasury, the Fed and Congress: JUST SAY NO.

Robin Hood in Reverse

Here are some thoughts following Friday's surge across certain financial issues from the New York Times:

The news quickly revived investors in those and other firms. Lloyd C. Blankfein of Goldman Sachs, for example, did not seem to need a rapid infusion of capital for his firm. Irreverent commentators pointed out that Goldman’s former chief executive, Henry M. Paulson Jr., now the Treasury secretary, had administered medicine that would, as it turned out, help his old friends.

Another battered firm, Morgan Stanley, continued merger talks with Wachovia but with considerably less urgency, since the government said it was willing to buy up depressed mortgage assets to keep the financial system working more smoothly. That relieved pressure on its chief executive, John J. Mack, because short sellers betting heavily against Morgan Stanley’s stock were forced to call off their relentless assault — at least temporarily — under the new market rules.

The only remaining independent banks, Morgan Stanley and Goldman Sachs, were once again the golden boys of Wall Street. But all manner of financial institutions could benefit from the plan, from Citigroup and its big investors, like the Abu Dhabi Investment Authority; to Washington Mutual and its large private investor, David Bonderman; to perhaps even the American International Group and its former chairman and chief executive, Maurice R. Greenberg.

Among the surprising twists was that A.I.G. shareholders raised the prospect of repaying the government’s $85 billion loan quickly so that the government would not take a majority stake, as announced just days earlier.

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

Although Washington Mutual’s stock closed Friday at $4.25 a share, several analysts said its options looked much brighter with a government bailout. The thrift’s business must change, said Howard Shapiro, who follows the bank for Fox-Pitt Kelton, but its deposit base would make it attractive.

“Though we don’t know the terms of a government bailout,” he said, “I think WaMu could be worth between $7 a share and $20 a share.”

While I'm not much of a conspiracy theorist, I may become one in short order if the likes of TPG and Maurice Greenberg are written a check for several billion dollars off the backs of the U.S. taxpayer. Messrs. Bonderman and Greenberg are legendary investors who deserve kudos for the legitimate profits they've made in the past, but that is not the situation here. TPG was early in their deal with WaMu, and not even their stock-settled put spread that was supposed to protect against a down round financing could protect them. They waived this right in order to raise fresh capital at any cost. The stock was on its way to zero. But now it got a bump because of the probability that an ill-conceived bailout plan might just save WaMu and, by extension, TPG. WaMu was not a good investment, yet somehow Bonderman et al might just come out of this smelling like a rose. Problem is, it smells really, really bad to pretty much everyone except TPG's partners and LPs. TPG does not need to be paid in order for the credit markets to become unlocked and for the bailout to succeed.

Valuation is the Key

Valuation of troubled assets is clearly the thorniest issue to be confronted when constructing the bail-out plan. As outlined in the Wall Street Journal:

The Treasury would buy assets through a process to be determined, hold them until the market stabilizes and then sell them back into the private market. That would remove the toxic assets at the root of the current crisis.

Valuing these assets will be one of the trickiest questions. For the plan to succeed, financial institutions must be able to get these assets off their books at a high enough price that their balance sheets aren't further pinched.

The government is, in some respects, constrained in driving a hard bargain because the whole point of the program is to help banks get back on solid footing -- not to force them into deep write-downs, potentially exacerbating their pain. At the same time, the market turmoil has complicated efforts to determine the "real" value of the assets.

The mechanics of any sale are expected to be worked out between the asset managers and the Treasury. One option is a reverse auction. In that case, the Treasury could determine a type of assets it wants to buy (say, all AAA-rated mortgage-backed securities) and would then buy securities from financial institutions that offer to sell at the lowest price.

The key issue with full or partial Good Bank/Bad Bank deals is how the bad assets get capitalized. If the Treasury buys the assets cheap and forces further markdowns, the remaining Good Bank will be under-capitalized. Conversely, if the Treasury buys the assets rich the U.S. taxpayer gets screwed and the common stockholders get a windfall. Neither of these situations is optimal. And let's remember, the difference between the RTC circa 1989 and the proposed 2008 solution is that the RTC took over entire institutions, while the new plan envisions only purchasing troubled assets (which may potentially encompass mortgage loans, mortgage securities and derivatives). So how do we bridge the gap, ensuring that troubled institutions are adequately capitalized after offloading bad assets at depressed prices while protecting the U.S. taxpayer?

Fixing the Problem - the Right Way

Buying assets at anything other than fair market value is against every principle we should be enforcing. Transparency. Accuracy. Full disclosure. This is a non-starter. Who cares where the assets are carried on a firm's books? If Morgan Stanley has them at $.30, Merrill at $.32 and Goldman at $.50, this is not the point and should play no part in the analysis. There should be a reverse auction to determine price, with the Treasury buying the cheapest and moving up the line. Depending on where firms are carrying these assets, it might require a write-down that would threaten its solvency. If not, great. The firm has liquified the assets and the U.S. taxpayer gets the upside over time (monetizing the liquidity option, in my parlance). However, if there is a capital gap I'd suggest that the Treasury gets issued convertible preferred stock on attractive terms, supporting the firm in its operations while substantially diluting common equity holders. In this case jobs are saved, the institution continues to operate as a smaller, leaner, hopefully more prudent firm while the U.S. taxpayer, once again, owns the liquidity option.

As time goes by, the markets stabilize and the convertible preferred moves in the money, the U.S. Treasury can "privatize" its holding thorugh a public offering or a private sale, recouping funds that bridged the firm to health and hopefully making a profit for the U.S. taxpayer in the process. This would be a win/win. The only loser here are the common stockholders of troubled institutions. And this is as it should be. Losers shouldn't become winners overnight because of Government largesse, and hopefully our policy-makers know that we're watching. As is the rest of the world.

From Capitalism to Socialism to ???: Crossing the Line

The U.S. Government's historic reaction to the financial crisis firmly puts us in a place not seen in generations. We have officially crossed the line from capitalism to socialism in less than a week. The Fed synthetically owns Wall Street as we speak. The historic checks and balances built into the system, e.g., the ability to freely buy and sell, have been suspended for a large segment of the market. While the sayings "Wall Street privatizes gains and socializes losses" and "When there is too much capitalism you need a little socialism, and when there is too much socialism you need a little capitalism" have had symbolic meaning to me, they have never sounded so true than they have this week.

I believe in times of crisis that while moral hazard must be noted and managed, addressing systemic problems swiftly and decisively is absolutely critical. And to the Fed and the Treasury's credit, they appear to have shifted from a one-off crisis management model to a far-reaching, comprehensive approach for dealing with the crisis. However, there is a line between protecting the U.S. citizenry while supporting the health and functioning of the global financial system and pro-actively redistributing wealth based upon the political tides, and I believe this line has been crossed. And the line has been crossed specifically with respect to the temporary ban on short-selling 799 financial stocks.

It is very easy to dislike shorts. They profit if things go badly, and we in this country are an optimistic lot. It seems practically un-American to be shorting stocks, profiting at someone else's expense. The problem is, both ordinary citizens and those in Washington simply don't get it. Short-sellers keep companies honest. How many recent examples have we seen of companies being economical with the truth in order to prop up their stock prices and fatten the wallets of those in the executive suite (see FNM, FRE and AIG, for starters)? It is the shorts who sniff this out and make other investors aware in order that they can re-calibrate their expectations, and to perhaps sell before it is too late. This is how Enron was busted, with one of the catalysts being that now-famous conference call when Jeff Skilling went stark-raving mad on one of the Managing Partners at Highfields Capital who had factually cornered him.

We are now in the midst of a witch hunt, in order to pin the financial sector devastation on this particular group people love to hate. A scapegoat - how convenient! Of course, it was those shorts ganging up on those poor, well-managed financial firms with those sterling portfolios! Do rational people who know anything about the markets, capital structure and investor motives really believe this drivel? Consider some quotes from a recent Bloomberg piece, and think about the motives of those being quoted:

``The shorting rules gave investors the belief the world is not coming to an end,'' said Phil Orlando, New York-based chief equity strategist at Federated Investors Inc., which oversees $334 billion. ``You had a lot of the hedge funds ganging up on these financial companies and putting them out of business.''

What Mr. Orlando really is saying is "Praise the Fed for protecting my long-only portfolios, because I'm getting totally smoked here."

Cuomo said he'll use the state securities-fraud law, the Martin Act, to pursue investors for illegal sales. The law permits criminal and civil actions. ``The federal government has been ineffective when it comes to regulating these markets,'' he said. ``I want the short sellers to know today that I am watching.''

Mr. Cuomo has now found his populist issue around which to mount his Mayoral campaign, following in the footsteps of fellow muckrakers Giuliani and Spitzer.

``You have to enforce the rules with regards to short selling,'' said Mario Gabelli, who oversees about $28 billion as chairman and chief executive officer of Gamco Investors Inc. in Rye, New York. ``Shorts were running amok.''

Mario, Mario, Mario. Just a little self-serving, no? You've taken lots of heat for your own comp package and now you are going to dish some out, huh?

``There is no rational basis for the movements in our stock,'' wrote Mack, who contacted Cox and Treasury Secretary Henry Paulson. ``We're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down.''

So when the dust settles, I'd recommend that Mr. Mack might just consider shutting down the stock loan piece of his prime brokerage operation, in order to conform to his views on fairness. Except that might drop revenues by, oops, several hundred million dollars?

``We seem to have capitalism on the upside and socialism on the downside,'' Chanos, one of the first to raise questions about Enron Corp.'s accounting, said on Bloomberg Television. ``That's a pretty heady brew for country that holds itself out as a free market paragon.'' Chanos said his firm isn't shorting any of Wall Street's largest investment banks and is the ``least short the financial sector as we have been in three years.''

Quite possibly among the most feared (but respected) hedge fund managers on Wall Street. He's tired and frustrated by people telling he and his colleagues that they're crooks, bad guys, bad for the market. He puts out great research, has surfaced dozens of scandals yet gets no respect.

``Regulators are stepping in and saying, `This needs to come to a stop and this is how we're going to fix it,''' said Kelli Hill at Ashfield Capital Partners in San Francisco, which oversees $4 billion. ``This is the thing the market needed.''

No, Ms. Hill. This is not what the market really needed. What the market needed was for the Fed and Treasury to adopt a broad-based approach to the crisis, set up a Good Bank/Bad Bank vehicle to break the liquidity logjam, bridge Fannie Mae and Freddie Mac, and work on regulations that focus on disclosure and transparency in reporting. The market did not need a ban on shorts. The big institutional money management lobby needed it. The politicians who wanted to look strong, decisive and "in support of the people" needed it. But this type of move destroys confidence in the integrity and fairness of our the U.S. financial system. It communicates that the game is rigged, and undoes some of the good provided by the certainty of an RTC-type solution. It will hurt capital flows and market efficiency if investors believe its effects will be anything other than short-term. And in the long run, this is good for no one.

Addendum:

Please read my friend Howard's post here.

Investing 2.0

We are about to enter a new and scary phase, one where there are few good answers to the question: Where should I invest my money? Risk premiums and liquidity costs are skyrocketing. Short-term Treasury yields are approaching zero and could possibly go negative, as they did in Japan during the depths of its crisis (when holding short-term government debt is akin to paying a custodian for holding a physical asset). Long stock investments likely won't look attractive on a stand-alone basis for the foreseeable future. Long bond investments except for top-rated corporates and sovereigns will pretty much be avoided. Real estate? Commodities? The problem is exacerbated for pension and endowment managers, whose liabilities still need to be fulfilled even if portfolio returns drop. The thirst - in fact, the necessity - for identifying and capturing alpha will be even greater than it is today. So how should investors think about navigating today's hostile environment?

My hypothesis is that the investment portfolios will begin to look like a barbell, where institutions will hold:

1. Larger pools of cash and near-cash;
2. Smaller portfolios of long-only stock and bond investments; and
3. Growing portfolios of alternative investments.

There is a concept in bond math called convexity. Positive convexity is good because it means for parallel shifts in the yield curve, portfolio value rises more and declines less than it does with less convex portfolios. And convexity tends to be maximized by creating barbell portfolios, those containing a mix of very short maturities and very long maturities and nothing in between. I see a strong analogy between this dynamic and that of Investing 2.0 portfolios, where the stuff in the middle, long-only portfolios of stocks and bonds, will be out of favor while the twin objectives of liquidity and alpha will dictate portfolio construction. And those portfolios will be barbells.

Fiduciaries of all stripes are sweating. How can we possibly achieve our return goals in an increasingly adverse investment environment? The fact is that opportunities abound for those with ample liquidity and a long holding period, and will only become greater as the market continues to work through the debt overhang accumulated over the past decade. And this purge-and-cleanse period will likely take even longer due to the lack of trust rippling through the system, where many constituencies - from employees to retirees to small and large investors across the globe - feel they were hurt by their companies, regulators and leaders. Sad, yes, but this adjustment phase will create enormous opportunities for those with the vision and capital to take advantage.

Savvy, long-term investors will use this opportunity to deploy capital in alpha-generating strategies with longer time horizons, while using their large pool of short-term liquidity to meet current obligations. As some of the gains from the long-dated portion of the portfolio are harvested, they will be redeployed into new alpha-generating strategies or used to augment the liquid portfolio.

And as I noted in Investment Banking 2.0, small is beautiful. Boutique investment banks focused on providing merger advice, general corporate strategy, private placements and alternative investments. Venture capital firms that still do real venture capital, focusing on seed stage, A and B round investments. Focused hedge funds that are excellent at specific disciplines, and haven't diversified away the lions' share of managers' returns.

I also believe that classic bulge-bracket investment banking, e.g., underwriting, research, distribution and trading, is a natural oligopoly. The high fixed-costs associated with operating these platforms screams out for consolidation. The world does not need 50 of these firms; possibly not even 20. I see the middle getting squeezed, with regional and industry-specific full-service broker/dealers falling by the wayside. They simply won't have the resources necessary to compete. Again, we will see a barbell structure, one dominated by a handful of giants enjoying scale economies and smaller, nimble, highly profitable boutiques.

One issue that needs to be addressed is capital formation between the venture-backed start-up and the $1 billion+ IPO. This is a gap the must - and will - be filled. I see a rise of alternative exchanges, like GSTrUE and Opus-5, stepping up to meet this need. Venture capitalists need exits. Companies need to diversify their investor base and gain access to new pools of capital. And investors need access to top emerging companies before they reach multi-billion dollar valuations. Innovation, as always, will rise to meet the challenge.