The PPIP: It's NOT the Liquidity, Stupid. It's the Marks.

You can say something about the current Administration: they are really trying. The recently released Public-Private Investment Program ("Program") details show both a lot of thought and some really good ideas. Unfortunately, the essence of the Program and its messaging are still missing the boat on a few important fronts. The main issue: the Government perceives the problem to be one of investor liquidity and the ability to finance broken asset portfolios. The problem is that they are wrong. It is all about banks not wanting to own up to inflated balance sheet values. But here are some other problems with the Program and its positioning:

• Still enamored with short-term stock market movements. Larry Summers stated that the Administration is "gratified" by the stock market's reaction to the Program. Why, oh, why, do Senior Government officials, especially those with ostensibly high IQs, say such stupid things? Guys, the focus should be on doing the right thing for the long-term, not on what will goose the market for a day or two. And while Summers et al claim to be all about the long term, then why do they keep on talking about stock market reactions to policy decisions? If there is one thing we know for sure, it's that the market is very, very jittery and volatile, and is apt to make sharp moves in response to almost any news. While the Dow could rally 500 points today, it could just as easily fall 500 points if liquidity fears rear their ugly head, another bank runs into trouble, populist rantings by Congress spook the markets, Pandit is given a long-term employment contract, etc. Bottom line: the Administration needs to stop talking about and caring about short-term stock prices. Stock prices are not unlike the Treasury yield curve: easy to manipulate on the short-end, difficult if not impossible to impact for a sustained period on the long end.     

• Forgetting the appetite of the supply side. The Program, with all the benefits provided to approved buyers - equity matching funds, cheap leverage, etc. - lists only a single line when addressing a key weakness: Participant Banks don't actually have to participate. Participant Banks can submit portfolios for auction, Approved buyers can line up, valuation firms can estimate the worth of portfolios submitted for auction, buyers can submit their bids and Participant Banks can say: no. I fail to see how the Program is a material departure from the current landscape, except for the fact that the Government is providing cheap financing. The buyers are still running equity risk regardless of the 1-1 Government match (as they should), and will only submit bids that reflect their assessment of risk and return. This may result in prices that are still far out-of-line with current bank carrying values, causing banks to reject the highest bids in a move to avoid further asset write-downs. So even a protracted auction process could result in a whole lot of nothing. What does Larry Summers think a failed auction will do to stock prices? I shudder to think.

• Perpetuating entrenched and failed managements. The Program is a vehicle for helping broken firms liquify broken asset portfolios. What it doesn't do is help broken firms get rid of broken managements that got us into these problems in the first place. In the rush to protect major lenders from going out of business (and protecting stockholders and debtholders in the process), the US taxpayer is given scant protection from the cadre of poor leadership teams that led firms into troubled waters. Why is AIG the sole whipping boy for the Government when plenty of other firms were complicit in damaging the financial system? While legacy AIG management deserves much of the scorn they've received, most broken bank executives have gotten off with nary a scratch. This I do not understand.

• Not reflecting the true magnitude of the Government's involvement in the numbers. If I read the materials properly, it seems as if the only money being counted against TARP are the equity matching funds being provided. What about the leverage being guaranteed by the FDIC? Depending upon the values realized for the purchased portfolios, those guarantees might come into play, increasing costs well beyond the equity commitments. This is more an issue of truth-in-advertising. While yes, having the private sector side-by-side is a good thing, the Government via the FDIC is providing the debt guarantee. If this isn't incremental exposure to the US taxpayer, then I don't know what it is. This needs to be clearly factored in as an explicit cost of the Program. 

My program, as discussed many, many times on this blog, is different than PPIP in one major respect: it does not rely upon the banking sector's willingness to participate; it forces the issue. Maybe banks will finally be willing to separate themselves from loan and securities portfolios at prices less than their marks. But I don't think so. The Government's plan is predicated upon the assumption that a lack of investor liquidity is the issue. But they are wrong. The issue has almost nothing to do with investor appetite and everything to do with banks avoidance of facing into the market values of their portfolios. And when push comes to shove, they will beg off and avoid selling into auctions that will validate the inadequacy of their capital positions and invalidate the quality of their marks. The only way they will do so is by force. This means Good Bank/Bad Bank, Crisis Style. 

Why is the Government wasting so much time and taxpayer money dancing around the issue? If my read of the situation is wrong and the Program is a smashing success, I'll be the first one to say so on this blog. But if my perception is right - the same perception I've had for, oh, nine months - then I'd like Treasury, the Fed, the FDIC and the President to move quickly to address the toxic asset issue once and for all. The PPIP contains many of the mechanics necessary to pull of Good Bank/Bad Bank: the main difference is compelling the supply side - the big, broken banks - to participate. Guarantee depositors funds without limit. But say goodbye, stockholders. Goodbye, unsecured debtholders. Goodbye, loser managements. Hello private investment in Good Banks. Hello, private investment in Bad Bank assets with profit sharing along with the US taxpayer at current market levels. Can't we just skip the PPIP and go straight to this? Because we know who will participate in my program: Everybody.

Note to the Administration: The AIG Flap is Because of YOU

The AIG bonus kerfuffle is beyond absurd, but what else would you expect from a flawed bailout program with conflicted motives littering the landscape? Congress and the Treasury should be ashamed of themselves: they've committed hundreds of billions of taxpayer dollars yet work to undermine its value and efficacy, in real time. A casual observer from another planet looking at the recent flap would invariably say: short the US - or at least its legislators.

Consider a few observations:

• They (Congress, Treasury and the Administration(s)) entered into a bailout program with the stated (and reiterated) idea that sick institutions must be kept alive, e.g., preserving value for common stock and debt holders;
• They initially worked to minimize the Government ownership associated with bailout funds, hurting the US taxpayer's return on investment while ostensibly allowing the recipients free rein over how to deploy the funds;
• When it became clear that the capital injections were insufficient for the largest and most troubled institutions, more funds were committed on the same unstructured basis as before;
• When even these amounts were deemed inadequate, either more money was put in (AIG) or senior claims were converted to subordinate claims (Citigroup's investors' conversion of preferred shares into common stock);
• As ownership in bailed out instituions crept up, notwithstanding the earlier desire not to have the Government involved in the management of bailed out firms, Congress decided it was time to pass judgment on how the businesses were being run; and
• Now we have a Congress smelling blood (and a PR opportunity), passing odd and abusive legislation to convey their moral outrage (hypocracy, anyone?), while simultaneously damaging the US taxpayers' massive investment in the bailed out firms (and any firm either forced or desperate enough to take Government money).

President Obama, Congress and our friends at Treasury, you can't have it both ways. Either you are making investments and letting the private sector decide what to do with it or you are taking control and restructuring troubled businesses. By choosing a middle-of-the-road strategy, you have guaranteed failure. Troubled institutions are not getting fixed, and you have wasted US taxpayer money and damaged investor sentiment. All of this could have been avoided by supporting a Good Bank/Bad Bank initiative from the outset (one Government-controlled Bad Bank; many Good Banks). This would have enabled you to:

• Clearly segregate illiquid bad assets from the sound operating businesses, focusing US taxpayer dollars on bridging the liquidity gap for the Bad Bank while raising private capital for the Good Banks;
• Replace legacy managements and Boards of Directors to avoid the PR damage and ongoing concerns about the stewardship of restructured institutions;
• Hire a team to work out the Bad Bank over months and years, paying a small management fee and carry on the assets sold while staying out of the management and compensation policies of the privately-funded Good Banks;
• Avoid micro-managing private institutions with massive public ownership and driving the value of the public stakes into the ground.

I'm hoping it is abundantly clear that the Government's plan for handing sick institutions has been an unmitigated disaster. The primary argument against Good Bank/Bad Bank - the difficulty valuing the illiquid, bad assets - almost looks like a joke today. Yes, it would have been difficult. But yes, it could have been done. The collateral damage associated with the Administration's handling of AIG and Citigroup is only just beginning to be felt. What is now a public relations circus which makes for entertaining reading is anything but funny: it threatens the value of the bailout funds already deployed and has boxed the Government into a corner. Congratulations on showering your moral outrage on AIG; the fact that this issue could have arisen is simply indicative of your ongoing failure.

The Hedge Fund Industry: Going Where?

If there was ever an industry in turmoil, Hedge Funds 2009 squarely falls into this category. Characterized by terrible press, awful returns, massive capital outflows and threatened regulation, the future of the industry appears in doubt. Or does it? Notwithstanding these challenges to its role in the investing landscape, I believe its future is secure albeit in a somewhat different form: fewer multi-strategy firms, particularly where strategies have vastly different liquidity profiles; capitulation of the public hedge fund complexes; a massive shake-out across the fund-of-funds industry; and a quest for truly orthogonal investment approaches and data sets. I do not see the absolute level of hedge fund compensation as being at risk, but the timing and manner of payment, e.g., matching the timing of incentive compensation with realization of gains. But for those who are sounding the death knell of the hedge fund industry, think again.

The hedge fund will rise again and preserve its role as a differentiated alpha generator - but only for those which generate REAL alpha for those that are willing to pay. But the shape of the industry may change as well. While the 2000s witnessed the creation of a barbell (small funds and mega-complexes) with the middle being squeezed, we may see the renaissance of the mid-sized hedge fund, one with enough resources to compete but at a size where true, uncorrelated alpha can be generated.

From the investor perspective, here are some of the ways in which hedge funds - as an industry - failed:

• Lack of positive absolute returns
• Significant correlation with broad market indices
• Absence of beneficial diversification from multi-strategy funds
• Liquidity profiles out-of-line with investor expectations

The theory behind hedge funds (get it, "hedge" funds) was to generate attractive returns in any market environment, and to fully align the motives of the general and limited partners. Many in the industry, however, strayed from these objectives. "Crowded" trades (e.g., piling into the same trades as your buddies); off-the-hook asset growth (where management fees far exceed the costs necessary to run the business; and a relative returns, "benchmark beating" mindset. These conspired to damage the reputation and status of the hedge fund industry, and justifiably so. Further, you had the IPO-ing of several hedge funds both here and in Europe, which continued to dilute the hedge funds' original mission. There is an inherent conflict between being an alpha generator and an asset manager striving for growth, and those that went public clearly lost their way. Succession planning and a currency for incentivizing employees? Garbage. Top ticking a trade, scooping out liquidity playing the "greater fools" game? Absolutely. Sheer size also didn't help with correlation, because as more assets flowed into a strategy only two things could happen: liquidity would suffer as positions got chunkier (and more risky), or positions became more diversified, returns would fall and correlations would rise. Either way, a bad outcome.

Almost by definition, hedge funds have to become smaller. Generating real alpha on a $10 billlion+ fund? Good luck. On $500 million, perhaps $1-2 billion, tops? Much more likely. Separate funds could fall under a single complex, as long as each strategy could be invested in individually such that investors could create the risk/reward/liquidity profile they want. If the days of the long/short fund with a 20% carve-out for illiquid assets isn't gone, it should be. Create a side-car fund that can be subscribed to separately if the liquid long/short book wants to size up in a particular trade (which effectively becomes illiquid), or finds an attractive PIPE or private equity opportunity in its area of expertise. But the commingling of assets with vastly different liquidity characteristics simply doesn't work, and recent market events have shined a bright light on this unanticipated and disastrous liquidity mismatch.

I think the fund-of-funds industry will undergo a massive shakeout, as its denizens have become "the rating agencies of the hedge fund world," replete with conflicts, systemic breakdowns and breaches of fiduciary duty. Who in their right mind would be comfortable ceding due diligence responsibility to a fund-of-funds after what we've seen over the past 18 months? They are getting paid handsomly for doing essentially one thing: homework. Unfortunately, it appears as if their dog ate it. Again and again and again. And while it's not fair to paint an entire industry with a broad brush, the breakdown is so pervasive and the breach of trust so great that it's not clear who will - and deserves - to survive. What could have been a rallying cry for the fund-of-funds industry - "We didn't put our investors into Madoff because our due diligence turned up too many red flags" - has become a source of derision and humiliation. Caveat emptor, friends.

But when the dust settles there are still a few immutable truths:

• Sophisticated investors have trilions to put to work, and a hedged approach to investment will be more desirable than ever
• Investors will be less convinced that mega-funds are a source of true alpha, and will work to create diversified portfolios of individual managers meeting their criteria
• Great managers do exist who are willing to more closely align their motives with those of their LPs, e.g., matching investment liquidity and incentive compensation horizons
• Great managers, however, are a very scare commodity, and will continue to garner 2/20-type fees as they do today

While tomorrow's trends are unlikely to look like those of yesterday, the top performing hedge fund manager will live on and thrive, Government regulation be damned.

Tax Policy: A Tool for Good or a Weapon of Mass Destruction?

President Obama, Congress and much of the public have torches in their hands, storming the fortress that is alternative assets - venture capital, private equity and hedge funds. The issue: taxation of earnings. What is the character of the earnings, ordinary income or capital gains? Unfortunately they're missing the point. How about creating an environment where there are more earnings - which generate even higher taxes, employment, new business creation and innovation? And consider the larger issue of the capital gains tax rate itself. President Obama wants to raise it, to at least 20% and perhaps beyond. The disgruntled public and PR-happy Congresspeople are excited at the prospect of raising taxes on these constituencies, and getting to raise the pelt over their heads with the message "We just generated billions of dollars, took from the rich and gave to you, the middle class." The fact is, nothing could be further from the truth. This short-sighted publicity stunt will do nothing but hamper the US economic recovery, create disincentives for investment and cast a pall over an industry that has been a key source of competitive advantage for the US over the past 30 years.

Congress would have you believe that venture capitalists and investors in emerging businesses are a bunch of selfish, money-grubbing capitalists. And they'd generally be right. But consider that success is inextricably bound to making good investment decisions, the kinds of decisions that help promising companies get launched and funded for growth. These companies develop new technologies, employ people in growing industries, pay taxes and spawn a new crop of entrepreneurs who can do it all over again. Venture investors play an essential role in the business formation and job creation process, and why anybody in their right mind would raise taxes on this constituency at any time - much less a time like this - boggles the mind. We should be doing everything in our power to encourage investment, which I'd prefer to see via simplification of the tax code rather than creating additional complexity for one-off programs. How about slashing the tax rate on investment in small businesses to spur investment and risk-taking? Wouldn't this make more sense than trying to close a trillion-dollar deficit with punitive tax increases?

Also, the sentiment of "soak the corporation" is wrong-headed and illogical as well. Corporate cash flow is used to do many good things: pay employees; invest in the business; and pay dividends. After-tax earnings is the primary generator of this cash flow. So when Congress in its populist zeal beats the war drums about low effective corporate tax rates, just how exactly do they think jacking up taxes on corporations is going to help the employees, the working people of this country? Keep corporate taxes low, have fiduciaries (Board members, powerful investors such as pensions and endowments, etc.) do their jobs and compensate and incentivize senior executives intelligently (as opposed to egregiously) and let companies re-invest in their businesses or dividend cash out to shareholders. And by all means, simplify the corporate tax code so there is greater transparency between book tax and cash tax liabilities. Investors should be able to look at an income statement and have a sense of the taxes a corporation is paying. Unfortunately, this is anything but the case today.

If you really want a progressive tax regime that encourages investment and fosters economic growth, focus on taxing consumption instead of relying on earnings. This is clearly not a panacea, because if consumption is taxed too heavily then individuals won't spend enough to support the economy, either. Striking the right balance between savings and investment is critical. But I can imagine a tax regime that discriminates between luxuries and necessities, and has a progressive character based on aggregate consumption. I think this is much easier to engineer and administer than an uber-complicated earnings-driven tax policy such as we have today. 

Bottom line: tax policy should be used to help us grow out of our problems, not generate cash for bailing our way out of our problems. And the current budget proposals do not give me comfort that Obama & Co. have their heads or hearts in the right place.

Entrenched Managements: Yet One More Reason Why TARP = CRAP

Citigroup is up almost 80% over the past few days, while Bank of America has nearly doubled. Each CEO has come out with a bullish statement, Citi to the effect of "We're raking it in" while B of A has defiantly exhorted "We don't need no more stinkin' money." These words helped set off a frantic rally, as market sentiment has, almost overnight, been flipped on its head. Could things have looked more bleak last week? I don't think so. But today's feeling was downright optimistic. Did we get a plethora of new data to cause this reassessment? Not that I saw. Have we seen credit spreads dramatically tighten in line with the equity markets bullish rampage of the past few days? Nope. So what gives? At least as it relates to the financials, the key message is this: TARP has turned big-time CEOs into traders with losing books swinging for the fences. Not exactly what Congress or the Treasury had in mind when they decided to bail out the biggest, most complicated financial institutions. With our money.

Clearly much of the price appreciation is due to a vicious short-covering rally that Messrs. Pandit and Lewis kicked off. But the fact is, what do they have to lose? If they can fool us long enough, credit spreads will come in and recovery will become a self-fulfilling prophecy. Otherwise, Congress (read: the US taxpayer) will bail them out once again. Citi, B of A and AIG have each had multiple bites of the bailout apple, so what's another bite among friends? They are inclined to do this because their reputations are already severly damaged; in essence, short of outright fraud, they can't get any worse. Therefore, they are motivated to throw caution to the wind, be super-positive and hope for the best. If new management with fresh reputations were on the scene, the would be much less inclined to release bullish statements without empirical data to back it up. This is a major flaw of TARP: letting incumbent managements stay around. It has created perverse motives that serve neither the troubled institutions nor its shareholders very well.

How are buyers of Citi going to feel if they enter at $2, think it's going to $5 because of Vik's words and then see it crater to $0.80 based on deteriorating fundamentals and the need for additional dilutive equity issuances? i'll tell you how - pissed off. Now you can say "caveat emptor," and you'd be right. But wouldn't you rather have new managements with motivations aligned with those of shareholders, instead of old managements motivated to rehabilitate their reputations? Rather than be so focused on capping pay, how about insisting that a new slate of managers take over as well as some new independent directors? I think this would yield far better outcomes for everyone involved. Congress and Treasury have taken their eye off the ball. Time for a little less populist BS and a little more common sense reform.

Oil - Up or Down?

I was just watching the MacroTwits hour with Gregor Macdonald (@gregorMacdonald), and got to observe some very interesting banter about the hot topics of the day - SPX, USO, sovereign debt issuance, etc. But oil seems to be on everybody's mind. General sentiment is that USO is ticking up, as both OPEC cuts and basic supply/demand forces it higher. As with US stocks, I also believe that oil is likely to tick up - in the near term. But I can't help feeling that it is bound to fall before too long:

• OPEC production cuts will not keep pace with falling demand. They can play this game for a while, forcing inventory drawdowns (as we've seen oil lose its contango and flatten out) and prices for near-term delivery to rise. But if my thoughts are right that we are still in the early innings of a global economic slow-down, OPEC won't be able to cut fast enough to avoid inventories from building anew.

• OPEC will not be able to hold its cuts, anyway. We are not in a situation where OPEC countries are rolling in cash and looking for places to put it. Every major economy the world over is hurting, regardless of their natural resources. A few more cuts and more than a handful of OPEC nations will be starving for hard currency, and will surely sell some extra barrels to generate that needed loot. And once a few defections are noticed, it will be come a free for all - and a free fall in oil prices.

• There will be hundreds of billions of dollars globally deployed towards "going green." This won't have any near-term effects, but may impact the psychology of the oil markets over the next several years.

That said, once the inflationary cycle kicks in all bets are off - oil will take off like a rocket ship, and likely not stop until it is $200/bbl or beyond. What I am really talking about is the next 12-24 months. Oil is a very complex asset class with myriad factors impacting its price, and guys like Gregor are light-years ahead of me in understand the nuances. But from a simple-headed finance pro's perspective it just seems that we are more likely to see $30 before we see $80. Time will tell...

Is the US Treasury the Next Bear Stearns?

Gap management. A very easy and straight-forward concept that has been butchered by countless firms, laid bare by the financial crisis. Funding long-dated assets with short-dated liabilities? A profitable strategy when everything is rosy, but potentially fatal when conditions turn negative. Consider Bear Stearns. Lehman Brothers. AIG. Washington Mutual. They all share the same underlying problem: assets with durations and liquidity characteristics out of step with how they are financed. Good banking, getting back to the basics, was all about gap management. Acknowledging the risks taken, quantifying the risks, and dynamically managing them based upon market conditions. At some point the combination of greed, laziness and complexity caused managers of financial institutions to stray, sewing the seeds of the troubles we are encountering today. The US Government generally, and the US Treasury specifically, are being asked to spend our way out of the crisis. But once one gets over the ideological hurdle of bailing out busted constituencies - banks, finance companies, mortgage holders, assorted industries - to begin with (no mean feat), the question that must be asked is: how is the Government going to finance this largesse? And is it going to make the exact same mistakes as those institutions it is currently rescuing?

The actions being taken by the US Government do not only have near-term consequences; they are decisions that will stay with us for a long, long time, as will the debt associated with these decisions. And given the macroeconomic risks posed by the stimulus package, I think it makes sense to spend some time thinking about how all this spending will be paid for. Raising taxes? A bad idea from a policy perspective, as well as a shrinking well from which to tap due to the sharp downturn in our economy. Lower incomes. Smaller corporate profits. Fewer capital gains. All of these point to a sharp reduction in tax revenues, and the tax increases President Obama has in store will nary make a dent, and may well cost more than they generate over time. We could cut spending. One thing we can take away from the annual budget process is that true cuts, net reductions in spending, almost never stick. If this is where we are placing our hope we are living in fantasy-land. So the only other place money can come from is if we manufacture it. Sell Treasuries. Borrow and spend. The Great American Pastime.

But if we're going to do it, let's think about that old guidepost, gap management. The US has a tremendous amount of long-dated liabilities. Social Security. Medicare. Massive infrastructure spending as contemplated by the new stimulus bill. Near-term revenues (read: taxes), are going to be under pressure due to weak economic conditions. Treasury rates are near historic lows, due to both the economic downturn and a "flight to quality" as we are crumbling at a somewhat lesser pace than other developed and emerging economies. This makes it the perfect time for the Treasury to push the limit and issue as much long-dated paper as it can. Bring out a 40-year issue. Gauge demand for a 50-year and perhaps a 100-year issue, as News Corporation and Disney did in the late 1990s. This is akin to raising synthetic equity for the US Government, at a time when securing this kind of financing has never been cheaper. Even if we had to pay up due to abnormally long maturities, it will look dead cheap once inflation rears its ugly head (as it will) and the cost of rolling short-dated Treasury paper may well be in the double digits. Further, by issuing a slug of ultra long-dated paper we'll be better matching our obligations with our financing horizon. Hurrah! 

Treasury Secretary Geithner, it is a no-brainer. Get your team working on a financing package that takes advantage of the US Treasury's current position as issuer-of-choice before inflation spikes, the dollar craters and rates skyrocket. And let's see you do a better job of gap management than those dope firms you are bailing out. It may cost you a little more to get this kind of a financing done but trust me, you'll thank me in the morning. 

Where's The Trade?

Global equity markets are volatile and chaotic. Seemingly distressed paper is only getting more distressed by the day. Sovereigns will be forced to issue trillions of debt over the next 12-18 months to pay for aggressive stimulus programs. US Treasury yields are at historically low levels, notwithstanding massive deficit spending as far as the eye can see. Western Europe is crumbling, with special mention to the UK. Japan is on life-support. So with all this uncertainty and the deeply troubled US Government trading as if everything is rosy, e.g., why aren't both the USD and Treasuries getting crushed in the face of persistent trillion-dollar deficits, the question is: where's the trade?

A few observations:

• It appears that the "flight to quality" trade in the credit markets will continue for the foreseeable future, keeping Treasury yields low and the dollar strong. This has become a relative, not an absolute, issue. The US is in relatively good shape and absolutely poor shape, but given that money has to go somewhere it will continue flowing into Treasuries until the crisis abates. The "best guess" of when this might happen is a key input into the macro trading strategy.

• It also appears that the UK is trashed. As sick as the US banking sector happens to be, the UK system is even sicker. They have a broken financial system, massive public sector deficits and a collection of old, dying industries. This is not a formula for a strong currency and tight debt spreads. Unlike the US, there will be no "flight to quality"  into Gilts. A decent trade might be long 10-year Treasuries/short 10-year Gilts, as I'd expect the sell-off at the long end of the yield curve to be way more ferocious in Sterling than I would in USD. The trade certainly works across the Euro-zone as well.

• Crude prices are likely to continue falling. The X factor, of course, is China. The Chinese Government can stomp its feet and say "We're going to spend in order to make sure we'll hit 8% GDP growth, come hell or high water," but where is this growth coming from? Assuming they're not making up numbers (yeah, they've never done that, right?), and considering they are experiencing one of greatest human flights in recorded history from cities back to farms, and that their key trading partners aren't going to be buying much for quite some time, does all of this domestic stimulus really matter? I think not. Production may spike to make the Government planners feel better for a while, but it won't be sustained. Crude demand simply has to fall, and with it prices that I could imagine hitting $20/bbl before it's all said and done.

• Commodities prices will also continue falling. With global demand cratering and quiet protectionist barriers being erected all over the world, as with oil, who is going to be buying? Production capacity will be taken offline, new equipment purchases will be deferred, exploration will stall.

So, long Treasuries, short UK/Euro-zone Governments, short oil and commodities. Until... All this deficit spending coupled with mothballed production capacity is laying the foundation for explosive inflation. When? At least a few years out, I'd hazard 3-4 years from now. But when it turms, it will be dramatic. Oil won't go from $20 to $60, it will go from $20 to $200. Base metals? Up 5-10x also. Those businesses will have been starved for capital for years, only to be caught in a demand shock. Erect new rigs. Build new tankers. Invest in upgraded mining equipment. Get the exploration process going again. These industries can't turn on a dime, especially after being offline for several years. At that point I can imagine the "flight to quality" premium in Treasuries will evaporate, as the US will be at the epicenter of these inflationary forces. Differentials between the US, EURO and JPY will crash, and the dollar will get smashed. This will, of course, cause the Fed to jam on the brakes of money creation, working feverishly to choke off incipient (but now embedded) inflation. If done poorly (which I'm almost willing to bet on now), it could throw our economy right back into recession. In the mood to re-live the early 1980s? They were not fun times. We'll be experiencing that sometime around 2013/14, I'd say. And we'll need several years of purgatory to strip out those gobs of cash that the Fed and the Treasury have and will continue injecting into the system. I figure by 2020 we might be back in some kind of stasis.

In the end, are there some pretty interesting macro trading opportunities out there today? I'd say yes. But please, be very, very careful out there.

Regulatory Litmus Test: Can the "Four Horsemen" Ride Again?

As noted in my recent post with Matt Harris, the venture industry has massive problems of scale. Large investments from even larger funds are weighted down by a dark feature of the past decade: limited opportunity for exits. Venture-backed companies, if they go public at all, do so at much greater scale than they used to, necessitating many rounds of venture investment. It used to be that companies could go public on the NASDAQ much earlier, often brought by a host of middle-market investment banks like the "Four Horsemen" (Alex.Brown, Hambrecht & Quist, Robertson Stephens and Montgomery). Young growth companies could raise $20, $30, $50 million, at valuations in the $100 million range. It set the stage for subsequent share offerings as growth opportunities warranted, and the investment banks provided research on the young companies to keep investors informed of their progress. While many parts of Wall Street and our financial markets are broken, this was one area that functioned quite well and fueled the engine of innovation that led to the technology revolution. Yet in a classic case of unintended consequences, onerous regulations such as Sarbanes-Oxley have served to squelch the fires of creativity and capital formation to the detriment of our economy, our environment and our society.

Our regulators, Congress and yes, President Obama, need to take a big step back and ask the following question: what re we trying to accomplish with our regulatory framework? As with most things, regulations involve a trade-off: impose too many, stifle growth and innovation; impose too few, provide the basis for fraud and mismanagement. My fear is that our regulations have gotten both more strict and less effective, causing the venture business itself to be on life-support. Is this what regulators set out to do? I'm sure not. But here we are. Even a $250 million venture fund has a hard time returning carry - remember, you need $250 million in exits just to break even on a nominal basis, $500 million if you want a decent track record and return for your investors. Tallying up a cool half-billion in exits is no mean feat. Think about the $500 million fund that needs to return $1 billion: where is that coming from without an IPO market or corporate acquirers with huge financial capacity? This is why we need a vibrant middle-market investment banking function to help bridge the gap between A/B round investment and later-stage investment. 

The only other way around the problem: later-stage venture funds becoming a proxy for the IPO process, providing outside investors with an exit, letting the founders take a little off the table and re-incentivizing them to take the business to the next level. This way, the original outside investors don't have a massive layer of preferences on top of them, the founders are happy for partial liquidity, greater financial stability and a nice incentive package, and the later-stage fund gets to put big dollars to work efficiently. While this is fine, it is not a substitute for financial markets and structures that support the kind of growth needed to prepare this country, and the world, for the challenges of the 21st century.

Let's accept the fact that it is impossible to eradicate fraud. Some degree of fraud has to be acceptable, because the costs of 100% regulatory effectiveness would be to stop commerce altogether. The question is, how much bad behavior can we live with to support flexible and inclusive capital markets?And what kinds of policies do we need to support an active growth-company financing environment? Here are a few observations:

• Sarbox doesn't work. It is a tax on all companies, but is massively regressive (as smaller companies have far higher percentage compliance costs than larger companies). Therefore, it is the worst kind of legislation for a country built on small businesses and innovation. It needs to be scrapped and re-conceived.

• Accounting rules need to be simplified with an emphasis on transparency. We should move away from rules-based and towards principles-based standards. Enforce bad behaviors through regulators and the courts, and have companies submit grey-area issues for interpretation as they arise. The regulatory apparatus needs to be set up to handle these policy clarifications in a timely manner.

• Tax policy must be simplified, with incentives provided for start-up investment and R&D spending. Corporate taxes should be kept low and easy to compute. Tax shelters should be wiped away except for explicit policies geared towards investment. Forget about Sarbox: the cost of tax compliance (and tax "optimization") for public companies is a massive and rising expense due to increasingly labyrinthine tax rules. This is wasteful and has to stop.    

• The theory behind separation of banking and research needs to be revisited. In middle-market growth company underwriting, it is very hard to get third-parties to publish research on nascent companies. It is generally the role of the underwriter to keep investors current on the company's business and prospects. While conflicts of interest can certainly exist, and principles-based regulations should be applied (e.g., if you are "talking your book," you can get fined, censured, etc.), this is a model that can and does work for financing and supporting trading of growth company stocks.    

These are four of perhaps ten or more steps that need to be taken to address this issue. Bottom line: without the ability to take younger companies public as was done for decades, the large-scale venture business is not a viable business model. Too few exits. Not returning carry. Disenchanted LPs. Period.