Liar's Poker and the end of Wall Street

Michael Lewis wrote a couple of great books: Liar's Poker, which chronicled his time on Wall Street, as well as Moneyball, which covers the art of statistics & strategy in major league baseball. Recently he published an update on the current malaise affecting Wall Street, which is a very good read. Worth it just for the computer-generated picture of a supine bull in the street.


Here's a short excerpt:

Eisman stuck to his sell rating on Lomas Financial, even after the company announced that investors needn’t worry about its financial condition, as it had hedged its market risk. “The single greatest line I ever wrote as an analyst,” says Eisman, “was after Lomas said they were hedged.” He recited the line from memory: “‘The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.” A few months after he’d delivered that line in his report, Lomas Financial returned to bankruptcy.

The article also points out that credit quality on fixed income investments associated with consumers always strengthen in March and April. Why? Tax refunds.

What are they looking for: VCs versus LBOs

Neither one is looking so hot in this environment, but nonetheless...

Venture capitalists' desired investment characteristics:

• The size of the potential market
• The technology (feasibility, barriers to imitation)
• The management team

On the other hand, leveraged buyout shops are looking for:

• Demonstrated profitability
• Strong and predictable cash flows
• Readily separable assets
• Strong management team
• Non-high-tech products
  

Externalities in Energy and Credit

Why would the owner of a wind farm sell electricity to the grid at negative prices? This has been occurring with some frequency on the Texas electrical system in 2008. Partly this has to do with the isolated nature of the Texas grid and ERCOT, but the explanation also involves:

• A producer of electricity might continue to produce & sell power at a price below his marginal cost of production (even at zero) if there are added costs of shutting the generator down and restarting it when spot rates increase again.
• If a producer has low marginal costs and is receiving a subsidy based on production, then they may be incentivized to keep producing ever after the price becomes negative. If the producer knows that they will get a $35/MWh production tax credit then they'll keep the wind turbines running.

I wouldn't mind a few free kwh on my next electric bill, but a policy that essentially pays people to consume electricity seems a bit counterintuitive. While we can argue about the necessity of providing subsidies for renewable energy sources, this particular example highlights the unintended consequences that can result from even a well-intentioned policy.

It is somewhat reminiscent of the reaction to the Fed's commercial paper facility. Initially only the top rated A-1 paper could be purchased under the program. Of course, this resulted in A-2 issuers being at a disadvantage in the marketplace because no one wanted to buy their paper anymore, when they could get a government guarantee for a small premium. The CP facility basically crowded out other creditworthy borrowers who couldn't afford the 500bp spread.

Uncommon investment structures: tontine

I spotted news of Tontine Associates, a Connecticut hedge fund that is down +65% this year. But what's a tontine? Apparently, it's an investment vehicle which combines features of a group annuity, group life insurance, and a lottery. Each investor buys a share, and the funds are then invested, which pay dividends. As the investors die, the shares are redistributed among the surviving members until the last one collects the principal. Turns out this is no longer widely used because:

• People realized they could sign children up for it early and collect dividends for much longer than expected. A similar problem has been encountered by defined-benefit pensions as average lifespans have increased substantially.
• Investors were incentivized for killing each other to bolster their own share

To some extent, this structure still exists today in the form of joint tenancy with rights of survivorship. You might also remember an episode of the Simpsons involving Grandpa Simpson and treasures from WWII that featured a tontine.

Somali Pirates and Regressions

Shipping companies are having a rough go of it. First it was the crash in the Baltic Dry Index which may have pushed rates below operating costs, let alone debt service payments. If importers can't get letters of credit and trade financing, there's going to be less demand for shipping services. Then there was the increasing risk of highly levered firms being running into technical default due to declining volumes and lower collateral values based on the secondary market for cargo ships. Just when things couldn't get any worse, Somali pirates entered the picture.

Fortunately, we have researchers who studied this issue and summarized their results in a paper: Is Maritime Piracy Random? They cross-referenced a global registry of 350,000 ships against reported acts of piracy from 1996-2005 to develop a regression indicating the likelihood of attack based on flag of registry (country) and ship type. They find that pirates are non-random and tend to prefer Asian ships, especially fully loaded chemical/product tankers because they sit lower in the water, making them easier to board.

I'm not sure this tells us what should be done about pirates, but it does give us some indication of their modus operandi. One rationale cited by a Somali pirate is that illegal overfishing off the coast has destroyed what used to be a viable source of income for many. When you have a boat and you can no longer support yourself with fishing, what else are you going to do with it? Interestingly, the Asian financial crisis of 1997 was cited as a factor behind increased piracy in the region at the time. I guess pirates are the latest countercyclical asset, along with Spam (the meat, not the email) and the 99 Cents Only Stores.

Great movies: Kung Fu Hustle

Somali Pirates and TARP

This has been making its way around the web, but was too funny to pass up:

*SOMALI PIRATES APPLY TO BECOME BANK TO ACCESS TARP
*PAULSON: TARP PIRATE EQUITY IS AN `INVESTMENT,' WILL PAY OFF
*KASHKARI SAYS `SOMALI PIRATES ARE 'FUNDAMENTALLY SOUND' '
*Moody's upgrade Somali Pirates to AAA
*HUD SAYS SOMALI DHOW FORECLOSURE PROGRAM HAD `VERY LOW' PARTICIPATION
*SOMALI PIRATES IN DISCUSSION TO ACQUIRE CITIBANK
*FED OFFICIALS: AGGRESSIVE EASING WOULD CUT SOMALI PIRATE RISK
*FED AGREED OCT. 29 TO TAKE `WHATEVER STEPS' NEEDED FOR SOMALI PIRATES

Did short sellers deserve the blame?

Much has been made of short sellers role in pushing the price of stocks down, and while there are probably cases where one firm was unfairly targeted, do short sellers deserve all the blame they've received for stock market declines? The Bloomberg graph below shows the S&P500 index versus the monthly NYSE open short interest over the last three years. Up until September 2008, the trend is obvious, that shorts increased while the index decreased. Now that many forms of short selling have been regulated or eliminated, has the market bounced back? Unfortunately not. Even though short interest dropped by 50% in October, stocks continued their decline. This is even more disappointing when one considers that to close out a short position, the investor has to repurchase the shares, leading to an increase in net buyers as short interest drops.

Academic research shows that increasing short interest is correlated with stock price declines and poor operating performance, so shorts are well-informed and help with price discovery. Short sellers may also be good at detecting accounting manipulations. Moreover, banning shorts may not do anything to boost stock prices, and in fact could have the opposite effect if removing short sellers decreases the liquidity of the market.

Cost savings from plug-in hybrid

The New York Times just reported on a couple of plug-in hybrid vehicles, such as the GM Volt and the Tesla Roadster. One interesting fact is that the Tesla gets approximately 100 miles per 32 kilowatt hours (kWh). So how would your annual fuel cost vary between a 25MPG conventional gas engine and the plug-in? The chart below compares annual fuel costs for someone who drives 12,000 miles over a range of electricity and gas prices.

As of today, I'm paying $0.14/kWh for electricity and $1.75/gal for gas, so my annual costs would be $538 for the plug-in and $840 for the conventional. With $300 savings per year, it is hard to justify the price premium on a plug-in (the Tesla is over $100,000, the Volt is estimated to cost over $40,000). Of course, fuel is only one part of the total cost of ownership for a car, and plug-ins may become cheaper as the technology matures.

SMU MBA ranked 18th by BusinessWeek

The new BusinessWeek rankings are out, and Southern Methodist University (Cox) was ranked 18th in full-time MBA programs, which puts us in the same league as a lot of other very strong schools. Finally, our full-time program has received the same level of recognition as our part-time and EMBA programs! This is certainly exciting news and I hope the added attention enables us to continue attracting great students and building the school's brand. I have no doubt that SMU was the right choice for me, as it has opened so many doors over the last two years. As with most investments, the more you put into your MBA the more you will get out of it, and this program has certainly helped me maximize my ROI from graduate school.

Don't cash that mail-in rebate check

The credit crunch has claimed yet another unlikely victim: Continental Promotions Group (CPG) filed for chapter 11 bankruptcy on 11/14/08. Never heard of this company? You've probably done business with them before - they handled mail-in rebate fulfillment for companies like Canon, Sears, Costco, Home Depot, and many others. If you've recently received a rebate check from them, you should hold off on cashing it until you can contact the manufacturer or vendor and find out what the new rebate process is. Trying to cash the CPG check will likely be returned, resulting in no money for you plus a hefty fee. You could also run into bounced check fees if your balance drops too low after the check is returned in a few weeks.

So what does this have to do with the credit crunch? Let's look at the rebate process:

• Retail customer submits rebate to CPG
• CPG receives rebate request
• CPG requests & receives payment from product manufacturer
• 8-12 weeks later: customer receives rebate check

My theory is that CPG made bad investments with the manufacturer's funds that they were supposed to be holding in escrow for those 8-12 weeks; bascially, trying to take advantage of the float. If they started chasing yield by putting those funds in supposedly safe assets that turned out to be risky (auction rate securities, Lehman commercial paper, the Reserve money market fund, etc.) then they could've easily run into a liquidity crunch. It's entirely possible that they were just poorly managed, but I doubt they would've been putting those funds into short-term treasuries when they could get a few more basis points by taking on just a little risk. Either way, they were brought down by bad working capital management.

It's unclear if this is a positive or negative sign for the remaining rebate fulfillment companies, such as Dallas based Parago. With the holiday shopping season starting to ramp up and many retailers projecting dismal sales, rebates will probably be part of the marketing promotion to get customers to shop. But retailers and manufacturers who relied on CPG may not have enough time to establish a new program before it's too late. If holiday sales are down as much as forecast, there could be further shakeouts in the fullfillment industry, since they are generally paid based on volume of rebates processed.

The negative wealth effect

The wealth effect is an economic concept that says consumers will increase spending given a real or perceived increase in their assets. The same effect works in reverse if consumers feel they have lost value. One estimate says that GDP will decline $0.05 over the next two years for every $1.00 of wealth that is lost. If the equity markets have lost $4T and consumers perceive a similar loss in evaporated home equity (some think it could be three times as much) then that is $8T up in smoke. This translates to about $400B of disappearing GDP, which is enough to decrease GDP by 3%. I think the effect could be even more pronounced right now, given that holiday spending is about to begin. If retailers can't make it into the black this year due to lackluster sales, there could be a spill-over effect into other sectors of the economy in 2009, further worsening our economic condition.

Private equity deal flow & returns

Private equity firms aren't seeking 10 or 20% returns. They want to buy businesses with fully-capped (unlevered) returns around 30% and cash on cash returns (levered) in the neighborhood of 50%.

How many deals does a PE shop have to look at before they find the ones they want to fund? The deal flow funnel below gives you some idea of the process and the attrition rate.

Hybrid securities

Here's a nice payoff graph that illustrates returns to a bondholder, equityholder, as well as someone who's in the middle - perhaps the purchaser of a hybrid security like a convertible bond. Note that the steep decline on the left hand side of the graph reflects the increasing risk of default as the firm value approaches zero.

Legitimate reasons to hedge

The best criterion for determining if risks should be hedged: does the hedge increase firm value? From an HBS paper - what are some of the imperfections that make risk management relevant?

• Costs of financial distress
• Variability of investment needs such as R&D expense
• Taxes: progressive or convex tax functions, or diminished value of tax loss carryforwards
• Transactions costs: can the firm hedge at a lower cost than an individual
• Asymmetric information flows between managers, owners, and debtholders
• Poorly diversified managers (if value added by retaining managers > cost of hedging and there is no other contractual way to reduce managers' risk)

Auction fees: Christie's vs. eBay

Your great aunt passes away and as the sole beneficiary in her will, you decide to auction off the estate at Christie's. Your aunt had impeccable taste, so the collection is filled with works by the Old Masters (none of that post-modern nonsense) and is worth about $100MM. What's the auction house's cut?

• 25 percent of the first $50,000
• 20 percent of the next $50,000 to $1 million
• 12 percent of the rest

At roughly $12.1MM in commission, that seems a little steep to me. Maybe you can work a better deal at a competitor - what kind of final value fees would eBay charge?

• 12 percent of the first $50.00
• 6 percent of $50.01 to $1000.00
• 2 percent of the rest

Ignoring the listing fees and some other small charges, eBay only wants $2MM - quite a bargain. Of course, you'll have to have positive feedback, and there is some question whether the hordes on eBay will appreciate your collection enough to pay top dollar.

Number of the day: 86 million

Barrels of oil consumed globally per day in 2008. 2009 could be the first year since 1983 where we see lower total demand.

On a somewhat related note, here's the word of the day:

Bete noire (noun)

1. An object or abstract idea that has the potential to cause great harm.
2. A flourless dark chocolate cake.

[From the French for dark beast]

Industry reading materials

How do we bridge the gap between academic research and industry? These two resources are a good start.

The Journal of Applied Corporate Finance (published quarterly)

The Financial Analysts' Journal (published bimonthly)

Number of the day: 538

Electoral college votes.

Needed to win: 270

Crude oil in contango

Contango is the term to describe a commodities futures price that is greater than the spot price. This graph from the Wall Street Journal shows how strongly contangoed the price of crude oil has become. Perhaps the days of $60/barrel oil are not long for this world.

Finally done with October

I don't know if there was anyone out there who actually made money in October, but if so, my hat is off to you. People are probably thinking this story sums up the inner workings of the market...

"Once upon a time, in a village, a man appeared and announced to the villagers that he would buy monkeys for $10 each. The villagers, seeing that there were many monkeys around, went out to the forest and started catching them. The man bought thousands at $10 and, as supply started to diminish, the villagers stopped their effort. He further announced that he would now buy at $20 for a monkey. This renewed the efforts of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The offer increased to $25 each, and the supply of monkeys became so small that it was an effort to even find a monkey, let alone catch it! The man now announced that he would buy monkeys at $50! However, since he had to go to the city on some business, his assistant would now buy on behalf of him. In the absence of the man, the assistant told the villagers. "Look at all these monkeys in the big cage that the man has collected. I will sell them to you at $35, and when the man returns from the city, you can sell them to him for $50 each." The villagers rounded up all their savings and bought all the monkeys. They never saw the man nor his assistant again, only monkeys everywhere! Now you have a better understanding of how Wall Street works."