Going Private

Ignorance of the Master

Going Private readers are a tough bunch to write for.  Short the kind of novelty that qualifies one for a visit to Stockholm in December, elucidations of theory are unlikely to be new or other than obvious to the readership here.  This puts a particular burden on Going Private's author and often prompts from her the exclamation, with apologies to Jacob Cohen (a.k.a. Rodney Dangerfield): "Tough crowd."  A case in point is this missive, which arrived in Going Private's box over the weekend:

I was happy to see another edition of the usually insightful Equity Private pop up on my blog reader until I realized that it was a simply an eloquent rehash of the Soros classic, Alchemy of Finance (albeit seasoned with some details of the current credit crisis). The Soros model of reflexivity cites the "participating function" which is typically left out of the prevailing view of financial markets, despite the perverse connection of expectations on that which is expected. As Soros asserted:

1. Markets are always biased in one direction or another
2. Markets can influence the events they anticipate

Your piece, while informative, is but a shadow of the Platonic Ideal of boom/bust cycles articulated by Soros. I hope your efforts were in ignorance of the master, and not a failure of proper citation.

Though I would normally plead my case by pointing out that my incentive alignment discussion does not bear a strong resemblance to Soros' content, I fear that, in the end, I must plead "ignorance of the master."

Green in the Red

It is difficult not to gloat at the fate of green investing or crack a silent grin at the unintended consequences the "green economy," has begun to inflict- that is until one realizes the harm such nonsense is doing to the rest of us.  In my case, this is partly because I resent the thick air of smugness, the snide sneer belaying the unspoken boast of moral superiority among those who, for example, drive about the sprawling highways of California in hybrid cars, pledge to burn only ethanol, and buy "carbon offsets" to undo the damage to the earth inflicted by the 22,000 kilowatt hours sucked down by their 10,000 square foot homes every month.  In short, I take pleasure in the misfortunes of green snobs.

The primary reason is because the green snobs are engaged in a dirty business.  Wittingly or unwittingly they use very old and very dangerous rhetoric to sabotage free markets.  This is not a new approach, it is so old, in fact, that it has become a very reliable gauge to attribute rank and naked populism for the sake of accumulating power to any public figure who purports to have an altruistic solution to some social problem.  Consider this passage:

One of the great mistakes is to judge policies and programs by their intentions rather than their results. We all know a famous road that is paved with good intentions. The people who go around talking about their soft heart -- I share their -- I admire them for the softness of their heart, but unfortunately, it very often extends to their head as well, because the fact is that the programs that are labeled as being for the poor, for the needy, almost always have effects exactly the opposite of those which their well-intentioned sponsors intend them to have.

This, of course, was Milton Friedman back in 1975.  I think Professor Friedman was a little generous, but this may be a sign of the times for, you see, today even the most docile investigation into our self-righteous, green do-gooder will reveal that they are using their hybrid car (which actually has a larger lifetime energy impact per mile than does your politically incorrect gas guzzler) to speed their illegal narcotics developed by the very pharmaceutical companies they have been demonizing in the press for years across the California highway system at 100 miles per hour, so they can arrive in time to celebrate the riches they reaped by investing their "carbon offset" payments in the private equity vehicle they co-founded.

It doesn't bother me one bit that the self-appointed leader of such movements shells out $30,000 in electricity and natural gas bills a year even after the contribution of solar panels and the like.  This is as it should be.  Electricity is provided at a price and paid for.  What bothers me is two-fold:

First, that a semi-market system is good enough for the green snobs to use in vast quantities for their purposes, but not for the rest of the planet.  Any hint that their overt consumption is out of the ordinary is excused away with some argument akin to: "How is it fair to compare an active politician's power use to the average family?"  The implication is that the business of the green leaders is more important than that of the rest of the planet.  They are excepted from compliance.  But, as an affirmative defense, they also "offset" their egregious use of resources with "carbon offsets."  Never mind that these are thinly veiled private equity investments inaccessible to any but the rich by virtue of SEC net-worth edicts.  Really, I am less offended by the investment structure than I am in the absolutely non-existent attempt to even mask the naked fraud being perpetrated here.  There isn't even the slightest effort to make a legitimate argument that investing in a private equity vehicle is even remotely connected to "carbon offsets."  It is as if they never thought anyone would dare to look.

Second, that these same populists have created an inefficient power market in the first place by effectively fixing prices for consumers.  This has, of course, ostensibly been to insulate the poor and needy from expensive power or (god forbid) fluctuations in its price, and to prevent the greedy power companies from taking advantage of consumers.  Why, in this day and age, a spot price for kilowatt hours is not displayed in every home on a digital readout, permitting users to allocate their power usage according to cost, and that power to be priced according to demand, is beyond me.  But then, I look to the green snobs and realize, suddenly, who they are.  They are the politburo members, sped quickly down the reserved center lane, past the teeming crowds who must wait in traffic.  Spared the ravages of the system they created for "the rest," so that they can conduct the important business of the state in comfort and style- unmolested by scrutiny.  Insulated by their smug superiority and their certainty that their bold plans will prevail over such trivial things as supply and demand.  So certain of their entitlement that they need not even pretend to justify their immunity to the rules for "the rest."

In this context, the Going Private reader will understand my skepticism then at the many incentive programs for ethanol that have cropped up (if you will excuse the pun) in the last several years.  That same skepticism is the source of the sad, thin smile on my face today after reading the Financial Times.  To wit:

Governments need to scrap subsidies for biofuels, as the current rush to support alternative energy sources will lead to surging food prices and the potential destruction of natural habitats, the Organisation for Economic Co-operation and Development will warn on Tuesday.

The OECD will say in a report to be discussed by ministers on Tuesday that politicians are rigging the market in favour of an untried technology that will have only limited impact on climate change.

“The current push to expand the use of biofuels is creating unsustainable tensions that will disrupt markets without generating significant environmental benefits,” say the authors of the study, a copy of which has been obtained by the Financial Times.

The survey says biofuels would cut energy-related emissions by 3 per cent at most. This benefit would come at a huge cost, which would swiftly make them unpopular among taxpayers.

The study estimates the US alone spends $7bn (€5bn) a year helping make ethanol, with each tonne of carbon dioxide avoided costing more than $500. In the EU, it can be almost 10 times that.

It says biofuels could lead to some damage to the environment. “As long as environmental values are not adequately priced in the market, there will be powerful incentives to replace natural eco-systems such as forests, wetlands and pasture with dedicated bio-energy crops,” it says.

Market Rhetoric

There are two realities of rhetoric that bother me.  Not enough to prevent me from deploying them in particular situations, but it is a guilty pleasure.  The first is the sweeping generalization.  Yes, we are supposed to hate these.  No, that doesn't mean they aren't often highly accurate.  The second is the extension of a metaphor.  Yes, these are supposed to be trite too.  No, that doesn't keep them from exposing idiots where they live.  (Though this just may be the effect of a massive concentration of idiots skewing the appearance of causality).  Allow me to demonstrate:

If I were to give the always savvy Going Private reader some socio-economic and demographic information of an op-ed author along with a subject, I think we could safely assume that she could pretty much call the tenor of the article.  Let's try it out:

California state representative * Rampant brown-outs = Price controls for electricity!
UAW representative * Labor cost competitiveness = Buy American!
French waiter in Paris * Seasonal downturn in tourism = Strike immediately for higher pay!

Fun, no?

Ok, try this one (no peeking):

Public Policy Professor at University of California Berkeley, former U.S. Secretary of Labor (Clinton administration) * CEO pay = ??

Yes, of course:  "This economic explanation [market forces] for sky-high CEO pay does not justify it socially or morally. It only means that investors think CEOs are worth it. As citizens, though, most of us disapprove."

This brings me to the second rhetorical device, the extended metaphor.  It works quite well here.  For instance:

"This economic explanation for sky-high gold prices does not justify it socially or morally. It only means that investors think gold is worth it. As citizens, though, most of us disapprove."

"This economic explanation for sky-high oil prices does not justify it socially or morally. It only means that investors think oil is worth it. As citizens, though, most of us disapprove."

"This economic explanation for sky-high baseball ticket prices does not justify it socially or morally. It only means that investors think watching a game is worth it. As citizens, though, most of us disapprove."

"This economic explanation for sky-high [x] does not justify it socially or morally. It only means that investors think [x] is worth it. As citizens, though, most of us disapprove."

Yep.  Exactly.  Notice the distinction between "citizens" and "investors."  You can't be both, apparently.  I know, I know.  I'm nitpicking.  Ok, so how do we fix this?

"But if America wants to rein in executive pay, the answer isn't more shareholder rights. Just as with the compensation of Hollywood celebrities or private-equity and hedge fund managers, the answer -- for anyone truly concerned -- is a higher marginal tax rate on the super pay of those in super demand."

Or perhaps:

But if America wants to rein in gold prices, the answer isn't more gold holder rights. Just as with the compensation of Hollywood celebrities or private-equity and hedge fund managers, the answer -- for anyone truly concerned -- is a higher marginal tax rate on gold returns."

But if America wants to rein in oil prices, the answer isn't more gasoline rights. Just as with the compensation of Hollywood celebrities or private-equity and hedge fund managers, the answer -- for anyone truly concerned -- is a higher marginal tax rate on the gains to petroleum ventures."

But if America wants to rein in baseball ticket prices, the answer isn't more baseball fan rights. Just as with the compensation of Hollywood celebrities or private-equity and hedge fund managers, the answer -- for anyone truly concerned -- is a higher marginal tax rate on ball players."

But if America wants to rein in [x], the answer isn't more shareholder rights. Just as with the compensation of Hollywood celebrities or private-equity and hedge fund managers, the answer -- for anyone truly concerned -- is a higher marginal tax rate on the returns to [x]."

Or perhaps: "To rein in prices, just increase costs."

Genius.  Pure genius.  Play ball!

Portfolio Incentives

Perhaps because it is the only way Portfolio magazine can persuade anyone to even look at their rambling, ad infested prattle that passes for financial journalism, I have somehow been sentenced to a term on their mailing list.  The result?  Various individuals at Portfolio repeatedly demonstrate their audacity by emailing me 1.5 megabyte .pdf files of various uninteresting (or oddly leftist) articles from their publication.  My repeated requests to end the sending of same have resulted in exactly nothing.

Heretofore I have generally ignored Portfolio, excepting one article after the unveiling of the publication.  I realize now that this has misaligned incentives for the magazine, which has apparently taken my lack of interest as license to "win me back" as a fan (hard to win back what you never possessed, but still).  Therefore, as of today, I will begin to review the writing on Portfolio.  Whenever I encounter a well written, financially astute piece, I will simply ignore it.  Whenever, however, I come across a piece that leaves an opening for stinging commentary, I will bring the full weight of what literary prowess I possess to bear with a particular emphasis on the way each piece reflects a total lack of talent at every level throughout the publication.

Who do readers have to thank for this distraction?  The author of the latest Portfolio spam that clogged my in-box, Ms. Emily Weber.  Please feel free to deliver your opinion on the topic to Ms. Weber.  Fortunately, she has provided her contact information in the latest spam:

Emily Weber
[email protected]
212-286-6373

The irritated Going Private reader may find my email to Ms. Webber instructive:

----- Forwarded message from Equity Private <[email protected]> -----
Dear Ms. Webber:

For months now, I have attempted to ignore the inane, poorly
written, badly researched and shallowly conceived print which
purports to pass for "writing" in your publication "Portfolio." 
Unfortunately, your repeated, unsolicited, uninteresting and
uninspiring emails (typically with large .pdf attachments designed
to clog my inbox) have not permitted me to continue ignoring your
work in perpetuity.  Accordingly, and while I am not typically a
vindictive person, I have elected to take a more serious interest
in the "work" of your publication.  (See my latest weblog entry:
http://equityprivate.typepad.com/ep/2007/09/portfolio-incen.html )

Unfortunately for Portfolio, my appraisal of that work is almost
universally negative.  It is my intention, therefore, to publish my
most stinging and biting commentary for my 1200 or so regular
readers in the financial community whenever I am reminded of your
publication (for instance, when I receive unsolicited email from
you or any other associate of Conde Nast) until I lose interest. 
Of course, the only way I will eventually lose interest is if I
stop receiving unsolicited email from you.  I leave it to you to
decide how to handle this most recent development.

Best Regards,

-ep

Equity Private
http://equityprivate.typepad.com

On Mon, 17 Sep 2007 09:16:49 -0500 Emily Weber
<[email protected]> wrote:
>
>FOR IMMEDIATE RELEASE
>SEPTEMBER 17, 2007
>
>THE BANANA WAR
>
>[Blah Blah Blah]
>
>
>Emily Weber
>[email protected]
>212-286-6373

Liquidity Feedback Loop

An early intuitive model supporting the time distortion effects of near light speed travel imagined a beam of light bouncing between two perfectly reflective and perfectly parallel surfaces hurling through space at great speed.  Today, the image and the recursive metaphor conjures up more thoughts about liquidity, its dark side and the after effects of liquidity related bubbles.  In particular, it seems useful to reflect on how to clean up after liquidity related market distortions.

The term "too big to fail," is generally attributed to Congressman McKinney and was apparently uttered during hearings before the Subcommittee on Financial Institutions back in 1984.  The topic back then was the then shocking $1 billion bailout of Continental Illinois Bank.  A great piece on the effect of the "too big to fail" (TBTF) mentality can be sleuthed out by interested Going Private readers as a 2005 staff report by Donald Morgan and Kevin Stiroh over at the outstanding website of the Federal Reserve Bank of New York.  As the authors point out:

The naming of eleven banks as “too big to fail (TBTF)” in 1984 led bond raters to raise their ratings on new bond issues of TBTF banks about a notch relative to those of other, unnamed banks. The relationship between bond spreads and ratings for the TBTF banks tended to flatten after that event, suggesting that investors were even more optimistic than raters about the probability of support for those banks. The spread-rating relationship in the 1990s remained flatter for TBTF banks (or their descendants) even after the passage of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), suggesting that investors still see those banks as TBTF. Until investors are disabused of such beliefs, investor discipline of big banks will be less than complete.

Indeed.

More recently, the effect of the "Greenspan Put," or the notion that undue speculation has been encouraged by a propensity (real or imagined) of the Federal Reserve to "bail out" reckless speculators with rate cuts has a similar feel.  As I am fond of coining terms, and noting that recent events in financial markets suggest that the "Put" might still be in play even in the absence of its namesake, I think that "too big to burst," (TBTB) might be a better moniker for the effect.  So what is the appropriate role of regulators generally and central banks in particular when unwieldy bubbles threaten to burst?

I recently focused these pages on the topic of liquidity and the "dark side" thereof with a particular focus on the nature of surplus liquidity.  Certainly, there is a "race to the bottom," as liquidity begs to be absorbed and puts pressure on market actors to place it in increasing undesirable (from a risk-reward pricing view) investments.  Recapping that discussion, two dynamics influence this shift.

First, as liquidity pours into opportunities, the number of favorable risk-reward opportunities dries up, pressing liquidity ever lower on the risk-return scale.  Second, as asset prices are driven up by the competition for assets, the returns available to higher risk assets diminish.  (The risk premium narrows). 

These two effects drive liquidity seeking the same level or returns into increasingly risky assets.  These effects are, as I pointed out, complicated by the structural need for particular risk tranches to service structured products or the issuance of instruments in securitization transactions (CDOs and such) that depend on efficiency frontier portfolio design.  These instruments can, therefore, create an "artificial" need for high risk assets and drive these asset prices up, even as their quality diminishes.

In the present example, and in the words of a CDO manager I quoted before: "I gotta keep accumulating collateral, and I gotta issue the liability against that collateral."  This, in turn, drives loan origination into overdrive and so reduces the oversight and loan standards that less than qualified borrowers are given a pass where they otherwise never would have.

Of course, the first urge that a "too big to burst" approach reacts to is to save the many borrowers who "never should have been borrowing" and who may face foreclosure in the face of the market's whims.  The Center for Responsible Lending predicts 2.2 million homes will be lost to foreclosure related to sub-prime lending practices.

Of course, this brings up several questions involving the wisdom of making poor financial decisions painless.  The general populist answer to this, that borrowers were somehow "duped" by lenders into accepting loans they had no means to repay depends on a particular brand of paternalism that should leave a metallic taste in the mouths of Going Private readers.  But, when such large numbers of properties are involved (there are more than 6 million "sub-prime" loans and another 6+ million "alt-A" loans, all of which are backed by collateral that is difficult or impossible to sell in a declining real-estate market) we revert back into a "too big to burst" issue.  How does one balance the need to avoid dramatic shocks to the economy and the need to avoid moral hazard issues?

Regulators effectively have three options for action:

1.  None.  The market will deal (perhaps harshly) with the problem.
2.  A Direct Bailout.  This might take two forms.  First, bridging the gap between home values and mortgage obligations with government funds.  Second, assistance for homeowners in the form of government funds to make mortgage payments.
3.  Bankruptcy Modification.  Permit homeowners to write down mortgage obligations in bankruptcy.

Going Private readers will easily predict my distaste for #2.  They may, however, be surprised that I could be persuaded to support #3.  Consider:

Today, ironically, in a Chapter 13 bankruptcy one can discharge loan obligations on everything from boats, cars and vacation homes to almost anything else, except the mortgage on your primary residence.  Your only option here is to attempt to cure any defaults pre-bankruptcy and still potentially face foreclosure.  Making modifications to these restrictions could prevent "forced sale" foreclosures and permit lenders to recover more value while also supporting the populist notion that foreclosure works an injustice on the borrowers.

There are a number of other advantages to lenders that I will discuss tomorrow.

(Art Credit: Yayoi Kusama. Infinity Mirror Room--Phalli's Field (or Floor Show). 1965).