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Monday, March 03, 2008

Cascades Are a Poor Excuse for Stupidity

prettier cascades Not all that long ago, Armin said something that frightened me.  We were traveling between one meeting or another and, in the midst of waxing poetic on operational improvements, a topic on which he had much to say and for which I had an endless appetite, he announced, "...but you will eventually outgrow Sub Rosa."  He must have seen the sudden protests I was already composing in my head coming a mile away, for I didn't get the chance to verbalize them.

"No, no, you will.  You have already matured as an investor to the point where private equity will bore you, if it does not already.  As you have no doubt already discovered, few deals are about the kind of smart investing you seem to crave.  Yes, Sub Rosa can and does realize gains through operational improvements, but consider why that is so.  Usually, we find targets where the owner-operator simply did not have the will to execute on difficult decisions because of the attachment to the company."  It struck me that he said "owner-operator," as if the sellers we had courted all this time were long-haul truck drivers.  "Often, I suspect, a sharp management consultant would have done just as much good and cost the owners far less in opportunity costs.  In reality, most of the transactions we have managed to complete are about our access to capital and the luck of opportunity."  It is pretty hard to argue with that kind of self-reflection in a senior partner.

This is the kind of conversation with Armin that, as is often the case, caused me to slip into a deep meditative state, thinking about the economic lenses through which I view the world.

I can probably best describe my thinking, to the extent regular readers of Going Private haven't already gotten a strong dose, by example.  That is, in the form of the kinds of ideas and concepts that interest me and prompt further thought (or in some cases, even sleepless nights).

Bubbles, and the dangers of investing into them and out of them- as well as the dangers of betting against them, have occupied a good part of my investment brain of late.  No surprise then that the yummy likes of Abnormal Returns picks a Sunday (damn you and your Sunday links, Abnormal Returns!) to drag to the surface old concepts from the deeper reaches of my economics education.  This Sunday?  Information Cascades.  Therein we are pointed to real estate bubble reflective articles in the New York "Were all these people stupid? It can’t be." Times and the always interesting Calculated "inaction of policy makers" Risk.

The take-away from the Maxwell Smarts at the New York Times, or in this case Professor Robert J. Shiller "professor of economics and finance at Yale (draw your own conclusions here) and co-founder and chief economist of MacroMarkets LLC", is that certain hardwiring in the brain causes questionable decision making.  This, it seems, contributed in large measure to the housing bubble.

A long line of study in this area has resulted in a deeper understanding of a number of cognitive phenomena including the likes of bounded rationality, confirmation bias, endowment effect, hyperbolic discounting, irrational escalation, mere exposure effect, pseudocertainty effect, zero-risk bias, loss aversion, base rate fallacy, and so forth, which may tend to color otherwise rational decision making.

Categories of these phenomena and their study, like Heuristics, Framing and Anomalies, make up the larger schema of "behavioral economics," which, removed from the obfuscating umbra of academia, is probably more commonly understood as "ways market actors can be irrecoverably stupid."

One of the problems I see with behavioral economics is that the tendency is to diminish the perceived agency of market actors in the investing process.  One or another cognitive feature easily becomes reason to throw up collective hands and attempt to redesign (or unwind) markets or market actions to compensate for flawed thinking.  Let us, dear reader, focus for a minute on the most ready example, information cascades.

The term stems from an article, A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades, written in 1992 by Sushil Bikhchandani, David Hirshleifer and Ivo Welch.  From the abstract:

An informational cascade occurs when it is optimal for an individual, having observed the actions of those ahead of him, to follow the behavior of the preceding individual without regard to his own information.  We argue that localized conformity of behavior and the fragility of mass behaviors can be explained by information cascades.

And from Professor Shiller?

As others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own.

Mr. Bikhchandani and his co-authors worked out this rational herding story carefully, and their results show that the probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.

Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.

And here is the part that disturbs me.  It is subtle, because it is so tempting to be lulled into the thinking that enables it.  Take another look:

Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.

Optimal behavior is defined relatively, but, more over, cognitive flaws are now apparently part of "absolutely rational and calculating."  There is a careful nuance added to the information cascade definition that permits this interpretation, but it strains the bounds of credibility in my view.  More on this later.

And less we conclude this was a momentary slip, the Professor concludes:

It is clear that just such an information cascade helped to create the housing bubble. And it is now possible that a downward cascade will develop- in which rational individuals become excessively pessimistic as they see others bidding down home prices to abnormally low levels.

Excessively pessimistic rational individuals.  Yep.

In any other context this sort of rationalizing of rationality would sound fantastically naive.  How well could any of us be expected to respond to "Well, Cindy and Bob were buying a house, so I thought I should do the same"?  If your mother were present to hear this pale excuse, surely she would quickly intone "So if Cindy and Bob jumped off a building, would you do it to?"  Granted, I don't know your mother.  Perhaps she has a Ph.D. in behavioral economics, but I suspect an easier explanation: she simply isn't stupid.

As an excuse put plainly, it is merely sad.  As a cognitive flaw, however, it quickly becomes a reason for bailouts, and curbs on those of us uncaring and cold enough to resist the herd mentality, and who may have taken some sheep to the cleaners in the process.

Still, informational cascades have some other features which make them less than compelling excuses for investment missteps.

In our model, individuals rapidly converge on one action on the basis of some but very little information.  If even a little new information arrives, suggesting that a different course of action is optimal, or if people even suspect that underlying circumstances have changed (whether or not they really have), the social equilibrium may radically shift.  Our model, which is based on what we call "informational cascades," explains not only conformity but also rapid and short-lived fluctuations such as fads, fashions, booms and crashes.  In theories of conformity discussed earlier, small shocks lead to big shifts in mass behavior only if people happen to be very close to the borderline between alternatives.  Information cascades explain why society, on the basis of little information, will systematically tend to land close to the borderline, causing fragility.

As you might expect from this passage, cascades exist where decisions are borderline.  This is, in fact, the nuance I referred to above that allows all actors to be individually "rational" in making the correct selection where the aggregate of the information available to them would clearly point to the opposite "correct" decision.  This implies either that little information to make a decision exists, or that it exists but that little has actually been collected.  This, at least in my mind, begs the question, why are such information light dilemmas resulting in major investment decisions?

As I pointed out in an earlier post:

Debt can either magnify returns generated by true alpha, or disguise (that is increase information asymmetry in) returns that may or may not have anything to do with alpha.  The correct response to investment strategies that appear to generate abnormal returns but are of such complexity to defy understand[ing] is not to invest.

It strikes me as quite tortured to label a market actor who possesses so little actual information about the contemplated transaction that he or she might be caught up in a cascade as "rational."  Particularly where, as here, the costs of an erroneous decision are extremely high and the decision is not forced.

Not This Shit Again

awwww g'z I must be in the minority in thinking that the term "sophisticated investor" implies a degree of self-reliance, confidence in nothing one hears and a percentage of what one sees that won't cross the threshold requiring a 13D filing.  How else can one explain the increasingly common notion that relying with complete or near complete exclusivity on third party research when making investment decisions is not only appropriate, but what "sophisticated investors" do.  Have things slipped so far in the United States that we need third party research as a crutch- and a scapegoat for everyone who invests?  Seems so.  Moreover, people who should know better have taken the bait.  To wit:

Many of these investors have been so sophisticated that they created a demand for services which provide them with the underlying ratings of muni bonds regardless of bond insurance.

Wow, now that is sophisticated.

But then?

It may help to take a look at why muni investors require such granular credit analysis. The reason is relatively easy to understand: municipalities have far less and less consistent financial transparency than corporations, especially public corporations.

Oh, of course.  Less available information, less individual research.  Silly me, I thought the rule was "less available information, less investment."  I have seen my error.  Makes perfect sense now.  If only we had better more detailed more exclusive, more inclusive, more granular, ratings, everyone would have the great American dream entitlement, low no risk, high return investments without any never-ending bubbles.

Monday, March 10, 2008

The Sun Also Sets

signs of the lost generation The Wall Street Journal today gently, oh so gently, prods the likes of Sun Capital Partners.  Because it annoyed me, the takeover of Dow Jones easily becomes the focus in my causal searches for very real declines in Wall Street Journal quality, and my sense that they "go easy" on their subjects (even when the topic really calls for a good impaling) is just as strong now as it was last week.  Why they have elected to spare Sun Capital- floundering, as it is, in an emulsion of ennui and leverage- some much needed scorn is somewhat beyond me.

The Journal does hit some of the key flaws that have plagued Sun (and many other buyout firms) but where they touch the wound and issue soft, almost cooing "tut tut tut"'s, I would call for the retractor.  To wit:

Sun remains active in the deal market. Last month it made its biggest investment ever, paying $542 million for apparel maker Kellwood Co.

The wilting economy hurts Sun's companies, but also offers more bargains on ailing businesses. "This is a phenomenal environment in which to invest," says Mr. Leder, but it "requires a strong stomach."

Someone must own stock in a pig lipstick company.  The reality is that firms like Sun have been victims of their own overreaching and the nature of the incentive structures and fund raising cycles in private equity.  Given my views on the nature of human nature...

Man is basically lazy.  Innovative and complex incentive and disincentive structures must be continually created and refined to compel any desirable behavior (including the absence self-destructive behavior).  Excessive gaming of the system will be employed at every opportunity to avoid doing anything resembling work.

...even the novice Going Private reader will understand my focus on incentive structures (both designed and resulting from unintended consequence) and the behaviors that they, well, incentivize.  As such, it should be easy to see why the only prompting I need to start shaking my head is the "management fee" section in Sun Capital Partner's Private Placement Memorandum.

I have pointed out before that the purpose of a management fee is supposed to be infrastructure support, not a profit center, and that, one would think, infrastructure costs for a fund like Sun Capital would not scale linearly with capital under management.

We can hardly blame the likes of Sun Capital for endeavoring to raise ever larger and larger funds.  But we might look skeptically at any firm that jumps its assets under management 400% from one fund to the next.  Perhaps it was a sign of excessive growth, that a firm that made its best returns, even recently, investing in slices under $25 million, was raising $6 billion last year.

I remember this period.  It is right about when teasers for three or four companies that had barely been owned by a certain brightly glowing parent (who shall remain nameless) for 12-18 months, landed on the desks of our Business Development folk.  Too small now.  They wanted out fast to concentrate on larger things.  No time to manage these anymore.

Let's consider:

More than half of the revenue from Sun's 75 companies comes from retailers, restaurants or auto businesses -- all cyclical industries that depend on ever-fragile consumer-spending levels.

Serious over-concentration in cyclicals...

Sun attracted wider notice when it closed a $6 billion fund last spring, four times the size of its previous one.

...with a necessary reduction in quality filters and increase in investment size to accommodate a much larger swath of money...

While private-equity firms protest they are not into "financial engineering," Sun embraces the concept.

...returns highly correlated to financial engineering...

Because Sun often puts little money into its deals, a single successful investment can generate huge upside.

...and leverage...

Like other buyout shops, Sun has departed from its core buyout strategy. It launched a stock-picking vehicle in 2004. Sun Capital Securities Fund applies its turnaround expertise to the stock market, buying stakes in ailing public companies.

...with a shift from core strategy of turnaround and control investments, results in...

Sharper Image seeks liquidation

Private equity firms should be turn around shops.  But there are limits.  And those sit below $6 billion funds, and the skills required to succeed seem to contraindicate PIPE transactions and long-short equity strategies.  Why should this surprise us?  Looking at small underperformers and identifying problems that invite control investment and an active parent simply doesn't prepare you for value investing in public equities.

"We were on the board but were not operationally involved," Mr. Leder says. "It was just a bad stock pick."

I think it was more than that, Mr. Leder.

Mark the Mark to Market Provisions

mark it to mark it Never slow on the draw, the always yummy Abnormal Returns catches The Economist pointing out that "Mark to Market," really isn't so bad after all.  As a lover of markets and price discovery, I find many of the arguments proffered quite compelling.  But, and it pains me to say so, I think The Economist naive in this particular case.  Consider:

In a crisis prices fall until bottom-fishers start to buy. Yet when assets were booked at their original price, rather than the market one, banks could delude themselves—and investors—that dross was gold. Under historic-cost accounting, the banks had every reason not to restructure assets, because that meant owning up to their losses. Look at Japan, where the economy was sunk for most of the 1990s by stagnant loans to “zombie” companies. Historic-cost left investors in the dark about valuations; it was also prone to fraud and fraught with moral hazard, since sloppy lending went unpunished.

True, from a historical perspective, it is interesting to reference 1990s Japan, or fret that "banks had every reason not to restructure assets," but this presumes that banks even hold these assets on their books today, and mostly they do not.  In fact, they take rather great pains to avoid doing so.

Today the dynamic is different, but the effect the same.  Instead of holding the assets on their books, the banks hold derivatives with the underlying assets elsewhere- certainly "off balance sheet" somewhere.  Moreover, instead of possessing no incentive to restructure, they have every reason not to permit a market transaction- an easy endeavor in an already illiquid market and where their fingers are on the pulse of any number of other instruments (credit default swaps, collateralized debt obligations, etc. etc.) in the marketplace.

Are we surprised when people point fingers at Bear and suggest, for instance, that they are buying up the underlying assets and loosening credit terms on the debtors to avoid a default, a mark to market problem and, to boot, to avoid paying, for instance, on credit default swaps- for which their liability is much greater than taking a complete loss on the debt itself would be?

There are any number of instances where firms that stand to lose from "Mark to Market" or other provisions in instruments that might be triggered by chaotic markets, employ any number of tricks to avoid a repricing, or the pain of market action.  CDOs and such are not nearly the beginning or end of such tactics.  The wonderfully emergent Financial Crookery (a new favorite here at Going Private) spots similar flips in the LYON markets.  To wit:

Merrill Lynch today announced it was exiting the subprime mortgage origination market. Probably good news, right? At the same time it announced a modification of the terms of one of its existing convertibles.  No discussion, no reason, just a modification.  Probably bad news, but not for convertible holders.


Today's sweetening amendments (i) increase the conversion ratio by 17% and (ii) add a couple of put dates in 2010 and 2014 (the maturity date is 2032). Merrill get nothing in return for these new features, they are unilaterally value-enhancing for the bonds. The bonds' fair value is now presumably sufficiently above next week's put strike that bondholders will not exercise. Cash call avoided, at least for now.

Beware "Mark to Market" accounting where:

1.  Liquidity is limited
2.  Instrument issuers/holders have:

(a) An incentive to avoid markdowns via a transaction
(b) The ability to prevent or delay market transactions
that would trigger a markdown

In chaotic markets, be prepared for holders and issuers to "pay any price, bear any burden" to avoid the consequences of chaotic markets.  Structure yourself to be on the winning side of these dying gasps, and never forget that you can win "too well," if you aren't careful, and be hulled by a government bailout, sympathy for the stupid or the subject of malicious envy from the slower wildebeests in the herd.  Remember, there are few animals more dangerous than a wounded and envious wildebeest facing markdowns connected to derivative liabilities.

A Little Noise to Leave You With

photo submitted without comment "You hear some preacher thundering about faggotry and the next thing you know he's going to be found down on his lousy knees."

- Christopher Hitchens, February 29, 2008

Tuesday, March 11, 2008

"Going Private Regrets the Error"

for whom the bell tolls An avid reader wonders after my post on the dangers of being ringside to hear the death rattle of desperate financial institutions or other issuers/holders on the wrong side of credit crunches and collapsing asset prices.  I pointed out that the nature of "Mark to Market" accounting incentivized market actors to avoid transactions that might cause markdowns, or otherwise attempt to "manipulate" markets to minimize their exposure to derivatives.  I commented:

Are we surprised when people point fingers at Bear and suggest, for instance, that they are buying up the underlying assets and loosening credit terms on the debtors to avoid a default, a mark to market problem and, to boot, to avoid paying, for instance, on credit default swaps- for which their liability is much greater than taking a complete loss on the debt itself would be?

There are any number of instances where firms that stand to lose from "Mark to Market" or other provisions in instruments that might be triggered by chaotic markets, employ any number of tricks to avoid a repricing, or the pain of market action.  CDOs and such are not nearly the beginning or end of such tactics.

"Loosening credit terms on the debtors," isn't exactly an apt description of the kinds of things that would be particularly effective in dealing with e.g., credit default swap liabilities.  However, buying up defaulted asset backed securities at par to artificially prop up CDO valuations (mark to market, remember), inject cash into the flagging CDO structure and avoid triggering credit default swap liabilities on the instrument, is.  The key distinction that makes it wildly worth it to attempt such a thing if you are on the wrong side of a credit default swap is the fact that 10:1 to 100:1 leverage is often being applied such that the derivative liabilities floating above the assets may vastly outweigh the value of the underlying instruments.  Pretty cheap to just stick your hand in the black box of "mark to market" and prevent a write-down that way, nay?

Then there are the other little tricks we are starting to see.  For instance, resort to "mark to model" (or "mark to myth") accounting, and turning a blind eye to the double digit asset price declines that should probably have been in the model six months ago.  Desperately trying to hang on to foreclosed assets to avoid a dump on the market that will push assets down even further.  And so on, and so on....

Thursday, March 13, 2008

Liquifying (then Liquidating) the Illiquid

liquidation next? It will surprise no regular reader of these pages that a major part of the tremendous housing boom the United States has experienced was played by the invention and marketing of mortgage backed securities (MBS).  Fans of the old Michael Lewis (who know that the new Michael Lewis seems to have been transformed into a bitter journalist hack, is the subject of an alien abduction and impostor replacement scheme, or perhaps has simply been browbeaten by life into a poorly disguised and very tired political operative) will delight in remembering his descriptions of the founding of Salomon Brothers' mortgage security department (the first on The Street) and the uphill battle Salomon sales folk fought to popularize the instruments.  Lewis recounts the "skit" that Salomon sales people acted out for his trainee class in Liar's Poker:

Two played Salomon salesmen; two played managers of a thrift.  The plot ran as follows: The Salomon salesmen enter the thrift just as the thrift managers are leaving, tennis racket in one hand and a bag of golf clubs in the other.  The thrift men wear absurd combinations of checkered pants and checkered polyester jackets with wide lapels.


The Salomon salesmen, having schmoozed their client, move in to finish him off.  They recommend that the thrift managers buy a billion dollars' worth of interest rate swaps.  The thrift managers clearly don't know what an interest rate swap is; they look at each other and shrug.  One of the Salomon salesmen tries to explain.  The thrift managers don't want to hear; they want to play golf.  But the Salomon salesmen have them by the short hairs and won't let go.  "Just give us a billion of them interest rate swaps, so we can be off," the thrift managers finally say.  End of skit.

That was the sort of person who dealt in home mortgages, a mere sheep rancher next to the hotshot cowboys on Wall Street.

Lewis is being a bit tongue in cheek, but the sophistication spread between the characters he paints is quite understandable.  The business of writing home mortgages is, as Lewis aptly describes it, messy.  Personal.  "Down home."  The asset itself, the collateral, is anything but fungible, or liquid.  The debtors, too, are anything but fungible and (mostly useless attempts at credit scoring notwithstanding) subject to a great opacity with respect to their ultimate creditworthiness.

And this, I think, is an interesting point.  The opacity that accompanies attempts to liquefy the illiquid and its impact on markets, particularly when they have to unwind.

Even messier than their creditworthiness, mortgage debtors are prone, in good times anyhow, to prepay the entire debt or to refinance at a lower rate.  There is nothing more annoying to a long-term, fixed income investor than a fixed income instrument that might, randomly, just prepay one day.  Just when those interest rates were looking good you get left with a pile of cash and, should you reenter the market, lower returns.

Short of prepayment, there is "curtailment," where debtors make larger payments than scheduled, reducing their debt expense, and, again, complicate the cash flow characteristics of the underlying instrument.

The key thing to remember about both of these effects is that they boost early cash flow (but reduce capital at work) in good times.  More importantly, they can have the effect of a net reduction in cash flow in bad times, relative to good times- exactly when you don't want cash flow trending down.  Modeling these cash flows is, of course, a non-trivial exercise.

Then there is the fact that people sign mortgages when they are ready to, not on "mortgage signing day," once a year.  That means maturities for each mortgage, obviously, vary.  Again, this is messy.

All of this conspires to keep them illiquid, and reinforce their tendency to hang around on balance sheets and increase reserve requirements for institutions holding them.

Mortgages also just don't have much scale.  To get enough size to be interesting for large scale financial instrument work you have to pool a bunch of them.  Once that is done you have yet another layer of opacity.  What market actor (except maybe Bill Ackman) is going to poke around and analyze all those individual mortgages?

Of course, pools are appealing in some sense, as slaves to normal distributions will rush to point out, because of the diversification against any single mortgage default they create.  So the effort becomes to develop a set of characteristics, standards, that describe a given pool.  To "de-unique" them, a prerequisite to introducing some liquidity to the asset class.

How might we classify mortgages?  Size of the underlying mortgages, perhaps.  Interest rates, of course, are bracketed as descriptors.  "Weighted average maturities," which are dollar amount weightings of the time to maturity of the loans in a pool.  Prepayment speed.  Current loan balance (Low, below $80,000 or $85,000 to Super High, upwards of $150,000 or $175,000).  And, of course, in the never ending spirit of hopelessly simplifying the intrinsically complex, ratings- themselves based on a given set of characteristics and standards, "prime" and "subprime" being the main actors in that play.

Supposing a residential mortgage backed security (RMBS) has thousands of collected debtors (a good bet) it represents a somewhat arbitrary classification of an otherwise widely diverse bunch of counterparties.  And, technically, investing in an MBS isn't a cash flow investment.  It is an investment in the underlying collateral.  This is problematic, even if you do have a good model for predicting the ultimate cash flows.

You can quickly see where this leads.  Blending different MBS instruments into a portfolio helps if you want exposure to the asset class, but it doesn't change the cash flow issues, and diversification can be time consuming.  You either have to monitor a wide variety of MBS instruments (and along with all the portfolio optimization and balancing issues here you can complicate things even more by throwing in models to try to find uncorrelated MBS instrument classes and build a efficient portfolio) all the time, or you have to find a new job.  Wouldn't it be nice if some nice manager did all that work for you and gave you predictable cash flows?  Something linked to LIBOR for instance?  Wouldn't it also be great if you could get the MBS assets off your balance sheet so you could reduce your reserve requirement but still be exposed to (and enjoy the "safe" returns of) the asset class?  Enter the CDO.

CDOs reduce the number of underlying instruments in the pool to 200 or less, permit the issuer to use leverage to boost return, earn a management fee and to retain any excess return after the CDO notes, issued against the RMBSs or other securities, are paid.  These notes should, therefore, enhance liquidity since they are "un-unique," and (hurray!) have reduced balance sheet impact.

CDOs also introduce another opaque layer.  What does a buyer of instruments from a CDO know about the underlying asset pools?  Let's just see:

It is a condition to the issuance of the Notes that the Class A Notes be rated "AAA" by Standard & Poor's Ratings Services, a division of The McGraw-Hill Companies, Inc. ("Standard & Poor's") and "Aaa" by Moody's Investors Service, Inc. ("Moody's," together with Standard & Poor's, the "Rating Agencies"), that the Class A2 Notes be rated "AAA" by Standard & Poor's and "Aaa" by Moody's, that the Class A3 Notes be rated at least "AA " by Standard & Poor's and at least "Aa2" by Moody's, that the Class A4 Notes be rated at least "A" by Standard & Poor's and at least "A2" by Moody's, that the Class B Notes be rated at least "BBB+" by Standard & Poor's and at least Baa1 by Moody's, that the Class B2 Notes be rated at least "BBB" by Standard & Poor's and at least "Baa2," by Moody's, that the Class B3 Notes be rated at least "BBB-" by Standard & Poor's and at least "Baa3" by Moody's, and that the Class C Subordinated Notes be rated at least "BBB-" by Standard & Poor's.  The Class D Subordinated Notes will not be rated by any Rating Agency.

Not much.  Time to play golf yet?

As you can see from the Placement Memorandum excerpt above, issuers of CDOs quickly figured out that they could tranche out the returns of their pool in different instruments.  I've touched on the motivations for that sort of split before, citing a paper referenced some time ago by Alea.  In short:

For those issues where our model predicts a higher optimal number of tranches, we find that additional uniquely-rated tranches are associated with higher prices for the issue as a whole. This suggests that structuring is allowing issuers to exploit market factors – such as greater investor sophistication and heterogeneous screening skills related to asymmetric information – to their advantage via tranching.

All this lends the appearance of liquidity.  We have "fungibled" the unfungible and liquefied formerly illiquid assets.  But, just a second there.  There is a big difference between "potentially liquid" and "liquid."  True, they have all the ingredients of liquidity now, but that does not a market make.  I touched on this issue as well with reference to corporate and municipal issues, pointing out via the always interesting "Accrued Interest" that:

According to TRACE, which is a system for tracking corporate bond trading, about 4,300 TRACE eligible corporate issues trade each day. That's less than 3% of the total corporate universe. I note that trading activity in non-TRACE eligible bonds is not publicly reported. According to the MSRB, about 14,900 municipal bonds trade each day, or just over 1% of the universe.

This starts to make matters interesting when you delve into what I will crudely call "second order liquidity."  What happens when you have to unwind a CDO?  Whatever the liquidity of its instruments, what is the liquidity of the underlying assets, the collateral?  What is that composed of, and how liquid is it?

And this is where I return to the concept of "opacity."

So, traveling up the securitization chain, which opacity membranes do we pass through?

First, between the debtor and the lender: The character of the ultimate debtor.  Reduced to credit score (a somewhat mysterious, black art sort of ranking).  Between the lender and the collateral, the quality of the collateral itself.

Second, between the lender and the pool sponsor, the quality of collateral and debtor, further complicated by the nuances of individual mortgage originator policies on credit and credit verification- for which no easy classifications exist.  There might actually be an additional level of opacity here, if the lender used an "outsourced" origination mechanism (bet on it).  As to the quality of the collateral... as we move through opaque membranes, this is reduced almost entirely to purchase price (mortgage size, Jumbos, etc. etc.).  If we tried, could we possibly think of a more dangerous metric for collateral quality than acquisition price?  One that would have an even more exaggerated value inflation effect during a bubble?

Third, between pool sponsor and CDO issuer, just about anything about the basic collateral, aside from generalized descriptive characteristics of the RMBS instruments.  A reduction in creditworthiness score to "prime" or "subprime," is now evident.

Fourth, between CDO issuer and everyone else, anything specific at all about underlying collateral, including what the portfolio actually holds look today, to the extent the CDO manager is even remotely active.  These are reduced to ratings agency assessments of the instruments issued by the CDO (which, we assume, involve some scrutiny of the underlying assets and liabilities, albeit still obscured below the structure of RBMS instruments).  The underlying liquidity, two levels lower, is also effectively masked, unless the holder of CDO issued notes has a in-depth understanding of the CDO pool, what instruments compose it, the markets they trade in and their liquidity properties (read: unlikely).

Astute Going Private readers will enjoy these sorts of structural questions, understand their intrinsic connection with issues of structure and leverage, the impact of illiquidity on markets, and a careful analysis of incentives- looking each step of the way for information asymmetries (and what do you think "opacity" is exactly?) as they formulate the investment thesis for their next  shorting opportunity in multi-tiered, opacity laden, "liquefied" "securitizations."


DustAfter two long years, and in a fit of insomnia brought on by too many Coen Brothers films (a particular weakness of mine- my theory, after three viewings, on No Country for Old Men is that everyone who tries to straddle both worlds, the good and the evil, pays for it.  Only those who are pure, who accept and embrace the limits of their goodness, or their evil, Anton, the gas station attendant, Tommy Lee Jones, survive the film), I have updated Going Private's "about" page.  I suppose it is sort of amusing when you only have to change two digits on the date of the old "last updated" entry to reflect reality.  Ironically, there wasn't much new to add.  I suppose I could have fleshed out the "frequently asked questions" section some more, but not really.  I would have spent a lot of time reproducing obnoxious, or patently obscene questions.

For the most part I have endeavored to avoid personal reference, and personal commentary, aside from my view on e.g., economics, or policy- or perhaps to explain my inability to post regularly for a time.  Except in that sort of tangential way, I always had an aversion to making Going Private about "me."  To me it has always been more about the industry, the business, free markets, and suchlike.  It is not that I am not sentimental, well, ok, not solely that, but rather that it felt very... imposing?  Imposing and presumptuous to write yet another blog about "a day in the life of Cindy Q. Whoever."  Aren't there enough of those?

Still, it had been a vague desire of mine to do something retrospective for Going Private's two year anniversary.  Unfortunately, I happened to be so busy that particular month, that it passed me by unnoticed.

I feel like a contrite husband who worked right through his anniversary without noticing.  (Though, I will point out that you, dear reader, would then play the part of the vindictive wife who let the critical date pass in complete silence- without so much as a vague, veiled reminder- as a cruel test your hard-working husband was designed to fail).

That retrospective desire, however, battled with the sentiment that to do more than list a series of "anniversary facts" would be self-serving, self-indulgent and self-centered.  The tendency to prolific verbal exposition in my life, I always felt, should be limited to the late night calls I field from Laura The Debt Bitch after her long night of good coke and bad sex.

4:12 am
In hushed tones: "You ARE awake!  I have to tell you something about how I love working with you."
"Uh huh.  Uh, what time is it?
"Doesn't matter."
"Why are you whispering?"
"I'm in bed."

-moderate length pause-

"Your bed?"
"No, stupid.  He's sleeping.  Don't worry."

-long pause-

"What do you want, Laura?"
"I love working with you.  Really."
"Ok.  Thanks."

Trite.  Contentless.  Better never uttered in the first place.

Be this as it may, tonight (this morning) I cannot help myself.  I have enjoyed intensely writing Going Private.  I have reveled in the reader mail, the commentary, and some of the (by necessity distant) friendships Going Private has brought me.  It would be somewhat heartless of me not to inject a bit of sentiment, no?

And so, I give you, sort of a mean between extremes of the two battling forces of sentiment and sterility: Equity Private's top 15 Going Private Posts of 2006 (2007 to follow):

Swords at Dawn

Compelled to Submit to Privations

Punishing Talent for Fun and Profit
NYSE Buyout in the Works
Kierkegaard, Scientologists, Private Equity

What Spaceward Ho! Taught Me

Enron, Overhang and Private Equity

Control, Liquidity and "The Deal"

The New Baroque

They're KKRrreat!

Don't Cross the Debt Bitch
Mission Impossible Capital, LP
The Lost Wisdom of Polonius
Bourgeois Pigs

Difficult to Ignore

the elephant in the room It is beyond difficult to write a blog that purports to cover private equity and not mention (with some glee if you are in the middle market) the mounting woes that plague Carlyle in the face of daunting margin calls from lenders.  Oops.  Carlyle is, however, awfully lucky in that certain other Schadenfreude magnets have created a much larger media splash.  One would almost think Carlyle had no influential enemies with media connections for all the press silence on the issue.  Alea catches the quote of the year for private equity (and it's only March):

The last few days have created a market environment where the repo counterparties’ margin prices for our AAA-rated U.S. government agency floating-rate capped securities issued by Fannie Mae and Freddie Mac are not representative of the underlying recoverable value of these securities....

Wow.  What happened?  We couldn't have seen this sort of thing anywhere else, could we?

Only slightly less amusing is this quote from Carlyle last week:

Carlyle said it had hired Olivier Sarkozy, half-brother of French President Nicolas Sarkozy, from investment bank UBS as it looks to "capitalize on the dislocation in the financial services sector."

Buy buying their own distressed assets at a discount, perhaps?

Breaking Views has a good piece on the fiasco.  To wit:

Carlyle Capital's investment manager's report for January, shows its funds, amplified with heavy borrowing, were 99% invested in agency securities.

Where "agency securities" is Fannie Mae and Freddie Mac.  Says Reuters today:

Carlyle said it has defaulted on about $16.6 billion of its debt and said the only assets held in its portfolio as of Wednesday were U.S. government agency AAA-rated residential mortgage-backed securities.

Carlyle Capital said that during the last seven business days the company had received margin calls in excess of $400 million.

I think that's it for them.  Indeed, if their lawyers are worth their salt, a lot of these vehicles will be insulated, but this kind of damage goes deeper than pure legal liability.  Indeed, Bloomberg quotes a Carlyle spokeswoman, who points out that the buyout operations of the entity are (mostly) quite distinct, with:

The Carlyle Group's only material financial exposure to CCC is through a $150 million unsecured subordinated revolving credit agreement with CCC.

But their reputation capital must at this point be totally depleted.  Apparently they were leveraged in the neighborhood of 32:1.  Oops.  You can see that they knew this was a rather serious reputation issue in the tone of the death rattle they hissed forth towards the end:

The Dutch-listed company said U.S.-based buyout giant Carlyle Group participated actively in negotiations with lenders and was prepared to provide substantial additional capital if a successful refinancing could be achieved.

Carlyle Group managers have a 15 percent stake in the company.

It said negotiations deteriorated late on Wednesday when the pricing service used by certain lenders reported a drop in the value of the mortgage-backed securities collateral that is expected to result in additional margin calls on Thursday of approximately $97.5 million.       

Ouch.  Of course, astute Going Private readers will have taken my advice back in April, 2006:

Raising a distressed and special situations fund seems like a wise thing to do just now.

Art credit: "Tai," the painted elephant in the room in Banksy's September, 2006 exhibit, Los Angeles.

Wednesday, March 19, 2008

"That's Just Being Silly. Don't Be Silly."

gimme AGREEMENT AND PLAN OF MERGER, dated as of March 16, 2008 (this “Agreement”), between The Bear Stearns Companies Inc., a Delaware corporation (“Company”), and JPMorgan Chase & Co., a Delaware corporation (“Parent”). (Mmmm, optimism in terms).  WHEREAS, the Boards of Directors of Company and Parent have determined that it is in the best interests of their respective companies and their stockholders to consummate the strategic business combination transaction provided for in this Agreement in which Merger Sub will, on the terms and subject to the conditions set forth in this Agreement, merge with and into, Company (the “Merger”), with Company as the surviving company in the Merger (sometimes referred to in such capacity as the “Surviving Company”)....

What other interesting terms can we find I wonder?

"Surviving Company"
"Exchange Ratio"
"Risk Factors"
"Voting Debt"
"Broker's Fees"
"Material Adverse Effect"
"Covered Employees"
"Indemnified Parties"
"Alternative Proposal"
"Superior Proposal"
"HQ Property"
"Stockerholder Approval"

Anyone know where I can get custom refrigerator magnets made?

Mail Bombs

handle with care On or about December 3, 1994, defendant  THEODORE JOHN KACZYNSKI, a/k/a "FC,"  knowingly and willfully did deposit for mailing and delivery and knowingly and willfully did cause to be delivered by mail at North Caldwell, in the District of New Jersey, and elsewhere, according to the direction thereon, nonmailable matter, to wit: a device and composition which could ignite and explode, with the intent to kill and injure another, and which did result in the death of Thomas J. Mosser.

From:  Equity Private <[email protected]>
To:  aaa bbb <[email protected]>
Date:  Wed, 19 Mar 2008 09:20:38 -0500
This message is not encrypted, and is not digitally signed by .
On Wed, 19 Mar 2008 07:24:11 -0500 aaa bbb <[email protected]>

>I hope you read this and feel stupid:

Ah, look, my reader mail has brought me another angry, amateur,
"unbiased" armchair scientist and expert on the subject of electro-
intensive metal fabrication and manufacture.

Actually, I read it and feel smart.  I know most of the players
mentioned in the article, and I know how competent (incompetent)
they are and I know the flaws in their argument.

>Also,a brief editorial comment: please work on your literary
>voice.  Look up "verbose" in the dictionary.  Understand it has a
>negative connotation.  Remember , more and bigger words do not
>mean more and bigger intelligence.
>Aside from that, I enjoy your blog.

"More and bigger intelligence"?  Now that is a classic place for a
grammar flub.

If you are threatened by vocabulary and wit (and prone to rely on
Slate.com for your technical education) it is probably better if
you just find another blog to read- or at least resist the
masturbatory temptation to ejaculate your sticky commentary all
over my screen.

I suspect the world will eventually teach you that the slagging
rumble your email's tone- a sing-song, schoolyard whine- conveys is
something not entirely flattering to you.

Other than that I enjoyed your email.  Thanks for writing!


From: Equity Private <[email protected]>
To: aaa bbb <[email protected]>
Date: Wed, 19 Mar 2008 11:22:58 -0500
This message is not encrypted, and is not digitally signed by .

On Wed, 19 Mar 2008 10:51:56 -0500 aaa bbb <[email protected]>

>My what a witty and grammatically correct riposte - I'm genuinely


>However, you still seized on some  pseudo-scientific
>garbage (you ridicule Slate?), then deemed it sancrosanct fact
>because it fits your  self-image as some sagacious contrarion -

"Contrarian" ?

>somewhat reminiscent of Beckett's fictonal presentation to the
>Modern Language Society of Dublin, no?

You meant "fictional" I suppose.  And "sacrosanct," I think.

No, it was you who seized on pseudo-scientific garbage.  Slate is
pseudo-whateveritprints actually.

Toyota, for instance, in claiming an energy consumption number for
the manufacture of their hybrids, does not include the extraction
and refinement of their raw materials.  Aluminum and Magnesium in
particular are highly energy intensive to produce and form into
prefabricated forms (where Toyota takes possession of them).  All
the energy spend in those processes is before Toyota gets them, and
Toyota doesn't bother to count that, or count the post-manufacture
costs of, e.g., disposal, recycling, etc.  Convenient for Toyota,
this ignores as much as 85% of the energy cost of their "miracle"

But, since you rely on the likes of Slate to make me "feel stupid,"
you wouldn't know any of that.  This is because you are an arm-
chair reactionary, much more married to your own preconceived
notions of "reality" than an exerciser of critical thought or
skeptical inquiry.  Typical armchair leftist, I am afraid.

>And it doesn't matter that you deftly spin the phrase "electro-
>intensive metal fabrication and manufacture", and that you "know
>most of the players" and dismiss them as incompetent.  You still
>look like a fool.

To who, your ilk?  I take that as a compliment of the highest order.

Exercise for the student: What percentage of total electricity use
in the United States is consumed in the manufacture of aluminum?

Exercise #2 for the student: What is the "kilowatt per pound" cost
of aluminum manufacture?

You never should have written me with your preachy (but content
free) taunt without having these figures at your disposal- but
then, none of your ilk will let facts get in the way of your moral

>Now to my point about verbosity.  I am not threatened in the
>slightest by grammer

You mean "grammar"?  I can see you don't have enough of a
relationship with the concept to be threatened by your abysmal
proficiency in it.

>wit, or big words (btw the grammer flub was intentional genius).

Whatever helps you sleep at night.  (Your three others so far were
intentional too I suppose?)

>HOwever I've noticed you succumb to the
>common temptation to rely heavily on multi-syllabic words of latin

You mean "Latin" ?

[Drivel elided]

>also as an aside, its been my experience that intellectually
>arrogant people typically make crappy investors.

Gee, what do your returns look like?

My Photo

Offering Memorandum

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