Greed is Good?

Prof. Roy C. Smith, former managing partner at Goldman Sachs and my professor at NYU talks about bonuses at Wall Street firms. We discussed this topic in class and his rationale and points were worthy. Or was it that they seemed right because I was on a different side of the line? The professor said that the headline was not his idea and he didn't like it as well. He also said that he got close to a hundred hate mails for the article which appeared in the weekend edition.

Produced in verbatim, the article written by Prof. Smith in the Wall Street Journal
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1973 was a terrible year on Wall Street. An unexpected crisis in the Middle East led to a quadrupling of oil prices and a serious global economic recession. The president was in serious trouble with Watergate. The S&P 500 index dropped 50% (after 23 years of rising markets), and much of Wall Street fell deeply into the red. There were no profits, and therefore no bonuses.

I was a 35-year-old, nonpartner investment banker then and was horrified to learn that my annual take-home pay would be limited to my small salary, which accounted for about a quarter of my previous year's income. Fortunately the partners decided to pay a small bonus out of their capital that year to help employees like me get by. The next year was no better. Several colleagues with good prospects left the firm and the industry for good. We learned that strong pay-for-performance compensation incentives could cut both ways.

Many wondered if that was still the case last week, when New York State Comptroller Thomas DiNapoli released an estimate that the "securities industry" paid its New York City employees bonuses of $18 billion in 2008, leading to a public outcry. Lost in the denunciations were the powerful benefits of the bonus system, which helped make the U.S. the global leader in financial services for decades. Bonuses are an important and necessary part of the fast-moving, high-pressure industry, and its employees flourish with strong performance incentives.

There is also a fundamental misunderstanding of how bonuses are paid that is further inflaming public opinion. The system has become more complex than most people know, and involves forms of bonuses that are not entirely discretionary.

The anger at Wall Street only grew at the news that Merrill Lynch, after reporting $15 billion of losses, had rushed to pay $4 billion in bonuses on the eve of its merger with Bank of America. Because Merrill Lynch and Bank of America were receiving substantial government funds to keep them afloat, the subject became part of the public business. The idea that the banks had paid out taxpayers' funds in undeserved bonuses to employees, together with a leaked report of John Thain's spending $1 million to redecorate his office, understandably provoked a blast of public outrage against Wall Street. The issue was so hot that President Barack Obama interrupted his duties to call the bonuses "shameful" and the "height of irresponsibility." Then, on Wednesday, he announced a new set of rules for those seeking "exceptional" assistance from the Troubled Asset Relief Program in the future that would limit cash compensation to $500,000 and restrict severance pay and frills, perks and boondoggles.

In the excitement some of the facts got mixed up. Mr. DiNapoli's estimate included many firms that were not involved with the bailout, and only a few that were. Merrill's actions were approved by its board early in December and consented to by Bank of America. But the basic point is that, despite the dreadful year that Wall Street experienced in 2008, some questionable bonuses were paid to already well-off employees, and that set off the outrage.

Many Americans believe that any bonuses for top executives paid by rescued banks would constitute "excess compensation," a phrase used by Mr. Obama. But no Wall Street CEO taking federal money received a bonus in 2008, and the same was true for most of their senior colleagues. Not only did those responsible receive no bonuses, the value of the stock in their companies paid to them as part of prior-year bonuses dropped by 70% or more, leaving them, collectively, with billions of dollars of unrealized losses.

That's pay for performance, isn't it?

Source:Wall Street Journal
Wall Street" has always been the quintessential, if ill-defined, symbol of American capitalism. In reality, Wall Street today includes many large banks, investment groups and other institutions, some not even located in the U.S. It has become a euphemism for the global capital markets industry -- one in which the combined market value of all stocks and bonds outstanding in the world topped $140 trillion at the end of 2007. Well less than half of the value of this combined market value is represented by American securities, but American banks lead the world in its origination and distribution. Wall Street is one of America's great export industries.

The market thrives on locating new opportunities, providing innovation and a willingness to take risks. It is also, regrettably, subject to what the economist John Maynard Keynes called "animal spirits," the psychological factors that make markets irrational when going up or down. For example, America has enjoyed a bonus it didn't deserve in its free-wheeling participation in the housing market, before it became a bubble. Despite great efforts by regulators to manage systemic risk, there have been market failures. The causes of the current market failure, which is the real object of the public anger, go well beyond the Wall Street compensation system -- but compensation has been one of them.

The capital-markets industry operates in a very sophisticated and competitive environment, one that responds best to strong performance incentives. People who flourish in this environment are those who want to be paid and advanced based on their individual and their team's performance, and are willing to take the risk that they might be displaced by someone better or that mistakes or downturns may cause them to be laid off or their firms to fail. Indeed, since 1970, 28 major banks or investment banks have failed or been taken up into mergers, and thousands have come and gone into the industry without making much money. Those that have survived the changing fortunes of the industry have done very well -- so well, in fact, that they appear to have become symbolic of greedy and reckless behavior.

The Wall Street compensation system has evolved from the 1970s, when most of the firms were private partnerships, owned by partners who paid out a designated share of the firm's profits to nonpartner employees while dividing up the rest for themselves. The nonpartners had to earn their keep every year, but the partners' percentage ownerships in the firms were also reset every year or two. On the whole, everyone's performance was continuously evaluated and rewarded or penalized. The system provided great incentives to create profits, but also, because the partners' own money was involved, to avoid great risk.

The industry became much more competitive when commercial banks were allowed into it. The competition tended to commoditize the basic fee businesses, and drove firms more deeply into trading. As improving technologies created great arrays of new instruments to be traded, the partnerships went public to gain access to larger funding sources, and to spread out the risks of the business. As they did so, each firm tried to maintain its partnership "culture" and compensation system as best it could, but it was difficult to do so.

In time there was significant erosion of the simple principles of the partnership days. Compensation for top managers followed the trend into excess set by other public companies. Competition for talent made recruitment and retention more difficult and thus tilted negotiating power further in favor of stars. Henry Paulson, when he was CEO of Goldman Sachs, once remarked that Wall Street was like other businesses, where 80% of the profits were provided by 20% of the people, but the 20% changed a lot from year to year and market to market. You had to pay everyone well because you never knew what next year would bring, and because there was always someone trying to poach your best trained people, whom you didn't want to lose even if they were not superstars. Consequently, bonuses in general became more automatic and less tied to superior performance. Compensation became the industry's largest expense, accounting for about 50% of net revenues. Warren Buffett, when he was an investor in Salomon Brothers in the late 1980s, once noted that he wasn't sure why anyone wanted to be an investor in a business where management took out half the revenues before shareholders got anything. But he recently invested $5 billion in Goldman Sachs, so he must have gotten over the problem.

As firms became part of large, conglomerate financial institutions, the sense of being a part of a special cohort of similarly acculturated colleagues was lost, and the performance of shares and options in giant multi-line holding companies rarely correlated with an individual's idea of his own performance over time. Nevertheless, the system as a whole worked reasonably well for years in providing rewards for success and penalties for failures, and still works even in difficult markets such as this one.

As firms became part of large, conglomerate financial institutions, the sense of being a part of a special cohort of similarly acculturated colleagues was lost, and the performance of shares and options in giant multi-line holding companies rarely correlated with an individual's idea of his own performance over time. Nevertheless, the system as a whole worked reasonably well for years in providing rewards for success and penalties for failures, and still works even in difficult markets such as this one.

At junior levels, bonuses tend to be based on how well the individual is seen to be developing. As employees progress, their compensation is based less on individual performance and more on their role as a manager or team leader. For all professional employees the annual bonus represents a very large amount of the person's take-home pay. At the middle levels, bonuses are set after firm-wide, interdepartmental negotiation sessions that attempt to allocate the firm's compensation pool based on a combination of performance and potential.

Roy C. Smith, a professor of finance at New York University's Stern School of Business, is a former partner of Goldman Sachs.

The Incorrigible Optimist

What’s the definition of optimism?
An Investment Banker ironing five shirts on a Sunday evening.

In the times that we live in, it is an unfortunate joke that is perched on the pedestal of possibility. Given the weird and incessant layoffs that we see day in and day out, it is not difficult to assume that the above joke is not far from reality. Every other day, I get the unfortunate news of someone I know who was asked to leave.

Mostly, I would add for little to no fault of theirs. All those who are crying hoarse for the blood of investment bankers need to realize that the Associate and to a large extent the Vice Presidents have had nothing to do with the current issue other than to be the menial labour in the chain.

Unfortunately, the bleeding just doesn't stop. What that means is that good and deserving candidates like us [ take a hike if you think otherwise :P ] don't get an entry into the door to show our wares.

This is likely to go on for long, though we would like to hope and wish that this was not the case. Aah well, the problems of an incorrigible optimist I guess. Another thought of hope I guess.

Option Valuation

Overheard between two MBA students [A and B] as they discuss another MBA student [C].

A: We had basically been discussing the new year eve parties
and i was telling C he should value it like an option
B: You said youu wanted help with option valuation!
A: The potential for an encounter is subject to much volatility
B: Okay, I can understand the analogy.
A: We wanted your expertise in option valuation to value the price of the party
A: Obviously the strike price is the ticket
B: Okay
A: The time frame is known. The woman's response is the volatility factor which we are having difficulty assigning value to. Bernanke has also helped by lowering interest rates to zero.
B:: Women are empirically known to be more volitile than the market. You have to take the volatility to be atleat 50%. If C can choose between the party and the chick, it has to be valued as a chooser! The best of both outcomes. Else if is buying the ticket, and can seek a refund then it is a put option.
A: One will lead to the other. Where is the chooser in it? If he doesn't got to the party, where will he meet the woman
B: I thought that he can go to a party with us or take a chick for a date
A: No, he is talking about going to a party and finding a girl there.
B: Then, it has to be valued as a compound call option. Event 2 is dependent on event 1. If he comes to the party, then there is a probability that he finds a chick. The key is in choosing the right party.
A: I guess that for him time also will be inversely proportional if he finds the girl at 6 AM, she may decide to go to breakfast rather than for some other 'activity'.
B: Yes, it seems to be a very complex option depending on whom he finds there. You can raise this question to (Aswath) Damodaran for real options. Anyway, from what i can see, we are busy valuing the option and C is busy with the chicks.
A: Yes, that is true. He seems to have disappeared.
B: I will catch up with you later.
A: Cool. Later.

Cutting the LEH pie

He cuts the LEH pie. Well, he is doing his job and is getting paid for it. We are talking about Bryan Marsal, Lehman Brothers' Restructuring Officer. Nevertheless, his demands are not exactly reasonable. This sounds like a classic case of make hay while the sun shines.

An article on how the Lehman Restructuring Officer wants very high incentive fees. This is what I call highway robbery. Creditors and management should not allow it. I guess the verdict for this question really lies in the hands of the honorable bankruptcy judge in the court of South District of New York.

Produced in verbatim from Bloomberg.com below

Lehman Restructuring Officer Marsal Wants 25% Incentive Fees
By Linda Sandler and Christopher Scinta

Nov. 18 (Bloomberg) -- Lehman Brothers Holdings Inc.'s restructuring officer, Bryan Marsal, asked a court to pay his firm incentive fees as high as 25 percent on top of the hourly rates he's charging to liquidate the bank.

Marsal's company, Alvarez & Marsal, has 125 employees helping Lehman sell assets and unwind trades. Marsal previously asked for $2.5 million upfront and hourly fees of as high as $850 for himself and other top executives. Under a proposal filed yesterday, A&M would start earning its bonus after recovering $15 billion for unsecured creditors of Lehman, which listed $613 billion in debt.

"Especially in a case like this, where the firm is also getting hourly rates, you would not want to have triggers for the incentive payments that are too easy to meet," said Stephen Lubben, who teaches at Seton Hall University School of Law in Newark, New Jersey. "The triggers do seem to be low, and at the very least A&M should offer some explanation for why this should be so."

The restructuring firm's request is part of an estimated $1.4 billion in fees for lawyers, accountants and other professionals that will make Lehman's bankruptcy the most expensive ever, surpassing the record set by Enron Corp. in 2004 according to calculations by Lynn LoPucki, who teaches bankruptcy law at Harvard University and the University of California at Los Angeles.

Fee Enhancements
Restructuring experts often demand bonus payments. Perella Weinberg Partners LP in 2007 had to forgo a success fee it wanted for advising shareholders in the bankruptcy of energy company Calpine Corp., which objected to paying the bonus. A judge ruled the same year that law firm Cadwalader Wickersham & Taft, which represented Northwest Airlines Corp., wasn't entitled to $3.5 million in ``fee enhancements'' on top of its $502 average hourly rate.

Also in 2007, Alix Partners gave up a $5 million success fee it had sought on top of $25.6 million in professional charges while winding down futures-trader Refco Inc.

"Bonuses are normally only granted after the fact to crisis managers who produce exceptional, outstanding, and unexpected results," said Martin Bienenstock, a Dewey & LeBoeuf lawyer who represents Lehman creditors including Walt Disney Co.

"Crisis manager employees do not need to be guaranteed bonuses in advance because they expect short-term work and have no reason to threaten to leave (just the opposite, in fact)," Bienenstock said in an e-mail.

Lehman's lead law firm, Weil Gotshal & Manges, may earn $209 million in fees from the Lehman case, LoPucki estimated. Lehman would pay Weil, led by bankruptcy partner Harvey Miller, $650 to $950 an hour for partners and counsel, and $155 to $295 for paraprofessionals.

A&M Rates
A&M has said it will charge from $175 to $300 an hour for analysts or administrators and $550 to $850 for managing directors. It will bill Lehman for fees and expenses every month or more often if A&M prefers, according to court documents.

Lehman, once the fourth-largest investment bank, has said it foundered because of deteriorating subprime and structured investments. It filed the biggest U.S. bankruptcy Sept. 15 with mostly unsecured debts.

Rebecca Baker, a spokeswoman for A&M, didn't immediately return phone calls seeking comment today.

The case is In re Lehman Brothers Holdings Inc., 08-13555, U.S. Bankruptcy Court, Southern District of New York (Manhattan).

Bitter pill for GM

Article after article, class after class and discussion after discussion seems to lead to one topic these days: General Motors.
Be it Roy Smith, David Yermack, Nouriel Roubini, Ed Altman or any other finance professor in school, discussions invariably funnel down to GM and on what they believe is the right approach to solve the problem. Give or take a few, the unilateral resolution is for GM to file for Chapter 11 bankruptcy.

Let us take a look at the CDS spreads that I noticed on the Bloomberg terminal this past week for General Motors.
Source: Bloomberg terminal in school
Based on industry perception, currently, there is a 60% probability that GM will default on it 5 year and 10 year debt. That is a very high probability given that most firms have a sub 10% probability of default.

Max Holmes very interestingly taught us last week the basics of Bankruptcy law in the US of A. He talked about how it is a hotch-potch between the Queen's [British] Bankruptcy Law and the law devised in the US by the founding fathers [maybe not the founding fathers of the nation, but rather the founding fathers of the corporate and bankruptcy law]. Chapter 7 of the Bankruptcy law is straight from the Victorian era [for the uninitiated, that is the British part] which talks about liquidation and is fairly severe. Chapter 11 of the Bankruptcy law on the other hand talks about restructuring and reorganization rather than pure liquidation. It is far more accomodating and forgiving, though not always for the management.

The unilateral [footnote: the ones I have heard] opinion in the NYU Stern academic fraternity is that General Motors should file for a Chapter 11 bankruptcy. In order to facilitate in its transition and reorganization out of bankruptcy, the firm should raise DIP [Debtor-In-Possession] financing. This will most definitely wipe out the Equity holders under the new capital structure [not that they have much left on the table anyway]. It is likely to impair the various existing tranches of its debt as well [including senior secured debt] as the DIP creditors will hold the highest priority [after the lawyer and administrative costs of course].

While the credit markets have frozen, it is likely that DIP financing should be available for the firm as it will be on very favorable terms [for the creditor] and will hold the highest seniority. There will be a lot of monitoring mechanism in place as well. The biggest factor is the possibility that the government will either provide the DIP financing itself [less likely] or will secure the DIP loan.

The other benefit of bankruptcy will be that all the UAW contracts will be null and void. GM workers are currently paid higher wages than those [for the record: all of them are American workers, in the US] workers at Toyota, Honda and the like. Coupled with that are high health benefit costs, pension costs and labor restrictions as part of the UAW deal. While GM has been able to negotiate some of these liabilities with UAW, they are far from being optimal.

Another aspect of the bankruptcy will be its effect on GM's pension liabilities. When a company in the US files for bankruptcy, all of its pension obligations are transferred to a independent corporation called the Pension Benefit Guaranty Corporation or the PBGC. As the name would suggest, the job of the PBGC is to guarantee pensions. While this will place a cap on the maximum amount of pension paid out and restructure [read: impair] the pension payments, I am sure that is not the first thing that is there on management's mind. At least, it should not be. Bloody capitalist you may scream. Well, no. When the boat is sinking, the captain of the ship has to take tough decisions.

There is sufficient pressure on the government to act on this matter. The government is likely to give its current bailout of USD 25Bn to the Big Auto companies. However, this is more like pocket change, especially given that it will be split three ways. GM's problems are far more grave than most people realize. Definitely more grave than a third of USD 25Bn for sure. The other option that the government has is to double the bailout package to USD 50Bn. Even in this scenario, GM is only likely to postpone judgement day. All it will achieve will be that it will live to fight another day. What GM and Big Auto need are policies that go beyond this.

Let us take a step back and see what GM is doing as a firm to address its problems. First of all, it has been working very hard on the technology front. While it was the last kid on the block when it comes to smaller and cleaner cars, it is desperately trying to play catch up. From what we hear, it is on the right track. Business is fairly diversified. The Latin America Africa Middle-East or LAAM business actually posted a profit on increase in sales. China, India and rest of Asia have seen a bit of slowdown, mostly due to decreased consumer spending in this region. In the US, the firm has been hit in a multi-fold problem: lower consumer demand, difficult financing options, financial crisis and oil prices.

On the financial side, the firm has tried to free USD 15 Bn. in cash to support these challenging times. This includes measures such as stopping dividend payments, reducing capital expenditures, streamlining processes and earmarking labor efficiencies. They have also looked at asset sales and raising money from the debt markets, though that has been the most difficult part. At the end of their previous quarter, they increased their self-help targets from USD 15 Bn to USD 20 Bn. These measures will significantly reduce the cash burn and free up additional cash for the firm.

These are merely short-term measures. One of the four scenarios are likely to happen.
General Motors gets NO bail-out: Highly unlikely, though a probability. The firm uses its self-help measures to sustain itself. Car sales go down drastically because customers are worried about the status quo and what that means to the future of GM, their cars and spare-parts and after sales services for them. This seems like a business killer.

General Motors gets a bail-out: This is what the firm is lobbying for. In Washington and through voters, the firm is trying to drum up support for this idea. This may work only if the credit market are back in time before GM has exhausted its new resources. However, the firm is still saddled with the possibility that this could mean a reduction in customer demand for their products, owing to the uncertainty.

Credit Markets get back to good ol' days: If the credit markets get back into shape before GM has to cry 'wolf', GM could potentially tap the credit markets to raise operating capital. Credit markets are probably the single most important reason that GM is facing the crisis of today. I agree that a lot has to do with sub-standard products and strategies in the past and a late realization of their fallacies. Nevertheless, GM would not have been in such a bad shape, if the credit markets were in a better shape. The possibility of credit markets coming back soon is remote, purely based on the manner in which they have broken down. That said, they will eventually come around. The question is: will it be in time? A million dollar question that I [and most economists] don't have an answer to. The general perception though is a flat NO.

General Motors files for Chapter 11: Firm gets the money to restructure, liabilities are pushed into the future and the firm comes out of bankruptcy [whenever it does] leaner and fitter.

The final option seems to be the most plausible, reasonable and most likely to work towards a long term solution. Nevertheless, we need to consider the impact it will have on the US markets. While it will in no way match the mayhem seen in the aftermath of the Lehman Brothers bankruptcy, it will be perceived as a major failure. While most people expect it to happen, when it finally dones, it will be seen a major stamp on the malaise that the US markets are seeing right now. This is likely to adversely affect other major corporate names on Main Street.

It is interesting to note that the management is pushing very hard for a bailout package from the government. All they say is that they are doing what they can from their end. And they are looking towards Washington for help. As Rick Wagoner said, 'Bankruptcy is not an option'. All of this leads me to wonder why the firm is so shy of courting bankruptcy.

First of all, there is the point of a tarnished image. There are a lot of costs associated with the bankruptcy. This will spell difficult times. Brand value will decrease. This could result in a reduction in their sales. Suppliers and dealers will not provide credit [assuming that they do right now] and may not be ready to stock up inventory as well. Overall, this will have a negative impact on the business. The question is whether it will be more than we currently see right now.

Another factor is that the firm believes that this is a credit market phenomenon and if credit facilities are made available, they should be able to tide this time and come out stronger. This goes in line with the live to fight another day belief.

I personally believe that the biggest factor in this 'No Bankruptcy at all costs' pitch is the fact that management will most definitely lose their jobs in such an eventuality. Rick Wagoner is unlikely to be around, even if he is an inside man and may be the person best suited for the job. Simple reason is that he sat over this current crisis and did not see it coming.

With DIP financing in place, with our without government support, there will be a strong clamor for the management to be replaced. On the other hand, if the management are able to secure a bailout or are in any manner able to hold off bankruptcy, they will be hailed as messiahs. This, even though they were the people who got them into this mess in the first place.

When management starts talking about the burden on PBGC in the scenario that GM were to go bankrupt, you know that there is more to it than meets the eye. When management talks about bankruptcy not being an option, you know that there is more to it than meets the eye. Or when they talk about shareholder value or fallout on labor for that matter. Corporate Governance? I think otherwise. Each one for himself if you ask me.

Greed and Short-Selling

An article on the Icahn Report which talks about the need for better control, the overwhelming effect of greed and the need to ensure and maintain short-selling as a market-equilibrium force.

Some interesting statements:
An unfortunate aspect of human nature is that some people will always try (and succeed) at "gaming" the system, no matter how prescient and attentive our regulators. - MaxSpeak: Sounds very familiar. Seems like someone that we know. Some people never learn.

The next time Warren Buffett labels something..., he could instead tell us which companies to bet against. - MaxSpeak: Would he rather not use it to his own personal benefit. And for the benefit of his firm. And once he has, its a moral dilemma.

Reproduced in verbatim from the Icahn Report
By Dylan Ratigan

Warren Buffett recently urged us all to follow his lead in buying American stocks during this fear-driven down market, invoking his common sense wisdom of being greedy when others are fearful and being fearful when others are greedy.

While I appreciate and agree with Buffett that it may be a good time to invest in this great country's long-term future, I also think there is a lot the Warren Buffetts of the world can do right now to help ensure a prosperous future.

First, we need to take a realistic view of how we got into the current financial calamity.

Instead of creating a society that harnesses the powerful force of capitalism to benefit us all, which resulted in the development of light bulbs, automobiles and computers, we have created a system in which the spirit of innovation has been hijacked to find better ways to cheat society for personal gain.

We have to face the reality that regulators alone can never keep ahead of the cheaters. An unfortunate aspect of human nature is that some people will always try (and succeed) at "gaming" the system, no matter how prescient and attentive our regulators.

I believe the solution to the current and historical problems with capitalism is to enact two pieces of regulation.

First, we must never again allow any company to become "too big to fail." Companies, by their very nature, take risk. Because of the competitive nature of capitalism, there is no amount of regulation, transparency or prudence that can successfully prevent companies from occasionally failing. This is especially true of banks, which will always be tempted to increase profits by pushing the risk envelope and will always find ways to do so.

Just as traditional commercial bank regulators have the authority to curb an excessively risky bank, we need to enforce a limit on the size of non-bank financial entities. This measure could help stop the inevitable failures that cause the systemic failures for which we are all now paying.

Second, and the most pertinent to Mr. Buffett, is that we need to promote, not stamp out, short-selling. It is only through the use of the skeptical force of short selling that those who would seek to inflate their company’s value by hiding or manipulating information will be forced to provide transparency that regulations could never mandate.

The wonderful thing about a stronger system of upward and downward pressure is that it forces companies to be more accountable. And if there is anything lacking these days, it is accountability among managements.

So instead of an activist like Carl Icahn trying to take over the board of a company, he could simply raise a "short" fund to target companies that have loaded their boards with cronies and yes-men.

Or the next time Warren Buffett labels something like derivatives as "financial weapons of mass destruction," he could instead tell us which companies to bet against. This will force these companies to change their behavior more than any government regulation ever can.

There is a reason why CEOs who helped get us into this mess regularly blame short sellers for their failures.

It is because short selling forces CEOs to either disclose what they are doing or suffer consequences for their secrecy. But rather than admit to 40-1 leverage, they loudly stigmatize those who would dare to bet against their companies.

Unfortunately, merely choosing "not to buy a stock" is not enough to force this kind of necessary transparency, for there is always a "greater fool" down the road to buy it. We need to actively punish these companies and managers in our role as profit-minded investors.

In simplest terms, choosing not to buy a stock because you don't like the company is like refusing to be friends with a drunk. But shorting a stock is like sending a drunk into rehab. Many of these companies, drunk with money and neglectful of risk, should have been sent to rehab a long time ago.

Obviously, we can never again allow the system to become so vulnerable to inevitable future corporate failures. But just as obviously, we can also no longer trust government alone to catch the cheaters and liars that have bastardized American capitalism.

Let's apply the human nature that creates these problems to expose and punish them financially. We must no longer pay heed to disgraced CEOs who falsely claim that their downfall was caused by "those evil short sellers."

Let’s face it - sober people do not mistakenly end up in rehab because it is so easy to prove that they are sober. But when we discover they are regularly drunk at lunch, that's where we can send them.

I can think of no one better than Warren Buffett to be that kind of friend to both our country's companies and its citizens.

Dylan Ratigan has established himself as a top financial anchor and reporter through his work on CNBC shows such as "On the Money" and "Closing Bell" as well as during his tenure at Bloomberg News, where he served as a Global Managing Editor and host of its "Morning Call" program. He is the anchor and co-creator of CNBC's "Fast Money"and the co-anchor of "The Call" and the 3 p.m. hour of the "Closing Bell."

The tough go to Dubai

Picture Source: Sumera's Blog on wordpress.com

An article that tells the tale as we know it. People are flocking to the GCC in hope of the fortunes that have dried up in New York.

Reproduced in verbatim from the NY Times Dealbook.

The global economy may be in the doldrums but many young, adventurous Americans — especially those in the floundering finance industry — think they know a place where the good times will keep rolling. The latest issue of New York magazine reports on how college graduates and recently laid-off young professionals are flocking to Dubai in hopes of finding riches and riding out the credit meltdown.

The Mideast emirate, a kind of desert-turned-theme-park, is sending out signals that it is still booming despite the downturn in the world economy. The young Americans are coming to do deals, hawk condos and create marketing ads touting Dubai’s benefits.

“For the first couple years I was here, I didn’t have any American friends at all,” one Emirati, munching lasagna at his Monday-night football watching party, told the magazine. “I’ve met more Americans in the last six or seven months than in all the time before that.”

But the article points out that Dubai has not been immune from the troubles in the larger financial system: Stock and real estate prices there have dropped sharply in recent months.

The article suggests that Dubai’s status as a safe haven may be closely linked to someplace else: Abu Dhabi. “The conventional wisdom now is that what ultimately safeguards Dubai’s future is not its near-mythical energy and savvy,” the article said, “but its oil-drenched sister up the coast.”

CDS and their perils

Interesting article by Prof. Figlewski and Prof. Roy Smith on Credit Default Swaps or CDS and how they wrecked the system. Prof. Smith often talks in class about how these instruments were supposed to diversify risk and be good for the system, only to be abused and misused beyond repair.

Reproduced in verbatim from the Forbes.com

Commentary
Credit Default Swaps Are Good For You
Stephen Figlewski and Roy C. Smith, 10.20.08, 12:55 AM EDT
What is dangerous is their misuse.

Warren Buffett has said that "derivatives are financial weapons of mass destruction," and in a credit crisis like the one we're in, many people think he wasn't kidding.

Recently, an auction was held to determine the size of the settlement on "credit default swaps" (CDS) that were written on the outstanding debt of Lehman Brothers. Each of these swaps was a contract between one party wanting to insure against the risk of a Lehman default and another willing to sell that insurance. (Lehman had nothing to do with the contracts, but the over-$600 billion of debt for which it was responsible had attracted about $400 billion in outstanding swap contracts).
About 350 different counterparties to the Lehman CDS contracts attended the auction, where it was determined that Lehman's debt would be worth only 8.62 cents on the dollar in bankruptcy. Those who sold insurance against Lehman's default (the "protection sellers") therefore must pay out 91.38 cents for each dollar of debt they insured. This is the largest payout ever in the $55 trillion credit default swap market. After netting out offsetting positions, cash payments will be approximately $270 billion, a huge amount even for this crisis, which has seemed to know no limits on the size of write-offs. And all this for just one default!
What Buffett didn't say was that while derivatives come in many sizes and shapes, every one of them is a zero-sum game for the users--for every loser, there is always a counterparty who wins an equal amount. Such contracts don't eliminate risk, and they don't increase it. They just transfer risk from one counterparty to the other. But this enables those who bear a risk to protect themselves against it, and considering the huge volume of risk-taking that occurs daily in financial markets, the ability to redistribute risk has to be seen as very useful.

Receiving the payments on the Lehman CDS contracts (which offset losses they had insured against) were a number of banks, brokers and other financial intermediaries. They had extended credit to Lehman but wanted to hedge the risk that it might default, an unlikely event at the time perhaps, but one with serious consequences if it occurred.

On the other side of the contracts, making the payments, were end-user investors such as insurance giant AIG [NYSE: AIG], PIMCO, the world's largest bond fund, and Citadel, a large hedge fund group. They took on the Lehman credit risk in exchange for a regular quarterly payment that seemed at the time to be a fair premium for insuring a default that probably would never happen.

For diversification, protection sellers maintain large portfolios of credit default swaps, just as an automobile insurance company insures a lot of cars. They lose on those that crash, but make it up on those that don't. Apparently none of these insurers have been buried by their Lehman exposure. But if there had been no credit derivatives and the banks and other intermediaries had been unable to hedge the risk, they would either refused to lend to Lehman at all or, more likely, they would now be adding these losses to the others they have already endured in this unusually difficult credit cycle.

Banks and investment banks function as both market makers, which requires them to carry inventories of risky securities for brief periods, and also as proprietary investors. They manage credit exposure in a number of ways, including hedging with credit default swaps. This transfers the risk to other investors, often outside the banking system (whose safety and soundness may benefit). A competitive market in credit default swaps contributes to the transparency of price-setting and thus to the efficiency of the whole process. This lowers the cost of financial risk management in general.

The vast majority of transactions in the credit default swap market are straightforward, insurance-type transactions. But losses on ordinary insurance contracts are sometimes much higher than expected, for example, when an unusually severe storm causes a lot more damage than was provided for when the homeowners insurance premiums were set. Such a storm may wipe out the insurer's reserves and even its capital, as appears to be AIG's unfortunate experience with its financial products insurance business. But that's the risk of providing insurance on events with low probability of occurring, but which result in large losses when they do.
A big problem in the over-the-counter credit derivatives market is the risk of counterparty default. The protection seller may be unable to fully cover the loss it is insuring against. To mitigate this risk, the protection seller may have to post collateral, but amounts and terms are negotiated between the counterparties and not standardized. When AIG's credit rating was cut from AAA to A in mid-September, it was suddenly obliged to post more than $14 billion in collateral against its CDS positions. This is what drove them over the edge. When Bear Stearns was teetering on the brink, the Fed examined the extent to which the firm was connected to other firms through their extensive web of OTC derivatives contracts and decided that it would be too disruptive for the market to let Bear fail.

These problems are significantly reduced for exchange-traded derivatives like futures and options. The exchange and its Clearing House establish high standards for the contracts, provide a centralized marketplace for them, establish and enforce rules on posting collateral and making payments and act as a guarantor that trades will be money-good and that users will not have to rely on individual counterparties to pay what they owe.

The over-the-counter credit default swap market needs such an exchange. Over-the-counter markets are too fragile, too loosely regulated and too opaque for such an important financial derivative as credit default swaps. What makes these swaps dangerous is misuse; an orderly exchange would help make them safer.
There have been informal efforts by the industry to organize such an exchange, which would have to operate globally in view of the size and breadth of the market, but so far, the effort has not been successful. It would benefit greatly by having the governments of the leading banking countries--which will soon be taking up a broader regulatory framework for banks after the current crisis--to require one to be established and regulated banks and broker dealers to participate in the credit default swap exchange.

Stephen Figlewski and Roy C. Smith are professors of finance at the Stern School of Business at New York University

No to Detroit?

Interesting article by Prof. Yermack on the auto industry and his perspective on the same. Academically sound and theoretically the right thing to do. Practically, impossible that Democrats will allow anyone to go down this road, especially after all the promises that have been made to this effect.

As usual, a question that I ask: Why did they not think when Lehman Brothers was going under. It could have saved them so much grief.

Produced below in verbatim from the Wall Street Journal.

NOVEMBER 15, 2008 Essay
Just Say No to Detroit
Given the abysmal performance by Detroit's Big Three, it would be better to send each employee a check than to waste it on a bailout, says David Yermack.

Before Michael Moore became famous for documentaries like "Fahrenheit 9/11" and "Sicko," his first big success came in 1989 with "Roger and Me." In that film, Mr. Moore followed General Motors chairman and chief executive Roger Smith with a camera crew, asking him why the company was closing plants and producing low-quality vehicles. Mr. Smith looked flustered and inartfully avoided Mr. Moore's camera crew while it lingered outside his country club or GM's executive offices.

Debating the Bailout "Roger and Me" was entertaining, but it missed the real story about Roger Smith, who turned out to be a forward-thinking genius. Mr. Smith made big investments in information technology and satellite communications, acquiring Electronic Data Systems in 1984 for $2.5 billion and Hughes Aircraft in 1985 for $5.2 billion. Mr. Smith's successors divested those businesses at huge profits -- EDS was taken public in 1996 for more than $27 billion, and Hughes, renamed DirecTV, went public in 2003 for more than $23 billion. (The man who sold EDS to Roger Smith at a bargain price was H. Ross Perot, who then convinced many people that the experience qualified him to be president.)

Mr. Smith understood all too well that GM shouldn't continue investing in its failing automobile business. That was 25 years ago. Today, our government is being asked to put tens of billions of dollars in GM, Ford and Chrysler, but we would be much better off if Washington allowed these companies to go bankrupt and disappear.

In 1993, the legendary economist Michael Jensen gave his presidential address to the American Finance Association. Mr. Jensen's presentation included a ranking of which U.S. companies had made the most money-losing investments during the decade of the 1980s. The top two companies on his list were General Motors and Ford, which between them had destroyed $110 billion in capital between 1980 and 1990, according to Mr. Jensen's calculations.

I was a student in Mr. Jensen's business-school class around that time, and one day he put those rankings on the board and shouted "J'accuse!" He wanted his students to understand that when a company makes money-losing investments, the cost falls upon all of society. Investment capital represents our limited stock of national savings, and when companies spend it badly, our future well-being is compromised. Mr. Jensen made his presentation more than 15 years ago, and even then it seemed obvious that the right strategy for GM would be to exit the car business, because many other companies made better vehicles at lower cost.

Roger Smith, who retired as chairman in 1990, seemed to understand that all too well, and so did Chrysler's management, which happily sold their company to Daimler Benz for $30.5 billion in 1998. That deal, one of the savviest corporate divestitures ever, ended very badly for Daimler, which essentially paid Cerberus a few billion dollars (by agreeing to retain pension liabilities) to take Chrysler off its hands in 2007.

Over the past decade, the capital destruction by GM has been breathtaking, on a greater scale than documented by Mr. Jensen for the 1980s. GM has invested $310 billion in its business between 1998 and 2007. The total depreciation of GM's physical plant during this period was $128 billion, meaning that a net $182 billion of society's capital has been pumped into GM over the past decade -- a waste of about $1.5 billion per month of national savings. The story at Ford has not been as adverse but is still disheartening, as Ford has invested $155 billion and consumed $8 billion net of depreciation since 1998.

As a society, we have very little to show for this $465 billion. At the end of 1998, GM's market capitalization was $46 billion and Ford's was $71 billion. Today both firms have negligible value, with share prices in the low single digits. Both are facing imminent bankruptcy and delisting from the major stock exchanges. Along with management, the companies' unions and even their regulators in Washington may have their own culpability, a topic that merits its own separate discussion. Yet one can only imagine how the $465 billion could have been used better -- for instance, GM and Ford could have closed their own facilities and acquired all of the shares of Honda, Toyota, Nissan and Volkswagen.

The implications of this story for Washington policy makers are obvious. Investing in the major auto companies today would be throwing good money after bad. Many are suggesting that $25 billion of public money be immediately injected into the auto business in order to buy time for an even larger bailout to be organized. We would do better to set this money on fire rather than using it to keep these dying firms on life support, setting them up for even more money-losing investments in the future.

Two main arguments are being raised to justify a government rescue of the auto industry. First, large numbers of jobs may be at stake, perhaps as many as three million if one counts all the other firms that supply the Big Three. This greatly overstates the situation. Americans are not going to stop driving cars, and if GM, Ford and Chrysler disappear, other companies will expand to soak up their market share, adding jobs in the process. Many suppliers will also stay in business to satisfy the residual demand for spare parts even if the Detroit manufacturers go under. If the government wants to spend $25 billion to protect auto workers, it would do better to transfer the money to them directly (perhaps by cutting each worker a check for $10,000) rather than by keeping their unproductive employer in business.

Second, it is suggested that the failures of the U.S. financial industry, which have cost us something like $700 billion, justify bailouts of other sectors of the economy. This makes no sense. If the government diverts our national savings into businesses that have long track records of destroying investment capital, eventually we'll end up with an economy like France's -- or Zimbabwe's.

Other arguments are on the table as well. Some see the troubles at GM and Ford as opportunities to retool the auto industry to produce environmentally friendly cars. Given their long track records of lobbying against fuel economy standards and producing oversized gas guzzlers, this suggestion seems ridiculous, sort of like asking cigarette companies to help with cancer research.

Not many of my students today remember "Roger and Me" (many confuse the film with another picture from the same era about the cartoon character Roger Rabbit). However, Roger Smith's example casts a long shadow over the auto industry today. It's time to cut our losses and let society's scarce investment capital flow to an industry with more long-term potential to create jobs and economic value.

David Yermack is a professor of finance at New York University's Stern School of Business.

Scrap the car

Interesting article by Ed Altman on what he thinks to be the future of General Motors and how it should be handled.

I had an interesting discussion with Prof. Roy Smith after my Global Banking class on what he thought to be the way forward for General Motors. I am happy to have access to professors such as him who have a thorough and indepth understanding of the matters at hand. I am sure that he will soon publish his views in the press and hence will not divulge the details of our conversation.

Financial Crisis explained

If you could read patiently and understand, it's a great knowledge!

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.

- There were 3 citizens living on this island country. A owned the land. B and C each owned 1 dollar.
- B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar.
* The net asset of the country now = 3 dollars.

- Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars.
* A has a loan to C of 1 dollar, so his net asset is 1 dollar.
* B sold his land and got 2 dollars, so his net asset is 2 dollars.
* C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar.
* Thus, the net asset of the country = 4 dollars.

- A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result, A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar.
* B loaned 2 dollars to A. So his net asset is 2 dollars.
* C now has the 2 coins. His net asset is also 2 dollars.
* The net asset of the country = 5 dollars. A bubble is building up.

- B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A.
* As a result, A has got his debt cleared and he got the 2 coins.. His net asset is 2 dollars.
* B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars.
* C loaned 2 dollars to B, so his net asset is 2 dollars.
* The net asset of the country = 6 dollars; even though, the country has only one piece of land and 2 Dollars in circulation.

- Everybody has made money and everybody felt happy and prosperous.

- One day an evil wind blew, and an evil thought came to C's mind. "Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more."

- A also thought the same way.

- Nobody wanted to buy land anymore.
* So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars.
* B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar.
* C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his Heart is palpitating.
* The net asset of the country = 3 dollars again.

- So, who has stolen the 3 dollars from the country ? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B's net asset is still 2 dollars, his heart is palpitating.

- B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now.
* A owns the 2 coins, his net asset is 2 dollars.
* B is bankrupt, his net asset is 0 dollar.. (He lost everything)
* C got no choice but end up with a land worth only 1 dollar
* The net asset of the country = 3 dollars.

There is however a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.

A few points worth noting
- When a bubble is building up, the debt of individuals to one another in a country is also building up.

- This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island's own currency. Hence, there is no net loss.

- An over-damped system is assumed when the bubble burst, meaning the land's value did not go down to below 1 dollar.

- When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.

- If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game, he will neither win nor lose. But he will see the value of his money or land goes up and down like a see saw.

- When the bubble was in the growing phase, everybody made money.

- If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A ) and take part in the game. But you must know when you should change everything back to cash.

- As in the case of land, the above phenomenon applies to stocks as well.

- The actual worth of land or stocks depend largely on psychology

Source: Email forward

Using knowledge Effectively

Over the past one year, I have learnt a lot at business school. As a Finance and Accounting major, obviously those aspects of the business. Besides that, I have also learnt a lot about Business Strategy, Marketing and Operations. However, that knowledge is useless, unless you know how to use it effectively. Here is an account of the one chance that I got to use this information for personal gain.

I needed to transfer cash from my home country. I have an education loan that takes care of living expenses and I replenish it periodically depending on my own needs. Close to more than a month back, I saw that my funds were dipping low and I needed to get some more money. I also saw that the exchange rate to the dollar was much higher than it was in recent memory.

The US dollar has been appreciating since the FED rates have been dropping in this country [the US]. This has also been accentuated in a way by the increase in interest rates by the central bank in my own country as it attempts to fight the rising levels of inflation in the country. Inflation there is currently higher than it has been in recent memory, a classic case of the workings of supply and demand. The demand for food and foodgrains has increased, and has not been met with corresponding supply in recent times. A drop in supply, combined with astute [and illegal] black marketeering by business(wo)men have ensured that inflation is significantly high.

Then there is the effect of oil prices. Oil has ensured that the local inflation rate in my country has gone higher. This also indirectly affects other prices as it shoots up transportation costs at all levels of the marketplace. Oil prices has also ensured that the demand for the US dollar is higher and that has appreciated the dollar even further, making it more expensive to buy.

When I thought about asking for money, I astutely [in my belief] thought that this was a bubble waiting to burst. Oil prices were at unsustainable levels. With the winter arriving, there was no way that the US could afford to go into a oil-guzzling-heater weather at such expensive levels. There had to be a decrease. Also, with the price of gasoline at such high levels, demand had predictably dropped as people moved to restricting its usage. Ford and GM, promoters of the guzzlers in the US reported huge drops in demand for their SUVs and vans as the US general public moved to cleaner, greener cars.

The OPEC also noticed a sudden drop in the demand for oil. This was accompanied by loud rhetoric to explore and exploit alternative sources of energy which would reduce the dependence on oil, bring prices down and be more environmentally friendly. Suddenly you had Barack H. Obama, John McCain and even Paris Hilton commenting on their green policies. You saw legendary investor T. Boone Pickens coming out with the PickensPlan with a strong focus on wind energy as the source of the future.

Having followed companies in the alternative energy industry space myself, I saw the importance and relevance of solar, wind and other alternative energy companies. The OPEC saw it too. They saw this as a potential drop in the demand of their mainstay product. This warranted even Hugo Chavez, the Venezualian premier who has been trying hook, nail and sinker to ensure higher prices of oil, to comment that oil prices were not sustainable at these levels.

As you must have guessed, I predicted with fair certainty that oil prices were almost certainly going to drop. Levels were not real and then had to get to a sense of normalcy. Midway through the time that elapsed, economists at major investment banks and financial gurus began to chant this mantra as well. I followed USO, an ETF on the American Stock Exchange [AMEX:USO] very closely and found it to be behaving as previously predicted.

I was of the belief that if oil dropped as was predicted [and corroborated by the gurus], this would reduce the demand for the US Dollar. This would also drop the inflation rates in my country [to some extent, this could be lagging or stuck in govt. bureaucracy]. The net effect would be a depreciation of the US dollar to my own local currency and that would buy me more dollars for the same amount of money.

I held out, not telling my parents the real reason. I also thought that it was unlikely that the dollar would appreciate any more than it currently had. It was unlikely to go any stronger. In a way, I did take a bet; a bet in a situation that I should not have taken one [ as a debt ridden b-school student, you dont want to take one]. Yet, as I saw it, it was better to do this than to leave myself to chance. In a normal situation, I would have taken the prevelant rates and transferred the money without giving it a second thought. Atleast this way, I was better informed that there was a higher likelihood of the prices going lower than going higher.

The bet paid off. I waited until I could no longer hold out and needed the money. After that, I asked for the money to be transferred. A net gain of 400 basis points. Not a lot some would say, but then again, it was something. You really cannot expect to make that much of a bet on such non-volatile instruments in such a short period of time anyway.

I am just happy that the knowledge at business school is helping me think like a real business leader who makes his/her decisions based on the prevelant conditions in the market.

For all those undecided, take the plunge. B-school will be the single best investment that you can make in yourselves [ short of getting married rich :-D ]