A truth that's told with bad intent
Beats all the lies you can invent.
It is right it should be so:
Man was made for joy and woe;
And when this we rightly know
Through the world we safely go.
Joy and woe are woven fine,
A clothing for the soul divine.
Under every grief and pine
Runs a joy with silken twine.
— William Blake, Auguries of Innocence
Happy Thanksgiving.
© 2008 The Epicurean Dealmaker. All rights reserved.
While descending turns are commonly performed by pilots as a standard flight manoeuvre, the spiral dive is differentiated from a descending turn owing to its feature of accelerating speed. It is therefore an unstable flight condition and pilots are trained to recognise its onset, and to implement recovery procedures safely and immediately. Without intervention by the pilot, acceleration of the aircraft will lead to structural failure of the airframe, either as a result of excess aerodynamic loading or flight into terrain. Spiral dive training therefore revolves around pilot recognition and recovery.
— "Aircraft Dynamic Modes," Wikipedia
I do not know whether you already know this, O Dearly Beloved, but apparently human beings are not well designed for powered flight. No, no, I am not pointing to the incontrovertible fact that few humans outside of the occasional Managing Director at Goldman Sachs possess either wings or the chest and back muscles to power them. Rather, I refer to the rather more subtle limitation that our internal mechanism for determining motion and orientation is not well suited to many of the maneuvers one can and does perform in three dimensional space at the controls of an airplane.
Especially when one does not have an external visual reference point to fix on, executing a gradual, sustained, or slow turn in flight can trick the inertial orientation system in your inner ear (and hence you) into believing that you are not turning, but are rather holding to a straight course. This can be disorienting when you attempt to change direction, since your body has no kinesthetic clues as to your current course. All sorts of spatially disoriented behavior can result, including my favorite, the "leans."
[While I have never piloted an aircraft myself, I have experienced a rather similar disorientation now and again when I have unexpectedly discovered myself listing to port or starboard on the perch of a barstool somewhere in the Midwest while plying clients with booze and other controlled substances. The bartender moves away, and suddenly you notice a thoroughly disreputable character, tilted thirteen degrees from vertical, leering at you from the mirror, with the tip of his Hermes tie swimming in his neighbor's Budweiser. It's not a pretty sight, and it's even less pretty when you realize that's your tie which now needs to be drycleaned. But I digress.]
Among the most dangerous maneuvers resulting from this disorientation, the cheerfully named "graveyard spiral" usually happens when a pilot loses sight of the visual horizon and enters a gradual turn. After 20 seconds or so, the pilot loses all sense that he is turning, but rather feels that the plane is descending in a gradual straight line. If the pilot does not consult his instruments to check whether he is indeed level or in a turn, he will likely try to pull out of the dive by pulling back on the stick and applying power. Unfortunately, if you are already in a turn, aeronautics dictates that doing this will only tighten and accelerate the turn, locking the plane even tighter into its downward spiral. Eventually, if the pilot does not correct, he gets trapped in a high speed spiraling dive that is almost impossible to pull out of.
The right thing to do instead, apparently, is cut the throttle to reduce acceleration, check your instruments, and gently turn out of the spiral. This will feel weird, but the point is that you have to trust your instruments, not your gut, the seat of your pants, or your inner ear.
As we witness the increasingly fast, increasingly narrow turns that Citigroup is making this week on its continuing spiral toward a sticky end, I wonder whether it is too late to give CEO Vikram Pandit a little in-flight training. Clearly he thinks the appropriate response to Citi's sinking stock price is to pull back on the stick and goose the throttle, proclaiming ever more strenuously that all is well and that he intends to stay the course. But Citigroup is not in a straight line level dive.
What Pandit does not seem to realize—and what Bear Stearns' Alan Schwartz and Lehman's Dick Fuld failed to realize before him—is that his company is experiencing a potentially deadly spiral of evaporating confidence. The more loudly he proclaims his own confidence in Citigroup's solvency and bright prospects—which may, for all I know, be objectively true—the more investors take a look at Citi's swooning stock price and rocketing default insurance premia and conclude he doesn't realize how desperate his situation is. They think management is in denial, or uninformed, or lying. This, in turn, destroys even more confidence, and the downward spiral speeds up. Trying to halt a slide in confidence by boosting confidence alone is not only futile: it is counterproductive.
No, what he obviously needs to do is slow things down, and begin acknowledging to his stakeholders that Citigroup needs to change course. (How he should do this, and what changes he should propose, are above my pay grade, although I might be persuaded to take the job for $25 million a year plus options.) Only these actions have a chance of persuading investors that Citigroup can last the weekend. Once they believe Pandit and the board acknowledge the seriousness of the situation, and are examining every alternative to correct it, they will stop running for the exits in panic. Confidence will stop evaporating, at least temporarily, and the company will have a few more days or weeks to pull some rabbits out of its hat.
(Of course, you still have to land the plane after you pull it out of a graveyard spiral, but at least you have more time, and a chance to do it without executing that charming maneuver, "flight into terrain.")
The real question of interest for me, Dear Readers, is what this promising but perhaps painfully extended metaphor means for the future management of highly leveraged, public financial institutions like commercial and investment banks. It is clear from the spectacle of Bear Stearns, Lehman Brothers, and other victims of the current panic that many if not most top managers of these firms were the rankest amateurs, in terms of management or piloting skills. Give them a clear, cloudless day, gentle supporting thermals, and no other traffic in the sky, and these panjandrums were more than capable of piloting their tricked-out Cessnas the five hours from Reno to Orange County. They got paid ridiculous amounts of money for flying under perfect conditions, too, almost as if they were personably responsible for the favorable weather.
But put them over unknown terrain, in fog, cloud cover, or at night, and let them drift into a gentle turn, and they fell apart. They had neither the sensitivity to tell when they were drifting into trouble nor the training and skill to recover from it. Their insensitivity to changing conditions, exacerbated by arrogance, swollen heads, and the echo chamber of handpicked loyalists in the executive suite put them all on the path to doom and destruction. They just kept listening to their inner ears and staying the course, never realizing they were steering directly into the ground until it was too late. Even now, most of these guys have absolutely no idea what they did wrong or how they should have acted differently to avoid cratering their once-proud institutions. Just ask Dick Fuld.
Fortunately, however, now that the United States government owns every financial institution larger than a piggy bank, we can make sure that this type of disaster never happens again. I recommend we institute a federally mandated Financial Institutions Piloting course for every executive with management responsibility over more than 10 people. Perhaps there could be a tiered license system, with candidate CEOs for large financial institutions only eligible to take the job after they have proved their skill by not cratering a regional bank and putting in 1,000 hours of Executive Committee flight time.
Either that, or we can conduct regular ear exams.
© 2008 The Epicurean Dealmaker. All rights reserved.
Randolph Duke: "Exactly why do you think the price of pork bellies is going to keep going down, William?"
Billy Ray Valentine: "Okay, pork belly prices have been dropping all morning, which means that everybody is waiting for it to hit rock bottom, so they can buy low. Which means that the people who own the pork belly contracts are saying, 'Hey, we're losing all our damn money, and Christmas is around the corner, and I ain't gonna have no money to buy my son the G.I. Joe with the kung-fu grip! And my wife ain't gonna fu ... my wife ain't gonna make love to me if I got no money!' So they're panicking right now, they're screaming 'SELL! SELL!' to get out before the price keeps dropping. They're panicking out there right now, I can feel it."
Randolph Duke: "He's right, Mortimer! My God, look at it!"
— Trading Places
Citigroup below $7. Goldman below $56. Morgan Stanley below $11. Blackstone below $6. Fortress below $2.50.
I'm beginning to smell a black, black Christmas on Wall Street. Furthermore, I don't think we're going to see any babies born on the Upper East Side, in Greenwich, Connecticut, or in Mayfair next August, September, or October, either.
Get your G.I. Joes with the kung-fu grip while they're hot.
© 2008 The Epicurean Dealmaker. All rights reserved.
Congressional Committee hearings, like the one Rep. Henry Waxman held yesterday to survey five hedge fund managers on the current and future state of the financial industry, can be fascinating theater. With few exceptions, however, yesterday's proceedings turned out to be a disappointingly anodyne love fest, with grizzled populists and battle-scarred demagogues alike practically jumping over the dais to flatter and genuflect before the most concentrated source of potential campaign contributions ever assembled on Capitol Hill.1
With that in mind, let us see what kind of insights about Mr. Paulson can we glean from his prepared testimony.
First, we discover that he is not merely an obscenely rich financier in a tasteful suit. He is also a gentleman and a scholar:
Prior to founding the firm, I was a Managing Director in Mergers & Acquisitions at Bear Stearns. I am a summa cum laude graduate from New York University and graduated with high distinction, as a Baker Scholar, from Harvard Business School in 1980.
Modest, too.
Notwithstanding his documented brilliance, however, I get the sense he's a bit muddled as to the true reasons for his success:
We believe that our ability to protect our investors’ capital and generate positive absolute returns with low volatility over the long term is the reason we have grown to be one of the largest hedge funds in the world.
Actually, Paulson & Co. started in 1994 as an event-driven investment fund betting on M&A transactions and other corporate "events." This is a reasonably uncomplicated, well-understood strategy with a long pedigree and relatively low volatility, assuming you can handicap merger deals with any degree of success. Mr. Paulson enjoyed consistent but distinctly modest returns with this strategy for most of the early life of his fund. As late as July 2003, for example, his fund employed only nine people and controlled assets under management totaling a mere $700 million.
This is nothing to sniff at, mind you, but long-term, low volatility returns is not the primary reason current investors have entrusted 37 bajillion smackeroos to his care. No, I tend to think it has much more to do with the fact that Paulson made approximately 32% more money than God last year by betting on the complete collapse of the securitized subprime housing market.
Perhaps all those fresh billions bulging out of his safe deposit box have addled Mr. Paulson's memory. Or perhaps he thinks, secretly, that the Congressmen and women in the room—and the millions reading and watching at home—wouldn't respect him if they discovered he was just some washed-up, ex-Bear Stearns ambulance chaser who had a brain wave one morning in 2006 and won the investment lottery. They wouldn't respect his impressive college and business school degrees, or defer to his authoritative proposals on how to fix the current financial crisis, if they thought he was just some lucky schmuck from Queens.
Don't sell yourself short, John: You were right, and your timing was almost spot-on (if a little early). Rejoice in it, man! America loves a plucky, lucky bastard, and you were about the luckiest bastard in that committee room yesterday. Just ask Ken Griffin.
Most importantly, I think, we learn that Mr. Paulson is clever enough to wrap himself in the American flag when he is testifying before a Congressional Committee that is looking for someone to blame for the ongoing clusterfuck that is our economy and financial system. This shows some nicety of judgment, given that he and co-grillee Philip Falcone are two of the most prominent members of that tiny fraternity of investors who have profited personally and directly from the nuclear meltdown of the American Dream.
Either that, or he is a true patriot:
As Americans, we are proud of the leadership position the United States occupies in this industry, the jobs our industry has created, the export earnings we have produced for our country and the taxes we generate for the Treasury. For example, over the last five years, our firm has increased our employee count by 10x, creating numerous high-paying jobs for Americans.
Wow, John. You're a fuckin' force of nature, you are. That would be increasing your employee count to what, approximately 70 warriors for truth, justice, and the American Way? I guess we can all stop worrying about General Motors going bankrupt with that kind of job creation going on.
(As an aside, I always find it amusing to hear poobahs from hedge funds or private equity nattering on about their oh-so important "industries." They always seem to omit the critical modifier "cottage" in front of the word "industry." Christ, Citigroup fires more people in a week than work in hedge funds and private equity combined.)
But patriot or not, dissembling scoundrel or not, I think we can all agree that Mr. Paulson does not have a promising career awaiting him in international economics should he ever decide to hang up his investing spurs:
In addition, eighty percent of our assets under management come from foreign investors. The revenues we receive from foreign investors allow us to contribute to the U.S. economy like an exporter of goods, bringing in money from abroad.
What, exactly, does Mr. Paulson think his firm "exports" to all these eager foreign consumers in exchange for their foreign "revenues?" Why, last time I checked, that would be money. Hmm.
And where does this money come from? Why, from all those investors and institutions who were on the opposite, losing sides of Mr. Paulson's short trades in mortgage securities.2 Of which, I presume, the vast majority were American investors and institutions.
So, let's say for each dollar of investment Mr. Paulson took in, he earned around ten dollars in trading profit last year. After taking his cut of $2, he shipped $8 back to his limited partners, $6.40 of which went to foreign investors. Eighty cents of cash into the US; $6.40 out. That doesn't sound like a very favorable input to the current account deficit to me. In fact, it sounds much more like a massive offshore wealth transfer from American investors, institutions, and pension funds into the pockets of foreign investors. It's a good thing for Mr. Paulson that the Congressmen and women he testified before yesterday didn't have a fucking clue the sense to press him on this issue.
Of course, looking at the situation more broadly, re-exporting American wealth may be the fair thing to do anyway, considering how many of those toxic subprime securities we sold to German banks, Norwegian municipalities, and other furriners in the first place. In fact, it may be a small price to pay to maintain international peace and cooperation in today's uncertain, multipolar world. Americans and foreigners alike should be grateful for Mr. Paulson's strenuous efforts on behalf of the United States in this regard.
Some people have gone so far as to propose John Paulson for Treasury Secretary.
I recommend him for Secretary of State instead.
1 It always amazes me how the mere sight of a billionaire can turn Americans from practically every walk of life into cringing, tail-wagging puppies. Warren Buffett is Exhibit A in this respect. Rugged American individualism, my ass.
2 Given that such trading is a zero sum game, naturally.
© 2008 The Epicurean Dealmaker. All rights reserved.
The Dude: "Look, nothing is fucked, here, man."
The Big Lebowski: "Nothing is fucked?! The goddamn plane has crashed into the mountain!!"
— The Big Lebowski
Dealbreaker.com did a nice job yesterday quoting the I-Ching of all earthly wisdom, The Big Lebowski, in its blog post title referring to Drew Faust's November 10th letter to faculty, students, and staff of Harvard University.
In a remarkable and surprisingly realistic appraisal of the Stanford of the East's financial prospects now that the cream of Western Civilization is migrating from Park Avenue and Nob Hill into dingy caves in the West Texas Hill Country lighted only by Sterno, President Faust1 has warned her various constituencies that All Is Not Well:
... we must recognize that Harvard is not invulnerable to the seismic financial shocks in the larger world. Our own economic landscape has been significantly altered. We will need to plan and act in ways that reflect that reality, to assure that we continue to advance our priorities for teaching, research, and service.
Our principal sources of revenue are all likely to be affected by these new economic forces. Consider, first, the endowment. As a result of strong returns and the generosity of our alumni and friends, endowment income has come to fund more than a third of the University’s annual operating budget. Our investments have often outperformed familiar market indexes, thanks to skillful management and broad diversification across asset classes. But given the breadth and the depth of the present downturn, even well-diversified portfolios are experiencing major losses. Moody’s, a leading financial research and ratings service, recently projected a 30 percent decline in the value of college and university endowments in the current fiscal year. While we can hope that markets will improve, we need to be prepared to absorb unprecedented endowment losses and plan for a period of greater financial constraint.
Okay, so Ms Faust obviously didn't receive the memo that Moody's reputation for trustworthiness and probity currently ranks somewhere below that of Adolf Hitler or Caligula, but the rest of her remarks are sound. Losing 30% of an endowment the size of Harvard's—37 billion clams, or bones, or whatever you call them—is going to leave a nasty mark whatever the lighting. If Harvard chooses to maintain the absolute amount of operating support from the endowment at current levels, that will mean cutting into principal even more, and if it maintains the current percentage support, absolute dollars flowing into the university's operating fund will plummet.
Plus, leaving aside how much money Harvard chooses to bleed out of its investment kitty, the tyranny of compound returns—so charming, pleasant, and satisfying on the way up—means that it will take quite some time for the Crimson's rainy day fund to recover its current losses. Should Moody's estimate be correct, Harvard's investment managers will need to book more that 19.5% compound annual returns for the next two years running just to return to the high water mark of 2007. (Forget about growing bigger.) While this is certainly possible, those strike me as rather heroic return assumptions in today's post-bubble market environment, especially for an ocean liner like the Harvard Endowment fund.
President Faust then notes that Harvard's other sugar daddies are unlikely to remain as generous as they have been in the past, either, much less chip in enough to cover the expected shortfall from the endowment:
The economic downturn also puts pressure on other revenues that fuel our annual budgets. Donors and foundations will be harder pressed to support our activities. Federal grants and contracts for sponsored research will be subject to the intensified stress on the federal budget.
Right and right. It can be awkward and uncomfortable to rely on the kindness of strangers, especially when most of those strangers are either tapped out, over-leveraged and desperate themselves, or more focused on paying the mortgage and the grocery bills than buying another Rembrandt etching for the university art museum. Harvard will be lucky indeed if charitable donations do not drop by 50% or more this year, and government grants become a relic of the past. You can bet that Ms Faust and her minions are spinning rapidly into action to forestall the evaporation of millions of dollars in pledges made in happier times and to beat the bushes for those increasingly rare individuals who still have the wherewithal to underwrite the third biochemistry lab on campus. The John Paulson Real Estate Sciences Building, anyone?
But then, predictably, Ms Faust flies off the rails:
Tuition remains an important source of revenue, but in times like these we want to keep increases moderate, mindful that many students and families are facing economic strain.
Keep tuition increases moderate? Oh, President Faust, you were doing so well up until then. Since when have hallucinogenic mushrooms been on the menu at the Faculty Club?
To be fair to Ms Faust, I suspect that she is not alone among university heads in believing that raising prices in the face of a looming multi-year recession and the ongoing destruction of billions of dollars of net worth among the families which comprise her target consumers is even possible. When viewed in historic context, such apparent mass psychosis might even seem reasonable. After all, the price of a college education in this country has been rising at a compound annual rate over the past quarter of a century that is approximately double that of inflation. Given that this period has encompassed a couple of ruinous wars, the odd stock market boom and bust, general ups and downs in the economy, and several political administrations of varying fiscal rectitude, why shouldn't college administrators believe their target market is as hopelessly price insensitive as your average crack whore?
Sad to say, they have been right so far.
It is important to note that the very nature of education is such that it is afflicted with Baumol's cost disease. Education is one of those socioeconomic activities which is subject to very little improvement in labor productivity over time: it takes the same number of professor and grad student man-hours to educate little Billy or Sally today that it took to educate Adolphus and Hortense in 1842. Perhaps the content or comprehensiveness of the education delivered today is superior (perhaps), but the core delivery of service is subject to virtually the same constraints in effect when students wore caps and gowns to class.
Because education is so labor intensive, and because its laborers are still delivering the productivity of medieval scholars, the relative cost of education has grown at a pace well in excess of other activities subject to traditional labor productivity growth. This is exactly the case for other activities subject to the same dynamics, such as classical orchestras, for which Professor Baumol and his collaborator William Bowen famously noted "that the same number of musicians are needed to play a Beethoven string quartet today as were needed in the 1800s." As a result, it would cost a lot more Model Ts today to buy a season ticket to the Metropolitan Opera or four years of Ivy League education than it did in 1909.
You can see, then, that educational institutions are faced with constantly escalating labor costs which are effectively out of their control. Harvard does not set the wage for an Assistant Professor of Physics nowadays, Wall Street does (or did until recently). You price the services of a run of the mill Professor of Comparative Literature based on what he or she could earn as an auto assembly worker (okay, perhaps that is another bad example), not on the actual units of education he or she delivers. Harvard and its peers in the private education industry are price takers when it comes to labor inputs, not price setters. That is done elsewhere in our economy.
Unfortunately, a cursory examination of the physical plant or operating budget of a typical private college or preparatory school will quickly disabuse the curious enquirer of the quaint notion that its administrators are otherwise modest, frugal creatures who are only compelled to raise prices against their will by the tyrannical labor markets. In my admittedly limited and anecdotal experience, I have yet to encounter a Manhattan school Headmaster or an Ivy League Dean who would hesitate even one minute before sending the entire English Department on a ten-day "fact-finding" jaunt to China or who would equip the new Freshman Chemistry Lab with standard-issue microscopes when electron microscopes are available at ten times the price.
Last year, on the occasion of a reunion visit to the leafy groves of my own alma mater, I was dismayed to discover that practically all of the verdant green expanses of my salad days (perfect for snoozing over a physics textbook on a sunny day) were no more. There was almost no plot of grassy space left on campus that had not been filled with the hulking form of yet another architectural monument to the pride and vanity of some self-fellating panjandrum. On a previously nondescript and inoffensive corner, some brand-name architect had erected at undoubtedly outrageous expense a swooping steel and glass science library not ten minutes walk from a central library big enough to house in triplicate every book, magazine, and pornographic pamphlet published since 1362 plus have room left over for a small suburban mall. I did not see it then, but I fully expect to encounter gilded toilet paper in the Faculty Club mens room on my next visit.
In short, private education in America spends money like a drunken sailor with Warren Buffett's credit card.
Why they should want to do so is completely clear. How they have been able to get away with it for so long is more opaque.
My view, which you are welcome to classify under Education, Gratuitous Unverified Crackpot Theories Of, is that private educational institutions have been able to charge whatever the hell they want to for so long because Education has become the new Religion of the socially ambitious. There is almost no other way to classify the fervor, zealotry, and passion with which the parents and children of upwardly mobile classes pursue, discuss, and glorify the imprimatur of an Ivy League or equivalent degree, and the supposedly necessary interim steps thereto. Ask the typical upper middle class parents on the East or West Side of Manhattan whether they would prefer Junior to save his immortal soul or graduate from Princeton or Yale with a 4.0 grade point average, and they will look at you as if you had three heads. There simply is no question in their minds that eternal salvation takes a back seat to the right sheepskin on the wall.
This belief also explains why some New York parents are willing to pay so much money—the equivalent of $30,000 or more per year—to send their little darlings to the "right" private preparatory schools plus donate generously to the school's headmaster slush fund annual giving campaign to boot. They are convinced that a degree from Dalton, or Chapin, or Collegiate is a one-way ticket to the promised land on the banks of the Charles River. Once there, of course, there is no question that Mom and Pop will pay whatever Harvard asks to keep their offspring in crimson clover. After all, the Catholic Church got rich in the Middle Ages in part by selling indulgences. Why should Harvard, Princeton, or the University of Chicago be any different?
The skeptics among you will no doubt remain unconvinced, but I find it somehow revealing (and disturbing) that President Faust makes a point in her letter of mentioning that families with incomes between $60,000 and $180,000 per year "and typical assets" can expect to pay around 10 percent of their income as tuition to the Great Red Mother. Tithing to Harvard: some cultural forms never change, do they?
Whether this new Religion of Education will become an ossified, out-of-touch edifice ripe for challenge and Reformation by the iconoclasts of Google, Wikipedia, and Web 2.0, or whether it will pass unreformed straight through to the increasingly marginalized, irrelevant, and underfunded status of actual religions in the leading centers of Western Civilization is unclear to me. As federal grant-grubbing denizens of academe are wont to say: further research is required.
What is clear to me is that while the spirit may still be willing, the flesh (or the wallet) is beginning to get weak. Spending over half a million after-tax dollars per kid just to say that Little Bobby lost his virginity at one of the best universities in the nation is becoming harder and harder to justify for more and more parents. (Especially since one of the major reasons to send him there in the first place was to guarantee him a position in the immensely lucrative and prestigious fields of investment banking, securities law, or private equity. Oops.)
There is even shocking anecdotal evidence leaking out that formerly flush lawyers, investment bankers, and luxury goods retailers are beginning to pull their progeny out of the hallowed "feeder" schools of Upper Manhattan because they cannot afford the freight. Laugh if you will, but this is the upwardly mobile's equivalent of "jingle mail." Having written more than my fair share of eye-watering checks to such schools, I can only hope that the formerly arrogant, self-satisfied Headmasters and Headmistresses of New York are beginning to wet their beds on a regular basis.
This problem is not limited to the Ivy League, or Manhattan private schools, either. The entire over-leveraged, over-invested edifice of higher education in America is beginning to teeter and sway, and cracks are spreading across the foundation. Gone are the days, in my opinion, when university and preparatory school administrators could add sums collected from private and public donors to income harvested from the endowment, subtract that total from the amount of money they would like to spend in a perfect world, and divide the difference by the incoming student body to set the tuition.
No, it appears that the iron laws of economics have finally arrived on the peaceful doorstep of the Academy.
It's about time, too.
1 Forget Pascal's Wager. If anyone needs definitive proof that there is a Supreme Being, that It has a wicked sense of humor, and that It is currently laughing Its Divine Ass off, one need look no further that the name of the current President of Harvard University. Irony much?
© 2008 The Epicurean Dealmaker. All rights reserved.