Showing posts with label the agora. Show all posts
Showing posts with label the agora. Show all posts

Sunday, July 13, 2014

Shine On, You Crazy Diamond

Quick. What do you see?
Claudio: “Benedick, didst thou note the daughter of Signior Leonato?”
Benedick: “I noted her not; but I looked on her.”
Claudio: “Is she not a modest young lady?”
Benedick: “Do you question me, as an honest man should do, for my simple true judgment; or would you have me speak after my custom, as being a professed tyrant to their sex?”
Claudio: “No; I pray thee speak in sober judgment.”
Benedick: “Why, i’ faith, methinks she’s too low for a high praise, too brown for a fair praise, and too little for a great praise; only this commendation I can afford her, that were she other than she is, she were unhandsome, and being no other but as she is, I do not like her.”
Claudio: “Thou thinkest I am in sport: I pray thee tell me truly how thou likest her.”
Benedick: “Would you buy her, that you enquire after her?”
Claudio: “Can the world buy such a jewel?”
Benedick: “Yea, and a case to put it into.”

— William Shakespeare, Much Ado About Nothing

Matt Levine put an instructive and amusing post up at Bloomberg View two days ago on the nonsensical phenomenon which is CYNK that is worth your attention, Dearest of Readers, if only for a slow news Friday leading into a World Cup finals weekend. I recommend you enjoy it as an all-too-rare example of a financial journalist who actually tends to know what he is talking about trying to explain arcane and confusing epiphenomena of the financial markets to plebeians with wit and style. Levine, of course, is a former Goldman Sachs banker, which means, inter alia, that 1) he tends to know whereof he speaks (writes) and 2) you are free to disregard everything he writes as the sophistic outpourings of a confirmed agent of Satan sent to Earth to separate you and your orphaned, widowed Mother-in-law from any semblance of financial wherewithal and pin money. (These two things, by the way, are not necessarily mutually exclusive.)

Anyway, I have no particular interest in glossing Mr. Levine’s more than adequate gloss of this financial chicanery other than to point to a by-product of the CYNK story which features briefly in his story and which lesser mortals have been making quite the to-do about as this little passion play makes the rounds of Cialis-financed stock market news programs; namely, the purported market cap of this fraud professional short squeeze piece of shit security. As the Squid alumnus states,
Something about a company with no revenues and a brilliant but undeveloped business model (buy friends on the Internet! friends not included) having a $4, 5, 6, whatever billion dollar market cap struck me as fishy.
No shit.

* * *
In fact, if you segue on over to the font of all financial market wisdom, Yahoo! Finance,1 you will find that venerable market oracle calculates the market capitalization of this special snowflake without apparent substance or reason for being to be a delightful and highly substantive $4.05 billion as of Thursday’s “market” closing “price.” This is, of course, prima facie ridiculous, and it has been cited ad nauseam by every journalist and sundry whose secret brief and deeply held belief is that everything to do with the mysterious financial markets is bizarre, impenetrably obscure and opaque, and just plain dumb. On its surface, it is plain dumb, and, I am here to tell you, Delightful Readers, as your Guide to All Things Valuation, that the surface is all there is.

For a delicate glissade of the mouse over to CYNK’s historical price page on Yahoo! reveals that CYNK’s trading on Thursday (the last day of trading before exchange officials woke up from their bureaucratic pay scale-induced comas to ponder that something might not be quite right) occurred in a range of $9.80 to $21.95 per share for a total volume of 386,100 shares. Yes, that’s right, children, you read that right: 386 thousand shares. In other words, the blowout day of trading in a four billion dollar public company involved somewhere in the neighborhood of six million dollars2 of stock trading hands. Do you see the problem? Of course you do.

Imputing a “market value” to a public company on the price which obtains when 0.13% of its total shares outstanding actually trade is a dubious business, especially when it is clear that the supply of available shares is, as in this case, severely constrained. It would be another thing entirely if everyone holding CYNK’s 291 million other freely tradable shares looked at their Quotrons and said, “Huh. $21.95 per share. Yeah, that seems totally reasonable. I think I’ll hold my current position for future price appreciation potential.” But when supply is artificially constrained from meeting demand, the price which obtains in a market is not the equilibrium price, and the value which that price imputes is not the equilibrium value of the asset.

Microeconomics and common sense tell us that not everyone in the market for any asset must have the same individual supply and demand preference for that asset. There is some portion of buyers who are willing to pay more than the current market price, some sellers who are willing to sell below the current price, and many on each side of the market who are not. This is neatly illustrated by the following diagram of a hypothetical market operation, familiar to many a student who did not sleep through the first month of Micro 101:



The point is that there is a “market,” of sorts, at almost every quantity of asset supplied, and if the supply of willing sellers is abnormally constrained or abnormally bolstered, one should expect sales to occur along the buyers’ demand curve until a local “equilibrium” is found. That being said, a sensible person would not view such an abnormal market as a good indicator of the normalized value of the underlying asset in question.

So, therefore, one should firmly embed notions such as the “market capitalization” of short squeeze scams such as CYNK in pulsating neon scare quotes, so the great unwashed and their blinkered guides in the media do not take them as anything other than arithmetic exercises. So, also, one should not take reported implied market values from the technology economy, such as Series D or pre-IPO round investments by professional investors in vaporware startups, as anything other than the revealed price preferences of that particular investor in that particular company. The fact that Fidelity invested $100 million for a 1% stake in the illiquid equity of Doofr-rama does not make a strong case that Doofr-rama’s “value” is $10 billion. All it really tells you is Fidelity desperately wanted 1% of Doofr-rama. If you want to know why, you better go ask Fidelity.

* * *

Value is a highly subjective and evanescent thing, O Dearly Beloved, a fact which I have addressed in these pages before. Perhaps the greatest proof we have of this in the financial world is the unpredictable and often fraught process whereby private companies enter into the public agora via initial public offerings. What makes the rest of us take some comfort in the reliability of seasoned publicly traded stocks is that they are traded freely by and among hundreds if not thousands of individual investors daily, all of whom can express their wacky, idiosyncratic notions of value to the limit of their appetites and checkbooks, in competition and cooperation with other lunatics with contrasting notions, to their hearts’ content or distress during market hours. If there is some constraint or check on fully free trading, such as artificially constrained supply (e.g., CYNK) or a dangerous mix of newly released limited supply supported by underwriters’ legal stabilization techniques (e.g., every new IPO), the wise judge of value should look at any arithmetic calculation which purports to give such an entity’s worth with a gimlet and highly jaundiced eye.

The wisdom of crowds in the market, as everywhere else, does not arise from the wisdom of each and every member of the mob. It comes from the diversity of idiotic, ill-considered, and just plain dumb opinions held by everybody, which, by some thankful magic of human nature, usually tend to cancel each other out and supply a workable if not entirely transparent answer. It’s when we have only one lunatic, or a small handful, making value decisions that we tend to get the silly answers.

Of course, if you find that one special snowflake whose worth has no price, feel free to dive in headfirst. I won’t judge you: it’s your funeral. Just don’t expect the rest of us to follow.

Related reading:
Matt Levine, Cynk Makes the Case for Buying Friends, Naked Short Selling (Bloomberg, July 11, 2014)
Go Ask Alice (September 14, 2013)

1 Yes, I am aware that such a citation perhaps does not give you a great deal of confidence you are dealing with a professional’s considered opinion, but 1) it’s probably close enough, and 2) you don’t really think I’m going to spill my special secret top quality financial data sources into this pig trough, do you?
2 Based on the clearly incorrect assumption all 386,100 shares traded at the average of the high and low prices of the day. The correct calculation would involve what is know as the volume-weighted average price, or VWAP, of shares traded. But in order to get that, you would have to subscribe to a real market data service, for which you are definitely not paying me in your current subscription price. My ballpark estimate is close enough.

© 2014 The Epicurean Dealmaker. All rights reserved.

Thursday, April 17, 2014

We Have Met the Enemy, and He Is Us

As is usually the case, natch
Creditocracy and the Case for Debt Refusal by Andrew Ross1
OR Books, 280 pp, $17, February 2014, ISBN 978-1-939293-38-1

“Creditocracy (n.)
1. governance or the holding of power in the interests of a creditor class
2. a society where access to vital needs is financed through debt”


— Andrew Ross

If the book currently under review is any indication, Andrew Ross, a professor of social and cultural analysis at New York University, has never (or very, very rarely) met a creditor he really liked. This reader, no stranger to debt or creditors himself, is quite certain that similar attitudes are held by approximately 99.27% of all human beings extant who have undergone the experience of borrowing money. Accordingly, Professor Ross, a social activist who was instrumental to the creation of Occupy Student Debt and the Strike Debt forgiveness program, should have a very receptive audience for his message, which basically boils down to the assertion that debt is very, very bad.

What makes Ross’s tome different from advice dispensed by Suze Orman and dozens of other personal-finance mavens of greater or lesser credibility is his characterization of the socioeconomic institution of credit and his prescription for it. With respect to the former, he spends a great deal of time and effort outlining how debt and credit are inextricably intertwined with our lives and society, including personal consumption, housing, labor, climate, and long-term growth. As for his prescription for it, his message is bracingly simple: repudiate it.

Did I mention that Professor Ross thinks debt is very, very bad?

For if I did not, or if you forget between reading this article and picking up the book, you will recall it very quickly once you do. Ross is no fan of debt. He sees the current pervasiveness and economic and political power of what he has termed the creditocracy to be corrosive of our social fabric, destructive of participatory democracy, and particularly oppressive of the working poor. For the latter, he contends the current system of consumer and personal debt is but the newest incarnation of compulsory social and economic indebtedness for the poor that extends from and encompasses feudalism, indentured servitude, slavery, sharecropping, company scrip, and loan sharking. He has bad things to say about Wall Street, banks, hedge funds, payday lenders, the IMF, the World Bank, the Troika, the Club of Paris, advocates of austerity, politicians, lobbyists, Sallie Mae, Fannie Mae, college administrators, unpaid internships, student debt, revolving credit, compound interest, economic growth, Kenneth Orr, for-profit higher education, securitization, and colonialism. Did I mention debt?

Now lest you think I sport with Professor Ross or your intelligence, let me reassure you I found his book an interesting and, in places, a compelling read. He takes pains to declare that he is neither an economist nor an expert in all things credit or financial, and he makes no effort to offer up specific policy prescriptions or economic analysis to back up his arguments. He does cite reasonably extensive secondary sources throughout, which should enable diligent readers to check his facts and draw their own conclusions about his evidence. He leavens his narrative with the occasional fact or figure, some of which are well chosen to drive home his point. He employs a serviceable and not unpleasant writing style, which makes his book more readable than a run-of-the-mill polemic. He does shoehorn the intermittent left-wing shibboleth like “monopoly capitalism,” “high interest loans,” “high carbon industrialists” (the Koch brothers), and “Wall Street” into the flow of his text, but, as one would expect, these throwaway non sequiturs seem mostly placed to remind his readers of his (and their) political bona fides rather than carry any argumentative weight.

Ross also offers up interesting historical background on the use of debt as an instrument of political control by the IMF and the World Bank in developing economies, the development of the housing mortgage market in the United States after World War II, and the source and growth of the student loan market for higher education. He avoids many basic mistakes of fact or emphasis, and the occasional slip—like the comparison of stocks (bank assets) to economic flows (GDP)—is usually not so serious as to derail his arguments. He flubs the central premise of his chapter contra economic growth, contending that lending requires growth to function. (That this is not so can be illustrated with a simple auto loan.)2 He offers an entire chapter on what he titles climate debt to those of you who find such topics interesting. Sadly, this reviewer is not one of them.

However, he does make a compelling argument that the struggle between debtors and creditors has, for most people, replaced or superseded the struggle between labor and capital:
in societies that are heavily financialized, the struggle over debt is increasingly the frontline conflict. Not because wage conflict is over (it never will be), but because debts, for most people, are the wages of the future, to which creditors lay claim far in advance. Each new surrender of a part of our lives to debt- financing further consumes the fruit of labor we have not yet performed in the form of compensation we have not yet earned. Now that this condition has become inescapable, it is easier to imagine that the struggle between creditor and debtor is much older than the face-off between capital and labor that Marx proposed as a common sense explanation for economic life. After all, exploitation through debt long predates the era of wage tyranny, and its recent restoration as the most efficient means of wealth accumulation suggests that credit is a more enduring, all-weather organ of economic power.

His description of the endless treadmill of high interest, predatory lending suffered by the poor and less fortunate is believable and harrowing, and his description of the student loan market and its parasitic for-profit segment is eye-opening, and not in a good way. There is much to praise here.

* * *

And yet, given all these positives, this reviewer cannot help but feel that Ross has missed the mark. His foreground focus on the instruments and practices of debt has blinded him to an essential, incontrovertible fact: Debt is merely an instrument of economic interrelationships. A careful reader can see that Ross dances around this revelation every now and then, and even nods in its direction and alludes to its implications, but he retreats too soon to tackle the thorny fact directly. Missing this fact puts too much emphasis on the mechanism and history of the use of debt to sustain consumption in the face of stagnant or declining real wages for the majority of Americans, rather than the reason for it. Which, this reviewer believes, is ineluctably tied up with the issues and mechanisms of income distribution in the past several decades. (But that is another essay for another time.)

Ross is also not the first to confuse banks, which have increasingly taken on the role of intermediaries and originators of loans, with the holders of wealth who actually lend it out. But this is not true. Look at any bank’s balance sheet, and you will observe—as Ross correctly does at other places in his text—that banks borrow the lion’s share of what they lend out from other people: depositors, bondholders, other banks, the Federal Reserve. It’s not their money. Banks are conduits for transforming certain kinds of assets (money, investable funds) into others (loans, securities). More often than not, they transform short-term loans they borrow from their creditors into long-term loans to their debtors. This key bank function is called maturity transformation, and it is a critical, highly valuable socioeconomic service lending banks perform.

The real holders of wealth in the economy are not banks, which are only servants. The real holders of wealth are rich individuals, corporations, and institutional investors which manage trillions of dollars of their own and others’ wealth. The lion’s share of such wealth is and has always been invested in the fixed-income markets: sovereign debt, corporate loans, high-yield debt, municipal debt, and, yes, individual consumer debt in the form of securitized credit-card, auto, and student loans and mortgages. The complication, which Ross ignores, is that much of the institutional investment in fixed income is done by and on behalf of pension funds, retirement accounts, and mutual funds managed for individuals. Individuals—people, us—are the creditors we fear and loathe. Even someone with a simple passbook savings account is a lender: first directly to the bank she deposits at, and second indirectly to the debtors who borrow from her bank.

This is a critical point to understand. For it means that it’s not always so clear just whose ox is going to get gored if we go about repudiating debt wholesale. Ross makes a big deal about the retired city workers of Detroit being asked to reduce their pension benefits in the restructuring of the city’s debt. But Detroit’s municipal debt has been bought for years by, among others, professional fund managers on behalf of firefighters, policemen, nurses, and other public and private workers to support their pensions. By the same token, non-wealthy individuals have directly and indirectly purchased the loans and securitized debt of other individuals—i.e., made loans—to provide sources of income for their own futures. Who gets screwed if we start repudiating our credit card debt, student loans, home mortgages, and auto loans? Firefighters? Teachers? Our parents? Ourselves?

And waving one’s hands and saying the government should pick up the tab—as Ross suggests in the case of debt incurred for public higher education—just begs the question in another way. For who both lends money to government and pays taxes to pay its bills? We do, of course, directly and indirectly, in a thousand ways. Of course, we all have different exposures, both as creditors and debtors, to our governments. That, plus the fact we have different economic and political interests and preferences means we will have different opinions as to what debt, if any, should be repudiated and for whom. In other words, by focusing on the allegedly inherent evil of debt instruments, Ross elides the critical point that what needs to happen in our society is a political debate about power and inequality, not a technical debate about the mechanics of a debt jubilee.

This is the Gordian Knot we face when it comes to the problem of debt. I am sympathetic to the plight of the poor, I am outraged at the behavior of predatory lenders, and I am a firm believer in heavy regulation of consumer finance and a much heavier hand in prosecution of financial chicanery than we have yet seen. But the threads of debt shoot through our society and economy in such myriad patterns and interlinkages that it would be practically impossible for anyone to trace them all. Ross wants citizens to audit lenders for “bad” or “illegitimate” debt. But is he truly sure he or we can tell the difference? Is he truly certain repudiating “bad” debt will be good for everyone except lenders? Does he truly know who the lenders are? Who is going to pick up the tab?

Ross states he wants a “moral economy of debt.” He wants the privatization and financialization of basic human wants and needs—shelter, education, health care—reversed and taken out of the hands of private lenders, presumably to be put in the hands of government or, what is another word for the same thing, our common hands. But this is not a moral decision. This is a political decision.

And the last time I checked, we made those decisions through the ballot box. If Ross intends his book to be a call to action and a spur to political discussion of the transformation of our economy, all the better. We need more individual citizens involved. But he and they might find the answers they seek are not quite as obvious or acceptable to the rest of us as he contends they are.


1 This review first appeared in The New InquiryMoney” issue, published April 2014. It differs in minor cosmetic details from the published article, the online version of which can be found here. Any unexpected clarity and concision which has crept into my writing in this piece can be attributed to the excellent work of TNI’s editors. By the by, I recommend those among you who enjoy challenging your assumptions about the proper role of finance in society go check out the other thought-provoking articles therein by Steve Randy Waldman, Izabella Kaminska, Mike Konczal, and others. As is usual and proper among such econoblogospherical heavyweights, my piece was included for comic relief.
2 Should, for example, Ross decide to purchase a new Honda Accord for $22,000, he could finance it for 48 months at 4% interest for 48 level monthly payments of $495 each. Self-amortizing debt at fixed interest rates—which comprises a very large percentage of consumer and housing debt—does not require or depend on incomes or anything else growing. In fact, in general creditors tend to prefer a static or even deflationary economic environment, since inflation, which is usually associated with growth, erodes the real value of their fixed claims.

© 2014 The Epicurean Dealmaker. All rights reserved.

Saturday, September 14, 2013

Go Ask Alice

Like a box of chocolates
One pill makes you larger
And one pill makes you small
And the ones that Mother gives you
Don’t do anything at all
Go ask Alice, when she’s ten feet tall

Jefferson Airplane, “White Rabbit”

“Life’s a box of chocolates, Forrest. You never know what you’re gonna get.”

— Forrest Gump

Well, Children, it’s silly season again. Yes, that’s right: Twitter just filed an initial registration statement (or S-1) for its long-awaited initial public offering. Confidentially.1 And commemorated it with a tweet on its own social media platform, of course:


Tools.

* * *
This of course means every numbnuts and his dog are currently crawling out of the woodwork and regaling us with their carefully considered twaffle about what Twitter is doing, what it should do, and how much money we’re all going to make buying and selling Twitter’s IPO shares when and if they ever come to market. A particularly amusing sub-genre of said twaffle consists of various pundits of varying credibility and credulousness pontificating on what Twitter is actually worth, as if that is a concrete piece of information embedded in the wave function of quantum mechanics or the cosmic background radiation, rather than a market consensus which does not exist yet because, well, there is no public market for Twitter’s shares.2

But there seems to be something about IPOs that renders even the most gimlet-eyed, levelheaded market observers (like Joe Nocera, John Hempton, and... well, just those two) a little goofy and soft in the head. Perhaps they just can’t understand why such an obvious and persistent arbitrage anomaly as the standard 10 to 15% IPO discount on newly public shares—which everybody seems to know about even though they can’t explain it—persists as it does. Or why, given how many simoleons the evil Svengalis of Wall Street get paid to underwrite IPOs, there are so many offerings that end up trading substantially higher (e.g., LinkedIn) or substantially lower (e.g., Facebook) than the offer price they set once shares are released for trading.

So, out of the bottomless goodness of my heart—and a heartfelt wish to nip some of the more ludicrous twitterpating I expect from the assembled financial media and punditry in the bud—I will share here in clear and simple terms some of the explanations I have offered in the past.

* * *

First, the famous IPO discount.

I have written:

Now there is a longstanding tradition, rule of thumb, heuristic—whatever you want to call it—in IPO underwriting that issuers should sell their shares in an IPO at a discount to intrinsic or fair value. In normal, healthy markets, this discount is normally discussed in a range of 10 to 15%. ... The intended purpose of the IPO discount is twofold: 1) to help place the relatively large bolus of shares which an IPO represents with investors who have alternate potential uses for their money and 2) to bolster positive demand in the marketplace for follow-on buying. You see, an issuer of an IPO is not, unlike a company which is selling 100% of itself, trying to maximize total proceeds for existing shareholders (and fuck the newcomers). It is trying to attract a new set of shareholders who will be co-owners of the company for at least some non-trivial period of time. An IPO issuer only sells a minority of the total ownership position in the firm, and it wants to develop a positive, receptive marketplace for future stock sales in the public markets.

Now this is a critical point, so I’d like you to focus on it carefully. In virtually no instance I am aware of do the existing (pre-public) shareholders sell a majority of either i) the firm’s newly created, “primary” shares or ii) their own already existing, “secondary” shares in a IPO. For one thing the underwriters would strongly discourage it. Why? Because it looks bad. Here you have this brand new, shiny, exciting, expensive company coming to market, and the people who know it best, the insiders, want to sell out big time? Danger, Will Robinson! Institutional investors aren’t (usually) that stupid, for one thing, and for another we Wall Street underwriters typically have to deal with our clients on the buy side of the house much more frequently and for a longer time than our intermittent issuers on the sell side. We have no interest in intentionally selling Fidelity, Vanguard, or anybody else a lemon IPO, no matter how much Sleazebag LLC wants to pay us in underwriting spread. We are middlemen, remember? We have a reputation to uphold, believe it or not.

So in normal circumstances Wall Street banks encourage issuers to make primary company shares, which raise money directly for the company, the entirety or vast majority of its initial offering. That way, new investors feel they are coming into the ownership structure as relatively equal co-owners of the firm alongside existing insiders.3 If demand is strong enough, we can often slip a relatively minor slug of insiders’ secondary shares into the IPO also, usually in the form of the underwriters’ 15% overallotment option, or “green shoe.” In some instances, the company may not need any primary proceeds, and the IPO is actually done as a precursor to selling insider shareholdings over time (as, for example, in the case of a firm owned by a private equity investor). But even in such cases, investors are much happier to see the company raise primary proceeds by issuing new shares, even if the principal use of proceeds is to repay a loan taken out to fund a pre-IPO dividend to the inside shareholders. In any event, nobody—underwriters or new investors alike—likes to see senior company executives or large, controlling inside shareholders sell down much more than a modest percentage of their remaining holdings on the IPO itself. IPO investors want to see the rats invested in the ship they’re buying passage on, too.

And the reason for the discount itself is simple, as I stated before. You are selling a large slug (often hundreds of millions or billions of dollars) of a brand new, unproven investment to new investors all at once. Like most new product introductions, it should not be that surprising to see sellers offer an initial discount off the expected sale price to incentivize buyers to try their unproven product. And, as I hope I have explained to you above, the owners of newly public companies are trying to establish a receptive market for future share sales, whether primary or secondary. Surely a little dilution (eighty-five cents on the dollar for primary proceeds or a minor portion of your existing secondary shares) is a small price to pay to establish a healthy public market for your future fund raising activity, no? And the discount is not pocketed cost-free by investors, either. Underwriters make sustained efforts to allocate discounted IPO shares to investors who indicate strong demand to buy more in the aftermarket, and who promise to do so. And we do keep track, and punish backsliders and reward those true to their word in future, unrelated IPOs and security offerings. This is one of the core reasons to employ underwriters in the first place, no matter how sophisticated an issuer may be: we play a long game with the buy side, and we have the opportunity to enforce behavior helpful to our issuers by the way we play it. Intermittent issuers simply don’t have this kind of market power.4

* * *

Of course, all this focus on the IPO discount might give the naive observer a comforting sense of precision and predictability about the post-offering performance of the shares. But this is unwarranted. When I wrote that underwriters suggest a 10 to 15% discount to the “intrinsic or fair value” of IPO shares, the alert among you should have immediately cried, “Bullshit!”

And you would be right. We are guessing:

Before they ever approach the market, investment banks do a lot of work evaluating new issuers to come up with a price which they think the company will be worth once it is trading normally in the marketplace. They do this based not only on the company’s own historical and projected financial results but also on the trading multiples and profiles of comparable companies already public. ... Now, you can see that this exercise is an art, not a science. Investment bank IPO pricing is the epitome of (very) highly educated guessing. We often get it wrong, but, on average, IPO pricing is normally pretty accurate. After all, it’s our job, and we do it well. The picture gets complicated, however, when the company in question, like LinkedIn, does not have any comparable peers among listed public companies. Our guesses become much less educated and much more finger-in-the-air type things. There is no cure for this but to go to market and see what investors themselves tell you they are willing to pay.

You see, investment banks try to guess what the market will pay for a stock. But, to be completely honest, we have no idea.

... once we go to market, the issuer and the investment banks essentially hand the steering wheel over to investors. We pitch, and wheedle, and cajole, and praise the company to the skies, but it is investors who set the price, initially in individual conversations with the underwriters’ salespeople—where they indicate the number of shares, if any, they want to get in the offering and any price sensitivities or limits they may have—next when the banks set the final price for the offering, and finally—and, by definition, definitively—when they bid up the price in the aftermarket after the shares are released for trading.

Let me make this perfectly clear: Investment banks do not set the ultimate price for IPOs; the market does.

And sometimes, as in the case at hand, you get what we call in the trade a “hot IPO.” Investors work themselves into a buying frenzy, the offering becomes massively oversubscribed (e.g., orders for 10 or more shares for every one being offered), and the valuation gets out of control. Underwriters have a limited ability to respond to these conditions, which typically emerge during the pre-IPO marketing or “bookbuilding” process, including revising estimated pricing up, like LinkedIn’s banks did (+30%), and increasing the number of shares offered. But eventually you just have to release the issue into the marketplace and let the market decide what the company is really worth.

Investment bankers are not idiots. We have tons of experience and expertise to bring to bear on valuation, and we are in constant contact with institutional investors on the buy side to gauge market demand. We work with the issuer’s financial and operating metrics (like the ones nobody has seen for Twitter) and the market trading multiples of comparable companies, which are similar social media darlings, to derive a normalized trading value for the firm. But we cannot say whether the market, in its infinite, obscure, unexplained wisdom, will agree with us or not.

And it is the market which decides:


Don’t like that? Have some cake.

Related reading on IPOs:
Jane, You Ignorant Slut (May 21, 2011) – The LinkedIn IPO kerfuffle, part 1
Dan, You Pompous Ass (May 22, 2011) – The LinkedIn IPO kerfuffle, part deux
Size Matters (March 21, 2012) – The JOBS Act and why we see fewer IPOs nowadays
As Long as the Right People Get Shot (May 30, 2012) – No, John Hempton (inter alia), underwriters do not have a moral or fiduciary obligation to get the sellers of an IPO the highest price


1 Which novel-ish practice is allowed under the JOBS Act for what the SEC characterizes as “Emerging Growth Companies,” or tender little start-ups with less than $1 billion in sales. The JOBS Act, by the way, has done virtually nothing to create jobs. Sic transit the Legislative Branch.
2 Yes, yes, I know there is some sleazeball outfit selling participation units backed by previously sold Twitter employee shares (all other shares being prohibited from trading in advance of the IPO). But if you think you can establish the post-IPO trading value of the company based on illiquid trading in such a derivative gray market, I encourage you to meet me next Tuesday at the Manhattan entrance to the Brooklyn Bridge. I will then and there be delighted to sell you the deed (or rather a deed to the Deed) to this magnificent cultural artifact for the bargain price of $200 million in cash. Small, unmarked bills, please.
3 Yes, I also know there is a disturbing tendency, particularly among hot technology issuers, to sell IPO investors second-rate stock which does not carry the same voting rights as insiders’ shares. This is a reprehensible tactic which guts the potentially important corporate governance function fully voting shares convey, but it is a bull market phenomenon many issuers love to take advantage of if they can. For what it is worth, most underwriters don’t like it, but we hold our noses all the way to market. Hey, nobody made you buy Google or Facebook shares, did they, bub?
4 This is why caviling by several of my previous interlocutors about the unseemliness of Wall Street dispensing favors to the buy side on IPOs is both shortsighted and dense. It is because we dispense favors, and try to make our buy side customers happy too, that we have the power to twist their arms when we need to, and attract their attention to those issuers which do not have every newspaper in Christendom bloviating about their offering plans. Middlemen, duh.

© 2013 The Epicurean Dealmaker. All rights reserved.

Sunday, January 6, 2013

A Photograph, Not a Circuit Diagram

Oh, good. Now, would you mind explaining this to me?
Except in the simplest cases, one cannot expect observation alone to reveal the effect of the use of an aspect of economics. One cannot assume, just because one can observe economics being used in an economic process, that the process is thereby altered significantly. It might be that the use of economics is epiphenomenal—an empty gloss on a process that would have had essentially the same outcomes without it, as Mirowski and Nik-Khah (2004) in effect suggest was the case for the celebrated use of “game theory” from economics in the auctions of the communications spectrum in the United States.

— Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape Markets 1

By now, many of you may have already read Frank Partnoy and Jesse Eisinger’s lengthy, outrage-y article in The Atlantic about the ongoing horror that is bank accounting, and/or one of many, many responses and reactions to it. I will not try your patience (or mine) by addressing their each and every substantive argument, but I thought it might be useful to lay out in summary form here why I think the entire premise of their screed is wrongheaded.

First, I will take the liberty of condensing and paraphrasing Messrs. Partnoy and Eisinger’s 9,500 word confection for the benefit of those among you with limited time and attention spans:
Banks are opaque and hard to understand! This is scary! Even big, sophisticated investors don’t understand the risks big banks take! Financial reporting for banks is scary and complex and mystifying! To calm ourselves, we tried to understand stodgy, prudent Wells Fargo’s financial statements. What did we find? Wells Fargo is big, opaque, complex, and scary!! Even their friendly investors relations person could not or would not answer our questions! We are scared! What should we do? We should send more bank executives to jail for scaring us! Oh, and come up with better, more understandable financial disclosure! Otherwise no-one will ever, ever, ever invest in publicly traded banks again! And then, disaster!!
Sigh.

* * *

Before I begin, I think it is fair to concede our Cassandras’ contention that large commercial, investment, and universal banks2 are highly complex, risky, and opaque institutions. It is also fair to say that most of the bad or downright naughty things which have occurred in the financial sector over the past several years (although not all; viz., Bernie Madoff) have bubbled up from the bowels of large, complex, opaque banks and their brethren. But the notion that there is some sort of magical accounting regime which could simultaneously shine sunlight into the deepest reaches of multi-trillion-dollar global financial institutions, clearly convey the actual and potential risks these institutions face or create in their daily operations, and therefore usher everybody into a new era of financial transparency, trust, and mint juleps on the sun porch is simply ludicrous. It completely misunderstands what accounting is and what accounting is for.

It is a rookie mistake.

First, accounting is—as Donald MacKenzie characterizes (academic) economics in the quote above— an epiphenomenon to the actual day-to-day activities which any business conducts. It is a way to keep track of the financial outcomes of a firm’s true activity, which is conducting business. It is passive, it is backward looking, and properly used under normal circumstances it drives none of the important business decisions or activities which firm executives pursue. When accounting consequences do drive decisionmaking, as in tax avoidance strategies or manipulating earnings, it introduces distortions into the underlying business which can lead to all sorts of economic inefficiences, up to and including fraud.

Accordingly, reading a set of financial statements can tell you very little about how to run an actual business. That is why every business of even modest complexity runs its own internal management information systems which provide the people running the show with real time, targeted information which they can use to make decisions. These systems have very little, if anything, to do with generally accepted accounting principles. The daily trading book and profit and loss statement for a Wall Street trading desk will bear little resemblance to the balance sheet and income statement of its investment bank parent. Of course at year and quarter end each desk’s results do get rolled up and reconciled into its parent’s consolidated financial results, but this process by necessity compresses and distorts the actual real-time, granular information used to run a business into standard, pre-approved accounting categories. In addition, the backward looking nature of accounting for the period just ended means the more dynamic and changeable an underlying business process is—for example, sales and trading at a securities firm—the more out of date and potentially misleading the reported numbers can be to the current state of the business.

And it is not a matter of simply providing more, more detailed information more frequently. Put aside the common tension that most businesses compete with others, and detailing too much information in publicly available accounts would undermine their competitive position. (This is particularly important for market-making investment banks.) No, such a strategy would increase the complexity of a firm’s accounts, which seems exactly contrary to Messrs. Partnoy and Eisinger’s stated objectives of greater transparency and shorter financial reports. Not to mention still not get at the idiosyncratic risk and business practices of each such firm, because it is the entire point of public accounting to standardize reporting to enable comparability across firms.

And this last gets directly at a critical point which seems to have eluded our intrepid reporters: what accounting is for.

* * *

For that is what public accounting is: a public accounting of the financial results of a firm for the benefit of external stakeholders of various stripes, including lenders, creditors, business counterparties, regulators, and investors. It is meant to be an intermittent report on the health and progress of a firm to potentially interested parties, filtered, standardized, and formatted into a presentation which can allow those parties to compare the firm to its peers and competitors both within and outside its industry. It is not meant to be a real-time profile of the actual business operations of an individual firm; nor is it meant to give outsiders such operational knowledge of the firm that they completely understand and perhaps could even run the business themselves. It is a report card, not a class curriculum or even lecture notes.

And you should not think that regulators—who we might indeed prefer to have much more detailed, real-time operational knowledge of systemically important risky financial institutions—are hobbled in any way by the limitations of their regulatees’ public financial reports. Securities and bank regulators always have intimate access to the current operations and results of firms under their supervision and, arguably, should have much more. But this is true whether a firm files public reports or not.

Lastly, Messrs. Eisinger and Partnoy’s concern for the confidence of equity investors in banks is completely ass-backwards. A quick peek at the balance sheet of their subject Wells Fargo reveals that it derives only 10.4% of its outside funding from equity investors: the vast bulk is in the form of retail and other deposits, and the balance comes from other debt and preferred investors. Show me a retail depositor who decides whether to keep her money at Wells Fargo based on the footnote disclosure in its annual report and I—after I pick my lower jaw up off the floor—will show you a hot January. Likewise, equity investors were not the funders first to the lifeboats when Bear Stearns and Lehman Brothers ran aground. Stock investors were not the parties who cratered failing banks in the financial crisis.

That is because banks and investment banks do not rely on equity investors for daily funding or liquidity. They rely on trading counterparties, repo suppliers, short-term lenders, and prime brokerage hedge fund customers to roll over constantly maturing short term debt (often funded overnight) and keep their trading balances and assets at their firm. When these institutional investors lose confidence, a bank is toast. They refuse to roll over short-term funding, they yank their assets on deposit, and they may even put on a nice, juicy short against the beleaguered bank’s stock just for good measure. And you can bet your bottom dollar they are not going to wait for the quarterly 10-Q report to be filed 45 days after period end to make their decision.

* * *

Even the much maligned (by me) Securities and Exchange Commission understands the proper relationship of public accounts to equity investors. Remember that the SEC’s objective for public reporting is not to help you fully understand a business. It is to disclose all pertinent and relevant facts and risks about a business so an investor can make her own informed decision. Banks are big, opaque, risky, and complex. What do bank financial statements tell us? They tell us banks are big, opaque, risky, and complex. That sounds pretty accurate to me. The kind of disclosure our doughty duo proposes, including ludicrously simplistic “worst-case scenarios,” would not increase investors’ understanding of the real risks inherent in the mind-bogglingly complex business of global finance. In point of fact, these are only poorly or dimly understood by the very bankers undertaking them. Instead, it would promote a sort of unwarranted confidence that would be both dangerous and misleading.

Equity investors should be terrified of banks. After all, they are the last capital providers in line in famously and ineluctably evanescent institutions, firms whose very existence can wink out over a weekend if the depositors, counterparties, and institutional investors ahead of shareholders decide to take a powder. That is the nature of banks, then, now, and always. Banks are structurally short liquidity. When liquidity dries up, or becomes prohibitively expensive, banks fail, and they fail fast. It’s as simple as that.

And yet, notwithstanding all of poor Bill Ackman’s axe grinding, retail and institutional investors still seem to want to own bank stocks.3 Why is that? Well, notwithstanding the good money to be made owning them in good times, it seems the prices of bank stocks, whether measured by historical prices, P/E ratios, or price to tangible book value, have dropped to a level where investors feel fairly compensated for the risk they are assuming. You know: the risk disclosed in the banks’ public financial statements that they are big, opaque, risky, and complex.

Nowhere is it written that bank stocks should trade at a specific multiple of book value, no matter how accurate or believable book value is. Investors may be paying lower than historical multiples of book for bank stocks because they do not trust banks to have properly marked assets to market, they may not trust management not to destroy value by making stupid errors (or errors unavoidable in today’s volatile and unpredictable markets), or they simply fear more unanticipated systemic disruptions will sink even the best-managed, most conservatively-accounted-for banks (including threatened regulatory changes). Investors are paying lower prices for bank stocks because they require higher risk-adjusted expected returns.

This does not sound like a crisis of confidence to me. This sounds like sensible, prudent investing in an uncertain world.


Related reading:
Frank Partnoy and Jesse Eisinger, What’s Inside America’s Banks? (The Atlantic, January/February 2013)
Matt Levine, Turns Out Wells Fargo Doesn’t Just Keep Your Deposits In A Stagecoach Full Of Gold Ingots (Dealbreaker, January 3, 2013)
Felix Salmon, You can’t regulate with nostalgia (Reuters, January 3, 2013)


1 Cambridge, Massachusetts: The MIT Press, 2008, p. 18.
2 For the novitiates, simply, a “commercial” (or retail) bank is primarily a lending bank: they take in retail customer deposits and lend them out in the form of mortgages, commercial loans to businesses, and other retail loans. An investment bank acts as a market intermediary, buying and selling securities and derivatives on behalf of clients and itself and advising on mergers and acquisitions. A universal bank is a combination of commercial and investment bank. Most big banks you read about nowadays, including, e.g., Wells Fargo, are universal banks. Not enough for you? Want to go deeper down the rabbit hole? Start here.
3 How do I know this? Well, the trading volume and price of public banks and investment banks is not zero, that’s how. By the way, the price to tangible book value ratio for terrible, awful, scary Wells Fargo is currently 1.7x, or almost twice book value. Perhaps that’s because equity investors take great comfort from all those information-insensitive depositors ahead of them in the capital structure.

© 2013 The Epicurean Dealmaker. All rights reserved.

Wednesday, May 30, 2012

As Long as the Right People Get Shot

Do ya feel lucky, punk?  Well do ya?
“A man’s got to know his limitations.”

— Magnum Force


I like John Hempton, O Dearly Beloved. I truly do. The man is smart and principled, and he has attracted a global audience as a direct result of his fearless application of these two qualities to the analysis of investment opportunities and economic realities. I do not link to his work more often here because 1) macroeconomic topics and specific trading opportunities are not my focus or concern, either in these pages or in my professional life, and 2) accordingly I do not pretend to an expertise in such matters which would enable me to judge the quality of his analysis and advice. I value his reputation on the recommendation of others whom I respect.

But every man has his limitations. I am sad to say that, with his latest post, Mr. Hempton has overstepped his. This is what he says:

In an IPO an investment bank takes a fee from a business to place that stock in financial markets.

Or, more precisely, they take a fee from a business to sell part of that business.

Their customer is the company doing an IPO and they have a legal and moral obligation to get the highest price for the company they are selling. No more. No less.

However investment bankers have, as a practical matter, a desire to expand and improve their franchise. Their franchise consists of a huge number of buy-side investors (some retail, some institutional) who will buy from them whatever they sell so long as it comes in a prospectus.

Investment bankers expand that franchise by making sure the things sold in a prospectus have excess demand. If they can sell for $38 they chose to sell for $33 to guarantee a stag. Every time they do so they build their own franchise as an investment bank at a cost to the client to whom they owe a legal and moral duty and who is paying them fees.

The buy-side customers of investment banks have got used to playing in this little game of theft. We – as buy-siders – like to be able to buy IPOs and have instant stag profits. Indeed in the 1990s the game of giving favours to investment banks in exchange for instant stag profits became the way business was done on Wall Street.

The moral corruption of investment banks not only became accepted but we redefined morality around what investment banks did rather than what they should do. We though the process of systematically ripping off the sellers of IPOs in order to build the buy-side franchise of the investment bank was right-and-proper.

It is not right-and-proper and it never was right-and-proper.

Bullshit, John. Bull. Fucking. Shit.

* * *

Now for what it’s worth, the principal target of Mr. Hempton’s post seems to be buy-side investors who are screaming bloody murder in and with the eager support of the press that they did not receive what they appear to hold as their god-given right to a substantial IPO price “pop” once Facebook’s shares were released to trade freely. And in this I am in full agreement with him. Nowhere is it written that the price of an initial public offering must appreciate by a certain percentage after the offering, nor indeed that it must appreciate at all. It is even true that—heaven forfend—there is no divine prohibition that the price of an IPOed company’s stock cannot decline after the offering, as Facebook’s has done. As I will explain below, investment banks which underwrite IPOs normally prefer most IPO stock prices to rise modestly post offering (because their clients do), but nowhere is it written that any such outcome must occur.

So in this respect I agree with Mr. Hempton’s larger point: that the buy-side, institutional and retail alike, have no leg to stand on to criticize lead underwriter Morgan Stanley, Facebook’s CFO, or indeed anybody involved in Facebook’s IPO that the stock price has declined as precipitously as it has. Facebook’s IPO—as the most anticipated and hyped initial public offering in years—was a possible/potential/highly likely train wreck long in coming, and any moron who bought on the offering, or, worse, in the aftermarket, deserves every heart palpitation and shooting pain that’s coming to him. Caveat fucking emptor, people. Jesus. I have absolutely no sympathy for you.

However, where I do take extreme umbrage and exception to Mr. Hempton’s scribblings is in his characterization of Morgan Stanley’s purported acquiescence to Facebook’s CFO’s request to upsize the offering and price it at the top end of the indicated (revised) range as uniquely or particularly “ethical”; in contrast to what he styles as Wall Street’s typical “theft” and “moral corruption.” For it is clear that Mr. Hempton’s moral judgments hinge critically upon the ineluctable fact that, in this instance at least, he doesn’t know what the fuck he is talking about.

* * *

Virtually all IPOs in the modern era are done on a “best efforts” basis. This means exactly what it sounds like: underwriters contract with an issuer and selling shareholders (if any) to place its newly issued shares in the marketplace at a time, a price, and in a quantity which they are able to secure by exerting their best efforts to sell same to potential investors. IPO underwriters do not have any obligation—legal, moral, or contractual—to deliver any final terms to the issuer. Our job—the job which every potential IPO issuer hires us to do—is to help them take their offering to market and achieve the best possible outcome, which includes and is entirely contingent on the market accepting the final offered terms and buying the IPO. Nowhere in this arrangement, understanding, tradition, or even the contractual Underwriting Agreement which governs the underwriters’ and issuer’s mutual obligations to each other is anything said, guaranteed, warranted, or promised about the “highest price.” For what it is worth, by the same token nowhere it is contractually required that the issuer must agree to the final terms which the underwriters are able to deliver. If the issuer doesn’t like the final deal offered, it can tell the underwriters (and public market investors) to pound sand. No deal, no offering. Buh-bye.

Now there is a longstanding tradition, rule of thumb, heuristic—whatever you want to call it—in IPO underwriting that issuers should sell their shares in an IPO at a discount to intrinsic or fair value. In normal, healthy markets, this discount is normally discussed in a range of 10 to 15%. In today’s unsettled, Facebook-/Europe-/Presidential-election-addled markets, this discount can be as wide as 25 to 30%. The intended purpose of the IPO discount is twofold: 1) to help place the relatively large bolus of shares which an IPO represents with investors who have alternate potential uses for their money1 and 2) to bolster positive demand in the marketplace for follow-on buying. You see, an issuer of an IPO is not, unlike a company which is selling 100% of itself, trying to maximize total proceeds for existing shareholders (and fuck the newcomers). It is trying to attract a new set of shareholders who will be co-owners of the company for at least some non-trivial period of time. An IPO issuer only sells a minority of the total ownership position in the firm, and it wants to develop a positive, receptive marketplace for future stock sales in the public markets. (After all, how can the company raise future equity finance money and inside shareholders sell down their holdings in the future if public market investors are hostile to them? Oops, Facebook.)

As I’ve argued before, the IPO discount—which is well and truly disclosed, discussed, and argued over from the very first day competing investment banks pitch to underwrite an issuer’s proposed IPO—is the cost of going public. It is no secret. The issuer knows about it, understands its purpose, and agrees to it from the very first moment it agrees to proceed with the offering.

So here’s the deal, John:

IF EVERYBODY KNOWS ABOUT IT, UNDERSTANDS IT, AND AGREES TO IT, IT ISN’T THEFT.
THE IPO DISCOUNT IS A COST OF DOING BUSINESS.

It’s pretty fucking simple.

* * *

Now that you understand why IPOs are typically priced at a discount to intrinsic or fair value, it is no burden for me to admit that underwriters are not unhappy that we have these bargains to pass around to our friends and relations. Of course giving access to IPOs at 10 to 15% discounts to fair value is valuable currency for us to share with investors who trade with us, direct business to us, and generally bolster our bottom lines. We are in business, after all, and we have every right to treat some customers better than others if it promotes our own welfare. This is not moral corruption, it is business. But it falls out of the marketing imperatives which drive the successful placement of IPOs; it does not drive them.

And investment banks’ business, for those of you, like Mr. Hempton, who seem to get confused about the matter, is to be a middleman. We straddle the markets for issuers and investors of capital, and both issuers and investors are our clients. We are unavoidably riddled with conflict of interest because we serve two masters, and the masters we serve have conflicting interests. Other things being equal, issuers would like to sell shares high; investors would like to buy shares low. Our job, as underwriters, is to make those desires clear in the middle, and execute a transaction that equally satisfies—or equally dissatisfies—both parties. That’s our job. Everybody knows this.

So, if, on the other hand, you own a company and want to receive the highest possible price for your ownership stake, you should stay the hell away from the IPO market. Because I and my peers will be the first ones to tell you you can get a better price in the M&A market.

And we can help you with that transaction, too.

Oh. And Chesterton’s fence.

Lieutenant Briggs: “You’re a good cop, Harry. You had a chance to join my team, but you decided to stick with the system.”
Harry Callahan: “Briggs, I hate the goddamn system! But until someone comes along with changes that make sense, I’ll stick with it.”


Related reading:
Jane, You Ignorant Slut (May 21, 2011)
Dan, You Pompous Ass (May 22, 2011)
Chesterton’s Fence (March 5, 2012)


1 Forget the novelty of an IPO, which represents a new stock in an unknown company without an active trading market or established market price. IPOs usually represent a substantial amount and percentage of the issuer’s stock being offered all at one time. (Facebook’s IPO totalled $16 billion.) For established public companies, the analog would be a secondary offering or a very large block trade. Guess what, bubeleh: each of those clear the market at a material discount to the existing market price, too. When you’re trying to place a big block of stock—newly issued or not—you’ve got to offer a discount. Think WalMart, or buying in bulk. It’s really not that complicated.

© 2012 The Epicurean Dealmaker. All rights reserved.

Sunday, April 22, 2012

A Good Offense

Defense or offense?
Kind-hearted people might of course think there was some ingenious way to disarm or defeat the enemy without too much bloodshed, and might imagine this is the true goal of the art of war. Pleasant as it sounds, it is a fallacy that must be exposed: war is such a dangerous business that the mistakes which come from kindness are the very worst.

* *

If defense is the stronger form of war, yet has a negative object, it follows that it should be used only so long as weakness compels, and be abandoned as soon as we are strong enough to pursue a positive object.


— Carl von Clausewitz, Vom Kriege


Consider, Dear Reader, the question embedded in the mouse-over caption to the photo above: Should we consider a tank destroyer—a machine designed to destroy tanks—to be a defensive weapon or an offensive weapon? The Jagdpanther was designed and employed by the Wehrmacht during World War II primarily as a hunter-killer of Allied tanks. Heavily armored against frontal assault, highly mobile, and equipped with a powerful main gun fixed in a low-profile, turretless unibody chassis, the Hunting Panther was designed to lie in ambush for enemy tanks and knock them out in one-on-one frontal duels. Its design was ill-suited for infantry support, general patrolling, or massed attack across open country. Given that the tanks it opposed were usually employed in offensive thrusts, one could say the Jagdpanther was primarily a defensive weapon. And yet it was also a mobile cannon par excellence: a weapon purpose built to deliver armor-penetrating or high explosive shells against sundry targets mobile and fixed, none of which necessarily had to be an opposing tank. (Eighty-eight millimeter rounds could kill enemy infantry and destroy artillery emplacements just as neatly as they disabled tanks.) Of course the Germans could and did use the SdKfz 173 for offense. It was a weapon.

It is true that most weapons and implements of war are usually designed to be primarily offensive or defensive in nature. A shield’s primary use is to defend, a sword’s is to attack. And yet a sword can be used to parry; a shield can be used to bludgeon or chop. Offense and defense are different modes of use—that is, tactics—not intrinsic properties of the tools we employ.

The same is true, by analogy, of financial instruments and trades. A trade can be made for offensive purposes—speculation or investment1—or defensive ones, as a hedge. Speculation increases an investor’s risk exposure; hedging reduces it. And yet the same trade or financial instrument can be used in either way at different times and under different circumstances. Selling a thousand shares of Apple Computer can either be a perfect hedge, when it liquidates an existing long position, or rank speculation, when it initiates an open short sale. Context—and the other positions in an investor’s portfolio—is everything. This is very poorly understood by the common man or woman.

* * *

Hence we get the recent spectacle of financial journalists and market participants falling all over themselves to condemn with morbid fascination the large scale market interventions of J.P. Morgan Chase’s London-based chief investment office. Adding to the camera-ready copy of these stories, this trading team reportedly roiling the markets with its enormous volume and net positions apparently enjoys the leadership of a man some call the “London Whale” and others “Voldemort.” An eager journalist on the financial beat could not ask for more.

Of course the solitary string of outrage which journalists and their hedge fund sources—pot, meet kettle—keep harping on is that somehow J.P. Morgan is using the trading activities of its CIO to circumvent the regulatory and moral limitations on proprietary trading by systematically important financial institutions embodied if not yet enforced in the Volcker Rule. Jamie Dimon, as befits the fiduciary duties which accompany his lofty pay grade and authority in J.P. Morgan’s executive suite, of course denies that the London Whale or any of his minnows are doing any such thing. I am sure it will disappoint the anti-capitalist firebrands in my audience to hear that, subject to further stipulations, qualifications, and cautions noted below, I feel compelled to give ol’ Jamie the benefit of the doubt here.

For the assertion, which Mr. Dimon seems to be promoting, that his chief investment office is putting on massive securities and derivatives trades to hedge the bank’s already existing underlying risk exposures makes complete sense. Have you looked at J.P. Morgan’s balance sheet lately, O Curious and Inquisitive Reader? As of March 31, 2012, the redoubtable House of Morgan boasted total investments (consisting of deposits with other banks, debt and equity instruments, derivatives, and securities) of $953 billion, net loans outstanding of $687 billion, and other assorted doodads which added up to an impressive-in-this-or-any-other-world-you-can-think-of 2.3 TRILLION DOLLARS of total assets. That’s a lotta simoleons, children.

And while the mysteries of generally accepted accounting principles, trade secrets, and legal smokescreens prevent a humble outsider such as Your Humble Bloggist from penetrating the veil of opacity to any meaningful extent, I think it’s safe to assume a hell of a lot of those bright, shiny assets represent proprietary risk trades which the House of Dimon put on for the sake of its beloved and long-suffering corporate, governmental, and investment clients. Most people just don’t seem to get it, but even normal, everyday corporate lending is proprietary investing. A bank creates an income-producing asset for itself by lending money to a client. Loans are risky assets: the borrower may not pay principal and interest back on time (or at all), and the lender exposes itself to market-based interest rate risk either directly through the form of the loan’s interest payment mechanism (fixed or floating) or indirectly via its own funding requirements (banks borrow money to lend it, you know) or both. A normal commercial lending bank is by definition shot through with all sorts of risk, even when it shuns the racier ends of the swimming pool like securities and derivatives trading or structured products.

This becomes especially clear when you consider the funding side of a normal bank. J.P. Morgan did not create or purchase all those assets with $2.3 trillion in loose change it just had lying around the house. It borrowed over $2.1 trillion from anyone it could get its hands on—retail and commercial depositors ($1.1 trillion), corporate lenders ($726 billion), and trade creditors, plus $182 billion from gullible common shareholders—and went shopping. The bank is, to use an industry term of art, leveraged up the wazoo.2

But this is just the ordinary magic of a traditional bank’s business model: borrow cheap, flexible funding from as many naive savers as you can muster, and lend it out at higher rates to the desperate and underfunded. The magic—and the returns—come from the fact that the risks a modern bank assumes on the funding and the lending side are very different, often highly volatile, and incommensurate with leaving early on Thursday for afternoon golf. Identification, management, and control of borrowing and lending risks are core to the activities of lending banks. That is what they get paid for; that is how they earn their returns.3

* * *

Now given that Jamie’s Army is brooding over something slightly more than umpty bajillion dollars of proprietary investment assets tottering precariously on their balance sheet, you can be damn sure that I and everyone else with a natural aversion to Stone Age living conditions sure as hell hope J.P. Morgan is hedging the shit out of those assets. You can also be sure that a loan book of $687 billion and an investment portfolio a cat’s whisker shy of a trillion dollars offers numerous and substantial opportunties for its risk management group to put on enormous hedging trades in the markets. I would be shocked to learn that J.P. Morgan wasn’t moving the markets.

The only caveat to mention is that hedging is a tricky and mercurial thing. As I alluded above, the only “perfect” hedge for a trade or position is to unwind it completely, with the original counterparty or one who carries no residual risk. You can perfectly hedge your purchase of 1,000 shares of Apple only by selling them completely, for cash. The same is true for each and every individual financial asset: it can only be completely and irrevocably hedged by unwinding that particular asset or, as is sometimes done in the derivatives market, by immunizing it with an identical, offsetting mirror-image asset with the same counterparty. Anything else introduces one or more forms of what is broadly known as basis risk. Basis risk can take many different forms: credit risk, from different counterparties; interest rate risk, from different durations (e.g., long vs short); collateral risk; and, overarching and encompassing most of these, correlation risk. The latter is easiest envisioned in the case where an investor hedges her portfolio of individual stocks against a general market decline by buying a notional amount of S&P index puts equivalent to her portfolio value. But her success will depend entirely on how her individual stocks behave in relation to the portfolio hedge. If they move down in lockstep with the S&P, she will have protected her portfolio’s value, but if they decline while the S&P stays flat or rises, she will have suffered the worst of both outcomes, loss on both her portfolio and her protective puts.

The trick is that portfolio hedging is normally far more efficient and cost-effective than hedging each and every individual position in a risk book. While this concept seems to befuddle the occasional journalist, it seems to have penetrated even the thick skulls of the rule makers in Congress, who have carved out aggregated position hedging from activities banned by the Volcker Rule. After all, if one looks at commercial and universal banks as entities which manage the mismatch of assets and liabilities in their business for fun and profit, one can see that, in some important sense, it is the job of such financial intermediaries to generate returns by managing basis risk. In the argot of the market, banks are long the basis risk of financial intermediation.

But by that very token, examining the risk portfolio of a large financial institution can never be as simple as totting up each individual portfolio position and netting it against its very own particular hedge. Banks and investment banks manage risk across multiple dimensions, and one hedge or set of hedges may have (partial) hedging properties for numerous unrelated positions. They do so dynamically, too, since the basis risk which was well understood yesterday may diverge or uncouple drastically tomorrow. Market crashes and financial panics seem to have the nasty effect of driving return correlations to one across all financial assets and asset classes, which can bollocks up an otherwise nifty risk model no end. The monitoring and control function of regulators is made more problematic by portfolio risk management practices, too, since a trade which looks like a sensible and effective hedge in the context of the overall risk book may look like the rankest proprietary speculation in isolation. Needless to say, the counterparty to a trade by a big commercial or investment bank usually doesn’t have the beginning of an inkling of a whisper of a clue why and for what purpose Big Mondo Bank is calling him up. And you can forget about journalists.

In like fashion, a Russian tank commander on the outskirts of Warsaw in 1945 probably didn’t have the least notion whether the Jagdpanther fired its 88 at him because it was attacking, defending, or just range finding. Sorry to say, the reason didn’t matter much if an antitank round blew him to smithereens.

Fortunes of war.


1 For the purposes of this discussion, I consider “investment” and “speculation” to be one and the same thing. Both entail the assumption of risk in pursuit of return, as opposed to hedging, which entails the reduction of risk. That investment has a respectable connotation in our current culture and speculation does not is none of my concern. All investment—which constitutes a bet upon an uncertain future—is speculative. It would be wise for everyone to remember this.
2 Although by the standards of its industry, its profligate European peers, and the wild-eyed lunatics in pure investment banking, J.P. Morgan is downright conservative in its leverage ratio. The absolute numbers are what give any prudent person the bends. It’s all how you look at it.
3 Never forget, children: risk and return are conjoined twins. You can’t have one without the other. If you can’t identify the risks underlying a particular return, you’re either missing something, or I have a very attractive bridge crossing the East River I would like to sell you.

© 2012 The Epicurean Dealmaker. All rights reserved.

Wednesday, March 21, 2012

Size Matters

Don't believe the lies women tell you, boy, you need this
“It’s not the meat, it’s the motion.”

— Possibly apocryphal motto ascribed to certain Ivy League Lightweight Rowing Programs1


Felix Salmon and Pascal-Emmanuel Gobry have commenced an interesting tennis match with dueling blog posts recently. At stake is what is allegedly wrong with the market for initial public offerings in this country and what should be done to fix it. Apparently the whole brouhaha was triggered by some ludicrously-entitled piece of bipartisan bullshit evacuated by Congress known as the JOBS Act, the fundamental purpose of which seems to be to lower the barriers for smaller companies to access capital in the financial markets. Felix offered up the opening serve, Pascal returned serve here, and Felix has pelted the ball back over the net this evening.

Now I—as a mercenary intermediary in the capital markets whose livelihood and enjoyment of exotic delights unknown to ordinary humans depends in part on the introduction of persons in need of filthy lucre to those in uneasy possession of too much of the same—clearly have a dog in this fight. Interestingly enough, however, I freely admit that I couldn’t give a rat’s ass whether this piece of campaign-finance-inspired legislative pandering passes or not. Number one, it won’t affect my business in the least, and number two, it won’t really make a damn bit of difference to increasing the availability of financing for businesses which can contribute meaningfully to the economic growth of this economy. I mean, if you want to pretend that Kickstarter—that crowdsourced cesspit of Mickey-Rooney-like “Hey, fellows, let’s put on a show!” garage band nonsense—can make a material difference to the unemployment figures or economic growth trajectory of a thirteen trillion dollar domestic economy, be my guest. And after you’re through playing with yourself, I have an attractive bridge of historical significance to sell you.

Having witnessed the evolution of the equity capital markets over a two-decade period (longer than the conscious lifespan of most of the callow strivers populating the crowdsourced finance ecosystem), I do have a perspective and opinion which some might find illuminating. It boils down to this: neither Felix nor Pascal addresses the root source of the current dilemma. Public financial markets—and the institutional investors who dominate them2—have become too large to be an effective source of late-stage growth equity capital for most companies. The “round lot” (sorry, minimum size) for an effective IPO nowadays is at least $75 million dollars. But very few fast-growing companies ever need that much money to grow their business. Let’s face it: most startup companies with indisputably fabulous business models have no opportunity or intention of becoming the colossal world-beaters which Pascal identifies in his post. Furthermore, few insiders (management and original equity backers, whether VCs or otherwise) want to sell all of their holdings in these companies on an IPO, even if the underwriters allow them. After all, they usually believe in the story, and they want to continue their ride on the rocket ship. If the company doesn’t have a good use for the money, and pre-IPO shareholders don’t want to sell any meaningful portion of their stake, where the hell are the shares for the IPO going to come from? Exactly: they’re not.

* * *

Part of the problem lies with the current structure of the investment banking industry. Too many potential underwriters are just too large to consider run-of-the-mill, pissant IPOs to be worth their time and attention. To paraphrase 1980s supermodel Linda Evangelista, bulge bracket banks like Goldman Sachs, JP Morgan, and Bank of America Merrill Lynch just won’t get out of bed in the morning for less than a $300 million offering. They can’t even pay their defense counsels’ retainers with the commissions earned from such business. And for various reasons, smaller investment banks which could make a decent living off such fare are relatively few and far between.

But the real problem lies with the primary audience for IPOs, institutional equity investors themselves. Over the past few decades, the public equity markets have evolved from a relatively staid and selective backwater, a playground for pension funds, insurance companies, and the idiot sons of wealthy men, into a gigantic global pool of capital, driven and supported by huge amounts of money from literally everybody. Equity markets have become tremendously democratized, both directly with the individual participation of non-wealthy punters and indirectly with the huge reallocation of pension fund and pooled institutional capital into publicly traded stocks. I will leave it to an enterprising PhD student to research the data, but I suspect the aggregate amount of equity market capitalization as a percentage of GDP has swelled tremendously over the past three decades. Equities have gone mainstream, and as they did, the size of equity markets ballooned.

As they have done, the minimum size investment which your average institutional investor in public equities can entertain has ballooned, too. I remember a senior equity capital markets banker (IPO shill, to you) telling me a story years ago about how a friend of his had joined one of these institutional behemoths as a portfolio manager at the same time he joined the sell side. His friend explained that when he started managing equities in the 1980s, he had a total portfolio of around $100 million dollars. To devote sufficient time and attention to each of his positions, this PM limited his portfolio to no more than 100 individual companies (which, frankly, was pretty energetic and ambitious). By the 1990s, good luck, skill, and a rising tide had swollen his portfolio to $10 billion in size, but he still adhered to his limit of no more than 100 portfolio company investments. In other words, his average investment in an individual company’s shares had grown from $1 million to $100 million. Each. And he was neither unusually successful nor particularly large.

You can quickly see, Dear Readers, that such a portfolio manager must think long and hard whether he wants to spend the time and energy investing in, following, and adding to a position in a company in which he will be limited to no more than a 10% portion of the initial public offering.3 Especially if his initial investment in a $75 or $100 million IPO is 10% or less of his ideal average size portfolio holding. This also explains, indirectly, why investment banks have grown to a size where it is not economically efficient or profitable for them to underwrite IPOs of less than $75 million in size: as middlemen, we have followed the money, and our buy side clients, after bigger game.

* * *

Now whether this so-called JOBS Act is a sensible alternative to the current jury rigged system of angel investors, venture capitalists, and private investors in late stage growth equity capital which has grown up to fill this widening structural gap in the capital markets is above my pay grade. As I said above, I suspect it will have very little effect on mainstream, Wall Street underwritten IPO business at all. But I must agree with Matt Levine of Dealbreaker when he observes that

either the SEC registration process is necessary to protect investors, in which case it’s especially necessary for smaller newer companies, or it’s not, in which case it’s no more necessary for large companies than for small ones.

It is a little disconcerting to me that bipartisan knuckleheads in Congress seem intent on reducing regulation, protection, and oversight in retail finance at the same time they are putting other parts of my industry into testicle clamps. But I suppose political campaigns just don’t pay for themselves.

In any event, you may rest assured that one perennial truth about entrepreneurial business funding markets will never change, no matter what changes to the legislative and regulatory environment may occur:

The retail investor will always get screwed.


1 Quibble, cavil, and plead all you want, Gentlemen, I am here to tell you—after decades of personal experience—that size does indeed matter. Any woman who tells you otherwise is protecting your feelings. And probably looking for her next boyfriend/husband, besides.
2 Yes, yes, retail investors make up a portion of the public equity markets too. But hear this: no-one in my business ever asks the opinion of Aunt Millie or Uncle Joe about the proper price of an initial public offering. No underwriter in my industry, now or ever, has relied upon the retail demand of a bunch of ignorant, emotion-addled, staggeringly poor (relatively) individual investors to drive the size, pricing, and ultimate success of an IPO in the US markets. At best, retail investors are fleas on the asses of lumbering institutional investors like Fidelity, Vanguard, and myriad public pension funds which put in orders for hundreds of millions of dollars of stock. At best, retail investors comprise 15 to 20 % of the total demand of an IPO. Frankly, my dears, you could all simultaneously get hit by buses crossing the street the day before the offering, and it wouldn’t make a damn bit of difference to us or the issuer. Sorry to break it to you like this, but when it comes to initial public offerings, retail investors are irrelevant.
3 IPO underwriters like to limit “anchor” or lead investors to no more than 10% of the initial offering size. The hope is that they will want to add to their position in aftermarket trading, thereby providing ongoing buy-side support to the shares. IPO offering books are usually anchored by no more than 3 to 5 such 10% holders.

© 2012 The Epicurean Dealmaker. All rights reserved.

Saturday, February 4, 2012

Leverage This

What's your collateral?
Jessie Stevens: “It was exciting at first, but you know now I think it’s more exciting to have them stolen.”
John Robie: “Yes, because you can’t lose financially as long as Hughson is around to make out the check.”
Jessie Stevens: “Well I’d be crazy to take this attitude if I did.”

— To Catch A Thief


I have had an absorbing day thinking about moral hazard, unlimited liability, and the modern financial system, O Dearest and Most Inquisitive of Readers. My thoughts have been guided by two intriguing articles; one, a blog post by Carolyn Sissoko at Synthetic Assets in response to Steve Randy Waldman’s recent pieces on opacity in finance, and two, a speech given by Andrew Haldane of the Bank of England last October. Both have enlightened me immeasurably about the long-term history of banking and finance, of which, I am mildly chagrined to admit, I have apparently been woefully ignorant. Such are the shortcomings of a Modern Man of Action.

Having little to recommend me as a guide to the fields of financial history or economics generally, I will spare you my amateurish glosses on each of these pieces, and encourage you instead to read them yourselves. Suffice it to say that I found their narratives of the transformation of banking and other financial intermediaries from their original state as small partnerships sharing unlimited liability to today’s limited liability corporations fascinating. For one thing, I was unaware of the common intermediate step, which obtained from roughly the second half of the 19th century through the 1930s, in which bank shareholders were subject to “extended liability,” which required them to put up additional (but not unlimited) capital in the event it was required to meet the bank’s obligations. While this system—and the unlimited liability regime which preceded it—did not prevent the occurrence of numerous bank runs and financial panics during this period, Ms Sissoko contends that it performed pretty well as a shock absorber for the financial system. Bank losses hit bank shareholders and partners first, often with the effect of bankrupting them, and depositors were able to recover their monies, albeit with notable delays. Naturally, as one might suspect, having liability in excess of direct capital invested encouraged an excess of caution among banks in the loans they underwrote.

Andrew Haldane explains:

Bank balance sheets were heavily cushioned. Equity capital often accounted for as much as a half of all liabilities, while cash and liquid securities frequently accounted for as much as 30% of banks’ assets. Banking was a low-concentration, low-leverage, high-liquidity business. A broadly-similar pattern was evident across banking systems in the United States and in Europe.

This governance and balance sheet structure was mutually compatible. Due to unlimited liability, control rights were exercised by investors whose personal wealth was literally on the line. That generated potent incentives to be prudent with depositors’ money. Nowhere was this better illustrated than in the asset and liability make-up of the balance sheet. The market, amorphously but effectively, exercised discipline.

It was given a helping hand by market-based prudential safeguards. Directors of a bank had the capacity to vet share transfers, excluding owners without sufficiently deep pockets to bear the risk. Shareholders also maintained their liability after the transfer of their shares. This put shareholders firmly on the hook, a hook they then used to hold in check managers. Managers monitored shareholders and shareholders managers. In this way, the 19th century banking model aligned risk-taking incentives.

Given the common diagnosis of the recent financial crisis as arising, at least in part, from excess risk taking by commercial and investment banks due to misaligned managerial incentives and the (ultimately correct) perception that society would step in to cover bank obligations during a panic, it is tempting to view such a regime as preferable to the one we have now.

But before we force Jamie Dimon to sell his houses and cars to stem a run on JP Morgan, it is important to understand why unlimited and even extended liability banking was replaced. According to Haldane, unlimited liability proved “rather too effective as a brake on risk-taking” and insufficient to the provision of credit in the face of increased societal demands for “capital to finance investment in infrastructure, including railways.” Society’s demand for growth investment began to outstrip the appetite of the wealthy to provide it. Subsequent solutions—first, to extend unlimited liability to a broader shareholder base, and second, to cap liability at two to three times the investor’s initial investment—merely compounded the problem, by bringing in investors without the financial resources to sustain periodic losses and exacerbating panics by calling capital from investors under duress. Banks and other financial intermediaries like investment banks consolidated as their economies grew, and the span of control problem inherent in vetting ever increasing shareholder bases became unmanageable. So, by the 1930s, our current system of large, limited liability financial institutions with dispersed and anonymous shareholder bases was largely in place.

* * *

The question I am left with is the following: given that historical precedent (and common sense) seems to indicate that restricting banking to those wealthy enough to sustain personal losses well in excess of the amounts they invest in such activity limits credit provision, why should we believe there are enough risk-loving wealthy people nowadays to support the enormous credit demands of our national and global economies? To use a more limited example, why should we believe there are enough wealthy investment bankers eager and willing to support the capital requirements of ten mini-Goldman Sachs, each with one tenth the assets of the Vampire Squid? More importantly, where are the wealthy commercial and retail bankers eager and willing to support the lending activity of 1,000 mini-JP Morgans, each with one one-thousandth the assets of the House of Dimon? Certainly one can imagine there are lots of retail depositors and wholesale creditors who would be eager to lend to such personally backstopped institutions, but why would a shareholder with potentially unlimited liability—to the extent of her entire personal and family net worth—be remotely interested in borrowing ten times her equity in order to earn 12% on her money?

Hedge funds cannot fill the gap, either: they manage other people’s money. Why would those other people—mostly institutional investors like pension funds, insurance companies, university endowments, and the like—be remotely interested in assuming unlimited liability? For one thing, it would violate their own fiduciary duty: for the most part, it’s not their money, either. It’s firefighters’, teachers’, and pensioners’ money. Do you really think those people want to take unlimited risk? As Steve Waldman says, those people want safety.

Certainly there is a good argument for aligning the payouts and incentives of persons who engage in risky activities more closely with outcomes. It is a noble and desireable objective to undo the privatization of returns and the socialization of risk that we find ourselves plagued with nowadays. But I worry that those who argue for a wholesale return to unlimited liability for the owners of financial intermediaries simply have not thought out the problem of scale inherent in the current global economy.

Plus, I thought we all agreed we don’t like being under the thumb of the very rich. Do we really want to go back to Potter’s Falls?

Related reading:
Carolyn Sissoko, In defense of banking... (Synthetic Assets, January 30, 2012)
Andrew Haldane, Control rights (and wrongs) (The Bank of England, October 24, 2011)


© 2012 The Epicurean Dealmaker. All rights reserved.