Saturday, August 11, 2007

More Works to Look On and Despair

It has been not quite three months since I last regaled you Dear Readers with a hand-picked selection of my best work to date, modestly entitled "The Canon." Accordingly, it is about time for my semi-annual review1 of blog post candidates for beatification and enrollment onto the list.

To my delight, folly, avarice, and hubris have been thick on the ground these past few months, so I have had plenty of grist for my metaphorical mill. Having slaughtered many innocent pixels on the altar of Better Information Through Vanity Publishing on the Internet, I had copious material from which to select the following gems. (Those of you sensitive to Green issues can consider this my contribution to global recycling, if you wish.)

Without further ado, I offer you the current crop of the best and brightest:

It's Good to Be the King: Corporate wives do their utmost for their husbands' companies' shareholders. What's not to like?: Mel Brooks and a boob picture. A reader favorite. (You naughty dogs.)
The $7 Billion Mouse ... er ... Man: Steve Schwarzman is both rich and short. I know, I know, it was a shock to me too.
Tax Breaks for Everyone!: TED beats the dead horse of private equity taxation with abandon and thoroughly enjoys himself. (More related sniping can be found at The Taxman Cometh and B(ogus Ta)X.)
Ch-ch-ch-ch-changes: The Chrysler buyout financing runs into a ditch.
Marks in the Sand: The first installment in my ongoing rant on the subprime CDO imbroglio. Many, many words. Consider yourself forewarned.
Penny Wise: A rare inside view into what goes on inside Steve Schwarzman's head. Crack investigative reporting, if I do say so myself.
Fingernails that Shine Like Justice: TED dresses in drag and discovers that women are few and far between in investment banking. Whassup? A clear favorite with time-wasters and Cake fans.

All the Dealmakers toddle off to our ancestral manse in sub-Saharan Winnipeg tomorrow, so this font of wisdom is officially closed, at least for a few weeks. Try not to burn anything down while I am away.

1 Yes, yes, I know: three months does not a semi-ann make. But time moves faster on the internet. Go back to your Sudoku puzzle.
© 2007 The Epicurean Dealmaker. All rights reserved.

Friday, August 10, 2007

Grains of Sand

To see a World in a Grain of Sand
And a Heaven in a Wild Flower,
Hold Infinity in the palm of your hand
And Eternity in an hour.

— William Blake

So, what’s next?

Based on yesterday’s and this morning’s market events around the world, it appears that what might have been a small snow slide resulting from problems in the US subprime mortgage sector has turned into a true avalanche involving multiple market sectors and geographies. Sectors as apparently far afield as commercial paper, equity “quant” trading, and overnight bank credit markets all seem to be roiled with troubles. But is the contagion spent already, or is it gathering momentum?

This writer and many others have pointed to the principal sources of this contagion across sectors: cross-sector investment portfolios (which transmit selling pressure across nominally unrelated security classes and markets when price declines in one market encourage an investor to liquidate unrelated securities to meet margin or redemption requirements) and financial leverage applied to portfolios. This writer has further maintained that—notwithstanding the broad dispersion of risk across investors in recent years—market-making investment banks remain important if not critical transmitters of both of these forces in the market. Unfortunately, knowing the proximate causes of contagion in the markets does not provide much illumination as to when and whether the meltdown will stop, or indeed how further contagion might play out.

To get some sense of the landscape, one needs to step back a level or two and think about the market as a chaotic, non-linear dynamical system, and the current swoon as a phase change in a system which has organized itself into a critical state. In this view, “the market” is a complex system composed of numerous interacting elements, where the interactions are characterized by non-linear features such as feedback, looping, etc., and one in which the history of its development has brought it to a critical state, in which a small change in one of its variables can trigger an abrupt change in the state of the system.

The archetypical analogy used to think of such systems is the pile of sand (or rice), as Mark Buchanan describes in his book Ubiquity: Why Catastrophes Happen.1 Back in 1987, three physicists at Brookhaven National Laboratory began to investigate nonequilibrium systems by using computer simulations of avalanches in sandpiles:

So in seeking some answers concerning the rhythm of the pile’s growth, Bak and his colleagues turned to the computer. They instructed it to drop imaginary “grains” onto an imaginary “table,” with simple rules dictating how grains would topple downhill as the pile grew steeper.

What they discovered was not reassuring for fans of the stable and predictable.

The first big surprise came as the answer to a simple question: What is the typical size of an avalanche? How big, that is, should you expect the very next avalanche to be? The researchers ran a huge number of tests, counting the grains in millions of avalanches in thousands of sandpiles, looking for the typical number involved. The result? Well... there was no result, for there simply was no “typical” avalanche. Some involved a single grain; others ten, a hundred, or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain tumbling down. At any time, literally anything, it seemed, might be just about to happen.

But whence this unpredictability?

... Bak and his colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, “ready to go,” color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by dominolike action, cause sliding at other nearby red spots. If the red network was sparse, and all the trouble spots were well isolated from each other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever.

So, if the timing and size of a phase transition in a relatively simple complex system—a virtual sandpile consisting of uniform grains subject to simplified forces of gravity and friction—is a priori unpredictable, what are we to say about a complex dynamical system like the global financial markets?

* * *

In his new book, A Demon of Our Own Design, Richard Bookstaber identifies two characteristics of modern financial markets which he believes increases their susceptibility to crises: complexity and “tight coupling.” Together, these factors facilitate what he calls “normal accidents” in complex systems, accidents which he rather disturbingly exemplifies by the ValuJet crash, the two space shuttle disasters, Three Mile Island, and Chernobyl. But as Mr. Bookstaber describes it, tight coupling is a designed-in, local feature of financial interactions:

Tight coupling means that components of a process are critically interdependent; they are linked with little room for error or time for recalibration or adjustment. A space shuttle launch sequence is a tightly coupled process because each step—the ignition, the liftoff, the clearing of the tower boom—all must proceed at precise intervals and cannot be interrupted without scrubbing the whole operation.2

What Mr. Bookstaber does not address is what one might call the “loose coupling” that develops in financial markets as an emergent feature of their development. While it is true that margin loans, repo agreements, and most derivative securities can be characterized as tightly coupled, I think few would argue that the links leading from subprime mortgage collapse in the US, through investors such as IKB and BNP Paribas, to the asset-backed commercial paper market are anything but loosely and contingently related. And yet such couplings provided effective pathways for market contagion to spread.

Finally, one cannot ignore an increasingly important pathway for contagion in the current market crisis, one which is now taking center stage. This is, of course, the wholesale panic and near paralysis gripping investors across the globe as they run in fear from the market meltdown. After all, the metaphors and analytical frameworks we have been discussing have their predictive limits, even in broad outline. Grains of sand are not conscious, and they cannot and do not alter their behavior based upon the actions of their neighbors, much less those on the other side of the sandpile. Even the complexity and tight coupling of intercreditor agreements, repos, and derivative contracts are relatively mechanistic things, and should play out based upon their engineered characteristics. But one cannot predict the behavior of human beings very well at all, and an investor in Minsk or Rio de Janeiro with no margin leverage or other pressure to sell may very well liquidate all his US stockholdings purely out of a sense of fear (or prudence).

So it is fair to say that no-one—Federal Reserve or ECB included—knows what will happen next. (It appears that tornados do occur in Brooklyn, after all.)

For what it is worth—not too much, I know—I do not think we are on the brink of Armageddon. I do think the damage to investor portfolios and the institutional health of financial entities is far from over, and I think we will continue to see slow-motion wreckage (some from surprising quarters) for some time to come. And the contagion is not over, either. (I predict we will finally see the end of the incredible market-defying levitation of luxury real estate in New York, London, and other financial hotbeds, as more hedge funds close their doors and investment banking bonuses get slashed.)

On the positive side, the sheer breadth and diversity of hedge fund investment strategies must mean that there are a bunch of guys out there making a killing in this market. (It might not be the obvious suspects, though.) Furthermore, people have been paying hedge fund traders 2-and-20 for years on the assumption that they are simply better at trading than mere mortals and can deliver better than market returns in periods of market distress. Now is the time for them to deliver, or go back to scalping client tickets on the govvie desk. Also, there was a day when volatility was an investment bank’s friend. We will see if any of them are able to counteract the carnage in their principal portfolios and their margin books with healthy trading results.

And one final thing: I think the market gods would react quite nicely if the current brouhaha deflated some of the hubris and vanity sucking up all the air in Manhattan and Mayfair. We might even be able to get a decent lunch reservation once in a while.

1 Mark Buchanan, Ubiquity: Why Catastrophes Happen. New York: Three Rivers Press, 2001, pp. 19–20.
2 Richard Bookstaber, A Demon of Our Own Design. Hoboken, NJ: John Wiley & Sons, 2007, p. 144.

© 2007 The Epicurean Dealmaker. All rights reserved.

Friday, August 3, 2007

Reader Survey

There is just no pleasing you people, is there?

I have received some strenuously negative feedback from certain of my Devoted Readers concerning the recent redesign of this blog site, especially as concerns the background color. Attentive Readers with too little to do during the current market swoon will remember that I changed it from its previous lemon-lime-yellowish-kind-of-thing to the current white in response to complaints that it lacked a certain gravitas.

Well, now I learn that some of you were quite devoted to the original yellow, either as an invigorating visual substitute for caffeine and Adderall in the morning or as a reminder of my—shall we say—rather bilious world view.

So, being too lazy to work out all the aesthetic issues myself, and being too mindful of the happiness of the majority of my Dear Readers, I have decided to resort to that last refuge of a scoundrel, the reader poll. (Up next, online focus groups?)

You will find it nestled comfortably under my image to the left of this blog. I believe I have anticipated all possible color choices you might have, but I have allowed you to vote for more than one choice, should you be wracked with existential doubt. The poll will remain open for the rest of the month. Exercise your rights, Citizens!

© 2007 The Epicurean Dealmaker. All rights reserved.

Thursday, August 2, 2007

Penny Wise

Ever since the Blackstone IPO, I have been curious to know how Steve Schwarzman and his fellow PE-tocrats over at The Blackstone Group have been handling the experience of being a public company. After all, even though they have a lot of experience taking portfolio companies on round trips to and from the public markets, this is the first time in years that many of them have been subject to daily report cards on their business from Mr. Market, not to mention real time updates on a major portion of their personal wealth.

Well, thanks to my talent for suborning disgruntled junior PE professionals, I can now report on the reactions of at least one altitudinally challenged squillionaire. It appears that Mr. Schwarzman has been taking time almost every day—even while on a less-than-satisfying French vacation—to record his reactions to the daily ups and downs of BX stock. No wonder, since for every penny BX shares move his personal net worth goes up or down by $2.5 million.

My mole inside has forwarded a screen shot of the personal worksheet Steve has been updating, which I attach below for your viewing pleasure (click for a closer view). Who knew that ol' Steve still knew how to use Excel?

© 2007 The Epicurean Dealmaker. All rights reserved.

The Great Chain of Being

Give me a place to stand, and I will move the Earth.

— Archimedes, on the power of leverage

You know something is up when even a blogsite devoted to the hedge fund industry posts a piece entitled "Do hedge funds cause systemic risk after all?"

AllAboutAlpha—which usually has a noticeably positive perspective on hedgies and their machinations—broke with precedent this past Tuesday with the aforementioned post, in which Alpha Male cites both a recent New York Fed study and Richard Bookstaber's new book, "A Demon of Our Own Design," as offering a resounding "Yes" answer to the question he posed in his title. Each of the extensive quotations Mr. Male cites supports the argument made by a wise man of my acquaintance, reported elsewhere and confirmed by research, that embedded leverage among the hedge fund community and elsewhere has a high potential to end in tears.

(Never mind that Mr. Bookstaber is the same individual who by his own admission had a substantial part to play in both the market meltdown of October 1987 and the 1998 blow up of Long-Term Capital Management.1 My wise acquaintance is always grateful for any and all support.)

Now, to be fair,2 hedge funds did not invent the use of leverage in investment management, and they are not the only market participants who use it. Nevertheless, I think few would argue that hedge funds, in aggregate, deploy a great deal of leverage,3 in pursuit of higher returns. Much of this is direct leverage, in the form of margin loans borrowed from their prime brokers, the investment banks. But another substantial chunk consists of embedded leverage, which takes the form of structural leverage embedded in tradeable securities and derivatives. Often, hedge funds use margin loans to purchase and hold structurally levered derivatives, thereby compounding leverage upon leverage. This, as I am sure you will agree, can be a combustible mix.

Complicating the picture is another transformation in the market from previous practice, concerning the distribution of risk. Risk—fundamentally in the form of risky securities and derivatives—is widely believed to have become far more broadly distributed among investors, hedge fund and otherwise, than it used to be. A common example is the new paradigm for corporate loans. Where before commercial banks originated and held such obligations on their balance sheets for the duration of the loan, now commercial and investment banks originate, package, and distribute the lion's share of such loans to a broad universe of investors, thereby diffusing these risks throughout the system.

Some market pundits argue that this development (and analogous developments in other securities markets) has not only made the financial markets more efficient—by directing specific risks to those investors with particular appetites for them—but also safer, since the consequence of any one particular security or issuer blowing up should be more broadly and diffusely distributed across the universe of investors. Should Chrysler go belly up, the argument goes, a great many investors will feel a fair amount of pain, but no one investor or lending institution should blow up with it. Furthermore, the proliferation of hedge funds with different investment strategies means that there are plenty more investors out there to take the other side of losing trades. Shocks to the system should get dampened pretty quickly. Intuitively, these concepts make a lot of sense.

But if this is true, why does the recent meltdown in the subprime mortgage market seem to be spilling over into other, apparently unrelated securities markets, like those for corporate and high yield debt? Do investors really believe that subprime mortgage defaults in Florida and Las Vegas are going to affect Cerberus Capital's ability to repay the loans it wants to use to buy out Chrysler? Why has the blow up of Bear Stearns' subprime hedge funds put the kibosh on KKR's ability to issue debt to buy British pharmacy operator Alliance Boots? Whence this fabled "contagion" whereof everyone speaks? Wherefore the "flight to quality?"

Well, consider this. A fund with a highly levered balance sheet, and its investment fingers in many pies, is hit with losses in one of its sub-portfolios. Due to the nasty two-edged bite of leverage, its equity drops significantly, and the only way it can restore its risk profile is to raise more equity or liquidate some of its investments. Given the poor market conditions in the affected sub-portfolio, it is often more prudent to liquidate securities in other sub-portfolios. But this, as you can imagine, puts downward price pressure on securities in those previously unrelated markets. Presto, contagion. This is the "common holder" problem which some believe is the primary culprit.

Consider further. What if a substantial portion of our hedge fund's holdings consisted of loans to other investors—hedge funds, perhaps—whose own portfolios were experiencing losses? Well, then, "liquidating" those positions and reducing its risk exposure would look an awful lot like calling the loans, or reducing their outstanding balances. Finally, add this to the mix. What if our fund had another side to its business, which generated revenues from the origination, market-making, and placement of securities, which revenues were negatively affected by turmoil in some or all of the markets where it also had investments? Well, that would be a triple whammy, and our little hedge fund would look an awful lot like a prime broker investment bank.

Market-making investment banks are usually net long in many securities markets at any one time, so they are directly affected by declining liquidity and declining prices. Prime broker investment banks are also by definition long credit exposure to hedge funds and other levered investors, and when the portfolio values of those investors come under pressure, the risk and value of those margin loans goes up and down, respectively, forcing the prime brokers to deliver margin calls. (Unlike most hedge funds, clearing banks and securities firms are subject to intense regulatory oversight on their own creditworthiness, so they do not normally have the luxury of sweeping problems under the carpet, as some might suggest.) And finally, investment banks earn substantial fees from activities like M&A, securities underwriting, and securities placement, which all come under pressure in times of market turmoil.

Investment and commercial banks remain the primary transmitters of contagion in times of market stress, because they remain the central nodes through which the lifeblood of credit flows, and because they are exposed so strongly to both direct and indirect effects of market swoons. They remain the lenders of last resort—at least in the short term—as the gently swaying spans of tens of billions of dollars of hung equity and debt bridges can attest. And they are the quickest and fiercest enforcers of the risk reduction and delevering responses to market disruptions, because their own highly levered balance sheets keep them regularly poised on the edge of the abyss themselves. And should their commitment to financial probity waver, or should they be tempted to argue with their auditors over the value of that last illiquid CDO in the portfolio, there is a nasty little man with a briefcase waiting in the lobby to stiffen their spine.

He is from the government, and he is here to help.

1 In the first instance, he was one of the busy little beavers in Morgan Stanley's derivatives business who sold "portfolio insurance" to timid institutional and corporate investors to protect them from equity market swoons. Suffice it to say that portfolio insurance had rather the opposite effect of that intended by its inventors, including such Nobel luminaries as Robert Merton, and by all accounts helped accelerate and deepen the decline when it happened. Perhaps that was because—abstracting from all the pretty Greek letters and partial differential equations used to market the mess—the strategy consisted of selling into a market decline. Hmm ... I wonder why that didn't work?

In the second, Richie-poo tried to figure out why Salomon Brothers' bond arbitrage desk was losing more than $100 million in 1998 with a supposed interest-rate neutral strategy in a declining interest rate environment. Apparently, he couldn't figure it out, so cranky new owner Sandy Weill of Travelers pulled the plug and liquidated the group's positions. This set off a downward liquidity spiral across a number of interest rate markets, which trapped LTCM into similar or identical trading positions of immense size and precipitated its demise and eventual rescue and takeover by Salomon and other Wall Street banks.

Members of the Plaintiff's Bar, take note.

2 Heck, why not? I'll try anything once.

3 Because there has been tremendous growth in assets under management by hedge funds over the past several years, and because there has also been tremendous growth in the volume of derivative securities outstanding, it is a short step to assert that the aggregate dollar amount of leverage in the financial markets has grown substantially. Whether this is in fact true, and the separate question as to whether the aggregate percentage of leverage in the system has increased, are both empirical questions that should be subject to a definitive answer, one way or another. (Perhaps this has been done already.) In any event, unless it is proven otherwise, I will believe on the basis of common sense that at least the former is true. The answer is not central to my argument.

© 2007 The Epicurean Dealmaker. All rights reserved.