Merrill’s Financing Strategy: Harming Shareholders

A bank issues a bond, which has a maturity date. When the bond matures, the bank needs to essentially roll over the debt: it issues a new bond for the same amount of money, at (these days) a higher interest rate. The bank’s shareholders aren’t particularly happy about the extra interest that the bank has to pay, but ultimately the bank’s cost of capital is already built in to its share price.

Or, you could be Merrill Lynch.

Andrew Clavell has found some eyebrow-raising news: Merrill has an outstanding convertible bond, known as a LYON, which is puttable back to the bank on March 13. Now in a normal world the bondholders would either tender their bonds or they wouldn’t. If they didn’t, fine; if they did, Merrill would presumably have to borrow that money elsewhere.

But Merrill didn’t want to risk anybody tendering their bonds. So it unilaterally increased the value of holding on to the bonds, by announcing that they would convert not into 14.1 shares, as originally contracted, but rather into 16.5 shares. Oh, and it gave bondholders another couple of redemption dates, too, in 2010 and 2014, which increases the optionality of the bond and therefore makes it more valuable. Says Clavell:

Merrill get nothing in return for these new features, they are unilaterally value-enhancing for the bonds. The bonds’ fair value is now presumably sufficiently above next week’s put strike that bondholders will not exercise. Cash call avoided, at least for now.

Which is all well and good for the bondholders, but it’s pretty bad for the shareholders: Merrill stock sank 7% today, wiping $3.35 billion off the bank’s market capitalization. Which is more than the entire value of the LYONs that Merrill modified. Jeffrey Harte of Sandler O’Neill was mystified, according to the AP:

The increased conversion rate means there will be more shares of Merrill Lynch common stock, diluting outstanding stock.

The reset is part of Merrill Lynch’s normal financing strategy, and is considered an attractive financing option in today’s market, a spokeswoman for the bank said. Merrill Lynch also has ample liquidity to handle any securities put back to it by investors, the spokeswoman added.

Harte said the reset conversion rate "appears to be dilutive, but not enough" to warrant a slide in the share price.

But it’s not really future dilution which causes stocks to fall whenever a bank issues (or modifies) convertible bonds. Rather, it’s the simple dynamics of the convertible market: these things (especially highly complex instruments like LYONs, which, Clavell explains, are "variable rate accreting nominal, puttable, callable zero coupon convertible bonds") are bought and held overwhelmingly by hedge funds playing the ancient game of convertible arbitrage. Which involves going long converts and short the stock. Clavell:

The increase in conversion ratio increases the delta of the bond, or its sensitivity to the stock price. The required additional delta hedging by convert arb funds, plus the inconvenient reminder that Merrill’s balance sheet is stretched, is plenty enough to prompt the share price falls seen today.

I’m quite sure that fiddling around with conversion rates "is considered an attractive financing option" within Merrill: it costs the bank nothing, at least in the short term. But I’m equally sure that it’s not considered a very attractive financing option if looked at from the point of view of shareholders, who have now seen their stock sink to levels not seen since 2003.

On the other hand, riddle me this: according to Yahoo Finance, Merrill Lynch is now trading on a price-to-book ratio of 1.68. Meanwhile, Goldman Sachs is trading on a price-to-book ratio of 1.62. Are those numbers correct? If so, can anyone explain what’s going on?

Posted in banking, bonds and loans, stocks | Comments Off on Merrill’s Financing Strategy: Harming Shareholders

Richard Bitner, Teller of Subprime Tales

I’ve been meaning for a while now to link to Richard Bitner, a former subprime mortgage broker who has published a very readable book entitled "Greed, Fraud & Ignorance:

A Subprime Insider’s Look at the Mortgage Collapse". Here’s a taster:

Although the industry had no published standard, five years of funding and selling subprime mortgages told us that 10% was an acceptable deviation for our four investors: Countrywide, RFC, Household, and Citi. This means that if the investor’s underwriter thought the property was worth $310,000, they’d accept an appraised value of up to $341,000. Anything above this threshhold ran the risk of being declined.

Yep, a loan which officially had a loan-to-value ratio of say 95% could actually have a loan-to-value ratio of 104.5%, using the investor’s own appraisal!

Bitner is also great on personal color. For instance, here he is on Richard Bell:

I, as a wholesale lender, never suspected him of anything remotely suspicious. In one case, I remember him calling me on a loan in process and out of the blue saying he needed to cancel the Gonzalez file. He just caught the borrower trying to pass off phony pay stubs and he did not want me to get stuck with a fraudulent deal. He went on to say that he called the local FBI field office and informed them of what happened. When I contacted the FBI office directly, I verified his story. From my perspective it was ultimate selfless act. He could have turned a blind eye, made his income and no one would have known. Instead, he saved me from what likely would have been a costly loan repurchase…

When I sold my interest in my company in late 2005, I seriously contemplated going into business with Richard and moving my family to Houston…

He was originally charged with over 6 counts of bank fraud but struck a deal to reduce everything down to two charges. When sentencing comes in April, he could face upwards of 35 years in jail.

Was I lucky to have avoided the carnage of Richard Bell? It sure seems that way. Like other brokers before him, I could easily have been thrown under the proverbial fraudmobile, but was somehow spared. I have witnessed more than most when it comes to the greed and carnage of this industry and after a while you almost become immune to it. But after hearing this news, you will excuse me if my faith in humanity has become a little shaken.

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BRICs: Over Half of the Top 25 Billionaires

Forbes has released its 2008 ranking of the world’s billionaires; it now takes $19.3 billion to crack the top 25. What jumps out at me? Indians account for four of the top ten; Russians account for seven of the top 25. Between them, the BRICs account for over half of the top 25, and there aren’t even any Brazilians on the list.

Still, North America has a stranglehold on the top three, which is all of the individuals worth more than $50 billion.

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Fannie Mae Datapoint of the Day

Fannie Mae’s credit default swaps are trading over 200bp, despite their implicit government guarantee. Writing protection at these levels seems like a no-brainer to me: even if there is an event of default, recovery is going to be very close to par, and you get all the insurance premiums in the mean time.

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Tim Geithner on the Financial Crisis: A Mock Interview

I popped uptown this afternoon, to the Council on Foreign Relations, to hear NY Fed president Tim Geithner give a big speech on the current financial crisis. Geithner is the central banker closest to the markets, but he’s been pretty quiet through this crisis until now, so a lot of people were very interested in what he had to say.

In the end, he gave a shorter version of the speech on the NY Fed’s website; he also had a brief Q&A session at the end. I’ll try and pull out some of the more interesting bits of what he said in Mark Thoma’s mock-interview style. Anything in italics was spoken, and not part of the prepared speech.

Q: In the current financial crisis, things got very bad very quickly. Given how fast the markets move these days, does that mean there’s hope for a relatively swift resolution to the crisis, too?

Tim Geithner: I am going to talk today about some of the challenges facing the U.S. and financial system. These problems took a long time to build up, and, even with a forceful mix of public policy and action by the private sector, they will take time to resolve.

Q: What have you learned from the crisis about the state of risk management on Wall Street?

TG: The crisis exposed a range of weaknesses in risk management practices within financial institutions in the United States and throughout the world. Today, a group of the primary supervisors of the largest banks and investment banks in the world released a comprehensive assessment of risk management practices in these institutions. This assessment will help lay the foundation for consensus on changes to supervision going forward in the major financial centers. The report examines a range of practices that helped determine relative performance during this crisis. It’s a pretty powerful indication of the returns on good risk management.

In effect, some major banks and investments banks made the choice to follow the market down as underwriting practices eroded. They took on more exposure to low probability but extremely adverse events, despite the potential consequences of getting caught when the music stopped.

Q: How pro-cyclical is risk management on Wall Street? To what extent does protecting against a downturn exacerbate that downturn?

TG: As market participants have moved to reduce exposure to further losses, to step on the brake, the brake became the accelerator, amplifying the shock. Measured risk has increased more quickly than many institutions have been able reduce it, and attempts to reduce it have added to volatility and downward pressure on prices, further increasing measured exposure to risk. Uncertainty about the market value of securities and about counterparty credit risk has increased, and many hedges have not performed as intended. The rational actions taken by even the strongest financial institutions to reduce exposure to future losses have caused significant collateral damage to market functioning. This, in turn, has intensified the liquidity problems for a wide range of bank and nonbank financial institutions.

Q: Do people even have faith in markets any more? And could a loss of faith in markets damage the economy more broadly?

TG: The intensity of the crisis is in part a function of the size of the preceding financial boom, but also of the speed of the deterioration in confidence about the prospects for growth and in some of the basic features of our financial markets. The damage to confidence–confidence in ratings, in valuation tools, in the capacity of investors to evaluate risk–will prolong the process of adjustment in markets. This process carries with it risks to the broader economy. Macroeconomic and supervisory policies have an important role to play in containing those risks.

Q: Well, you’re on the FOMC, you can help contain those risks by cutting interest rates and by pumping liquidity into the banking system. How big do you think the risks are?

TG: The critical risk to the economic outlook remains the potential for the strains in financial markets to have an outsized adverse effect on real economic activity, particularly by exacerbating the already significant weakness in the housing sector. It is important for monetary policy and liquidity instruments to be used proactively in addressing this risk.

Q: But might cutting rates like that not feed through into higher inflation?

TG: Headline and core inflation have come in higher than anticipated, and inflation expectations have also moved up. If the risk of significant damage to growth from these financial market pressures is attenuated and if global growth remains strong and drives a continuing rise in energy and commodity prices, then inflation may not moderate as much as we anticipate. If the medium term outlook for inflation deteriorates significantly, the FOMC will move with appropriate speed and force to address this risk.

Q: So you’re not really worried about stagflation, then: for you, the inflation risks only really go up if the financial risks are "attenuated". What happens if the financial risks stick around for a while, as you said at the beginning of your speech that they would?

TG: We cannot know with confidence today what level of the short-term real funds rate will be consistent with our objectives of sustainable growth and low inflation, but if turbulent financial conditions and the associated downside risks to growth persist, monetary policy may have to remain accommodative for some time.

Q: How do you feel about the recent capital injections into banks from sovereign wealth funds?

TG: The Federal Reserve is working closely with other financial supervisors and regulators to facilitate the adjustment underway in markets. This approach has two important elements. … The second element is to encourage new equity capital raising, so that the burden for preserving capital ratios does not fall principally on actions, such as asset sales or reduced lending, that might exacerbate the credit crunch. We have seen a very, very substantial flow of new capital into the financial system much more quickly than has been the case in past crises. More will come. Those institutions that move more quickly will obviously be in a stronger position to deal with the challenges, and take advantage of the opportunities, ahead.

Q: And how about President Bush’s fiscal stimulus package? Is that going to help?

TG: Overall policy will be more effective, particularly given the strains to the financial sector, if the full burden does not fall on the tools available to the Federal Reserve. Fiscal policy can play an important role. The stimulus program signed into law by the President will provide a meaningful level of support to growth, somewhere in the range of three quarters to one and half of a percentage point of GDP growth over the next few quarters.

Q: "Next few quarters"? Can you be more specific?

TG: The next two quarters.

Q: Thanks, I guess that’s when the tax rebates will come through and be spent. And how about all those bills and announcements relating to the housing market specifically? Will they help?

TG: Carefully designed, targeted programs in cooperation with the private sector can play an important role in resolving the various constraints that are now impeding economically viable mortgage restructurings. Given the breakdowns in the securitization process and its potential impact on the supply of new mortgage credit, it also makes sense to explore ways to expand the scope for existing government programs to support financing of new homes.

It’s easier to state that than it is to navigate one’s way through. You need a mix of pragmatism and creativity to navigate this, but it’s a really important focus of attention.

Q: It all seems like a lot of mopping-up. Wouldn’t it have been easier to be more on the ball earlier on, and to have prevented the credit bubble from forming in the first place? Have you learned anything which might help you stop this thing happening again in the future?

TG: Was this preventable? I don’t believe that asset price and credit booms are preventable. They cannot be effectively diffused preemptively. There is no reliable early warning system for financial shocks. And yet policy plays an important role in determining the dimensions of financial booms, and policy helps determine the ability of the financial system and the economy to adjust to its aftermath. We need to undertake a broad set of changes to address the vulnerabilities in our financial system revealed by this crisis. Just as a long list of factors contributed to the trauma, there is no single reform that offers the promise of sufficient change.

The Presidents Working Group on Financial Markets and the Financial Stability Forum, which bring together policymakers and regulators from the major financial centers around the world, are in the process of outlining a comprehensive framework of reforms. Many of these recommendations will focus on changes to the mortgage finance market, the ratings process for ABS and structured credit products more broadly, regulatory and accounting treatment of these instruments and special purpose financing vehicles, the disclosure requirements on instruments and institutions, and other dimensions of the securitization process.

Q: Was the complexity of the US regulatory structure at all to blame?

TG: The regulations that affect incentives in the U.S. financial system have evolved into a very complex and uneven framework, with substantial opportunities for regulatory arbitrage, large gaps in coverage, significant inefficiencies, and large differences in the degree of oversight applied to institutions that engage in very similar economic activities. Some illustrations of this include the large shift in subprime mortgage originations to less regulated institutions; the incentives to shift risk to where accounting and capital treatment is more favorable; and the amount of risk built up in entities that operate in the grey areas of implied support from much larger affiliated institutions.

We need to move to a simpler framework, with a more uniform set of rules applied evenly across entities involved in similar functions, and a more effective balance of regulation and market discipline. And institutions that are banks, or are built around banks, with special access to the safety net, need to be subject to a stronger form of consolidated supervision than our current framework provides.

Charlene Barshefsky: Hank Paulson said this week that most of the losses were in regulated institutions, not unregulated institutions. What does that say about regulation in this country?

TG: Economists wouldn’t be surprised by that. They say that regulation brings moral hazard, and moral hazard brings risk-taking.

Problems occur in the middle: institutions attached to banks, or institutions which were a source of credit protection, or asset-backed financing vehicles, where there’s a mix of explicit and implicit credit support. Banks were well capitalized going into the crisis and absorbed their losses reasonably well. The more awkward stuff was in the awkward middle.

This is all a product of the incentives created by regulation. We want to look at simplification and consolidation.

Q: Did regulators’ rules about marking assets to market, and their focus on the health of individual banks rather than the system as a whole, end up exacerbating rather than helping the situation?

TG: The U.S. banking system entered this financial shock with capital cushions significantly above the regulatory thresholds, and in a stronger position to withstand a downturn than was the case in the past. This has made it possible for bank balance sheets to expand rapidly, which in turn has helped offset the effects of the withdrawal of many nonbank financial institutions from credit markets.

Yet the shock absorbers in the financial system as a whole–the financial cushions that are critical to financial stability–have proved to be thinner, and behavior has been more pro-cyclical than desirable.

This is in part the consequence of changes in the structure of the financial system. Because banks are now a smaller share of the system, a given level of stress on nonbanks creates greater strain on the system as a whole. It is in part the consequence of the fact that the present system focuses on mitigating the risks of firm specific shocks, rather than a systematic market shock. And it is in part the consequence of the fact that the present system is not designed to induce institutions, particularly the largest ones, to internalize the negative consequences, the negative externalities, of their actions on markets as a whole in conditions of stress.

Q: How about the markets? Did recent innovations there help or hurt?

TG: The resilience of the broader financial infrastructure has been a source of strength for the financial system during this crisis. However, the systems and practices that support the over-the-counter (OTC) derivatives market significantly lags that of securities markets and other mature markets. We need to move quickly to put in place a more integrated operational infrastructure that supports all major OTC derivatives products, is highly automated, has robust operational resilience and risk management, and is capable of handling very substantial growth in volumes.

Q: And how are those markets behaving now? Are they more risk-averse than might reasonably be warranted?

TG: Prices and risk premia in many markets already reflect a much more sober and cautious view of the world than they did a year ago. You could say, well beyond caution, in many markets. And the degree of stress on markets that we have seen over the past six months is due in part to the sheer magnitude and speed of that adjustment to a more cautious view of the future.

Q: But are you ultimately hopeful?

TG: The United States, the world economy, and the financial system as a whole, are more resilient, than they were on the eve of previous downturns. The improvements in productivity growth in the United States of the past decade have been followed by significant improvements in potential growth and wealth accumulation in many other countries. The scale of investable assets around the globe is very substantial, and this will be an important source of demand for risk assets. The improvements in monetary policy credibility and in financial strength developed over the past few decades mean that policy around the world has more room to adjust to deal with the challenge in the present environment.

Nevertheless, the challenges that remain are substantial. The speed and agility with which public policy makers and private financial institutions respond to the continuing pressures in a rapidly evolving environment will determine how quickly and how smoothly market conditions return to normal–and how rapidly the risks to the economic outlook are mitigated.

Q: Thank you.

TG: Thank you.

Posted in banking, fiscal and monetary policy, regulation | Comments Off on Tim Geithner on the Financial Crisis: A Mock Interview

Search Engine Capitulation of the Day

When I first saw this over at Aaron Schiff’s, I thought it must have come from the Onion. But no, it’s for real:

In a dramatic about-face, Ask.com is abandoning its effort to outshine Internet search leader Google Inc. and will instead focus on a narrower market consisting of married women looking for help managing their lives…

The decision to cater to married women primarily living in the southern and midwestern United States comes after Ask spent years trying to build a better all-purpose search engine than Google.

Now that’s what I call a scaling-back.

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Retail Sales and the Weather

Parija Kavilanz is excited about retail sales reports:

A surprising rebound in February sales gave retailers a much-needed respite after a very difficult winter sales season that had pointed convincingly to a pullback in consumer spending.

"It’s very interesting that consumers are actually showing some signs of life," said Ken Perkins, president of sales tracking firm Retail Metrics.

Perkins said part of last month’s sales strength, which came on the heels of broad-based softness in December and January, was in part because of "pent up demand."

"The sales numbers were just so weak in December and January that you almost had to expect consumers would come back at some point," he said.

Which prompted Glen Lineberry to email me:

Does anyone ever factor weather into an analysis of consumer spending?

This is admittedly purely anecdotal, but there were major storms across the

midwest and northeast in both December and January. If I lived in Cleveland

and it was zero degrees out, I’d skip going to Best Buy to check out the new

flat screens, and I suspect most people are the same way.

Just curious if anyone out there compares sales stats to average

temperatures or snowfall or such.

Which would give a whole new meaning to the term "seasonally adjusted". Retail sales in February are always much lower than retail sales in December, which is why the numbers are "seasonally adjusted", or else looked at only on a year-on-year basis. What Lineberry is asking for is some way of adjusting the winter months’ sales volumes somehow in order to account for how cold it was outside. In order to calibrate that, you’d need a long history of weather reports – we have that – as well as an equally long history of same-store retail-sales reports – which would be much harder to find. I can’t say I’d find it easy to have much faith in any such calibration.

Instead, then, we have the annual ritual of retailers blaming poor sales on the weather. Which is almost comforting, in its own way.

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How Lahde Capital Makes Money

Sam Jones has Lahde Capital’s month-by-month performance results for 2007. The flagship real-estate fund, which has already been wound up, returned 870% over the course of the year, which implies that it went up in value by more than 77% 21% per month, every month, compounded. Except here’s the interesting thing: the fund only had two five months with a gain of more than 77% 21%, and in fact in four of the 12 months it posted a loss.

The key to Lahde’s enormous gain, it seems, is the 97.3% return that the fund posted in October. That 97% might not seem a lot more than the average 77% needed to get to the annual result, but it turns out to be crucial, largely because it came late in the year, after the fund was already up substantially. Let’s say you invested $1 million in the fund on December 31, and cashed out $9.7 million one year later: of that $8.7 million gain, fully $4 million – almost half – arrived in the single month of October.

Lahde is also a compelling letter-writer. Here’s what he has to say about commercial real estate:

The Wall Street Journal published an article on February 22, 2008 regarding the CMBX. Part of the title was a quote from someone, “[It] doesn’t make sense.” The person quoted was referring to the dramatic drop in prices for virtually all CMBX indices, absent any significant losses surfacing, yet. I’d like to use an analogy from Peter Schiff’s book. If the commercial real estate market was a beach ball, picture my arm holding the ball. If I take my arm away, everyone knows that ball will fall to the ground. However, many foolishly believe that somehow if you take cheap financing (my arm) away, the ball will remain afloat. Risk premiums for this type of debt have skyrocketed as exhibited by the CMBX. If you dramatically increase the risk premium for an asset class, especially one that is so heavily financed, the value of that asset class must fall. End of story.

The losses will materialize. Admittedly I don’t have a clue how severe the losses will be. I don’t have a model that can correctly predict all the variables. Luckily no one else on the planet has such a model either. I gave up on the ability of models to correctly predict the value of securitizations a few years ago. I do know one thing though. It is safe to assume a market is dead when deal volume falls to zero, as was the case with CMBS issuance during January 2008.

There are always only three investment decisions – buy, sell or do nothing. The latter being the favorite course of action for myself, as well as others like Warren Buffett. Going back to the “cheap option” theme, there are no cheap options to buy in the CMBX space. Thus, we sit and wait for the next shoe to drop.

Which explains why Lahde’s returns are so concentrated in one or two months. You wait, and you wait, and you have negative-carry trades on the whole time so you’re losing money so long as nothing happens – and then something happens, a shoe drops, and you make a fortune.

Update: Sorry for the innumeracy earlier, I can’t seem to tell the difference between 9.7 and 970.

Posted in hedge funds | Comments Off on How Lahde Capital Makes Money

Deteriorating Statistics

Mike Mandel asks what statistics I would like to see improved. Answer: all of them.

Back in the post-war years, some of the smartest economists in the world set up statistical agencies in the leading industrialized nations. If they can’t measure how an economy is doing, policymakers are essentially driving blindfolded. So a lot of time and money and effort was put into getting those measurements right.

Since then, however, a lot has changed. For one thing, globalized economies have become much more dynamic and fluid and fast-moving, which makes them much harder to measure. But at the same time, statistical agencies have become intellectual backwaters, home to underpaid and underfunded technocrats who receive roughly zero in the way of thanks or glory and who are much more likely to be on the receiving end of budget cuts than they are to get the significant increases in funding that they need to keep up with the economy’s complexity.

Nowadays, the only time that governments really put a lot of time and effort into improving their national statistics seems to be during periods when emerging-market countries are running large current-account deficits and need to borrow a lot of money from worried international bond investors. Which is hardly the case at the moment. So I’m not hopeful that anything is going to improve significantly, either in the developed or in the developing world. After all, "I’ll provide funding for higher-quality statistical datasets" is not exactly a major vote-getter in any democracy. More’s the pity.

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Carlyle Capital Brings Back the LTCM Memories

Remember Long Term Capital Management? The problem there wasn’t that it was investing in risky securities, like Russian bonds. Instead, Russia’s default set off a more generalized spread widening and flight to liquidity, which hit super-safe assets like off-the-run US Treasuries. Because those assets were super-safe, LTCM had been able to invest in them with enormous amounts of leverage. And so when the sell-off arrived, LTCM went under.

Do the markets ever learn from prior mistakes? Because what happened to LTCM in 1998 seems to be exactly the problem facing Carlyle Capital in 2008.

Carlyle Capital isn’t investing in risky bonds: it’s investing in securities issued by Fannie Mae and Freddie Mac. But the problem is that it’s doing so with enormous leverage: "The company leverages its $670 million equity 32 times to finance a $21.7 billion portfolio," notes the WSJ today. The result? A failure, yesterday, to meet a margin call. Which, in my day, used to be known as "default".

Carlyle Capital will probably survive, unlike LTCM; I even have a certain amount of sympathy for a company which is hit by seven margin calls totalling $37 million in one day, despite investing only in assets which have an implicit US government guarantee. But that’s the kind of risk you take when you take on 32x leverage.

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China IPO Datapoint of the Day

Helen Thomas keeps an eye on the China Railway IPO:

The Hong Kong retail portion of the $5.5bn dual listing was 250 times oversubscribed – representing orders worth about $58bn.

And this in a market which is far from surging: in fact, it’s down more than 25% from its highs. What’s more, IPO stocks seem to be doing particularly badly, with all 8 January IPOs ending the month below their offering prices.

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Extra Credit, Thursday Edition

Learning from history at the LSE: "Citi shareholders must act, Goodhart said: all prospective chairmen should be tested for their quotability, and any with a talent for phrasemaking should be passed over ‘in favour of someone more boring’."

Annals of Reporting on Intellectual Property Disputes: Why are the owners of Scrabble negotiating to pay a large sum to the owners of Scrabulous?

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Google: Expensive, or Cheap?

Herb Greenberg poses the conundrum, which I’ve translated into table form.

Date Price p/e ratio
IPO: August 2004 $100 52.3
July 2006 $386 65.3
March 2008 $444 23.6

By historical standards, the Four Horsemen are trading on very, very low p/e ratios – but their earnings are so strong that their stock prices still look high by those same historical standards.

There is a case to be made that both Google and Apple are (for very different reasons) more media companies than tech stocks. That would fit with the higher earnings and lower multiples that we’re seeing right now. But they’re also both vastly more inventive and creative than any media company, which means they must have more upside.

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Blogonomics: Exit Through Acquisition

Breakingviews, one of the least web-savvy websites in the world, ran a column by Jeff Segal on Monday about blog valuations. And given that breakingviews tries to disable copying and for all intents and purposes bans hyperlinks, it’s probably not surprising that the column is almost hilariously off-base. Segal’s big idea is that blogs aren’t likely to be acquisition targets; I’m pretty sure that in fact they already are acquisition targets, and that the only obstacle at this point is agreeing on a price.

Segal seems determined to ensure we all know that he’s utterly clueless: after mentioning Josh Marshall’s George Polk Award and TechCrunch’s Google-YouTube scoop, he calls these things "Web 2.0 credentials". In fact, of course, they’re old-fashioned journalistic credentials, and have nothing to do with the web at all, let alone Web 2.0. Segal then continues:

There has yet to be an acquisition of a high-profile, pure-play blog, so it’s difficult to find pricing benchmarks.

Um, how about AOL’s acquisition of Weblogs Inc, which included arguably the most popular blog in the world, Engadget? On a smaller scale, there is definitely a market in more niche blogs: think of when the New York Times bought freakonomics.com. But no, the best comp that Segal can come up with is NBC’s acquisition of iVillage, which isn’t a blog.

Segal then talks of TechCrunch charging advertisers what he calls "a moderate $40 per thousand views – known as its CPM rate". A $40 CPM isn’t moderate, it’s very high. On the other hand, given the number of ads that TechCrunch runs per page, it’s entirely probable that Michael Arrington gets much more than $40 per thousand pageviews, once all the advertisers on those pages have paid him. Segal reckons TechCrunch has revenues of $1.8 million per year; I think it’s safe to say they’re significantly higher than that, especially once you include things like conferences.

Segal continues:

It’s not clear, however, that a valuation exercise based on comparable company performance can be applied to blogs. They differ from other forms of media – including online publications like iVillage. It’s much more difficult to estimate potential revenues. Moreover, there are no real barriers to entry. The hottest blogs spawn copycats, and potentially keener minds can swarm in and lure away readers.

Why on earth should it be more difficult to estimate potential revenues for a blog than it is for other forms of media? In the short term, most big blogs, like TechCrunch or BoingBoing or Huffington Post, know pretty much exactly what their revenues are going to be. And in the long term, no one knows anything in any medium.

But I’d really love Segal to give me one single example of a blog where keener minds swarmed in and lured away readers. That doesn’t happen in the blogosphere, because competition is a good thing, not a bad thing. I want other finance blogs to launch, the more the better. And I want them to be written by keener minds than mine. The more that happens, the more traffic I’ll get – that’s the way the conversation works. Other media don’t work like that: if I’m watching ABC, I’m not watching NBC. But blogs are different, and don’t operate according to that kind of zero-sum mathematics.

As for Segal’s idea that blogs lose traffic when their founder moves on – well, Nick Denton has proved that to be false many times over, and again it’s very hard to think of examples. Did Giga Om’s traffic suffer when Om Malik had a heart attack and had to take time off blogging? If it did, I doubt the effect was enormous. In fact, I think the single-person commercial blog is increasingly a thing of the past: the vast majority of big, profitable blogs are group efforts and all the better for it.

Once upon a time, Segal’s recommendation that big-media sites hire bloggers rather than buy blogs might have made sense. And indeed the likes of Time and the Atlantic have gone ahead and done just that, with reasonable success. But once a blog becomes extremely popular, its proprietor essentially becomes unhireable: there’s no way that Arrington, for instance, would leave TechCrunch behind to go work for someone else.

The fact is that many blogs do make sense as big-media acquisition targets, and I’m quite sure that approaches are being made on a regular basis to most of the bigger sites. So far, saying no has proved to be profitable: I’m quite sure that the numbers being bandied around today are bigger than the sums which were offered a year or two ago. But eventually the two sides will come to terms, and presently independent blogs will indeed be incorporated into bigger media entities.

(Via Kedrosky)

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Zubin Jelveh, Pacesetter

February 25: Portfolio’s Zubin Jelveh publishes a definitive article about NYU’s David Yermack and his research into CEOs’ gifts to their family foundations.

March 5: The WSJ and NYT write copycat pieces. Maybe they thought that if they waited for over a week, Zubin’s reporting would automatically become Old News and they could pretend that what they were writing was fresh.

(HT: Abnormal Returns)

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Delphi: The Post-Default Aftermath

Were you someone who wrote credit protection on Delphi? If so, you’re feeling a bit as though you dodged a bullet write now. Alea reports:

In 2005 when Delphi went bankrupt there was some fear of a short squeeze in the underlying bonds a the number of outstanding CDS was 12 times that of the underlying bonds. An auction was held to help get a cash settlement for excess CDSs.

Recovery price: 63.375

Delphi is having some difficulty getting out of bankruptcy and current recovery is estimated at around 32.000.

With the benefit of hindsight, paying cash instead of taking bonds was a very clever or lucky move.

Essentially, writers of protection had a choice: when the auction was over, they could either pay out $100 per contract and receive a Delphi bond in return, or else they could just pay out $36.625 in cash. Eleven out of 12 insurers paid the cash, which turns out to have been good for them, since the value of the bond they would otherwise have received in return has now halved.

On the other hand, as Satyajit Das notes, the bonds could have fallen much further:

Fitch Ratings assigned an R6 recovery rating to Delphi’s senior unsecured obligation equating to a zero to 10 per cent recovery band – far below the price established through the protocol.

In truth, the people who hold performing debt and the people who hold nonperforming debt are two very different investor bases. It might seem as though holders of Delphi bonds who protected themselves in the CDS market got a bum deal: right now their bonds are worth just 32 cents on the dollar, and they received only 36.6 cents on the dollar in cash. But in fact those holders will have long since sold their bonds by now, and Delphi’s debt is trading as quasi-equity, between very sophisticated and long-term vulture investors. Who need no one’s sympathy.

Posted in bonds and loans, derivatives | 2 Comments

The Limits of Unemployment Statistics

The Federal Reserve has a dual mandate: to promote maximum employment and low inflation. Note that it’s maximum employment, not minimum unemployment: that’s a very good thing, as any readers of today’s column from David Leonhardt will know.

The average unemployment rate in this decade, just above 5 percent, has been lower than in any decade since the 1960s. Yet the percentage of prime-age men (those 25 to 54 years old) who are not working has been higher than in any decade since World War II. In January, almost 13 percent of prime-age men did not hold a job, up from 11 percent in 1998, 11 percent in 1988, 9 percent in 1978 and just 6 percent in 1968…

Various studies have shown that the new nonemployed are not mainly dot-com millionaires or stay-at-home dads…

Instead, these nonemployed workers tend to be those who have been left behind by the economic changes of the last generation. Their jobs have been replaced by technology or have gone overseas, and they can no longer find work that pays as well. West Virginia, a mining state, is a great example. It may have a record-low unemployment rate, but it has also had an enormous rise in the number of out-of-work men…

The unemployment rate is a less telling measure than it once was. It’s simply no longer the best barometer of the country’s economic health.

I’d like to see the nonemployment figures reported alongside the unemployment figures in the monthly jobs report. Neither tells the full story, but both together are richer than either one alone.

Posted in economics, statistics | Comments Off on The Limits of Unemployment Statistics

Blogonomics: Tipjoy

Did you follow my link to Francisco Torralba’s blog entry on mortgage securitization in Spain? If you did, and if you read his entry all the way to the end, you might have seen a little button there:

Clicking that button gives a 10-cent tip to Francisco, through a new service called Tipjoy. It’s a really cool little service, because it’s very easy: one click, no stress. If you’ve never tipped anybody before, you enter your email address so that you can activate your tipjoy account later. Once you’ve done that, you tip happily away, as does the total amount that you’ve tipped. Eventually, you pay all your tips in one lump sum of $5 or so; those tips can then be used by the bloggers you’ve tipped, to either be donated to charity or put towards an Amazon gift card. (Tipjoy is too young and small to be licensed as a money transfer service, so it can’t – yet – pay cash.)

Aaron Schiff loves the idea, and is going to adopt it himself:

It’s very simple, and you can tip on credit. I couldn’t have done it better myself. The only restriction is that you have to give your earnings to charity, or use them to buy stuff from Amazon. That’s fine, I like books.

I like it too, anything which makes tipping bloggers easier is a good idea in my book. The big difference between this and a PayPal tip jar of the type seen at Calculated Risk is that Tipjoy is vastly simpler: just one click, of a small set amount, which doesn’t entail leaving the site or filling out forms or thinking hard about how much to tip.

Tipjoy even allows you to tip bloggers without a Tipjoy button, although I wouldn’t recommend it at the beginning. I’m hoping it’ll take off, and that soon Tipjoy buttons will work in RSS feeds too. Then I’ll get tipping!

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Healthy Stocks, Unhealthy Economy

Warren Buffett loves to talk about "moats": things which protect his portfolio companies from competition. And his core business – reinsurance – has some of the highest barriers to entry in the world. Chris Dillow takes these ideas to their logical conclusion:

A booming stock market is no proof of a healthy economy; the Zimbabwean market is doing well now. Indeed, in a really healthy competitive economy, stock markets would do badly – if they existed at all – because profits would be incessantly bid down by fierce competition. A rising stock market can therefore be evidence of a lack of dynamism in the economy, that incumbent firms are being sheltered from competition. The French market has out-performed the US over the long-term.

Try telling that to the talking heads on CNBC.

Posted in stocks | Comments Off on Healthy Stocks, Unhealthy Economy

Foreclosure Datapoint of the Day

From Barry Ritholtz’s Florida correspondent:

There is currently an 8-10 month wait to get a court date to have a foreclosure filing heard in Dade and Broward counties…

As one broker said to me, "these bums sitting in $3,000,000 homes overlooking the water are likely to be left alone by the banks for 2 years before the banks even get serious about foreclosure."

Homeowners who’ve defaulted on their mortgages are going to stay in their homes until they can’t any more, that’s true no matter the value of those houses. But the banks certainly seem to be in no hurry to foreclose.

Posted in housing | Comments Off on Foreclosure Datapoint of the Day

The Downside of Marking to Market

Holman Jenkins has an excellent column today headlined "Mark to Meltdown?" on the degree to which mark-to-market accounting standards have exacerbated the current crisis. Certainly the present system is pro-cyclical, helping both to inflate credit bubbles and make their bursting all the more painful. On the other hand, it’s far from clear that any other system is superior: no one wants to go back to the days when banks would keep bad loans on their books for decades just to avoid having to write them off. Holman doesn’t propose an alternative, and I can’t think of one either; all we can do I think is hope that bank regulators are increasingly aware of the problem and try in their own way to mitigate it both on the way up and the way down.

Posted in accounting, banking | 1 Comment

Citi Trading Below Book

Citigroup stock fell below book value yesterday – which is either despite or because of a long series of write-downs which served to lower that very value. Citi’s market capitalization is now $115 billion, which compares to, say, $177 billion for Johnson & Johnson. More to the point, Citigroup has just two thirds of the value of Bank of America, and only 87% of the value of JP Morgan Chase. I’m not saying it’s a buy at these levels, but I am having difficulty seeing a scenario where Bank of America maintains that kind of lead over the long term.

Posted in banking, stocks | Comments Off on Citi Trading Below Book

Don’t Trust Prediction Markets in the Final Hours

After the polls closed in Texas last night, the DEM.TX.OBAMA contract on InTrade – the one judging his chances of winning the Texas primary – spiked up to 85, before embarking on a long and steady decline to zero. Clearly InTrade got Texas wrong: Obama had been the market favorite for weeks. But equally clearly last-minute trading frenzies are simply not to be trusted. Justin Wolfers might still believe that later prices are always better than earlier prices; I think it’s becoming increasingly clear that an exception must be made for the final 24 hours or so of any political contract.

Posted in prediction markets | Comments Off on Don’t Trust Prediction Markets in the Final Hours

Blogonomics: Peer Effects

On Friday, David Harper asked me to introspect a little: he was impressed at how many blog entries I produced last week, and wondered how that happened.

I try to answer any genuine questions which are asked of me, so I’ll give this a stab. My gut feeling is that it’s a combination of three factors:

  1. The debt markets are crazy right now. From municipal bonds to auction-rate securities to negative-real-interest-rate TIPS, everything’s topsy-turvy. And I’ve always been much more of a debt person than an equity person, so this plays to my strengths. Ask me why the stock market is down, I’ll have no idea. But ask me why the bond market is down, and I might actually have something vaguely intelligent to say.
  2. The quality of the econoblogosphere has never been higher. Fantastic new blogs are launching all the time, and the quality of many of the older blogs is going up as well. Ideas get passed around between blogs more quickly and at a higher level than ever before. Blogging is much more enjoyable when it’s a genuine conversation as opposed to simply me providing commentary on whatever happens to appear in the WSJ that day.
  3. Standard statistical variation. I’ve been blogging at Market Movers for almost a year now, and some weeks are always going to have more posts than others. Maybe the posts were shorter than normal, or maybe I was just in a particularly ebullient mood last week.

I think the most important of these factors is the second. It’s well known that if you take a worker and move him from a group with average productivity to a group with above-average productivity, his productivity will increase: it’s a simple peer effect. It’s not done consciously, but I’m sure it’s going on here: I probably had to pick up my game, just in order to keep up with the level of discourse in the econoblogosphere generally. It’s like when you’re on a treadmill, and you automatically adjust your running speed to the speed of the track below you.

On the other hand, it might be much simpler than that. Blogging is a skill, and like any skill you generally get better at it the more you do it. I’ve been blogging at Market Movers for 11 months now, and I’ve been econoblogging full time at one website or another since September 2006. If you keep my hours constant and assume that a bit of experience helps to reduce the time spent per blog entry, then the number of blog entries I write more or less has to go up.

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Extra Credit, Wednesday Edition

This is what happens when you don’t blog for a day but you did have offline access to your RSS reader: the end-of-day roundup starts to get very long.

Treasury Five-Year TIPS Yields Fall Below Zero for Third Day

Will Default Rates on Muni Bonds Sharply Rise During the Recession? Most Likely Yes: By N. Roubini, natch.

What the hell is going on with munis? "Friday it was possible to buy 5-year pre-refunded municipals (which are backed by Treasury bonds held in escrow) at yields in the 3.50’s. In other words, around 80bps higher than Treasury rates. That is literally Treasury credit at a 80bps spread to Treasuries tax-exempt."

iTunes Now Number Two Music Retailer in the US

Who’s Gonna Win The Netflix $1 Million?

Rodrik and Borjas on the Kennedy School’s rebranding

An hour and a half with Barack Obama: As good a summary as you’ll find of how and why the intellectual elites are gravitating towards Obama.

Citigroup’s Model for Risk Management: LTCM?

Microsoft/Yahoo: Tracking the Deal "Spread" It’s widening.

Jet Blue’s Auction-Rate Blues

Young Japanese Just Say No to Cars

Whatchoo talkin about, Willis? "Because [the assertion that is all persistent performance is random] is unfalsifiable, I am afraid it is wrong at worst, idle at best, and sort of useless as a base case. "

Posted in remainders | Comments Off on Extra Credit, Wednesday Edition