Four Myths About the Stock Market

1. Global stock markets plunged this week (until the Fed rode to the rescue) "on recession fears".

You can argue the "decoupling" toss as much as you like, but there was absolutely no correlation between the degree that any given stock market went down, on the one hand, and the strength of that country’s economic ties to the US economy, on the other. This was about markets, not economics: the frothier the market (Hong Kong, India), the greater the fall. Everybody seems to be looking at the percentage-off-highs number, so it’s worth pointing out that by that metric, the worst-affected economies are Ireland and Sweden. Hm.

And if the trigger had really been something US-related, the market plunge would have started in the US. It didn’t: it started on a US national holiday.

2. Plunging stock prices are bad for the economy.

With the exception of the dot-com bubble, the economy has rarely relied overmuch on the ability of corporations to raise equity capital. All of those stocks trading on the stock market represent money that their companies have already raised, usually at prices far below the stocks’ present levels. And again, with the exception of the dot-com bubble, there’s rarely much of a wealth effect which translates higher stock prices into higher spending, or lower stock prices into lower spending. Falling stock prices are an effect, not a cause, of future economic slowdown.

3. The Fed’s role in all this is to set the level of overnight interest rates at its optimal level.

The Fed’s role right now is to prevent market panic and try to preserve liquidity. And the best way to do that is rate cuts, more than it is low rates. It’s an important distinction, and it explains why the Fed is going to cut rates again at its regularly-scheduled meeting next week. The Fed was probably going to cut rates by 75bp at its next meeting all along. So if it’s the Fed’s job to set the level of overnight interest rates, and if the worst stock-market panic is behind us at that point, then one might think that the Fed would say "we just gave you your present on Christmas Eve, you don’t get another one just because it’s Christmas Day". But they won’t. Instead they’ll cut again, probably by 50bp.

Over the long term, as we saw with the Greenspan-fueled housing bubble, low nominal interest rates can have an enormous effect on the economy. But as far as 2008 is concerned, the big question is how big and how soon the rate cuts are going to be – not what level interest rates are at. In a weird way, Bernanke is now grateful that he raised rates at the beginning of his time as Fed chairman, since that gave him a tiny bit more room to cut rates now. Remember Japan, hobbled by the fact that interest rates were already at 0% and having no more room to cut.

4. A key downward driver of stock prices was worries over the monline insurers.

See #1. You really think that the stock markets in Hong Kong and India care especially about MBIA and Ambac? And you really think that overnight the global stock markets suddenly became worried about credit – after proving time and time again over the past six months that they’re not? I suppose it’s possible. But if that were the case, then the lowest-rated companies would have performed particularly badly, and I don’t think that happened.

What about those companies with monoline wraps? Aren’t loads of investors going to have to sell their bonds in those companies in the event that the monolines lose their triple-A ratings? Well, maybe, but that would hardly be the end of the world. For one thing, the holders of triple-A-wrapped corporate debt constitute a completely different asset class to the holders of unwrapped corporate debt. And the monolines were pretty good about not wrapping plain-vanilla bonds which had any real chance of default.

Corporates in general – at least those corporates which managed to avoid being acquired by private equity – were generally extremely responsible about not leveraging up just because debt was cheap. That’s one of the reasons why there was so much appetite for subprime loans and CDOs: the corporate sector simply wasn’t issuing nearly enough paper to satisfy demand. It’s true that the buy-side firms who invest in unwrapped debt might have the problem/opportunity of having to provide a bid for wrapped debt which is hitting the market. But that’s not the kind of thing which worries stock-market investors in general. (Investors in Arsenal FC in particular, though – that’s a different matter.)

Besides, credit markets had exactly the opposite reaction to the rate cut that stock markets had. Stock markets generally rose over the hours they were open after the rate cut was announced: the FTSE 100 closed up 3% on the day. The iTraxx Crossover, by contrast, closed the day wider than it had started, the rate cut notwithstanding. Obviously the drivers in the stock market are not the same as the drivers in the credit markets.

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Ben Stein Watch

Is outsourced to Sandwichman. I don’t do Stein’s Yahoo columns, I’d go mad.

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Extra Credit, Wednesday Edition

ISDA Sees Default Swaps Losses at $15 Billion, Not $250 Billion

Self-Control, Delusion and Why Subscription Services Rule

Wal-Mart Gives The New Yorker (And Forbes, Fortune, BizWeek etc) The Boot

Does Senator Clinton Know How Little the United States Spends on Foreign Aid?

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Bernanke Hits the Panic Button

It feels a long time ago right now, but if I recall correctly, Ben Bernanke was talking in a generally positive way at the end of last week about the effects of a well-targeted fiscal stimulus. Well, so much for that. Right now is clearly no time for the kind of action which will take two or three quarters to kick in, it would seem: Bernanke has now decided to try to place himself ahead of the curve by slashing both the Fed funds rate and the discount rate by 75bp between meetings.

Does this mean that all the talk of "Helicopter Ben" and the "Bernanke put" was justified all along? Well, yes. And the statement is a little disingenuous, I think:

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.

There’s nothing in there to justify a huge rate cut in the week before a regularly-scheduled meeting. Tighter credit for some households? Come on. There’s one reason and one reason only that the Fed took this move, and it’s the plunge in global stock markets on Monday, along with indications that the US markets were set to follow suit.

Now the Fed is charged with keeping employment high and inflation low; it’s not charged with protecting the capital of investors in the stock market. So this action smells a bit like panic to me, and it might also have prevented the kind of stomach-lurching selling which could conceivably have marked a market bottom. I have to say I don’t like it.

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MBIA: The Longs Fight Back

Have you read anything positive about MBIA recently? The short-sellers – principally Bill Ackman, of course, but also Whitney Tilson – have been dominating the conversation, and since they’ve also been making a huge amount of money one can understand why.

Which is why it’s refreshing to see Jonathan Laing’s piece in Barron’s saying that MBIA is a screaming buy at these levels. Yes, the company might have huge liabilities, he says. But those liabilities are spread out over the life of extremely long-dated bonds: if MBIA wraps a 30-year bond which defaults, it only needs to make up the coupon payments on that bond – not the difference between the value of the bond and par value.

As a result, says Laing, MBIA’s maximum actual cash losses are decidedly modest:

Before Warburg cut its deal with MBIA it brought in outside consultants to stress-test the company’s portfolio, subjecting it to Armageddon-like housing and other economic assumptions. It found that annual loss expenses — actual checks written — came to no more than about $250 million a year under the harshest of conditions.

Against that there’s a liquidation value of over $30 per share, according to Laing (the stock closed last week at $8.55); there’s a revenue stream of over a billion dollars per year even if MBIA loses its triple-A credit rating and writes no new business at all; and, if it does manage to retain its triple-A, there’s the added market share that it will manage to snaffle as a result of the implosion of Ambac.

Now I am, I think, just about the only financial journalist in the world who hasn’t received a copy of Bill Ackman’s famous slide show explaining why MBIA is toast. So I’m definitely not qualified to adjudicate this particular dispute. And it seems pretty unlikely that MBIA stock is going to rise on Tuesday, given the meltdown in global stock markets that seems to be going on right now, led by the financials.

But I’m not gong to be here to see it: Tuesday is a day of travel for me, since the World Economic Forum kicks off bright and early on Wednesday morning with the annual economists’ panel, featuring not only my former boss Nouriel Roubini but also one of my heroes, Ngozi Okonjo-Iweala, among illustrious others. Expect this blog to be quiet on Tuesday, and then very Davos-centric for the rest of the week.

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Extra Credit, Tuesday Edition

For Clinton, Government as Economic Prod: Leonhardt interviews the favorite for the presidency on her economic policy.

Why 2008 isn’t 1971 (the first ever Curious Capitalist list!)

Just When I Thought I Was Out: The Epicurean Dealmaker vs Martin Wolf, redux. Most entertaining.

Citi Analyst Embraces Naked Shorting Conspiracy Theory

CDS : Who Is Suffering?

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Value-per-Employee Datapoint of the Day

Sun has bought MySQL – a company which gives its main product away for free – for $1 billion, or about $2.5 million per employee. Which is pretty much exactly the same valuation per employee as the market puts on Goldman Sachs.

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Counterfeiting Statistics: Still Atrocious

Do you remember the atrocious and disappointing OECD report on counterfeiting? Rather than come up with a realistic estimate for the value of counterfeits traded worldwide, it came out with a hugely exaggerated "ceiling" of $200 billion. All the same, it was the first remotely rigorous report attempting to pin a number on this phenomenon.

Which is why it’s so terribly depressing to see the NYT ignore the OECD report completely, and revert to the old "7% of world trade" number which was never based on anything and which has been comprehensively debunked many times, including by me. Indeed, the NYT places a $200 billion value just on US imports, never mind total global trade.

Dean Baker doesn’t even need to take issue with the number to thoroughly fisk the editorial. But it’s clear that the truth is simply never going to emerge on this subject. As I wrote back in 2005:

A lie has circled the world hundreds of times before the truth has even found its boots, let alone thought about putting them on. The contest between the truth and the lie is so incredibly unequal that the truth will never win: it’s now far to late for that.

Today, the situation is worse. Back in 2005, the exaggerations concentrated on counterfeiting. Today, counterfeiting is invariably lumped together with piracy, which can be calculated to be as big as you like, really, in this digital age. All I can do is to urge my readers to never believe any statistics you ever read on such matters.

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The Politics of Equity Capital Inflows

If a country runs a current-account deficit, that means that it’s going to run an equal and opposite capital-account surplus: it’s simple economic mathematics. And when the federal budget deficit is a bit over 1% of GDP while the current-account deficit is somewhere north of 6% of GDP, clearly there’s going to be much more to that capital inflow than the simple purchase of Treasury bonds by foreign sovereigns.

The NYT has a good piece up on one of the inevitable consequences: now that foreigners are pretty sated in terms of debt securities, they’re increasingly buying equity in US companies instead:

Last year, foreign investors poured a record $414 billion into securing stakes in American companies, factories and other properties through private deals and purchases of publicly traded stock, according to Thomson Financial, a research firm. That was up 90 percent from the previous year and more than double the average for the last decade.

I suspect that many of the people who have propelled this story to the top of the NYT’s most-emailed list are Americans worried about foreigners "taking over". Have a look at the lede of the front-page story in the NY Daily News on January 16, after US banks announced another tranche of capital injections:

America is for sale – and the buyers of some of our most iconic corporate assets are a passel of Mideast oil sheiks, Asian government investment funds and market Marxists.

This kind of knee-jerk xenophobia is, of course, rare among the cosmopolitan elite and the kind of people who are likely to support Mitt Romney or Barack Obama for president. But if it can be found in such unadulterated form in a front-page story of a not-particularly-virulent New York City newspaper, you can be sure that it’s pretty widely felt nationwide, perhaps among Huckabee or Edwards supporters.

I’m in Europe now, and to me this news is utterly unsurprising: I see it as a rather obvious money arbitrage, the corporate-finance equivalent of the hordes of British and Spanish tourists who descended on New York to do their Christmas shopping at the end of last year.

And it’s great for the US economy: a $3.7 billion investment in an Alabama steel plant, for instance, has a huge effect in terms of local-economy stimulation, and that $414 billion is more than three times the size of the fiscal stimulus mooted by George Bush.

Astonishingly, however, it’s a steelworker union official who seems most upset about all this new money and the new jobs which come with it.

“It’s the culmination of a series of fool’s errands,” said Leo W. Gerard, international president of the United Steelworkers. “We’ve hollowed out our industrial base and run up this massive trade deficit, and now the countries that have built the deficits are coming back to buy up our assets. It’s like spitting in your face.”

I suppose it is a bit like spitting in your face, if instead of saliva the spit was made up of billions of dollar bills.

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Gawker’s resurgence

I am so losing my bet. Thanks to Tom Cruise, Gawker is going to easily set a new record for pageviews this month. Remember that the old record was 11.5 million pageviews in the month of October; Gawker got 5.3 million pageviews in 4 days between January 15 and January 18.

The page with the Tom Cruise video has received over 1.8 million pageviews so far, and there’s another 400,000 or so over at Defamer, too. Nick knew that he had something unique and special on his hands, and he’s been taking full advantage of it, buying ads on other websites and driving a huge amount of traffic to the generic Tom Cruise page on Gawker. That’s smart: Nick wants readers of Gawker much more than he wants people who come for one video and then leave, never to return. And he seems to be getting those readers, judging by the ratio of total pageviews to video views over the past week.

Does this have anything to do with “Manhattan media news and gossip”, as the title of Gawker’s home page would have it? Well, no. But than again, as Nick will readily admit, Gawker’s pageviews have always been goosed by Hollywood celebrity gossip, even all the way back in the Age of Spiers. He’s not fussy: he’ll take those pageviews where he can get them. There’s nothing new or underhanded about this method of getting traffic, and Nick has won the bet (which he never actually took) fair and square.

Indeed, Nick, in hosting this video and keeping it up in the face of nastygrams from the Scientologists, has shown himself to have bigger cojones than his former employers at the FT.

I’m also glad that Gakwer Media has scaled enough, over the years, that Nick is capable of pulling this off. Back in the day, this quantity of traffic — especially video traffic — would have brought Gawker’s servers crashing down. And Nick and I actually received the same C&D back in March 2003, from Puma — back then, he didn’t have an in-house lawyer to reply to such things, and the great Khoi Vinh even offered money to help defend the lawsuit — which, of course, never materialized.

Today, Nick is a fully-fledged new-media mogul, and he has a monopoly on this video, since YouTube won’t host it, and Nick won’t allow it to be embedded on other websites. He’s managed to alight on one of the very, very few instances of internet content which can’t easily be copied and posted elsewhere, and he’s taken full advantage of that. I also give him full credit for obtaining the video and working out how to post it on his own web page: this is not elementary stuff.

We’ll see in February how much of this Tom Cruise spike translates into lasting traffic for Gawker; I suspect it might actually be quite high. Certainly there’s some real buzz surrounding the brand now, and it’s not of the pornographically scatological variety, either. If Jezebel is the new Gawker, appealing to the creative underclass, then maybe Gawker is the new Defamer, appealing to a slightly more sophisticated breed of celebrity-gossip consumer.

Back in December 2002, Nick wrote this:

Gawker is an online magazine for Manhattan launching in January 2003. It’s target audience is the city’s media and financial elite. Think of it as the New York Observer, crossed with Jim Romenesko’s MediaNews. The publication will be supported by advertising, primarily from real estate brokers and luxury goods retailers. It adopts the weblog format, and relies on links to external content.

Of course, it didn’t quite work out that way. But one of the reasons that Nick has become so successful is that he isn’t wedded to ideas which don’t work out. There are those of us who would very much like to be able to read a Gawker as it was originally envisaged. But one can hardly blame Nick for following the money.

Posted in Not economics | 1 Comment

Blogger Sans Email

Blogger disaster! I spent all Friday without any email, and it’s looking increasingly as though it’s not going to get fixed until Thursday at the earliest. This is going to be interesting – especially as I’m meant to be going to the World Economic Forum this week, and am having accommodation issues. In any case, for the time being, and especially if you have a lead on a Davos-vicinity hotel room, please use felix.salmon at gmail.

Update: Fixed now, thankfully.

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Extra Credit, Weekend Edition

Do we need a recession to purge the rottenness out of our system? It seems the Americans tend to say no, while the Europeans are more likely to say yes.

Bloomberg Still Deciding Whether to Buy Presidency: “At this point, buying the United States isn’t looking like such a good investment,” the adviser said. “At the end of the day, Mike might be better off buying Canada.”

The Early Bird Gets the Bad Grade: School should start later. And maybe Wall Street, with its addiction to 8am meetings, might do well to follow suit.

(Economic) Reality Bites: Pity the parents struggling to send their children to private school: "Sitting in a meeting and talking about real people with real children living in my community and anticipating the struggles they’re likely to endure in 2008 and for some years in the future, it feels bad. Really, really bad."

Folsom’s Departure Creates Opening to Fix The World Bank Fight Against Corruption

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Ken Lewis’s Call Option on Countrywide

The most recent deal not going according to the merger-arb playbook is Bank of America’s acquisition of Countrywide. The takeover takeunder is valued at $6.47 per share, but Countrywide is trading at only $5.11. How come? Well, have a look at the MAC clause (a/k/a section III 3.8(a) of the merger agreement), detailing the representations and warranties made by Countrywide:

Since September 30, 2007, no event or events have occurred that have had or would reasonably be expected to have, either individually or in the aggregate, a Material Adverse Effect on Company.

That’s the entire dreadful fourth quarter. My feeling is that this clause is a "get out of jail free" card for BofA: if Ken Lewis changes his mind, he shouldn’t find it too hard to find a material adverse effect at some point in the past few months.

And that’s not the only clause he has to rely on, either. There’s section III 3.5(c), too:

Company has previously made available to Parent an accurate and complete copy of each… communication mailed by Company to its stockholders since January 1, 2005 and prior to the date of this Agreement. No such Company SEC Report or communication, at the time filed, furnished or communicated (and, in the case of registration statements and proxy statements, on the dates of effectiveness and the dates of the relevant meetings, respectively), contained any untrue statement of a material fact or omitted to state any material fact required to be stated therein or necessary in order to make the statements made therein, in light of the circumstances in which they were made, not misleading…

And III 3.6(a):

The financial statements of Company and its Subsidiaries included (or incorporated by reference) in the Company SEC Reports (including the related notes, where applicable)… fairly present in all material respects the consolidated results of operations, cash flows, changes in stockholders’ equity and consolidated financial position of Company and its Subsidiaries for the respective fiscal periods or as of the respective dates therein set forth.. and have been prepared in accordance with GAAP consistently applied… The books and records of Company and its Subsidiaries have been, and are being, maintained in all material respects in accordance with GAAP and any other applicable legal and accounting requirements and reflect only actual transactions.

And there’s more where those came from. Maybe Lewis is smarter than the market gave him credit for: he basically bought a call option on the company at a very low strike, rather than purchasing Countrywide outright.

(HT: Deal Journal)

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Another Hedge Fund Tracker Launches

No one would ever design a mutual fund tracker, which returned a little bit less than mutual funds in aggregate. The reason is obvious: mutual funds in aggregate always underperform the market as a whole, so you’d be much better off in an index fund even before the built-in underperformance.

Hedge fund trackers, by contrast, seem to be quite popular: the latest is called Salto, and generally underperforms, by a little bit, the MSCI Hedge Fund Composite Index. In other words, take the returns from hedge funds, in aggregate – making sure to include the really bad ones along with the really good ones. Then remove all the fees they charge. And then remove a little bit more. The result is what you’ll get from Salto, which is described by the CEO of Innocap, the company which developed it, as outperforming "most, if not all, of the investable hedge fund indices on the market" – emphasis on the "investable".

Now the MSCI Hedge Fund Composite Index did reasonably well last year, and there’s good reason to believe that it will outperform the stock market as a whole if the stock market goes down substantially. On the other hand, it does seem as though we’re reaching a Great Unraveling of the kind of ultra-sophisticated structured products and relative-value plays in which many hedge funds have made their name. Now more than ever, it’s important to invest in something you understand – and a fund tracking hedge-fund returns does not fit that bill.

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Why Paying for Web Usage Might Make Sense

Time Warner is dipping its toe, ever so gingerly, into charging for data downloaded rather than bandwidth. Kevin Maney explains why this makes sense for them: they’re competing, on the video-content front, with online providers. But that doesn’t necessarily mean that it’s a consumer-unfriendly move.

It’s worth remembering that companies in the telecoms and media space have historically made their enormous profits largely by getting their customers to pay a lot of money for stuff that they don’t want and won’t use. Cellphone companies sell you minutes that you don’t use, cable companies sell you channels that you don’t watch, and ISPs sell you unlimited bandwidth and downloads, even if all you’re doing is checking your email once in a while.

This has been wonderful for the web, where many sites are much richer now than they were when they had to worry about users on dialup connections. It has also helped to create whole new business models, like Vonage or the iTunes music store, which rely on the fact that the marginal cost of downloaded data is zero. And Apple’s new Apple TV product has cheap movie rentals which start playing in just 30 seconds – if your connection is fast enough, of course, and if you don’t have to pay for the download.

But if my personal experience with Time Warner Cable is any indication, download speeds have been falling quite dramatically of late: when I view video content online, I now normally check the "medium" or "low" bandwidth option whereas in the past the "high" bandwidth option would play seamlessly. And the effect on my Vonage service has been quite nasty. It seems that the bandwidth glut bequeathed to us by the dot-com bust is finally running out.

So given that the bandwidth pipes are going to need upgrading, the next question is who should pay for that. Should all internet users pay equally, regardless of their usage, or should the people driving demand for bandwidth – the people downloading a large amount of video content are the ones cited by Time Warner, although I have no idea whether that’s true – pay more?

I’m not too worried about the long-term future of business models which are contingent on zero-marginal-cost bandwidth. Technologies like FiOS will help total bandwidth to keep up with demand, and ISPs generally like the unlimited-downloads model for a good reason: it’s very profitable for them. But paying for data downloaded is a bit like a-la-carte television: there’s no reason why it shouldn’t at least be an option.

Posted in Media, technology | Comments Off on Why Paying for Web Usage Might Make Sense

Telco Merger Datapoint of the Day

Dana Cimilluca:

When Sprint and Nextel agreed to combine in a “merger of equals” at the end of 2004, they were worth $70 billion together. The current value of the combined Sprint Nextel after the bleak news today from the company stands at just $26 billion…

That means the value of one or the other of the companies has been wiped out entirely.

Posted in M&A, stocks | Comments Off on Telco Merger Datapoint of the Day

The Bush Fiscal Stimulus Plan: Looks Good to Me

Bloomberg News has some details of the kind of fiscal stimulus George Bush is looking for:

The administration is considering a plan that may include $800 rebates for individuals and $1,600 for households as well as tax breaks to encourage businesses to invest, people familiar with the package said.

This seems sensible to me. It’s fair, in that everyone is treated equally, but at the same time it is reasonably well targeted at those who will spend it fastest – since the rich are a relatively small percentage of the population, they will receive only a relatively small percentage of the rebates.

What’s more, the plan is clearly temporary: no one’s going to expect these rebates to return in 2009. And it should help keep investment up, which is necessary for medium-term economic growth.

The money will also arrive relatively soon – as soon as people start filing their tax returns – which means that we won’t have to wait too long to see the effect of the stimulus.

Finally, the size seems about right to me: 1% of GDP, or about $140 billion, is affordable but not fiscally disastrous.

I’ll be interested to see what James Hamilton thinks, but my guess is that he’ll agree with me that insofar as we’re going to get a fiscal stimulus package anyway, this is a pretty good way of doing it.

But none of this, of course, should take away from the fact that keeping the broad economy on an even keel is properly the job of the Federal Reserve rather than the Treasury. A short-term fiscal stimulus will help at the margin, but the really crucial thing is to get monetary policy right.

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MBIA and Ambac Fight for Their Lives

Colin Barr:

On Friday, analysts at Citi and Bank of America downgraded MBIA and Ambac shares – to hold from buy. Skeptics might note that the move comes with Ambac stock down 94 percent over the past year and MBIA down 88 percent, suggesting that the previous “buy” call wasn’t totally spot on.

MBIA and Ambac are a completely binary play right now. The 73% chance of a default in the next five years is, frankly, a 73% chance of a default in the next five weeks. Given that they can’t raise new equity in this environment, and given that the ratings agencies have already shown much more forbearance than is really prudent, these companies’ only real hope is some kind of white knight – and the foremost contender, Warren Buffett, has already ruled himself out by setting up shop as a competitor.

Even if MBIA and Ambac do survive, however, it’s not clear that their stock is cheap at present levels, since there’s no particular reason for the aforementioned white knight to bail out current shareholders who might be underwater. Ignore the rise in Ambac stock today: it’s driven by technical factors and the dynamics of the enormous number of short-sellers in these stocks. The confluence of events which would make these stocks a good long-term investment seems highly remote at this point.

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Email down

I’m not receiving any email at my felixsalmon.com address, for some reason. If you need to reach me, my temporary email address is felix.salmon at gmail. Email back up. Crisis over.

Posted in Not economics | 1 Comment

Failed Hedge Fund Strategy Du Jour: Merger Arbitrage

Last week, I wondered whether Sam Heyman had lost $1 billion on a merger-arb strategy. And now Dana Cimilluca has found a couple of other companies where merger arbs are likely to have lost a huge amount of money, at least on a mark-to-market basis. Blackstone Group has agreed to buy Alliance Data Systems for $81.75 per share; that stock is currently trading at $52.82. And despite the fact that Merrill Lynch’s private-equity arm has agreed to buy Cumulus Media for $11.75 per share, Cumulus closed Thursday at $6.05.

In both cases, the buyer is saying that the deal is indeed going to go ahead. So forgive me for asking the obvious question: why on earth aren’t Blackstone and Merrill buying up their targets’ stock like it was going out of fashion?

In any case, it seems that merger arbitrage might be the new statistical arbitrage: a strategy which performed very well, until it didn’t.

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Extra Credit, Friday Edition

Fed Chief Backs Quick Action to Aid Economy

Tyler Cowen on inflation, glossed by Aaron Schiff

The Pressure Room: The Epicurean Dealmaker explains investment banking.

BF Dome In BF Louisiana Gets BS Treatment: The first industrial-scale geodesic dome, built by Buckminster Fuller in Baton Rouge, Louisiana in 1958, has been demolished. "Architecture’s collectible now, right?"

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The Bonus Bet

Some loyal readers may recall that back in October I entered into a wager with Jesse Eisinger, who had written in Portfolio that "bonus season this year will make Montgomery Burns look generous". If aggregate Wall Street bonuses fell by at least 10% in 2007, I’d buy him a bottle of Scotch; if not, he’d be the one doing the buying.

Now that Merrill has reported, all the numbers are out. According to Bloomberg, Wall Street bonuses in 2007 totalled $39.34 billion, up 8.7% from $36.19 billion in 2006. Of the five independent investment banks on Wall Street, only Merrill Lynch and Bear Stearns saw their bonuses fall: the rest saw rises.

Part of the reason I won the bet so easily is that total headcount on Wall Street grew substantially in 2007, from 165,293 to 185,687: a rise of 12.3%. Aggregate bonuses per employee, then, ended up falling from $218,945 in 2006 to $211,862 in 2007. But even that is a pretty modest drop of just 3.3%.

What happens if you exclude the uniquely-profitable Goldman Sachs? Ex-Goldman bonuses were $26.32 billion in 2006, and $27.23 billion in 2007. There’s still an increase, although it’s now only 3.5% rather than 8.7%.

All of this does help to explain how Manhattan property prices have managed to defy gravity even as the rest of the country is suffering through a nasty housing-market crunch. New York is an industry town, and that industry is continuing to pay its employees extremely well.

Posted in banking, housing | Comments Off on The Bonus Bet

Why Merrill’s Falling

I liked the Merrill Lynch earnings call this morning, and when I posted my take on it just after the markets opened, it seemed as though the bank’s stock would avoid much in the way of punishment for its enormous losses. But it was not to be. Merrill stock has been sliding all day, and just now dipped below the $50 level – that’s a drop of over 9.3% on the day.

What’s going on? Well, as Murray pointed out in the comments to the earlier blog entry, Merrill’s book value has plunged – it ended the fourth quarter at just $29.37, which means the bank is now trading on a price-to-book ratio of 1.7. That puts Merrill at a significant premium to both Lehman and Morgan Stanley, for no obviously good reason.

What’s more, the rest of Wall Street is dropping today as well: Goldman’s down 3.5%, Morgan Stanley’s down 4.6%, Lehman’s off 6.1%, Bear’s off 6.4%. So while Merrill is the worst performer today, much of the losses over the course of the session can reasonably be ascribed to a general move out of the investment banks.

And that move is clearly, I think, related to the implosion of MBIA – down 33% to less than $9 a share, compared to a 52-week high of $76 – and Ambac, which is down 54% to less than $6 per share, compared to its 52-week high of $96. None of Wall Street has yet to take the kind of write-downs which will be necesssary if MBIA and Ambac guarantees become worthless: Merrill alone has another $3.5 billion in exposure to AAA-rated insurers.

"We should all be helping and hoping that MBIA and the others get recapitalized," Thain told employees Thursday – but hope isn’t much of a strategy unless your name is Barack Obama. Thain can continue to hope; his shareholders will continue to worry.

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Bankers’ Pay: Should be Changed, Won’t be Changed

Why pick on banks, and bankers? Steve Waldman tells us:

It’s not because they’re bad people. Most bankers are very nice people. We should pick on them because, as Andrew says, banks intermediate. They are a point where all the lunatics meet to transact, a point where applying pressure can change everything… Banks are formal institutions, amenable to laws, regulations, and litigable norms and standards that are easily reshaped. We don’t have to throw up our hands at frailty and corruption and watch reruns from the 1930s over and over again. We can actually mess with banks (and other financial intermediaries) in ways that indirectly shape the behavior of the rest of us (and that are not terribly intrusive to most of us)… We allowed our institutions to evolve to a place where misbehavior was ordinary, caution uncompetitive, and prudence a firing offense. If we change the institutions, we change the behavior. We can do that, and we should do that.

Steve has some radical ideas, like deregulating the entire financial system outside a few ultrasafe "narrow banks" and then putting a very low cap on the maximum size that any financial institution can reach. Mohamed El-Erian’s ideas, by contrast, seem positively modest. Central banks should be much more involved in understanding and scrutinizing the financial sector, he says, and "central bankers need to revisit the conventional wisdom that calls for separation of monetary policy and bank supervision". That makes a lot of sense to me.

Meanwhile, the lead story in today’s WSJ also picks on bankers’ pay, following the footsteps of (but not quite going as far as) Raghuram Rajan and Martin Wolf.

All of which reminds me a little of the general consensus following the 2000 presidential election that the US voting system, including the electoral college, needed a massive revamp. It really doesn’t matter how much unanimity there is that bankers’ pay needs shaking up: nothing’s going to actually happen.

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Why Goldman Sachs was Short CDOs

Michael Lewis has a very peculiar column up at Bloomberg today, tied to Kate Kelly’s December 14 WSJ story about the subprime traders at Goldman Sachs. Lewis says that Goldman’s executives essentially overruled their own traders, thereby saving themselves from subprime losses:

Left to their own devices, traders in subprime-mortgage bonds would have sunk Goldman just as they sank Merrill Lynch, Citigroup Inc., Bear Stearns Cos. and every other major Wall Street firm…

The only difference between Goldman and everyone else was that Goldman had, in effect, an entirely separate enterprise, sitting on top of the firm, with the power to reverse the judgment of its own supposed experts in various markets. They were able to do this, apparently, without ever saying a word about it to their own traders. Instead of telling the fools trading subprime mortgages that they are wrong, and that they should unwind their positions, they simply offset their trades.

But really that’s not what Kelly’s story says at all. It was the traders in subprime-mortgage bonds who were told to go short, and who indeed were prevented from going even shorter at a few key moments. The "supposed experts" in subprime mortgages were if anything even more bearish than the higher-ups; Lewis’s "fools trading subprime mortgages" are never once mentioned in the story, and I’m far from convinced that they exist. Here’s Kelly:

Last December, David Viniar, Goldman’s chief financial officer, gave the group a big push, suggesting that it adopt a more-bearish posture on the subprime market, according to people familiar with his instructions. During a discussion with Mr. Sparks and others, Mr. Viniar noted that Goldman had big exposure to the subprime mortgage market because of CDOs and other complex securities it was holding, these people say. Emerging signs of weakness in the market, meant that Goldman needed to hedge its bets, the group concluded, these people say.

Note that the bearish bets weren’t an attempt to offset trading positions entered into by prop traders on a mortgage desk: they were an attempt to offset structural long positions built up as a result of Goldman’s activities putting together CDOs. It’s wasn’t traders who built up that position, it was bankers, structuring products, selling them to buy-side clients, and retaining some piece of them for the firm’s own books. It was the traders who rescued the bankers from building up huge potential losses, not the executives parachuting in some crack team to rescue the traders.

Lewis makes a good point, and then undercuts it:

All across Wall Street risk managers are being fired, reassigned or hovering under a cloud of contempt and suspicion. Heads must roll, and after the CEO, these guys are the most plausible to guillotine.

But at the same time it’s pretty clear that a lot of these so-called risk managers never really had the power to manage risk. They had to consider the feelings, for example, of the guys who ran subprime mortgages…

But at Goldman there were two intelligences at work: one, the ordinary Wall Street intelligence, which was allowed to get itself in trouble, just as at every other Wall Street firm; the other, more like an extremely smart hedge fund that made its living off the idiocy of big Wall Street firms, including its own people…

From now on, the ordinary traders and salesmen at Goldman Sachs can beaver away knowing that their opinions and judgments about the markets in which they operate are basically irrelevant. The guys at the top of the firm are making the market calls, and if the guys at the top disagree with them, well, they’ll just take the other side of their trades. But then, why do you need the traders? And what happens when the guys at the top of the firm are wrong?

Lewis is right about the risk officers. What Goldman did is what any decent risk officer should have done: look at the risks on the bank’s balance sheet, and then work to offset them. There’s a difference between that and "making the market calls". The guys at the top of the firm didn’t try to make money shorting mortgages, they just wanted to hedge their positions. In fact, they behaved much like the guys at Magnetar, who were structurally long CDOs, who therefore hedged their positions, and who wound up getting lucky when those short positions ended up returning much more than anybody could ever have anticipated.

One can argue about whether Goldman was lucky or whether it was smart. But I don’t think it’s fair to say that it was overruling its own traders.

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