Closing Private-Equity Tax Loopholes

Posted on June 15, 2007 by Felix

What to make of the Baucus-Grassley

bill designed to force Blackstone, and any other partnerships looking to

go public, to pay the corporate rate of income tax? It looks very much like

the closing of a loophole to me: there’s really no reason why public "unitholders"

of Blackstone should get to keep significantly more of its pre-tax income than

shareholders of similar companies with a different corporate structure.

Blackstone’s founders, of course, have benefitted themselves from a different

loophole, and one which the new bill will not address: the fact that their income

is taxed at the 15% capital-gains rate, since they’ve managed to persuade the

IRS that it’s not really income at all, but something entirely different, called

"carry".

Trying to close the "carry" loophole would be much harder, since

it affects many more people – private-equity and venture-capital professionals

across the country, rather than just those looking to take their partnerships

public. What’s more, it’ll be hard for politicians to attack those people now,

just as they’re asking for massive campaign contributions in the run-up to the

2008 elections.

And then, of course, there’s the third loophole, which is linked to the fact

that hedge-fund managers and private-equity professionals can keep a large chunk

of their income in offshore vehicles, where it can reside tax-free for years

before it is repatriated and taxed. That loophole, too, is unlikely to be closed

this side of the elections.

But especially if a Democrat ends up in the White House, it seems likely that

all of these loopholes are going to be closed sooner rather than later. A lot

of men have become dynastically wealthy partly by exploiting them, but all things

must come to an end. And there’s really no reason why hedge fund managers and

private-equity billionaires deserve the kind of tax treatment that they’re basking

in at the moment.

Posted in fiscal and monetary policy, hedge funds, private equity | Comments Off on Closing Private-Equity Tax Loopholes

Taxing Paris Hilton

Posted on June 14, 2007 by Felix

I’ve never been particularly on board with the concept of guest bloggers, especially

if they have a reasonably high profile. They often don’t really get the concept

of blogging, and instead of writing about what they’re reading about, they have

a tendency instead to write about what they’re writing about. This can take

the form of plugging

their own books, or, in the case of Jason Furman today,

plugging

his institution’s own research reports. On the other hand, I’m glad Jason

did so, because the paper

he’s plugging, by NYU Law professor Lily Batchelder, is

a really good one.

Batchelder proposes that the estate tax, which is going to fall to zero in

2010 only to start increasing again in 2011, should instead return in a significantly

different guise: an inheritance tax. The difference is that estate taxes are

paid by estates – the dead, basically – while inheritance taxes

are paid by inheritors, who are alive. And it turns out that in reality there’s

a big difference in terms of who gets affected. Under the estate tax, poor people

with small inheritances from large estates suffer from large effective tax rates,

while many large inheritances don’t get taxed at all.

Under an inheritance tax, by contrast, inherited income would be treated in

much the same way as any other income, whether earned or unearned or won in

the state lottery. Although the first $2.3 million of inherited income would

still come tax-free.

Furman sums it up by saying that we should tax "Paris Hilton, not Britney

Spears" – ie, tax the idle members of the lucky-sperm club,

rather than people who actually make a lot of money themselves.

The irony is that Paris Hilton is actually a money-making machine, whose earned

income vastly exceeds that of Furman, Batchelder, and indeed all of the other

contributors to the Free Exchange blog as well. To get an idea of the sort of

money Hilton makes, have a look at the D-list version of Paris Hilton: England’s

Tara

Palmer-Tomkinson, who apparently earns some $2.5 million in a good year.

An A-lister like Paris Hilton, with her own perfume line on

sale at Target, undoubtedly gets much, much more.

I’m all in favor of taxing unearned, inherited wealth. But there’s a good chance

that Paris is going to make more money on her own than she’ll ever inherit from

her parents.

Posted in fiscal and monetary policy | Comments Off on Taxing Paris Hilton

Should Banks be Worried About Equity Bridges?

Posted on June 14, 2007 by Felix

Michael Flaherty of Reuters is very

concerned about equity bridges. Just think of the downside to the banks

concerned of these high-risk, low-return vehicles!

In an equity bridge, investment banks lend some part of the purchase price

of a company which is being taken private. They then sell the equity to investors

after the deal has closed. Reports Flaherty:

The best-case scenario is that the investment banks quickly sell the equity

exposure to other buyers. But even then, banks typically earn only a 1.5 percent

return on the loan. That means for risking $500 million, they earn just $7.5

million.

The worst case is that banks can’t sell down the equity. Then they are left

holding the bag, in some cases with hundreds of millions of dollars in exposure.

The 1.5% return is interesting to me. Obviously these bridges are designed

to last only a few weeks, and equally obviously their exact duration can’t be

known in advance. But let’s say they last for one month. Then the $7.5 million

earned on a $500 million return would correspond to an interest rate not of

1.5% but of something closer to 18%. Which is really not so shabby.

And then of course there’s the opportunity cost of not extending the

equity bridge. Refuse to offer such a thing, and you won’t get the associated

M&A mandate – which will undoubtedly be extremely lucrative.

Finally there’s the question of the downside risk. I’m pretty sure that Flaherty

is wrong when he says that the risk is that the "banks can’t sell down

the equity". Instead, I think that Andrew

Ross Sorkin is right, when he says that

If the private equity firms cannot find new investors — and it is their

job, not the banks’, to find them — or if the value of the asset

falls sharply, the banks are left holding the bag.

In other words, there’s no actual work involved here, for the banks, beyond

writing a big check and receiving in return a bigger one a few weeks later.

And indeed Flaherty doesn’t find a single person who thinks that there’s a serious

risk the equity won’t get sold. Instead, he warns more darkly about the bigger

picture:

LBO deals are still being pumped out with no end in sight. But the growing

prospect of interest rate rises has led some analysts to believe the frothy

debt days are numbered.

That’s as may be – but the fact is that if there’s no frothy debt, then

there won’t be any equity bridge either. The equity is the final piece, which

gets layered on top of all the debt. If there’s no debt, there’s no equity,

and if there’s no equity, there’s no equity bridge, and no risk of it failing

to get distributed.

In fact, the way that private-equity shops are structured means that the equity

almost sells itself, as I explained

in February. If you’re the kind of person or institution who’s happy to invest

money in a private-equity fund, you’ll be ecstatic at the opportunity to take

out an equity bridge, since you get much more upside that way.

Equity bridges are certainly a sign of the frothiness of the market. But I

don’t think they’re particularly risky in and of themselves – especially

if the M&A bankers at the banks concerned are doing their jobs right and

are convinced that the deal is a good one.

Posted in private equity | Comments Off on Should Banks be Worried About Equity Bridges?

A Bull-Market Song

Posted on June 14, 2007 by Felix

China’s many stock market miracles will last forever.

(Via

Knobel)

Posted in stocks | Comments Off on A Bull-Market Song

More Signs the Art Market is Peaking

Posted on June 14, 2007 by Felix

I’m no market timer, and I tend to laugh at people who try to call a top –

or a bottom, for that matter – to any market. Many observers have been

predicting a nasty crash in the frothy contemporary art market for years now,

and have been proved stunningly wrong, as it has continued to soar. But I’m

finally coming round to their way of thinking, and not just because Richard

Prince’s new paintings are going for $7

million apiece.

I do think that the Prince datapoint is important, however, because it shows

a degree of capitulation to the market on the part of blue-chip galleries such

as Barbara Gladstone. Up until now, galleries have sold their biggest artists’

work only to the most copper-bottomed collectors, often at prices well below

market. The high prices that works received at auction were often a function

of low supply rather than high demand: most collectors simply had no direct

access to a lot of artists they wanted to buy, whch meant that they had to pay

through the nose in the rare cases that works were available to the general

public.

Now, however, the market has literally got out of control – out of the

control of the galleries, that is. Here’s Damien

Hirst, explaining why he simply has to price his diamond skull at $100 million:

"You have to get the price right, or it will come back into the market,"

said Hirst today in an interview at London’s White Cube gallery, where the

skull was shown to reporters. "A lot of people buy things and flip them,"

making a quick profit if the work has been underpriced, he said.

What this means is that galleries aren’t underpricing their art any more. (As

if you couldn’t tell that from the $7 million Princes alone.) In turn, that

means that a major driver of auction prices and frothiness has now been removed

from the market. It also means that galleries are behaving very much as though

they want to extract every last dollar of juice from the market now, rather

than playing the long game like they normally do. This is understandable when,

according to ArtTactic,

"The ArtTactic Market Confidence Indicator is still standing at an all

time high, where market optimists outweigh pessimists in a ratio of 16 to 1."

Confidence indicators, of course, are the classic contrarian indicator.

As are websites like www.artforprofits.com

(I kid you not), run by a self-proclaimed "art market guru" in his

mid-20s who makes for some inadvertently hilariously reading. (Try this

blog entry, for starters.) It’s bad enough that some people are now buying

art in the hope of making money; needless to say, people with such hopes nearly

always see them dashed. But when the number of people looking to make money

by investing in art is large enough to spawn a whole other industry of people

trying to make money from people trying to make money from investing in art…

that, I think, is a good sign of the beginning of the end.

Posted in art | Comments Off on More Signs the Art Market is Peaking

Questions About Bear and Goldman’s Mortgage Exposures

Posted on June 14, 2007 by Felix

What exactly is the connection between the subprime mortgage market and weakness

in earnings at Goldman Sachs and Bear Stearns? Both the Wall

Street Journal and the New

York Times think that the subprime exposure at both companies is so important

that it’s worth putting in the headline of the story about the banks’ earnings

reports. And Bear Stearns certainly has a hedge fund which seems to have been

hit

hard by subprime weakness in April. But losses at the fund will have very

little direct impact on Bear’s earnings, since the bank has only a small stake

in the fund.

That said, Bear has historically made a lot of money from securitizing subprime

mortgages, and as the flow of such business has dried up, its fixed-income revenues

have fallen. But according to Bear’s earnings press

release, there might be more to things than just that:

Mortgage-related revenues reflected both industry-wide declines

in residential mortgage origination and securitization volumes and

challenging market conditions in the sub-prime and Alt-A mortgage sectors.

(Emphasis added.)

Does this mean that Bear Stearns itself is long mortgages, and that it marks

those mortgages to market, resulting in losses when the value of the mortgages

falls? It’s not entirely clear. But it’s clearer than the Goldman press

release:

Net revenues in Fixed Income, Currency and Commodities (FICC) were $3.37

billion, 24% lower than the second quarter of 2006, primarily reflecting lower

net revenues in commodities and weak results in mortgages, principally attributable

to continued weakness in the subprime sector.

I thought that banks were meant to make money from volatility, which is what

we’ve seen in mortgages. Instead, it looks as though they’ve been making money

simply by being long credit, and making mark-to-market profits as the market

has risen. When the market turns south, they start losing money. In other words,

they’re behaving more like mutual funds than like traders, who should be able

to make as much money in down markets as they do in up markets.

But there are lots of unanswered questions here. For one thing, why is the

subprime weakness hitting these banks now? Their second quarters cover the period

from March to May, while the big collapse in subprime mortgage prices happened

in the previous quarter, from December to February.

And for another thing, why is Goldman’s press release in the form of a non-searchable

PDF file, which shows us images of words rather than the words themselves? Is

there a good reason why neither of these banks have put their press release

out on the web for the world to easily see? Both releases are in PDF form only,

although at least the Bear release is searchable and can be copied and pasted.

Posted in banking, bonds and loans, housing | Comments Off on Questions About Bear and Goldman’s Mortgage Exposures

Carbon Taxes in the Skies

Posted on June 13, 2007 by Felix

The UK Conservative Party has a

bright idea on the carbon-tax front: a tax on air flights which is directly

linked to that flight’s carbon emissions. At the moment, the taxation system

gives airlines no real incentive to be carbon-efficient, even though emissions

from airplanes are particularly harmful from a climate-change perspective. The

UK’s opposition Conservatives want to change that, and propose a tax which gives

every UK citizen one "free" flight per year, after which carbon taxes

start kicking in.

This week, London mayor Ken Livingstone, who is at least as far to the left

as the Tories are to the right, supported

the proposal, which has, inevitably, been attacked

by the airlines as a "tax on fun". Maybe the trick, at the outset,

would be to make the new carbon tax lower, in aggregate, than the £10

to £80 Air Passenger Duty it is designed to replace. If it can be spun

as a tax cut, it might garner less opposition. Then, as a "sin tax",

it can always be raised later.

Posted in climate change | Comments Off on Carbon Taxes in the Skies

Bill Gross, Prose Stylist

Posted on June 13, 2007 by Felix

Bill Gross, bond

investor, stamp

collector, philanthropist,

and billionaire,

can write pretty much whatever he wants. He can even refer

to the chairman of the Federal Reserve as "Ben the Pelvis". But

surely the upside of writing for the FT, as opposed to the Pimco newsletter,

is that you get to call upon the services of professional editors. Shouldn’t

they cut such stuff out? And how on earth did they allow into print the assertion

that "the wait is excruciating, and in some cases painful"?

Posted in bonds and loans | Comments Off on Bill Gross, Prose Stylist

Andreessen and Dyson on Facebook

Posted on June 13, 2007 by Felix

Really smart company research has always been hard to find, and today it’s

getting harder. On the one hand, many sell-side institutions are scaling back

their equity-research operations, and encouraging what analysts remain to spend

more time on the phone to high-value clients, and less time writing research

reports for the masses. On the other hand, there are thousands of bloggers with

opinions about individual companies, but it’s very hard to separate out the

signal from the noise.

Occasionally, however, the blogosphere comes up with the kind of analysis that

any highly-paid analyst would be incredbily proud of. In the past couple of

days, we’ve seen both Marc Andreessen and Esther Dyson

publish their takes on Facebook freely on the web, without any kind of corporate

firewall or conflict of interest. If you’re interested in the direction that

the web is going, both of these are must-read pieces.

Andreessen

says that "the new Facebook Platform is a dramatic leap forward for the

Internet industry," while Dyson

is thinking even bigger:

Facebook supports the attention economy — as opposed to the purchase intention

economy. Mark Zuckerberg said to me long ago (paraphrase): "The other

guys think the purpose of communication is to get information. We think the

purpose of information is to foster communication."

Think of Facebook not so much as information exchange as a place where you

can establish and spread your presence, and get attention back. That’s the

currency of the future … and it may or may not be directly exchangeable

for money.

Of course, Facebook isn’t a public company (yet), so all of this analysis is

hard to monetize. But if you’re interested in the future of the technology space,

increasingly blog entries are at the top of the required-reading list.

Posted in technology | Comments Off on Andreessen and Dyson on Facebook

JP Morgan Snubs Silverstein in Move Back Downtown

Posted on June 13, 2007 by Felix

This has taken rather longer than expected, but it seems that JP Morgan is

finally very close to inking a deal to move back downtown, where it belongs.

The WSJ’s Alex Frangos reports

that the bank’s new skyscraper, on the site of the not-yet-demolished Deutsche

Bank tower, will be 50 stories and 1.3 million square feet – a step down

from the 57 stories and 1.6 million square feet that were being

mooted back in February.

It’s good that JP Morgan is moving back to the financial district, although

I daresay it will continue to have a substantial presence on Park Avenue. It’s

certainly good that JP Morgan isn’t moving

to Stamford, not that it was ever really going to. But here’s the most interesting

part of Frangos’s story:

People familiar with the matter say J.P. Morgan spent over a month negotiating

with Mr. Silverstein about moving into his buildings, but the two sides were

unable to come to terms.

Silverstein’s towers have larger footprints than the Tower 5 site where JP

Morgan is going to build, which make them more natural homes for banks who want

huge trading floors. It’s interesting that Silverstein was willing to let JP

Morgan fall through his fingers: there aren’t that many banks who want to move

their headquarters to a new building in downtown New York, and he’s going to

need to find three. With Goldman Sachs and JP Morgan building new headquarters

already, and Lehman Brothers and Bear Stearns happily ensconced in their own

new buildings in midtown, it’s not clear who Silverstein is hoping to attract.

Posted in banking | Comments Off on JP Morgan Snubs Silverstein in Move Back Downtown

How Sheikh Ahmed Zaki Yamani Won the Cold War

Posted on June 13, 2007 by Felix

Did Reagan win the Cold War? Or, more broadly, did US policies in the 1980s

result in the collapse of the Soviet Union? A wonderful

analysis by Yegor Gaidar, who was there when it happened,

suggests that the answer is no.

Gaidar compellingly describes how a weak Soviet agricultural system, combined

with the mid-80s collapse in oil prices, was the key factor leading to the Soviet

Union’s collapse. The country, faced with an unsustainable financial situation,

stuck its head in the sand and started borrowing to the point at which no foreigners

would lend any more. And at that point, Moscow was essentially at the mercy

of any foreign countries who might conceivably lend it money.

Government-to-government loans were bound to come with a number of rigid

conditions. For instance, if the Soviet military crushed Solidarity Party

demonstrations in Warsaw, the Soviet Union would not have received the desperately

needed $100 billion from the West. The Socialist bloc was stable when the

Soviet Union had the prerogative to use as much force as necessary to reestablish

control, as previously demonstrated in Germany, Hungary, and Czechoslovakia.

But in 1989 the Polish elites understood that Soviet tanks would not be used

to defend the communist government.

The only option left for the Soviet elites was to begin immediate negotiations

about the conditions of surrender. Gorbachev did not have to inform President

George H. W. Bush at the Malta Summit in 1989 that the threat of force to

support the communist regimes in Eastern Europe would not be employed. This

was already evident at the time. Six weeks after the talks, no communist regime

in Eastern Europe remained.

So who do we thank for the collapse of the Soviet Union? If it’s one person,

that individual is not Ronald Reagan but rather Sheikh Ahmed Zaki Yamani,

the minister of oil of Saudi Arabia in 1985, who ramped up oil production in

that country and send the price of oil tumbling. Without its main source of

hard currency, the Soviet Union was doomed.

(Via Cowen)

Posted in geopolitics | Comments Off on How Sheikh Ahmed Zaki Yamani Won the Cold War

London Thrives in the Face of Insider Trading

Posted on June 13, 2007 by Felix

There’s more to the difference between New York and London than just a philosophical

disagreement over the question of whether rules or principles are the best way

to regulate markets. In New York, it turns out, insider trading is easier to

prosecute, and prosecutions are relatively common. In London, on the other hand,

where plea bargains aren’t allowed, it’s very difficult to make insider-trading

charges stick, and prosecutions are very rare.

A Bloomberg editor got needlessly snarky with their headline today, "FSA

Struggles With Insider Trading That Doesn’t Happen in UK": the FSA

doesn’t deny that insider trading is happening. But the story is pretty good

when it comes to laying out the scope of the problem.

As John

Carney notes, however, none of the insider trading seems to have done any

harm to London’s status as a financial center. And although it might offend

peoples’ sense of fairness, it doesn’t necessarily damage markets. To the contrary,

he says, "insider trading itself can make the market more efficient by

increasing the amount of information in the market".

If insider trading gets too rampant, then investors will start to shun a market

where what seems to be a good bid for their stock is reasonably likely to be,

rather, an insider bid with advance knowledge of a forthcoming takeover approach.

So it is incumbent on the FSA not to let insider trading get too blatant. On

the other hand, it’s quite easy to overstate the negative effects that insider

trading can have.

Posted in stocks | Comments Off on London Thrives in the Face of Insider Trading

John Paulson Continues His Quixotic Fight Against Bear Stearns

Posted on June 13, 2007 by Felix

The Bear

Stearns vs John Paulson saga shows no sign of going away any time soon,

and Bloomberg’s Jody

Shenn has a big article on it today. So far, however, no one has come up

with any evidence of the "market manipulation" which John Paulson

and others are so upset about – and, what’s more, no one seems to be remotely

convinced that it would be either illegal or immoral even if it were shown to

be happening.

One of the big problems is that specifics are very hard to come by, here. Tanta,

over at Calculated Risk, has devoted two very long and recondite blog entries

to this situation (here

and here),

but the lack of information means it’s hard to have an informed opinion on what’s

going on. Insofar as we do have an informed, impartial opinion –

and Tanta’s is about as close as it comes, for the time being – John Paulson

et al do not come out well at all.

Which is why it’s weird to see this, in the Bloomberg piece:

It would be "penny wise and pound foolish" for an issuer to conduct

significant buyouts other than to meet contractual requirements to make up

for misstated loan characteristics or fraud, because investors would shy away

from the company’s future deals, said Peter Cerwin, who runs the portfolio

management group at New York-based Credit-Based Asset Servicing and Securitization,

or C-Bass, an issuer and servicer.

I don’t understand what Cerwin is saying, here. If an issuer conducts significant

buyouts of degraded debt from a pool, investors would love it –

and would probably flock to that issuer’s future deals, if they reckoned such

behavior would be repeated. Remember, it’s not the investors in these deals

who are complaining. Rather, it’s the hedge funds who are betting against

the investors in the deals who are complaining.

Posted in hedge funds, housing | Comments Off on John Paulson Continues His Quixotic Fight Against Bear Stearns

Lant Pritchett’s Big Idea

Posted on June 13, 2007 by Felix

Did you not have enough time to read the Jason

DeParle article on Lant Pritchett in the New York Times

on Sunday? I have to admit that I skipped it: because DeParle managed to persuade

his editors to send him to Nepal, he spends most of the first 1,600 words of

his article there, and the main idea doesn’t come until about 2,800 words in.

Once you get there, however, it makes a lot of sense.

The rich world has lots of well-paying jobs and an aging population that

cannot fill them. The poor world has desperate workers. But while goods and

capital can easily cross borders, modern labor cannot. This strikes Pritchett

as bad economics and worse social justice. He likens the limits on labor mobility

to “apartheid on a global scale.”…

Part of Pritchett’s argument is mathematical. Drawing on World Bank

models, he estimates his plan would produce annual gains of about $300 billion

— three times the benefit of removing the remaining barriers to trade.

But the philosophical packaging gives his plan its edge. Pritchett assails

a basic premise — that development means developing places. He is more

concerned about helping Nepalis than he is about helping Nepal.

DeParle is clearly impresed, but not sold, on this idea, and he quotes no one

who’s fully on board with Pritchett’s philosophy. So Michael Clemens

at the Center for Global Development has now stepped

in to respond to some of DeParle’s criticisms. It’s worth reading the whole

thing, but here’s a taster:

Lant’s proposal involves creating three million jobs in the U.S. for guest

workers who would not have full citizenship rights. The Times article derides

this as "a Saudi Arabian plan in which an affluent society creates a

labor subcaste that is permanently excluded from its ranks." Unfortunately

this is not the Saudi plan, it’s the American plan, today, now. In the 1990s,

about 350,000 unauthorized workers entered the country every year (pdf). In

other words, over that decade, America took in three million low-skill workers

with no citizen rights and, thanks to the recent failure of the immigration

reform bill, little prospect of such rights. They were made much better off,

the countries they came from were made much better off, and the U.S. remains

the richest and most powerful country on earth.

This is a powerful rejoinder. What countries do is what countries do, no matter

what they say they do. Americans don’t like Saudi Arabia’s labor policy

because it’s a policy. But in fact they do like Saudi Arabia’s labor policy

in terms of the way that it effectively imports needed cheap labor into a rich

country where there are many jobs that citizens have no desire to do. Or at

least it looks very much as though Americans like that policy, because America

in general runs on illegal labor – and places like California and New

York City would grind to a halt without it.

The problem is that Americans don’t feel nearly as bad being harsh to laborers

who are here illegally as they do about being harsh to temporary workers who

would be here legally: they’re much happier to deport the former than the latter,

for instance, after three or five years. And in any case, the world’s system

of democratic nation-states simply isn’t designed for a quantum leap in free

labor mobility. But it would probably be a very good thing if it were.

Posted in development, immigration | Comments Off on Lant Pritchett’s Big Idea

A Closer Look at Cov-Lite Loans

Posted on June 12, 2007 by Felix

Catherine

Craig has a great, in-depth look today at the "cov-lite" phenomenon

whereby loans are increasingly being syndicated without the restrictive covenants

of yesteryear.

Craig’s piece is excellent because she doesn’t go down the lazy

knee-jerk route of automatically saying that cov-lite loans are toxic and

dangerous and something which pose a massive systemic risk to the international

financial architecture. Instead, she looks at the development in an impartial

manner, and although she doesn’t make any explicit conclusions, it’s clear that

there are quite a few reasons to consider cov-lite loans a good thing.

It’s certainly true that banks with cov-lite loans will have less power over

borrowers than they had in the past. But this is not necessarily a bad thing.

For one thing, many recent cov-lite loans, such as the $16

billion in acquisition financing that KKR is lining up for First Data, or

the same amount that it might borrow to acquire Alliance Boots, are huge. As

a result, any bank creditors committee would be enormous, unwieldy, and would

probably cause more harm than good.

What’s more, many banks with these loans will hedge their exposure in the CDS

market, which means that the real default risk is being borne not by the creditor

of record but rather by any number of hedge funds, CDOs, and the like. In such

a situation, it makes little sense for the bank in question to have serious

control over the debtor company.

It’s also worth noting that if a company doesn’t have restrictive covenants

on its loan, that gives it an extra couple of degrees of freedom should it ever

run into difficulties. The company’s owners can repay its bank debt however

they like, without being second-guessed by their creditors. Most importantly,

volatile financial results are much less likely, in and of themselves, to lead

to receivership or bankruptcy.

Many firms with cov-lite loans are highly leveraged, which means their financial

results are naturally going to be much more volatile. Cov-lite loans simply

make that volatility less likely to result in technical default on the part

of the company, with all the nasty consequences that implies.

And there’s also evidence that banks are receiving a premium for agreeing to

cov-lite loans:

At the riskier end of the spectrum, where more highly leveraged deals are

using deferred repayment instruments such as second lien instead of senior

debt, banks are cautious and likely to demand a higher price for the privilege

of covenant-lite terms.

This is great for all concerned: banks get the yields they’re looking for,

while sponsors get the freedom of action that they’re looking for.

The fact is that cov-lite loans are all negotiated, as it were, between consenting

adults. Maybe the banks, looking at the history of the likes of KKR, have decided

that KKR is actually better at running companies and working out what the smart

moves are than their own loan officers are. Or maybe they just think that they

can boost their total returns by lending cov-lite.

So does this mean there’s no systemic risk associated with cov-lite loans?

I’m not sure. No one seems to think that there’s major systemic risk associated

with bonds, and cov-lite loans are essentially loans which behave quite similarly

to bonds. But the collapse of a bondholder is a lot easier to cope with than

the collapse of a bank. So really it probably all comes down to the question

of how much of this debt is being retained by banks, as opposed to being sold

off or hedged. And that’s something which nobody knows.

Posted in bonds and loans | Comments Off on A Closer Look at Cov-Lite Loans

Art Market Bubble Watch

Posted on June 12, 2007 by Felix

Linda

Sadler reports:

At Barbara Gladstone’s stand, a 2007 Richard Prince painting of three women

was sold before the VIP opening. Prices for Prince’s big new works run from

$5 million to $7 million, said a gallery assistant who declined to be named.

This is crazy money. Prince’s auction

record, for one of his iconic cowboys, is $2.8 million. And although it’s

not unheard-of for new art to go for well above an auction record, one only

expects such a state of affairs when the auction record is weak and the new

art is particularly strong. Neither of those applies in this situation. Prince’s

new paintings, no matter how good they are, will never have the art-historical

importance (and therefore value) of his older rephotographed works.

I’m always very hesitant to call a bubble, but I’m doing that now, with respect

to Prince’s latest works. Collectors are paying for square footage and for a

brand name, and they’re paying through the nose: these paintings are priced

at or above similarly-sized paintings by the likes of Hirst and Koons. In fact,

they might be the most expensive new paintings on the market today: I’m not

even sure that Johns or Twombly or Richter could sell their work for more. And

Johns, Twombly and Richter are all great painters. Prince might be a great artist

(I’m not sure about that), but he certainly isn’t a great painter. These prices

simply will not stand the test of time.

Posted in art | Comments Off on Art Market Bubble Watch

Why Europe is Right on Climate Change

Posted on June 12, 2007 by Felix

The normally-excellent John Kay seems to be very confused

today, in a column about energy

policy and climate change. Incredibly, he says that George W Bush

is right, and that the Europeans, led by Angela Merkel, are

wrong.

Kay’s main problem is that he thinks Europe wants to reduce its carbon emissions

by means of a big, overarching energy plan.

Energy, along with agriculture, is the last home of the methods of socialist

planning. Agriculture exemplifies micro-management, in which yet more complex

measures follow from the unintended consequences of earlier plans, and carbon

trading promises to go the same way. Energy offers an irresistible temptation

to engage in long-range planning because of the extended lead times associated

with investment in both production and consumption. All such planning requires

that those who would undertake it hold information that they do not have and

to which they cannot realistically aspire…

We should not allow Europe’s energy needs to be planned by multinational,

multi-utility behemoths or set a target for the temperature of the world.

But there is no European conspiracy of governments and multi-utility behemoths,

all engaged in a massive multi-year plan. That’s the beauty of cap-and-trade.

The governments just set a cap on carbon emissions and step back; the market

does the rest. No long-range planning, no target for the temperature of the

world, nothing.

Kay complains that "the carbon emissions trading scheme borders on farce,

doing little to reduce emissions but providing a subsidy to emitters".

He then says that tightening the scheme in future will not alter the fact of

its "irrelevance". He’s entirely wrong on both counts. For one thing,

the scheme, though imperfect, is

working. And as Europe sets increasingly stringent carbon-emissions caps,

it will work better. This can be seen already in the futures price for carbon,

which is much higher than the spot price.

Kay’s proposed solution is… well, Kay doesn’t have a proposed solution. Instead,

he asks for "modesty of aspiration and acknowledgement that many uncertainties

cannot be resolved". In other words, absolutely nothing. We can –

we must – do better than that.

Posted in climate change | Comments Off on Why Europe is Right on Climate Change

Fed: Still Credible

Posted on June 12, 2007 by Felix

Last week, the Federal Reserve won its undeclared war against the market. For

months, the market had been pricing in rate cuts, despite the fact that the

Fed had given no indication whatsoever that any rate cuts were in the offing.

No longer: the curve is steepening, the priced-in probability of a rate cut

is down to zero, and the markets admit that worsening inflation is a bigger

problem for the Fed than falling GDP growth.

All this is not enough, however, for Irwin Kellner, who thinks

the Fed should

and will raise rates in two weeks’ time.

Judging by the number of signals that central bankers have sent in recent

weeks, the Fed could very well decide to raise rates as early as this month.

If they don’t move in June, then they’ll probably pull the trigger in August.

After all, there’s a limit as to how much more inflation the Fed can afford

to tolerate before the markets begin to question its credibility.

I can just about understand – although I don’t necessarily buy –

the June rate-hike call. Inflation is rising, the Fed has said that it’s worried

about inflationary pressures, and there’s got to be some chance that the Fed

will do what it has long said that it might do.

But I don’t buy the credibility argument at all. Remember that up until last

week, the market thought a rate cut would be more likely than a rate

hike – and they thought that without impugning the Fed’s credibility one

iota. If the Fed fails to hike in June, that will be just fine by the market.

The way I see it, the market increasingly sees a rate hike as possible, but

it’s a long way from seeing a rate hike as necessary. The Fed is still ahead

of the curve here, which means that its credibility, at least for the time being,

is not at issue.

Posted in fiscal and monetary policy | Comments Off on Fed: Still Credible

Outsize Returns From Investing in Microfinance

Posted on June 12, 2007 by Felix

In April, Mexico’s Banco Compartamos went public, raising $450 million. By

the end of the first day’s trading, the bank was worth more than $1.8 billion,

and the people who had invested money in the bank during its early days found

themselves sitting on enormous profits. It was a glorious day for Mexcian capitalism

– except for one small problem: Banco Compartamos is a microfinance institution,

devoted to improving the lives of the poor. What was it doing, then, improving

the lives of already-rich private shareholders instead?

Development group CGAP

was one of the early supporters of Compartamos, although it gave grants rather

than equity capital, so it made no profit on the IPO. The group has now released

a comprehensive

report by Richard Rosenberg about what happened, and whether

the outsize IPO profits came at the expense of the poor people Compartamos was

founded to serve. In a word, it seems, the answer is yes.

The Compartamos numbers are stunning. It has a return on equity of more than

50% – something more or less unheard-of in the banking world. The interest

rates that it charges borrowers are more than 100% per annum. When it went public,

it did so at a price-earnings multiple of 27, and then started rising from there.

When the company went public, private individuals, including Compartamos’s directors

and managers, owned more than 32% of the company; they’re now wealthy people

indeed.

Compartamos’s shareholders, when the bank went public, had paid just $6 million

for their equity in the company between 1998 and 2000. Their return on that

investment was 100% per year, compounded for eight years.

Now, profit is not necessarily a bad thing. But excess profits like these must

ultimately come from somewhere, and in Compartamos’s case they seem to have

come from its customers. In 1995, during the Mexican tequila crisis, Compartamos

was forced to raise its lending rates to 100%. But when the crisis ended, the

high rates didn’t – and Compartamos’s outsize profits fueled its very

fast growth. That fast growth, says Rosenberg, can be defended from a development

perspective.

But the bank’s lending decisions were not being made purely with development

goals in mind. The report concludes:

It is hard to avoid serious questions about whether Compartamos’ interest

rate policy and funding decisions gave appropriate weight to its clients’

interests when they conflicted with the financial and other interests of the

shareholders.

Other observers, with less of a history with Compartamos, might be less charitable

still. In a narrow sense, the bank serves the poor: the poor are its clients,

after all. But in a broader sense, it now concentrates on serving its shareholders,

who are going to want to see its enormous profits go up, rather than down. It’s

good that Compartamos is making money. But it doesn’t need to be making

this much money.

Posted in banking, development | Comments Off on Outsize Returns From Investing in Microfinance

Monetizing the Obesity Theme

Posted on June 12, 2007 by Felix

Merrill Lynch has a research

report up on its website on how best to invest in "the emerging obesity

epidemic". Check out Table 5, "Stocks that represent the ML Obesity

Theme," all the way from Alizyme PLC through Wild Oats Markets.

"The developed world is getting older and fatter," writes analyst

Jose Rasco. "People are increasingly eating more proteins and processed

foods, leading more sedentary lives and gaining weight." The number of

obese people worldwide is projected to rise to 700 million in 2015 from 400

million in 2005. But every cloud has a silver lining: Merrill Lynch is here

to help you monetize that trend. After all, if you don’t make money from fat

people, someone else will.

Posted in healthcare, stocks | Comments Off on Monetizing the Obesity Theme

US Population Density Datapoint of the Day

Posted on June 12, 2007 by Felix

"If every American were given a house on a quarter acre, so that every

family of four had a full acre, that distribution would not use up half the

land in Texas."

(From a March profile

of Ed Glaeser, resuscitated

today by Mark Thoma)

Posted in cities | Comments Off on US Population Density Datapoint of the Day

How to Write About Companies

Posted on June 12, 2007 by Felix

I love reading stories about virtually-unknown companies in decidedly unglamorous

sectors which are doing spectacularly well, and the WSJ has a classic

today on a firm with the unhelpful name of M&F. (Would it help if you knew

that stands for MacAndrews & Forbes? Didn’t think so.)

It turns out that M&F, which is controlled by the legendary Ron Perelman,

is doing very well with a very modern strategy. It buys unsexy companies in

old-fashioned industries such as licorice extract and check printing, and uses

the very predictable cashflow from them to raise vast amounts of debt, which

it then uses in turn for more acquisitions. The strategy has helped M&F’s

share price to rise to more than $65 today, from less than $17 six months ago.

So congratulations to the WSJ on finding a stock which really has flown under

the radar and which has some very interesting shareholders. But I’m only giving

the paper two cheers, here, because a lot of the article is very confusing.

There are a lot of numbers in it, but most of them are presented out of context,

in a way which seems designed to make it very difficult to understand what’s

really going on.

I’m not picking on any particular journalists, here: this is something which

happens a lot in financial journalism. But let me just use this article as an

example.

Firstly, the article tells us M&F’s share price, but hasn’t yet told us

its market capitalization. So when we read that a $1.25 billion hedge fund "owns

almost 7% of M&F’s shares," it’s hard to tell how big of a bet that

is. After all, 7% of a $5 billion company is a much bigger deal than 7% of a

company worth $500 million. Later on, we find another fund "with more than

$800 million in assets that owns about 600,000 shares of M&F" –

this is a bit more useful, since we know that the shares are trading at about

$65 apiece, but still we’re being forced to do the multiplication in our heads.

(It works out at about $40 million, or 5% of the fund’s total holdings.)

Then we have to have the obligatory detour into day-trading: "Shares of

M&F, which trade on the New York Stock Exchange, rose 28 cents to $66.38

in 4 p.m. composite trading yesterday." The intraday movement of the stock

price is completely irrelevant to the story, and no reader of this story cares

about details such as "composite trading" – a bit of financial

arcana which serves only to make a lot of readers feel stupid because they don’t

know what it is.

And then we immediately segue into a torrent of ratios and numbers relating

to the company:

The shares currently trade at about 37 times last year’s earnings per share

of $1.82, compared with a price/earnings ratio of about 17 for the overall

market. Noncash expenses related to acquisitions have taken a toll on per-share

profit.

But M&F’s cash flow — money left over after all expenses are paid out

— is impressive: M&F had $116 million of free cash flow at the end of

the first quarter, according to data company Capital IQ, a figure that represents

more than 8% of M&F’s $1.4 billion market value. It has $2.4 billion of

overall debt.

"M&F is one of the cheapest valuations to free cash flow you can

find," says Mr. Teitelbaum, who predicts M&F will generate $10 a

share in free cash flow in 2008.

You basically need to be a stock analyst with a calculator at hand to really

understand all this. There’s a p/e of 37, which seems high, but only, it would

seem, because the denominator is low due to "noncash expenses". No,

I have no idea what those might be. So is the p/e ratio a useful indicator or

not? And if not, why are we comparing it to the overall market as though it

is?

Never mind, we’re on to "cash flow". What’s that? It seems to be

a broader measure of income than earnings, but it’s also money left over "after

all expenses are paid out". Whether that includes those "noncash expenses",

whatever they might be, is unclear. In any case, it turns out that M&F’s

cash flow is 8% of its market value, which compares to the p/e of 37. Or, rather,

it doesn’t. You could talk about a price-to-cashflow ratio of 12, which would

compare. Or you could say that earnings were 2.7% of the company’s market value,

which would also compare. But most people reading the WSJ can’t do those kind

of sums in their head.

In the space of two paragraphs with less than 120 words between them, this

story hits us with no fewer than ten different numbers. That’s far

too many – and the fact that most of them aren’t even helpful just makes

things worse. Yes, it’s good for financial news articles to be quantitative,

when such things matter. But first and foremost, they should be clear and easy

to understand. And this kind of thing simply isn’t.

We then have to hop nimbly over an "overall debt" figure which seems

unrelated to the rest of the numbers, before coming up short against a target

of $10 per share in free cash flow next year.

Now, let’s see. The company has a market cap of $1.4 billion, and it’s trading

at $66.38 per share, so $10 of free cash flow would be 10/66.38 times $1.4 billion,

or – let me get out a pencil and paper here – about $211 million.

In 2008. Which compares to $116 million at the end of the first quarter, which

would be an increase of – hang on one sec, 211 minus 116, divided by 116

comes to 82%. But is that an increase over three quarters or over seven quarters?

That’s not obvious. Oh, never mind.

Eventually, we get to the interesting stuff about the company’s strategy, and

management, and all that kind of thing. But there’s absolutely no reason why

we have to wade through all this dense and very difficult to understand financial

information in order to get there. One or two carefully chosen figures, which

illuminate rather than obscure the situation, would be great. But this is just

a great solid mass of numbers, most of which are presented outside any kind

of useful context.

Posted in Media | Comments Off on How to Write About Companies

Regulating Subprime Mortgages

Posted on June 11, 2007 by Felix

The Economist’s Free Exchange blog today attacks

Elizabeth Warren, who would

like to regulate the subprime mortgage market. Given the name of the blog,

it’s quite easy to predict where it comes down on such matters. But in fact

the issue is not quite as black-and-white as either the Economist or Dr Warren

might like to think.

Warren, likes to compare mortgages to toasters. We regulate the latter, she

says: why don’t we regulate the former? To which the Economist tartly replies:

Safety regulations on toasters don’t keep me from overpaying for one at Williams

Sonoma when I could get the same item for half the price down the street.

The only way to correct that problem is to shop around.

Well, yes, up to a point. The problem is that no one ever made money on a Williams

Sonoma toaster, or thought of it as an "investment". Mortgages, on

the other hand, are the route to home ownership, which, over the past few years,

has been the best route to wealth. I only need to look at my peers back in the

UK: some of them were lucky or smart enough to buy property ten years ago, while

others didn’t. The former have now, pretty much without exception, made more

money on their property than they have by working; the latter, on the other

hand, have helplessly watched the bottom rung of the property ladder get further

and further out of reach.

In such a situation, some people don’t ask a lot of questions when a fast-talking

mortgage salesman tells them that they can afford to buy a house. And for most

of the past ten years, people who took out mortgages with low teaser rates did

very well for themselves. When the mortgages adjusted upwards after two years,

they simply refinanced, gleeful as they made much more money in the property

market than they did in salary.

In financial terms, what they were doing was making a highly leveraged bet

on property prices. By the time you added in points and fees and the like, they

were paying a lot of money for their loans, but the monthly payments were affordable,

and the potential profits were enormous.

A lot of these people ended up making a lot of money. If Elizabeth Warren had

her way, then no one could have extended them an adjustable-rate mortgage if

they weren’t likely to be able to make the mortgage payments a couple of years

down the line. The thinking here is entirely akin to the thinking which restricts

hedge-fund investments to the very rich: risky, leveraged bets should be confined

only to people who have a lot of money to begin with.

But of course there are all manner of risky investments which are open to any

and all, from biotechnology stocks to the roulette wheel. And as risky investments

go, housing at least gives you a nice place to live, as well as an opportunity

to get onto the property ladder.

I’m reasonably sympathetic to Dr Warren’s cause, however. For one thing, poor

individuals should not be put into any kind of investment which only works until

it doesn’t. If the only hope for a person with an adjustable-rate mortgage is

that they will be able to refinance it in two years’ time with the equity they

build from a rising property market, then that mortgage is simply not appropriate

for them.

And while the Economist likes to think that we all "shop around"

for our mortgages, the fact is that not everybody does, and that shouldn’t be

a license to take advantage of people who would easily qualify for prime-rate

loans and sell them subprime loans instead. In San Francisco on Saturday night,

a cab driver, pegging me (correctly) as a tourist, decided to take an extremely

circuitous route to my hotel in order to maximize his fare. He was regulated,

although obviously not regulated enough. My mortgage adviser should be regulated

too, to stop him from taking me down the subprime road when a much cheaper-to-me

(though far less lucrative to him) option exists. This is a common problem,

which means that the present set of regulations is clearly inadequate.

Finally, one hesitates to take the Economist’s side in this debate when it

comes out with stuff like this:

Nor does even the worst mortgage have a 1-in-5 chance of putting the family

on the street. Though some observers have bandied about a 20% figure for delinquencies

on subprime mortgages, the more commonly accepted figure is somewhere in the

13-15% range. And that is delinquencies, not foreclosures, which are currently

running below 5% of subprime mortgages. I expect that latter figure to rise.

But not to 20%.

We’ve

been here before. But, to reiterate: 5% of subprime mortgages is not the

same thing as 5% of subprime borrowers. If I take out an adustable-rate mortgage

and refinance it before it resets, and then refinance that mortgage

before it resets, and then default on the third mortgage, then I’ve

taken out three mortgages in all, two thirds of which suffered no default or

delinquency at all. Here’s

Tanta, a woman who knows whereof she speaks:

It is perfectly possible, at least hypothetically, to have a situation in

which 40% of subprime homeowners eventually end up in foreclosure or short

sale or jingle mail, but only after three or four loans, so that on any given

month, on the current total book of outstanding subprime loans, "only"

4% are currently in foreclosure.

No one knows what percentage of houses which were originally bought with the

help of a subprime loan will eventually end up in foreclosure. But we know that

the percentage of subprime mortgages in foreclosure figure, no matter how high

it rises, will always be no more than a lower bound for the actual figure.

Posted in housing | Comments Off on Regulating Subprime Mortgages

Cash Offers vs Stock Offers

Posted on June 11, 2007 by Felix

A couple of months ago I got a phone call from a friend who had put her house

on the market. She had a few offers, including one which was all-cash. Should

she go with it, she asked, even if it wasn’t the highest of the lot? Of course

not, I said. It’s no business of hers where the money comes from: she should

just accept the highest offer. Yes, there might be a small chance that the finaning

doesn’t go through, but that in no way makes up for the tens of thousands of

dollars she’d be losing out on by taking the lower offer.

All the same, realtors and home sellers seem to love all-cash offers. And in

that respect they’re startlingly similar to corporate boards. Often, when one

company offers to acquire another, boards will discount any offer made in stock

rather than cash. Indeed, in some instances, a company will agree to a lower

sale price just in order to get cash rather than the equivalent amount in stock

and/or debt.

What’s going on here? Part of the issue is that the sale price, in terms of

stock, is agreed before the stock is actually handed over – so if the

acquirer’s stock tumbles between the deal being signed and the stock transfer

taking place, then the shareholders of the target company end up getting less

money. On the other hand, such an eventuality can easily be dealt with: it’s

simplicity itself to hedge that kind of exposure to an individual stock price.

What’s more, if you’re getting a fixed number of shares, there’s a good chance

that they’ll go up in value before you receive them, rather than going down.

No, the real problem is not the value of the shares upon receipt. It’s the

long-term performance of those shares after they’ve been acquired.

For even people who prefer cash, it

turns out, are still more likely than not to hold onto shares if that’s

what they’re given:

Research by Associate Professor Malcolm Baker, Professor Joshua Coval, and

Harvard University professor Jeremy C. Stein shows that 80 percent of individual

investors and 30 percent of institutional investors appear to be more inertial

than logical. They take the default option, passively accepting the shares

offered as consideration in stock mergers and acquisitions…

"Investor irrationality is something that people tend to focus on when

they think about investing in capital markets," [Baker] continues, "but

there are also implications for corporate finance." For example, when

investors hold onto stock they’ve received in an acquisition—taking

the path of least resistance—it keeps those shares off the open market

and makes the price relatively higher than it would have been otherwise.

This explains a lot. It explains, for one thing, why companies don’t just sell

stock in a secondary offering and then use the cash to buy the company they

want to acquire. That would depress their share price. Offering stock rather

than cash, on the other hand, doesn’t hurt the share price nearly as much, because

most of the recipients of the stock won’t sell it.

And it also explains why boards are suspicious of all-stock offers. They know

their own weakness: that they’re likely to hold on to the stock rather than

sell it. But it doesn’t explain the attraction of all-cash offers for houses.

Finally it’s worth remembering all the entrepeneurs who turned down all-stock

offers from Google for their companies. If they’d taken the Google stock, rather

than holding out for more money, they’d be much better off right now than they

are.

Posted in M&A | Comments Off on Cash Offers vs Stock Offers

Quebec Taxes Carbon

Posted on June 11, 2007 by Felix

Quebec

has a carbon tax:

The tax, believed to be the first of its kind in Canada, will tax 0.8 cents

on every litre of gas sold in Quebec and will raise about $200-million a year

to finance the province’s green plan to reduce greenhouse gases.

The province will also slap a tax of 0.9 cents on each litre of diesel sold.

The plan was created to help Quebec reach its Kyoto protocol targets, which

is to reduce greenhouse gas emissions to 1990 levels by 2012.

I’ll do the conversion so you don’t have to: 0.8 Canadian cents per liter works

out at 2.85 US cents per gallon. By global gasoline-tax standards, this is tiny,

and will almost certainly have zero impact on gasoline consumption. And the

gasoline tax is going to account for over a third of Quebec’s total carbon-tax

revenues. So the chances of this carbon tax having any appreciable effect on

demand for carbon are slim indeed.

This is why countries need a three-pronged approach if they’re going to effectively

reduce their carbon emissions. A gasoline tax does make quite a lot of sense,

but a cap-and-trade system is better for other carbon emitters. And finally,

regulation is necessary too, as Quebec

knows:

By year-end, the government will unveil emission regulations requiring manufacturers

of light-duty vehicles sold in Quebec to meet the so-called California standard

for greenhouse gas emissions beginning in 2010. The California standard will

result in reducing greenhouse gas emissions for new vehicles by between 25

per cent and 30 per cent by 2016, according to government projections.

Quebec’s carbon tax, then, isn’t really Pigovian, because it isn’t large enough

to noticeably reduce carbon emissions. But it’s a good start, since it’s always

easier to increase a "sin tax" than it is to implement one initially.

Posted in climate change | 1 Comment