Felix Salmon

Question of the day, part 2. Skye Ventures: vultures, or just patsies?

It seems that Skye got sold a bunch of paper ostensibly issued by a now-bankrupt Venezuelan development bank — paper which, it would seem, was fake. So are they suing the people they bought the paper from? No. They’re suing Venezuela, on the grounds that in a now-reversed opinion which may or may not have been public, the Venezuela solicitor general (not even the finance minister) ruled that the bonds were valid.

But it seems to me incredible on its face that a court could grant a judgment to a “creditor” if no one ever lent any money to the supposed debtor in the first place.

Venezuela, naturally, seems to be cocking up the US legal case (in Ohio, of all places), and has recently fired its Florida-based law firm. But even the world’s most atrocious lawyer would have a pretty hard time losing this case.

Question for the day: Why aren’t there any activist mutual funds? (Or are there?) One big difference between equity hedge funds and long-only mutual funds is that the hedge funds often seek out underperforming companies, and then agitate for some kind of a shake-up. Today, for instance, we learn that the UK’s Toscafund has amassed a significant stake in ABN Amro, and would love to see the Dutch bank taken over by a more efficient rival.

Interestingly, Toscafund in this respect differs from the other big hedge fund with an ABN stake, TCI — which is looking more for a breakup than an acquisition by a competitor.

Either way, both funds are taking large long-only stakes — something no mutual fund is enjoined from doing. As hedge funds and hedge-fund replicators become increasingly popular among increasing numbers of investors, many of whom can’t invest in hedge funds or fund-of-funds directly, one might expect to see more mutual funds charging high fees for their own activism.

The only problem: Why would a fund manager go down that road, when setting up a hedge fund would be so more lucrative? If such managers do exist, I suspect they might emerge from the socially responsible investing space.

From an interview with Guillermo Calvo, excerpted at the Bayesian Heresy:

I joined the central bank and worked under Julio H.G. Olivera, whose orders to me were, essentially: Go to the library, get a copy of Allen’s Mathematics for Economists and Hicks’ Value and Capital and don’t leave your room until you are done with them. I felt like I had reached Nirvana!

There’s not going to be a lot of new stuff on felixsalmon.com today, mainly because I have to do my taxes. But I did get a phone call this morning from mortgage expert Josh Rosner, and I learned quite a lot.

For one thing, I can now answer the question which has been bugging me for months: What is the relationship between default rates and MBS prices? A vast amount of the commentary about the MBS market has been centered on skyrocketing default rates in the subprime market, and there’s been a decided implication there that if default rates on subprime mortgages go up, then the value of MBSs based on subprime mortgages will naturally go down.

Turns out, it’s not that simple. For one thing, as we saw on Friday, rising default rates can, in theory, actually be good for MBS prices. Rosner didn’t go that far. But he did say that as far as the cashflows from any given MBS are concerned, the default rate on the pool of underlying mortgages is very unlikely to have any real effect on the cashflow to the MBS investors. Ever and always, MBS investors are worried about prepayment first and prepayment second.

Indeed, if you look at what happened to the MBS market in the wake of Hurricane Katrina, pools which were concentrated in the affected states didn’t noticeably underperform pools which weren’t. Investors, it seems, simply don’t worry about the default rates in their MBS pools.

Now this doesn’t mean that MBS investors shouldn’t be worried about default rates. There are two main reasons why they should. The first is that default often ends up as a foreclosure, and a foreclosure is essentially a prepayment. The second is that MBS investors aren’t interested solely in the MBSs they’ve invested in; they’re also interested in the health of the MBS market as a whole. And the future of the MBS market looks a little unhealthy if default rates continue to rise.

Why? Two big reasons. For one thing, if default rates rise, the housing market goes into reverse, and underwriting standards tighten up, then naturally the total supply of MBS coming to market will fall. But for another thing, there’s also the question of all those workouts.

When borrowers go into default, lenders are likely to try to come to some kind of workout agreement, rather than foreclose immediately. That’s because foreclosure often involves loss of principal, and also because of HUD guidelines. Typically, the arrears will be capitalized, and a new mortgage will be written. Now, as Morgenson pointed out in her piece on Sunday,

Academic studies suggest that within the first two years of a workout, re-defaults can approach 25 percent.

Now that’s good, right? You’ve gone from certain default to a mere 25% chance of default. Not so fast: according to Rosner, those workout mortgages are pooled and securitized just like any other mortgages, and often carry the original FICO score as well, and the original underwriting. Investors who buy the new MBSs, says Rosner, have no idea that they’re buying a pool which includes mortgages with a 25% default probability.

Finally, on the ABX index: Rosner looks at it with disdain. It doesn’t, right now, reflect the price movements of any underlying securities, and because it’s the only easy way to play the mortgage market, it attracts volatility like a super-magnet, drawing it away from the rest of the mortgage-backed world. There are lots of reasons to be worried about the future of the mortgage market, but the ABX index is not one of them.

Note to self: Make sure that Josh Rosner reads this, by the inestimably fabulous Tanta, before I talk to him about the mortgage situation. The poor chap deserves a right of reply, I think. But right now it’s Tanta 1-0 Morgenson/Rosner.

I wasn’t a big fan of Paul Krugman’s column on Friday, and his responses to readers today make him seem even more thin-skinned an arrogant than usual. (Dean Kloner: “What’s the point of the column? Anybody can concoct a scenario under which the global economy slides into a recession, no?”. Paul Krugman: “Um, the reason for writing it this way was as a slightly more reader-friendly way of describing the risks than you usually read.”)

But down at the bottom of the column is a very interesting letter from Jim Krupp, in Amherst:

Historically, when stocks paid dividends tied to profit, one could argue that buying stock was an investment in a company and that the buyer wanted to participate in its profits. But for the vast majority of speculatively priced stocks today, there is clearly no return from owning a stock unless someone else at a future time is willing to pay more for it than you did. A company’s success or failure is immaterial as an owner of shares you neither gain if a company is successful, nor lose if it is not, until you try to sell. This is a straight gamble as to whether at some future time demand will be higher or lower than today…

Perhaps the origin of the meltdown was not a bad day on a Chinese market. Perhaps it was several generations ago when stock ownership became a speculative gamble and not a prudent bet on the success of the company?

Although Krupp automatically loses my respect by talking about the stock market as a “pyramid scheme”, I’m actually rather sympathetic to the bit of his letter that I quoted. The overwhelming majority of stock investors don’t consider themselves part-owners of companies, but rather full owners of securities which they hope to see go up in value. Stocks are somewhere to put risk capital to work, rather than somewhere to truly invest your money and, literally, reap dividends. The time horizon for stock-market investors (large-business owners) is often much shorter than the time horizon for small-business owners. And, insofar as there’s a difference between investors and speculators, the stock market is dominated by the latter: people who buy something with the intention of flipping it to someone else at a higher price.

Whether all this is a bad thing, I’m not sure. I’ve got most of my knowledge and understanding of financial markets in and around the bond markets, rather than the stock markets, so I’m not particularly comfortable opining on this sort of thing. Who are the best people I should talk to if I want to understand stocks the way I understand bonds? Or is that just not possible?

Jonathan Nelson of private equity shop Providence Equity had this to say at the Super Return conference in Frankfurt:

The model in our industry today is far different than the headlines would lead you to believe — and it’s far more sophisticated than it was 10 or even five years ago. In today’s environment, you have to improve businesses, not just arbitrage public and private capital structures. Or said another way, you must work on the income statement as well as the balance sheet.

Now I don’t doubt for a minute that private-equity shops are very sophisticated and that they don’t just buy, leverage, and flip. But I do think that in today’s environment of abundant liquidity and razor-thin spreads, it’s easier, not harder, to buy, leverage, and flip than it was five or 10 years ago. What makes Mr Nelson think that such a strategy can’t work any more? It certainly seems to be the main ingredient in most of the PE deals which hit the headlines, and which are nearly all funded with vast amounts of debt to layer on top of the debt which already exists in the target company.

Even a spectacular subprime wipeout like ResMae has value: Citadel is buying it out of bankruptcy for $180 million.

I don’t see any answer to the biggest question of all, though: Will Citadel still be forced to buy back loans which ResMae originated and which went immediately into default, or loans which were fraudulently misrepresented by ResMae to investors when ResMae securitized them?

It seems to me that originators going bust is one of the biggest risks in the subprime MBS market at the moment. How big is that risk, now, in the wake of the ResMae outcome?

(Incidentally, do not, under any circumstances, confuse Citadel and ResMae with Cerberus and ResCap. I know, it can get confusing.)

Back in January, I found a wonderful paper by the New York Fed’s James Vickery which showed that homebuyers are very, very sensitive to the details of the mortgages offered to them by banks. If fixed-rate mortgages rise by just 10bp, that reduces their market share by more than 10 percentage points. Though they may not know it, mortgage buyers turn out to be incredibly sophisticated financial consumers — at least, they certainly act as though they are.

Now, thanks to Christian Menegatti, I’ve found another paper, this time by Tomasz Piskorski and Alexei Tchistyi of NYU. This one shows that the explosion in option-ARMs and other exotic mortgages actually makes perfect sense, from an economic point of view:

This paper studies optimal mortgage design… We show that the optimal allocation can be implemented using either a combination of an interest only mortgage with a home equity line of credit or an option adjustable rate mortgage. Under the optimal contracts, mortgage payments and default rates are higher when the market interest rate is high. However, borrowers benefit from low mortgage payments and low default rates when the market interest rate is low. Thus, our analysis provides theoretical evidence that these alternative mortgages, which have recently generated great controversy, can benefit both lenders and borrowers.

In other words, maybe the very low default rates of the past were actually economically suboptimal. I’m sure that the default rate on 2006-vintage subprime loans has swung the pendulum too far in the opposite direction. But let’s blame underwriting standards for that, not the structure of the underlying mortgages.

Brad DeLong asks a question and then, well, doesn’t answer it:

If an investor today did wish to insure against geopolitical catastrophe, how would he or she do so?…

The principal risk I see today is that being borne by investors in dollar-denominated debt — and I don’t believe they are charging a fair price for what they are doing. But a quarter of my brain wonders how investors should attempt to insure against the lowest tail of the economic-political distribution, and that quarter of my brain cannot see which way somebody hoping to insure against that risk should jump.

He does note that there’s even, theoretically, some upside risk to an uptick in global risk aversion:

If people are risk-averse enough that increased fear of the future causes them to save more, rising global uncertainty will raise bond and stock prices, and lower interest rates and dividend and earnings yields.

In any case, let’s say that DeLong is right, and investors in dollar-denominated debt should get out early while they can. Where should they go in a world where “uncorrelated assets are not correlated“? If you believe the likes of Jerome Booth, at Ashmore, the answer’s easy: domestic-currency emerging-market debt. But that’s pretty hard to invest in, outside Mexico — and Mexican local debt is down 4.3% this year. Maybe we should all invest in euro-denominated bonds instead. But are they really uncorrelated with US bonds? And are they really a good bet in a rising-interest-rate environment?

As chief executive of HSBC USA, Martin Glynn was at the forefront of the mortgage revolution: his company brought the joys of homeownership to thousands of individuals who might never have been able to get a mortgage in the past. With ownership comes equity, a place on the property ladder — and, of course, the prospect of serious price appreciation.

Which is why it’s kinda interesting that we find out today from Footnoted that Glynn’s own mortgage was — well, he didn’t have one. And not because he bought in cash. But rather because he clearly thought it smarter to rent his apartment, at a cost of $14,800 per month. Did he think that the housing market was going to crash and that he’d be better off renting? Did he know that he’d be canned at the end of 2006? And what of his lieutenant, Brendan McDonough, who also rented his apartment — and got a bargain price of just $6,250 per month?

McDonough and Glynn even managed to get HSBC to pay their rent for them — nice! By the time that the bank threw in a “tax gross-up” and a “housing and furniture allowance”, Glynn got $327,600 and McDonough got $259,000 towards housing they didn’t even own. I wonder what their borrowers thought of the fact that their lenders were staying well away from the housing market themselves.

Palm, the maker of the Treo, has long been rumored to be a takeover candidate. The latest rumblings started last Wednesday, with a story saying that Palm might be bought by Nokia, or by a private-equity shop. Weirdly, the stock went absolutely nowhere either on Wednesday or on Thursday, but gapped up on Friday morning, prompting coverage in today’s WSJ — just in time to see the shares plunging 7.5% in early trading.

Why the fall? Well, since the world revolves around me, it’s clearly because I spent far too many fruitless hours on Saturday stuck in both the Apple Store and at home, trying to get my MacBook to sync with my Treo. Even Missing Sync, a $40 piece of software designed to fix all the horribles built in to the Mac-Treo interface, couldn’t fix my problems, and I’m now more determined than ever to get an Apple iPhone the minute they’re released. And that’s not an easy decision to make, given its price ($500) and the fact that I’ll have to return to the Satanic Cingular AT&T.

The Treo was a great product when it was released, but has only seen minor improvements since then, while competitors such as Nokia and Motorola — not to mention Apple — were storming ahead. Given that the forthcoming Treo 750 won’t even have wifi, I’m not sure why anybody would want this lemon of a company. But there’s no doubt in my mind that new ownership and new management can only improve matters.

Roddy Boyd tries to do some subprime math in the New York Post today, but I don’t quite follow his thread:

The subprime mortgage market collapse just might give private-equity titan Cerberus a headache for the forseeable future.

As the headlines mount about woes in the subprime sector, Park Avenue-based Cerberus’ 51 percent stake in GMAC – the owner of a massive subprime mortgage portfolio – is looking increasingly problematic.

With its GMAC stake, Cerberus also got one of the largest subprime players: a lender named ResCap Capital.

Cerberus, along with Citigroup and Aozora Bank, acquired the GMAC stake in November for $7.9 billion…

ResCap has $57 billion in subprime loans on its books as of Sept. 30, or a staggering 77 percent of a $73 billion portfolio…

Late last week, a Lehman Brothers analyst argued in a statement that GMAC* might have to reduce its book value by up to $950 million because of mortgage delinquencies.

If Cerberus’ consortium used standard financing, then the consortium likely put up around $1.58 billion in equity. If GM takes a write-down of $900 million to $950 million, Cerberus and its investors might have to write down up to $990 million – more than 50 percent of the initial equity investment.

Let’s say for the sake of argument that the Lehman report is spot-on. That would mean that probably the largest subprime portfolio in the world has total losses of less than $1 billion: big, to be sure, but hardly a systemic threat. After all, $950 million is just 1.3% of a $73 billion portfolio.

What I don’t understand is how a $950 million write-down at GMAC could correspond to a $990 million write-down for investors owning 51% of GMAC. Surely if they own half the company, they should take half the write-down? What am I missing here?

(Via)

*UPDATE: jck, in the comments, finds a CNBC piece which explains things: it’s GM, not GMAC, which is could see the $950 million write-down. So if GM, with 49%, writes down $950 million, then Cerberus, with 51%, could be forced to write down almost $990 million. Problem solved!

UPDATE 2: Murray, in the comments, has actually gone to the trouble of tracking down and, you know, reading the famous Lehman report. Go read his comment for the full skinny, but the upshot seems to be that (a) Cerberus’s downside is actually de minimis, and that (b) Roddy Boyd “Just. Doesn’t. Get. It.” So, basically, ignore the whole thing. GM might lose money on GMAC, Cerberus won’t.

Giuliani Capital Advisors, the boutique investment bank which Rudy Giuliani bought from Ernst & Young 27 months ago for $9.8 million, has now been sold, to Australia’s Macquarie. We knew this was going to happen; the big question was how much it would go for.

Dealbook recycles an old NYT story which said, implausibly, that the bank could sell for more than $80 million. But the WSJ doesn’t even hazard a guess. As for the press release, it says only that “the transaction will not have a material impact on

Macquarie’s balance sheet”.

There’s a great deal I don’t understand about Gretchen Morgenson’s column on Sunday, about mortgages. If nobody understands the mortgage market, how is she so sure that it’s a train wreck, and that the decline in the mortgage securities index is not an overreaction? She concedes that MBSs are “far tougher to value than other securities” — but she seems pretty darn confident that she knows what way the mortgage market is going. She also seems convinced that loss mitigation procedures — where mortgages in default are renegotiated — are a bad thing. Here’s how her column ends:

Academic studies suggest that within the first two years of a workout, re-defaults can approach 25 percent…

No one likes to face ugly realities like financially ailing borrowers who are so strapped that nothing can save them. Not the lenders, not the Wall Street firms that sell the securities, not even the holders. But experienced investors know that a reliance on fantasy will only prolong the pain that is racking the huge and important mortgage market.

If re-defaults are less than 25%, doesn’t that mean that workouts succeed more than three-quarters of the time? And does Morgenson really think that all of Wall Street is deluding itself, because it doesn’t like “to face ugly realities”? The one thing that you can be sure of is that if Wall Street smells blood, nothing will stop its sharks from attacking. And so far MBSs have been relatively unscathed: the triple-B indices are down, to be sure, but the underlying securities are doing much better. Is it really true that the MBS market, as opposed to the mortgage-origination business, is racked with pain?

I’m not sure myself of the answers to these questions, but I’m told that Josh Rosner, the chap who seems to have been Gretchen’s main, if not only, source for this column, might be willing to talk to me too. So if you have any questions for Mr Rosner, let me know. First on my list: What is the relationship between default rates and MBS prices? Most of the commentary on the MBS market seems to be predicated on the idea that it’s very simple, and that if default rates go up, then MBS prices should plunge. Is that true?

John Quiggin is getting his razor out; the least you can do in response is get your wallet out. I will be most disappointed if the blogosphere doesn’t propel him easily into the Top 30.

Rob Cox, at Breaking Views, reckons that Warren Buffett (read his annual letter to shareholders here) is going to have difficulty finding someone to replace him as chief investment officer.

Here’s Buffett:

I intend to hire a younger man or woman with the potential to manage a very large portfolio, who we hope will succeed me as Berkshire’s chief investment officer when the need for someone to do that arises. As part of the selection process, we may in fact take on several candidates…

Being able to list Berkshire on a resume would materially enhance the marketability of an investment manager. We

will need, therefore, to be sure we can retain our choice, even though he or she could leave and make much more money elsewhere.

There are surely people who fit what we need, but they may be hard to identify. In 1979, Jack Byrne and I felt we had found such a person in Lou Simpson. We then made an arrangement with him whereby he would be paid well for sustained overperformance. Under this deal, he has earned large amounts. Lou, however, could have left us long ago to manage far greater sums on more advantageous terms. If money alone had been the object, that’s exactly what he would have done. But Lou never considered such a move. We need to find a younger person or two made of the same stuff.

And here’s Cox:

Though Buffett has not revealed what Berkshire would be willing to pay to fill the post, he hints it will not be commensurate with the industry: “he or she could leave and make much more money elsewhere.” It’s easy for Buffett to say this. As the owner of so much Berkshire stock, for decades he has essentially given his prowess at allocating assets to the rest of the company’s shareholders more or less for free.

Cox then compares Buffett’s investing acumen with that of Edward Lampert, whose 1-and-20 hedge fund made him the first hedge fund manager to make $1 billion in one year. “Surely,” says Cox, “this would fly in the face of Berkshire’s anti-croupier culture.”

Cox is half-right: Buffett will not get, nor does he want, a would-be billionaire, let alone someone who aspires to earn $1 billion in one year. But that does not mean he won’t find what he’s looking for — I’m thinking here of someone like David Swensen, of Yale, who seems to be perfectly happy making $1.3 million per year.

It might seem weird to Rob Cox, but there are in fact people who understand the concept of diminishing marginal utility. Once you have $20 million or so in the bank, especially if you’re a halfways-decent investor, you’re very unlikely to spend all your money — certainly if you live the kind of life that Warren Buffett would admire. So from that point on you really don’t need to make any more: the money stops being something to spend, and starts being a way to keep score. There are many people out there who value a great job at Berkshire Hathaway and their own personal happiness above that desire to beat the next guy in the personal-wealth stakes. And if anybody can find them, Buffett can.

Understanding mortgage-backed securities is hard. They don’t behave like normal fixed-income instruments: even now, with subprime defaults soaring, the big risk on MBSs is prepayment, not borrower default. And research on MBSs frequently includes passages like this:

6-wala FN 6s have a gross WAC of 6.66%, while 10-wala FN 6s have a gross WAC of only 6.46%. But could 20bp of WAC explain why the 6-wala pools are prepaying at 19 CPR while the 10-wala pools are prepaying at 13 CPR? The short answer is no.

Got that? I’ll explain it to you if you want: people with mortgages written 6 years months ago are much more likely to refinance or otherwise prepay their loans than people with mortgages written 10 years months ago. Part of the explanation is that they took out their loans at higher interest rates, so they have more incentive to refinance. But that can’t be the whole explanation.

But all that is pretty much beside the point. My bigger point is that MBSs are a world unto themselves, and you can’t just jump willy-nilly from the fact that default rates are rising to the conclusion that the world of MBSs is doomed. In fact, the fact that default rates are rising is consequence largely from the fact that it’s becoming increasingly difficult for subprime borrowers to refinance. And fewer refinancings means fewer prepayments — and fewer prepayments could mean that subprime MBSs are actually more attractive than they were. Here’s Merrill Lynch:

Remember the good old days when lower credit borrowers were assumed to be slower in speed? When borrowers with high LTVs found it difficult to refinance or take cash out? When alt-A premium mortgage pools traded with a premium in price?

All of these ideas were predicated on the concept that a borrower who had low documentation, worse credit, or high LTV, either did not have as many opportunities to refinance or were on average less financially sophisticated and consequently less aware of movements in interest rates.

Over the past few years, however, this principle was stood on its head. With home prices rising relentlessly and lending standards generally easing over time, these borrowers became among the faster prepaying loans. They were eager to take cash out and/or trade up, and they were certainly the target of numerous mortgage solicitations by brokers. In contrast, more traditional prime borrowers who had less need for cash were likely to prepay slower during this period.

Are we drawing to the close of this rather remarkable period? Now that everyone is promising tighter underwriting standards, it seems likely to us that prepayments on more marginal borrowers are likely to decline as well. This suggests that premiums backed by these pools may once again turn out to have value.

I’m not saying that subprime MBSs are a screaming buy — and neither, I hasten to add, is Merrill Lynch. But this kind of dynamic is worth bearing in mind before anybody starts jumping to conclusions about the effect of rising default rates on the market in mortgage-backed securities. Norris, I’m looking at you.

Lars Toomre (via Alexander Campbell) thinks that yesterday’s SEC actions are just the first shoe dropping:

Toomre Capital Markets strongly suspects that more forthcoming enforcement actions will be filed in connection with the use of credit-default swaps and the use of inside information. The SEC’s unprecedented sweep of Wall Street’s equity trading records for the last two weeks of third quarter of 2006 coupled with information requests about prime brokerage funding activities during that period strongly suggests that certain leverage players (i.e. hedge funds) are going to have to explain why they were trading in certain securities just ahead of market moving corporate actions. TCM has no idea whom exactly is involved. However, CDS spreads have been moving too much ahead of unusual corporate events.

The issue of CDS spreads moving ahead of private-equity deals is known, and is a big one. To quote myself:

LBOs, by their very nature, need a lot of debt. That debt comes from banks and, increasingly, from hedge funds. And when those banks and hedge funds provide debt financing for an LBO, they hedge their positions in the CDS market, driving prices up.

But I am far from sure whether this kind of thing is likely to get prosecuted by the SEC. For one thing, it won’t show up in a “sweep of Wall Street’s equity trading records,” since equities aren’t involved in these trades. But much more to the point, hedge funds aren’t “going to have to explain why they were trading in certain securities just ahead of market moving corporate actions,” because CDSs aren’t securities.

So I’d love to ask the question, if anybody can help: Let’s say, for the sake of argument, that there was a cut-and-dried case of a hedge fund loaning money into a private-equity deal, and hedging that exposure in the CDS market before the deal was made public. First, does such activity fall within the purview of the SEC, and second, in any case, is it actually illegal?

You can’t have missed the insider-dealing news at this point. Just look at the SEC go!

Federal authorities said that they had exposed one of the most far-reaching insider trading schemes on Wall Street in decades, involving four investment banks and a web of hedge funds, day traders, lawyers and even a few supervisors, who upon discovering evidence of insider trading, blackmailed the traders to keep quiet about it…

Linda C. Thomsen, chief of enforcement at the Securities and Exchange Commission, described the scheme as one of the most “pervasive Wall Street insider trading rings since the days of Ivan Boesky and Dennis Levine.”

But what’s missing here? It takes over 600 words before the NYT bothers to tell us how much money is involved in this “far-reaching case” — and DealBook never tells us at all. Do you think that’s because, well, the amounts of money involved are pissant? The biggest crimes netted $6 million over 5 years; the smallest, just $9,500.

Check out the video of the SEC’s press conference: the deals they talk about netted profits of between $10,000 and $50,000. No wonder you’ve never heard of any of the hedge funds involved in this scheme: that kind of money might be nice for an individual, but it’s not going to do much for a big hedge fund’s total returns.

In other words, this is not Boesky II, no matter how hard the SEC tries to spin it that way. Of course, the SEC has a mandate to go after insider dealing no matter how big or small. But this particular scheme looks like it’s more the latter than the former.

Dean Baker is upset at the New York Times today. Apparently it’s running an article

which reports without comment Treasury Secretary Paulson’s assertion that free trade has been a cornerstone of U.S. prosperity and warning against protectionist barriers.

Baker doesn’t like this: He thinks that every time such comments are reported, the NYT should step in and note that the US could have even freer trade, especially in white-collar services.

But the really weird thing is that Baker is studiously avoiding a front-page article by Steven Weisman with the headline “A Cry to Limit Chinese Imports Rings at Paper Mill“. Here’s the lede:

For years the residents of this economically distressed hollow in the Appalachians have watched textile mills, glass factories and tire makers close down one after the other. Now its lone remaining big factory — “the last man standing,” as the production manager at the paper mill here put it — is threatened by imports of cheaper paper made in China.

“We’re still the economic engine for this whole area,” said Scott Graham, the production manager, referring to the river valley and forested hills surrounding the mill. “But our operations cannot compete with these below-cost imports.”

The story continues in a similar vein for over 1,700 words, and is very, very sympathetic to the protectionists. Here’s Weisman a bit further down, for instance:

Many lawmakers say it is time to stop treating China with kid gloves, arguing that Beijing no longer deserves a free ride in which it benefits from a special exemption generally forbidden to Japan, Europe and other advanced industrial powers.

He quotes lots of people on that side of the debate, but not a single individual on the other side. The closest he comes is quoting a lawyer for China, near the end of the article, saying that if the paper tariffs are imposed then steel tariffs are likely to come next.

He even implies that the tariff-raising policy might be coming from — wait for it — Hank Paulson:

Some in Congress also see the China actions as a sign that Mr. Paulson, who resigned as chief executive of Goldman Sachs to become Treasury secretary last summer, realizes that his policy toward Beijing is faltering…

“When Paulson came in, he thought all you have to do is talk logic with the Chinese,” said Senator Charles E. Schumer, Democrat of New York and a vociferous critic of China. “They talked very nicely and gave him ice in the winter. Now he’s learning that you have to be tougher. It’s not like doing a deal with Goldman Sachs.”

A spokeswoman for Mr. Paulson, Brookly McLaughlin, said that the dialogue was “not designed to replace other bilateral negotiations or the necessary enforcement of our trade laws.”

Now, I don’t know what Dean Baker thinks of this article, or whether he thinks that punitive tariffs on Chinese paper imports are a good idea. But I think that today, of all days, is not the best day for bashing the NYT for being too cozy with the “free trade” brigade.

There seems to be a lot of bellyaching from various pundits about equity bridges — one of the more startling innovations in the world of private-equity capital structures. Here’s Andrew Ross Sorkin explaining it, and putting the knife in at the end:

The arrangement allows leveraged buyout firms to buy companies with even less cash upfront. The idea is that the leveraged buyout firms will find other investors to ante up cash after the deal is announced.

These bridges can lead to trouble, however. 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.

“This is how things blow up; people take more risk,” said Andy Kessler, a former research analyst and hedge fund manager who has written books about Wall Street. “If you go back to the crash of 1987, all the banks had huge bridges that went bust.”

Blogging Stocks, Dealscape, and many others are taking much the same line: look at this risky risk! Which isn’t even being priced properly! Here’s Breaking Views:

Only a few deals have had equity bridges. So investment banks haven’t really learned how to price them. Some banks have charged close to nothing – what bankers facetiously call “fee break-even.” Some have syndicated equity for free just to get the other deal fees.

But Sorkin eventually comes clean on why equity bridges in fact aren’t nearly as risky as they look at first sight:

In the case of TXU, Kohlberg Kravis and Texas Pacific are expected to invite their limited partners — the investors in their own funds, like big pension plans — to invest directly in this deal. By investing alongside the private equity firms, these investors can share in the rewards if the deal pays off without paying the same enormous fees to the firms that they typically do to invest in their funds. Private equity firms offer direct investment as an inducement to also invest in their funds that do carry fees.

The point here is that the limited partners in private equity funds, pretty much by definition, expect to get impressive returns net of those funds’ fees. And now those limited partners are being offered the opportunity to get gross returns on top of that. Given that private equity funds are having zero problems raising capital at the moment, I can’t for a minute see how any of them are going to have any difficulty syndicating the equity. It’s much more likely that their problem will be with aggrieved limited partners who aren’t able to get in on the deal.

If the bridge were to public equity, then it would be far riskier, since it would involve trying to syndicate something which was already traded on the markets. But that’s not an issue. So the only real risk here is that between the deal closing and syndication, some kind of huge event will hit the sector concerned, and that the limited partners will balk at coming into the deal at its initial valuation. But my guess is that the amount of time between the deal closing and syndication will be measured in days. The investors aren’t really buying into the specific equity risk, so much as they’re buying into the private-equity shop’s reputation for generating high returns.