Felix Salmon

Counterparties: Reservations about reserves

Ben Walsh
Jul 31, 2012 23:00 UTC

Welcome to the Counterparties email. The sign-up page is here, it’s just a matter of checking a box if you’re already registered on the Reuters website. Send suggestions, story tips and complaints to Counterparties.Reuters@gmail.com

Banks currently have $1.5 trillion in excess deposits at the Fed, earning 0.25% — a reasonably healthy amount, in a world where T-bills yield even less. So why would banks want to move money out of the Fed and lend it into the economy? It’s possible that even the latest rumblings of new Fed actions to boost the economy may not have much effect, because the real anchor holding down growth is sitting in the Fed’s own vault.

That’s the core of Bruce Bartlett‘s diagnosis. For Bartlett, with interest rates already so low, the remedy lies elsewhere:

The Fed can penalize banks for holding excess reserves by charging them interest rather than paying them interest. This has been done in other countries. From July 2009 to July 2010, the central bank of Sweden charged banks 0.25 percent on their reserves, and on July 5 the central bank of Denmark announced that it would begin charging an interest rate of 0.2 percent on reserves.

In effect, this reduces the real interest rate received by banks and thus, ironically, would ease monetary policy and encourage bank lending.

Bartlett is pushing banks to get excess capital out of the Fed and into the economy. If bankers are “traveling money salesman” and the Fed stops paying interest on their excess deposits, why not give them a new task: hit the road and start hawking loans to customers.

Mike Shedlock disagrees with Bartlett: penalties on excess reserves “sure would get banks to do something, but that something might not necessarily be lending! For example, banks might bet against the US dollar, bet on gold, plow into the stock market, etc.” For Peter Stella the argument boils down to a misguided beliefs that excess deposits and lack of credit are connected. Reducing excess deposits, he argues, would actually cause credit to contract. Michael Pento thinks Bartlett’s idea would lead to more lending, but the wrong kind. Banks would “[shove] loans out through the drive-up window with a lollipop… They will be forced to take a chance on loans to consumers, at the exact time when they should be getting rid of their existing debt”.

Allen Binder thinks the British are on the right track in tackling a lack of lending from a different angle: Instead of penalizing excess reserves, “the more a bank lends, the more it saves on funding costs [from the Bank of England]… no bank is forced to lend, nor told what loans to make”. – Ben Walsh

On to today’s links:

EU Mess
Greece is on the brink of bankruptcy, with “cash reserves [at] almost zero” according to finance minister – Reuters

New Normal
Just 54% of Americans 18-24 were employed last year, the lowest level since data has been kept – FT
Bill Gross: The “cult of equity is dying”. Lenders, labor and the government will get returns – Pimco

Plutocracy Now
There’s just no place like America to be a billionaire – Mother Jones

When Regulators Stop Being Polite
Geithner: Fannie and Freddie’s refusal to use targeted principal reductions is not “the best decision for the country” – Treasury Department
DeMarco: Principal reductions do not improve foreclosure avoidance or reduce taxpayer costs – Federal Housing Finance Agency
DeMarco has “a deep aversion to reducing principal” that is common among bankers and lenders, and he should step aside – Jared Bernstein

Shares of companies with women on their boards outperform similar companies with all-male boards by 26% – Bloomberg

“We have no patience for mystery. We want the deciphering of gods. We want oracles … right now” – Ta-Nehisi Coates

The “linchpin of [Romney's] economic strategy is to further enrich the richest 1%” – American Progress


Banks DO NOT LEND RESERVES! Bank lending IS NOT RESERVE CONSTRAINED!Hoping to “force” banks to lend by penalizing them for holding exess reserves is the hight of stupidity. Anyone who considers such proposals knows nothing about banking. Bank lending is only constrained by: 1.Presence/lack of creditworthy borrowers 2. Capital reqiurements. That’s all that matters.

Posted by DLT | Report as abusive

Principal reductions: DeMarco vs Geithner

Felix Salmon
Jul 31, 2012 20:36 UTC

It’s Ed DeMarco vs Tim Geithner today, on the subject of principal reductions, and the fight is getting ugly.

DeMarco, in a letter to Congress, explains that the Treasury has put a lot of effort, and is willing to put very large sums of money, into something with the rather unwieldy name of HAMP PRA, where PRA stands for Principal Reduction Alternative. But here’s the thing: PRA is going to get nowhere unless Fannie and Freddie sign up for it. And they can’t sign up for it until DeMarco signs off on it. And DeMarco is refusing to sign off on it.

DeMarco has released a 15-page paper explaining his decision, although in reality his letter, and the reasoning in it, is much clearer. He basically says that principal reductions would be costly to implement, and he doesn’t have a lot of time for Treasury’s offer to pick up the tab: “although principal forgiveness may provide some financial benefit to Fannie Mae and Freddie Mac,” he writes, “it presents operational challenges for them and their servicers as well as a risk of loss to the taxpayer”. It’s not his job to worry about costs to Treasury or taxpayers generally — but he’s making it his job.

But the main thrust of DeMarco’s argument is less financial than it is moral. Any kind of principal-reduction strategy risks encouraging strategic default, and DeMarco hates the very idea of strategic default. And even if there’s no strategic default at all — and the letter from Geithner makes a very strong case that strategic defaults as a result of this plan would be de minimis — DeMarco still hates principal reductions on, well, principle:

Perhaps the greatest risk of the Enterprises’ allowing principal forgiveness is one with far more significant long-term consequences for mortgage credit availability. Fundamentally, principal forgiveness rewrites a contract in a way that other loan modification programs do not. Forgiving debt owed pursuant to a lawful, valid contract risks creating a longer-term view by investors that the mortgage contract is less secure than ever before. Longer-term, this view could lead to higher mortgage rates, a constriction in mortgage credit lending or both, outcomes that would be inconsistent with FHFA’s mandate to promote stability and liquidity in mortgage markets and access to mortgage credit.

This is a classic “parade of horribles” argument, and it’s not a particularly strong one, either. As Jared Bernstein says, “in unusual times, like the aftermath of the worst housing bubble implosion in decades with 30+% price declines, guess what? Write downs happen.”

But the weirdest thing about this argument is that the horribles aren’t particularly horrible. Higher mortgage rates? Um, fine: no one is exactly complaining that mortgage rates are too high right now. A constriction in mortgage credit lending? That’s fine too: it was too-lax credit lending that caused this whole problem in the first place. Both together? Even that’s fine: it would help bring homeownership rates down from their current too-high levels, and encourage more people to rent rather than own, creating a more flexible national labor force.

The fact is that while it’s imperative that we fix the problem of broken mortgages issued at the height of the credit bubble, the last thing we want to do is return to those days and tell anybody who wants a house that they can just go out and buy one, whatever their creditworthiness or cash position. If you want to make mortgages safer, you should ensure that homeowners have large amounts of positive equity in their homes. That means significant down-payment requirements for people buying houses. And it also means significant principal reductions for those who are currently underwater.


There are alternative rules for HAMP loan modifications with and without principal reduction. Under principal reduction there are additional alternatives where the lender can reverse the order of certain steps. And any of these sets of rules will find a way to lower the payment to 31% of income.

For a while I’ve had an Unofficial HAMP loan modification calculator up at http://www.armdisarm.com that can calculate these various rules. It is totally free, and the source code is available under the GNU public license.

While a tool like this can not answer the fundamental questions, it can be used to gain some experience with how the various rules might operate.

Posted by DrPaulBrewer | Report as abusive

How Pimco works

Felix Salmon
Jul 31, 2012 17:08 UTC

There’s an anonymous troll on the internet who doesn’t like my latest Pimco post. And frankly it’s really hard to take any post seriously when it’s tagged “born last night, clown questions, gmafb, horseshit, STFU”. This kind of macho bullying posturing is everything I hate about Wall Street — a place which is still home to far too many overconfident frat boys with overstuffed paychecks.

So, why am I rising to the bait? Mainly because some people I respect are taking the post seriously. And also because, hidden behind the sophomoric grandstanding, there are actually a couple of substantive points being made.

To take them in order, then:

Firstly, does Bill Gross pay himself, or is he “paid by the parent company that bought his firm”? I haven’t seen a lot of reporting on this, but everything I know about Pimco says that it’s a very arm’s-length, largely independent unit of Allianz. It certainly dividends profits up to its parent, but I don’t actually believe nor have I ever seen it reported that Allianz executives make granular decisions on how much Bill Gross, or any other Pimco employee, gets paid on a year-to-year basis.

Is there a formula governing Gross’s remuneration, based on some combination of Pimco revenues, Pimco profits, and the performance of the funds he manages? I’m sure there is. And if you want to reverse-engineer a way for Gross to have been paid $200 million in 2011 despite massively underperforming that year, then that’s surely the way to get there. Pimco doesn’t want to encourage short-term gambling among its employees, and so its pay is based on long-term performance rather than year-to-year fluctuations; Gross’s long-term performance remains excellent, and he manages an astonishing amount of money. And on top of that, Pimco is attracting spectacular inflows these days.

Still, Pimco told me that the numbers in the original NYT article were “seriously inaccurate”, and I’m quite sure that Gross, given his position in the company, does have a certain amount of discretion when it comes to divvying up the remuneration pool. He might not “have to answer to congress or a goofball parade of Occupy Wall Streeters”, but he’s still a leader — and even if we don’t know for sure how much he got paid last year, a lot of big-time money managers in the company know exactly what example he is setting. If they would risk getting fired after turning in such dismal performance, then it would be downright hypocritical — and bad for the cohesion of the senior management team — were Gross to accept a $200 million paycheck in such a bad year.

And how about the people whose money Pimco is managing? Yes, it’s easy to say that they’re sophisticated investors who “pay an agreed upon and transparent management fee up front” — but that doesn’t mean they’re happy with the fees they’re paying, especially not if they start reading about $200 million paychecks. And in a world moving swiftly away from the fund model and toward the lower-fee ETF model, it behooves any long-only money manager to keep a very close eye on fees and costs. The level of money-skimming which maximizes your payday this year is not necessarily the best way to keep on building your company’s franchise over the long term, especially in a world where index investing is becoming increasingly popular.

As for the assertion that long-only “buy siders that actually run portfolios north of 200 billion are paid at this level” — well, name some names. It’s a very short list, of course. But if you can find one or two other people who were paid $200 million a year for managing funds, and who weren’t hedge-fund managers collecting 2-and-20, then I’d be much more likely to believe that Gross is paid that much, too.

Next up comes a question about Mohamed El-Erian’s tenure at Harvard Management Company. I quoted an article about how “Mohamed was having a heart attack” while he was there, because Larry Summers insisted on taking Harvard’s spare cash and investing it in an endowment which was designed to have a virtually infinite time horizon. As a result, El-Erian’s job when it came to liquidity management was made extremely difficult. But now I’m told “this isn’t true”, on the grounds that all El-Erian needed to do was “explain” to Summers and others “that their allocation was inappropriate”, and then sleep well at night since the “allocation was made by Harvard officials not by Harvard Management.”

Maybe anonymous Wall Street trolls think that way, and wouldn’t worry about Harvard’s liquidity needs even if Harvard was effectively using them as a checking account. But a responsible money manager worries about liquidity every day, especially in a situation where Harvard can and will ask for large sums of cash on a regular basis. In any case, my larger point was that El-Erian can’t be blamed for liquidity problems after he left HMC, and there doesn’t seem to be any disagreement on that front.

Then there’s the question of the degree to which El-Erian’s ubiquity in the media is a Pimco marketing strategy, responsible for the large increase in assets that Pimco is seeing these days. I’m informed that the answer is a simple yes — but if that’s the case, that has interesting implications. A large chunk of Fabrikant’s article was based on the premise that Pimco’s investors wanted Gross’s bond-trading expertise, rather than El-Erian’s technocratic global-macro insights. But if indeed El-Erian’s regular TV appearances and various op-eds are responsible for the hundreds of billions of dollars which continue to flow into Pimco, then it seems that there’s a lot of appetite out there for a macro-led, rather than a trading-led, strategy.

On top of that, it’s notable that Gross, the great bond trader, has started to underperform Pimco as a whole, where investments are based very much on the global macroeconomic outlook. Pimco’s more than big enough for both Gross and El-Erian, of course. But the idea, in Fabrikant’s piece, that Pimco is effectively still Gross’s shop, and risks withering away were he ever to leave — that idea is pretty effectively demolished if in fact El-Erian’s media strategy is responsible for bringing in enormous amounts of new money. Certainly El-Erian never talks about trading strategies in such appearances.

Finally, there’s the question of Blackrock, a much bigger fund manager than Pimco, where, incidentally, the CEO, Larry Fink, was paid $21 million in 2011. How did Blackrock grow so big? In large part by buying a lot of index funds, thereby diversifying into one of the fastest-growing investment strategies in the world. And also, in part, by being a public company. And so I asked a question, and received an answer:

In order for Pimco to effectively compete with Blackrock, will it too have to go public?

No. How is that even a question? They are a wholly owned subsidiary of a firm that is significantly larger than Blackrock which allows them tremendously cheap financing if they need it. Allianz’s insurance assets also provides them with 23% of their AUM. Does JP Morgan Asset Management, SSgA, or Deutsche Bank Asset Management (all well over a trillion in AUM) need to spin off and IPO to compete with Blackrock?

I wasn’t suggesting that Pimco spin off from Allianz. But Pimco already has “shadow equity” which is traded among Pimco employees; there’s no reason that it couldn’t get listed as some kind of tracking stock. And that tracking stock could be a very valuable acquisition currency as Pimco seeks to diversify away from its historical core competence of actively-managed bond funds. There are many reasons why Pimco might well prefer to do things that way, rather than asking Allianz for “tremendously cheap financing” for an acquisition.

I’m sure that Pimco gets lots of value from having Allianz assets at its core. But Pimco is also reported to be “seeking more independence from its parent”, and in any case I don’t think it’s true that Pimco is wholly owned by Allianz, which bought only 70% of the company back in 1999.

My point about Blackrock is that by having its own stock and being master of its own strategy, it has managed to diversify, and grow, more quickly and effectively than Pimco has. Here’s a germane quote, from last year:

“The history of the asset-management business demonstrates time and time again that the most successful asset-management firms are those who are dedicated to investing rather than subsidiaries of banks and insurance companies where there can be lots of tension,” Burton Greenwald, a fund-consultant based in Philadelphia, said in an interview. “Fund companies tend to be entrepreneurial, while banks and insurance companies tend to be bureaucratic.”

There’s a case to be made that Pimco has in fact thrived under Allianz’s ownership — but it’s unclear whether that’s a function of Allianz being a great owner, or whether it’s a function of the fact that those years saw the greatest fixed-income bull market of all time. That bull market is going to come to an end at some point. And when it does, Pimco wants to be positioned much more evenly across various different asset classes and strategies than it is now. In order to do that, it’s not a completely horseshit clown question to ask whether it might want to take a leaf or two out of Blackrock’s book.

Update: David Merkel adds some very useful facts to the debate.


I think people focus on the “amount” that Bill Gross gets paid rather than the value that he brings to PIMCO / Allianz or Bill’s opportunity cost (how much he could be making elsewhere). By these measures, I calculate he significantly is underpaid at $200M or less per year. While I made a lot of big assumptions, my back of the napkin math suggests that Bill Gross should be getting paid in range of $700 – $1 billion per year. The math is described in the article:

http://www.learnbonds.com/bill-gross-com pensation/

Also, we have a poll – how much do you think Bill Gross should be paid?

http://www.learnbonds.com/bill-gross-sal ary/

Posted by LearnBonds | Report as abusive

Counterparties: Sandy beached

Ben Walsh
Jul 30, 2012 22:31 UTC

Welcome to the Counterparties email. The sign-up page is here, it’s just a matter of checking a box if you’re already registered on the Reuters website. Send suggestions, story tips and complaints to Counterparties.Reuters@gmail.com

After Sandy Weill had his say on breaking up big banks last week, backlash to his reversal was inevitable. It turns out Bank of America and Citi had already considered his idea: Execs at BofA studied breaking out troubled Countrywide Mortgage, which has been called the worst deal in finance history, as well Merrill Lynch’s securities business. Citi, apparently at the behest of regulators, did a similar analysis and even employed Bain to conduct it. The bank concluded that tax inefficiencies precluded a breakup; they have yet to pursue changing the tax code with the same vigor they applied to abolishing Glass-Steagall.

Somewhat paradoxically, BofA decided Countrywide was too bad to let go and that Merrill was too profitable to part with. The latter is just wrong, according to their own filings, as Jonathan Weil smartly points out: “Last quarter Merrill reported a net loss of $1.6 billion. It posted a $1.7 billion net loss for all of 2011″.

Before Weill made his comments, Jamie Dimon had already said that he doesn’t think any of JPMorgan’s business would be better off independently. He’s probably unlikely to take advice from a guy who once fired him said. Former JPMorgan Chairman and CEO William Harrison chimed in on the merits of Dimon’s firm with this faintest of praise: “you can screw [management and risk-taking] up at a small bank or a large bank”.

The WSJ reports that Dodd-Frank’s two eponymous lawmakers don’t agree with Weill: Former Senator Chris Dodd thinks Weill is “frankly too simplistic”; Representative Barney Frank says doing “something drastic to a major part of the economy isn’t a very good idea” right now.

Had Weill spoken up a few years ago, Frank says he would have been all ears. And there are also who think Weill hasn’t even started to address his past mistakes. Here’s the Roosevelt Institute’s Jeff Madrick in the NYT: ”What was most eye-catching was Mr. Weill’s claim that the conglomerate model ‘was right for that time.’ Nothing could be further from the truth”.

What we haven’t seen is a defense of big banks not just as the status quo or too complex to tamper with, but as better, more valuable businesses which are more socially useful than the alternative. Maybe that’s another legacy of the financial crisis: even their staunchest supporters have defined the benefits of big banks down. – Ben Walsh

On to today’s links:

Say goodbye to 10 consecutive quarters of US corporate profit growth – WSJ

Big government is gone, and what’s left keeps shrinking – NYT

America loves its cops and firefighters. Their pensions, less so – Reuters

New Fed action “will not increase the supply of, or demand for, credit” – The Big Picture

New Normal
A billionaire’s fear: Inequality is creating an impoverished underclass that threatens social stability – NY Mag

Mistakes Were Made
“We apologize”: HSBC sets aside $2 billion for failure to stop money laundering – FT
Why big banks have scandals – The Atlantic

EU Mess
The next make-or-break moment of the euro crisis: after everyone gets back from August vacation – Reuters
Germany and France endorse Draghi’s pledge to save the euro with decisive action – WSJ
The Bundesbank: still opposed to the ECB buying sovereign bonds – FT

Jonah Lehrer resigns from the New Yorker after admitting to lying about Dylan quotes – NYT

I’m Confused
Headline: “Stocks Continue to Defy Investors’ Sour Mood” – WSJ

Primary Sources
Dallas Fed’s manufacturing index hits 10-month low – Dallas Fed

“He was Isambard Kingdom Brunel, a prominent British engineer in the 19th century, not ‘a Dickens character.’” – NYT


About this -

“Mistakes Were Made
“We apologize”: HSBC sets aside $2 billion for failure to stop money laundering – FT”

No – can’t read it (paywall) and don’t need to. HSBC was a full-fledged, willing, knowing participant in an ongoing criminal enterprise; one operated by some of the most murderous thugs on Earth. That is orders of magnitude more damnable than “failure to stop money laundering”.

Why does Felix not pursue this matter, which is a far worse offense than anything involving Libor or The Whale? Why the softball favoritism toward HSBC, buckos?

Posted by MrRFox | Report as abusive

Why social mobility is important

Felix Salmon
Jul 30, 2012 21:46 UTC

Tim Harford is a fan of the clear way in which Alex Tabarrok has couched the debate — which started with a Tyler Cowen post back in January — about the desirability of intergenerational economic mobility. Or, in English, is it a good thing if quite a lot of poor people become rich?

The Marginal Revolution guys say that looking at economic mobility is overrated; Cowen, also in January, linked to a bunch of critics of that position, including John Quiggin, Brad DeLong, and Paul Krugman. Recently, DeLong resuscitated the discussion, and Krugman came back for a second go-round as well, all of which resulted in Cowen being rude about Krugman, and Tabarrok trying to clear things up.

Tabarrok’s post is indeed clear, but it’s clear in an invidious way. He basically starts with his conclusion, saying that if a high-mobility society has no better outcome, in general, than low-mobility society, then there’s not very much to choose between them. And similarly, he says, if both a high-mobility society and a low-mobility society have the same very good outcome, then again there’s not much to choose between them.

But this obtusely misses the fundamental reason why high mobility is a good thing: that it improves outcomes. A sclerotic society where no rich people become poor and where no poor people become rich is never going to be a hive of creative destruction. Cowen even comes close to admitting this, when he says that “if the general standard of living is rising, mobility takes care of itself over time” — except he has the causality largely backwards. If you have lots of social mobility, then the general standard of living is going to go up: you’ll have lots of poor people becoming richer, and you’ll also have the rich protecting their downside, in the likely event that they become poorer, by doing their best to improve the lot of the poor.

So when Cowen talks about economic mobility not mattering much “for a given level of income”, or when Tabarrok talks about “some simple societies” with fixed levels of income, they’re taking the variable in the equation and they’re turning it into a constant. What they should be doing is looking at two societies, equal in all respects except that one is high-stasis and the other is high-churn, then fast-forwarding to see which one turns out better. The answer, of course, is the high-churn society — which means, working backwards, that if you want growth, you also want social mobility.

As a result, it’s reasonable to conclude that anything which impedes social mobility — like rising inequality, say — also impedes growth. The effect might not be huge, but it’s there. And the only way not to see it is to effectively assume your conclusions.


Of course I meant “tenets”.

Posted by FifthDecade | Report as abusive

Libor non-scandal of the day, Citigroup edition

Felix Salmon
Jul 30, 2012 16:47 UTC

What kind of person confesses to a crime he didn’t commit? Omer Rosen, it would seem, for one. His piece in the Boston Review today is headlined “I, Too, Have Messed with LIBOR”, and after a lot of throat-clearing he finally utters the fateful words:

I was not setting the official LIBOR—no one would borrow money or otherwise make or receive payments based on my LIBORs. However, for the purposes of this particular deal, I was ‘setting’ LIBOR.

The scare quotes are doing a huge amount of work, there, because in fact Rosen not only wasn’t setting Libor; he really wasn’t even “setting” Libor, either. Here’s the tl;dr version of Rosen’s 1,700-word piece: Rosen was working at Citigroup, on a deal which would save a client millions of dollars in taxes. But banks know better than to put things in writing saying “you should do this deal because you’ll save a shedload of money in taxes”. So instead they concoct an ersatz financial justification for the deal which allows everybody to sit around a table gravely nodding their heads and saying “yes of course it makes perfect financial sense, in and of itself, for us to borrow at a high fixed rate instead of a low floating rate, and wow, look at that, there are tax benefits too, that’s just icing on the cake”.

In this case, the ersatz financial justification was about as simple as it could get: Rosen basically just said “hey, if you borrowed at a floating rate, then if interest rates went up, you’d end up paying more money than if you borrowed at a fixed rate”. And that, apparently, was all the wispy gauze of a financial justification needed for the deal to go through.

There was no setting-of-Libor going on here: there was just a possible future path for interest rates generally, combined with a willful ignorance of, say, the existence of interest-rate swaps. According to Rosen, he was told by his managing director that “tax transactions are illegal” — if that’s true, then the real scandal here has nothing to do with Libor, and everything to do with the fact that Citigroup put together an illegal transaction. But frankly I doubt that the transaction was illegal; I think the people structuring it just didn’t want to raise unnecessary red flags with the IRS.

But that’s the problem with things like the Libor scandal, I guess. Once a top-tier bank like Barclays cops to lying about Libor, everybody else wants to inflate their importance by joining their ranks. Even if what they did really had nothing to do with Libor manipulation at all.


I tried goodling and that didn’t work, so I then tried gooGling “scare quotes + dan bloom”. Yeah, what am I supposed to learn?

The top few links direct to some web sites designed in the paranoid style, with all the features you’d expect: random fonts in random sizes and random colors; no unifying argument or explanation of what is being read; a massive chip on someone’s shoulder. All amusing enough, but none of this actually answers the fscking question of why Felix is such an evil human being for using a term in common use.

Don’t believe me: look at this delightful page thrown up by google and tell me WTF is going on here:
http://open.salon.com/blog/danbloom/2012  /07/27/what_happens_when_scare_quotes_b ecomes_a_hot_tweet_potato

Posted by handleym99 | Report as abusive

Questioning El-Erian

Felix Salmon
Jul 30, 2012 04:38 UTC

When Geraldine Fabrikant decided to write a rather odd and meandering profile of Mohamed El-Erian for the NYT, she made sure to bury the lede, deep in the article’s sixth paragraph. But Clusterstock knew where the news value was (“KA-CHING: PIMCO’s Mohamed El-Erian Got Paid $100 Million Last Year”), while Bloomberg led with the revelation about El-Erian’s co-CIO: “Pimco’s Bill Gross Paid $200 Million Last Year, N.Y. Times Says”.

Fabrikant’s source for both numbers is a single individual, “a person with knowledge of Pimco’s finances”. The whole thing was rather reminiscent, to me, of what happened last February, when Reuters reported that Pimco’s top partners are making an average of $33 million each, and Pimco responded by calling those numbers “wildly inaccurate”. So I asked Pimco what it thought of Fabrikant’s reporting, and got this back from a spokesperson:

The article contains numbers that are seriously inaccurate, as well as other factual errors.

Fabrikant spent a lot of time on this article — she says that her joint interview with El-Erian and Gross took place “earlier this year” — and so I suspect that she’s pretty confident in printing those numbers. That said, however, Gross, who’s already a multibillionaire and really doesn’t need the money, would have had to be utterly tone-deaf to pay himself $200 million in 2011.

2011 was the year, remember, in which he published a 3-page note entitled “Mea Culpa”: “I’m just having a bad year,” he said. “This year is a stinker.” He continued:

This is big league ball, where your ticketholders come to the park expecting not a circus Willie Mays catch but more wins than losses and a yearend performance that places your bond assets near the top of the standings.

That didn’t happen. Instead, Gross placed in the bottom 10% of bond-fund managers for 2011. Given that, it’s hard to see how he could justify extracting $200 million from Pimco’s investors, or three times the record $68.5 million that Lloyd Blankfein was paid in 2007.

Certainly that kind of payday is within the realms of possibility, given that his firm manages $1.8 trillion, and his Total Return Fund has $263 billion under management: $200 million is just 0.01% of the former, or 0.08% of the latter. On the long-only buy side, the way you get paid for performance is that your performance attracts new money, and the new money pays management fees. And so long as Pimco’s assets under management are going up rather than down, I can see how Gross’s pay might do likewise. But still.

I can’t say that the rest of the article makes it seem particularly reliable, either. Fabrikant lays out the case against El-Erian on two fronts: firstly that he isn’t much of a bond trader; and secondly that his tenure running Harvard’s endowment was “somewhat controversial”. Overall, she says, “his track record for managing money is mixed”.

But I can’t work out how Fabrikant comes to that conclusion. El-Erian has managed money at two places: Pimco (twice), and Harvard. In his first stint at Pimco, between 1999 and 2005, he managed emerging-market bonds through the Russian and Brazilian crises and the Argentine sovereign default; he ended up making an annualized return of 18.4%, which was very much, in Gross’s words, “near the top of the standings”. What’s more, he amassed a much larger emerging-market bond portfolio than any of his competitors: he was just as good at attracting funds as he was at generating alpha.

At Harvard, El-Erian also did well, at least in terms of published returns. Of course, there’s more to managing an endowment than maximizing annual returns: you also need to be assiduous about liquidity management. And after El-Erian left Harvard, the endowment ran into massive liquidity problems. Fabrikant says that “several experts on endowments”, none of whom are named, blame El-Erian’s investment strategy for those problems, along with his abrupt departure. But I see things differently: I think the real problem at Harvard was leadership, or rather the lack thereof.

El-Erian’s departure was indeed abrupt — but I suspect that had he been managed better by the university’s grandees, including Larry Summers and Robert Rubin, they could have done a better job of persuading El-Erian to put in place a considered succession strategy. And then, after El-Erian left, the endowment was left effectively headless for the best part of a year before Jane Mendillo was hired in July 2008. That’s not his fault.

Asset allocation is something endowments do on a very long timeframe: once El-Erian had worked out where he wanted the endowment’s money to be invested, it was probably OK to keep that same allocation until a new head could be found. But liquidity management is another thing entirely: that kind of thing can’t be run on autopilot, and has to be actively managed. Especially when Summers is busy losing $1 billion of the university’s money elsewhere. Remember this?

Through the first half of this decade, Meyer repeatedly warned Summers and other Harvard officials that the school was being too aggressive with billions of dollars in cash, according to people present for the discussions, investing almost all of it with the endowment’s risky mix of stocks, bonds, hedge funds, and private equity. Meyer’s successor, Mohamed El-Erian, would later sound the same warnings to Summers, and to Harvard financial staff and board members.

“Mohamed was having a heart attack,’’ said one former financial executive, who spoke on the condition of anonymity for fear of angering Harvard and Summers.

In other words, El-Erian was having a hard enough time on the liquidity-management front when he was in the office every day, thanks to the internal politics of the university; he can’t really be blamed for failures after he left.

Finally, El-Erian started managing money directly at Pimco again in 2009; since then, his funds’ returns, in Fabrikant’s words, have been “relatively lackluster”. But these are small funds, with just $10 billion between them — a rounding error, at Pimco. As CEO and co-CIO of the whole company, El-Erian should be properly judged on the whole company’s performance, and Pimco seems to show no deceleration whatsoever when it comes to the pace at which it is accumulating assets under management. Not that you’d learn that from Fabrikant’s story.

Instead, we get very silly stuff like this:

Mr. El-Erian was headed east and people were buzzing. Some wondered if he was taking the job to cultivate a relationship with Lawrence H. Summers, a former Treasury secretary who was then Harvard’s president, in the hope of finally landing atop the I.M.F.

Who are these “some”? We’re never told, of course. But since when has the president of Harvard had any say at all in who becomes the next head of the IMF? Summers did return to government eventually, but that was by no means a foregone conclusion, or even likely, in 2007. What’s more, even once he was in government, I don’t think that Summers played any real role in selecting the next head of the IMF — a choice which is made by Europeans, not Americans.

And what we don’t get, from Fabrikant’s article, is any real substance on the task facing El-Erian. If you’re writing a profile of him, here are some questions I look forward to you trying to answer:

To what degree is El-Erian in the process of replacing Gross, and to what degree is he doing something completely different? What will happen to the Total Return Fund when Gross retires? Does Pimco need to replace Gross with another great bond trader, or is it now a very different animal to the company that Gross founded, in need of someone who thinks on a more macroeconomic level? And how is El-Erian, who is CEO as well as CIO, as a manager?

How much time does El-Erian spend appearing on television, writing op-eds, and otherwise cultivating the media? Is that all part of some Pimco marketing push? To what degree does it distract from his day job? Same questions for Gross, too.

Finally, and most interestingly, how did Larry Fink manage to amass twice Pimco’s assets under management despite the fact that Bill Gross, the greatest bond investor of all time, had a more than 15-year headstart on him? What is the story of Blackrock vs Pimco, and how is it likely to play out in future? In order for Pimco to effectively compete with Blackrock, will it too have to go public? (Incidentally, Fink was paid $21.9 million in 2011.)

El-Erian is an interesting character, but it seems to me that the most daunting job facing him is the fact that he is being asked to run an enormous buy-side institution which he didn’t found. Many people have been asked to do that; very few of them have ever succeeded. What will it take to buck the trend? And will the world’s institutional investors stick around long enough to find out? Or will El-Erian finally get that IMF job, and move to Washington, before it comes to that?

But yeah, it would also be fascinating to find out how much he’s really being paid.


Interesting piece. For part of it I thought this might have been written by the PIMCO public relations team. The author’s take on how mangers are compensated on the buyside is idealistic and naive. Depending on how the sell agreement was negotiated with Allianz the compensation numbers may be correct as it’s not unusual for the selling firm to retain a % of the revenues and the autonomy to run the business as they see fit (i.e. they maintain control over the culture, comp, strategy, etc…) While Mr. Gross may have had a bad year I’m 2011 most investors recognize that he (and team) have consistently added alpha far above the benchmark on a relatively consistent basis (use rolling time periods to get a clear picture of the consistency). As a founder of on organization that might generate $7b in fees (assuming avg fee across structure of enterprise 50bps) and a 35% revenue sharing agreement (not that uncommon) is it that crazy to think 10% of the revenues may go his way? By and large this is a sticky business as long as you don’t consistently have major blow-ups. Indeed, the author tacitly acknowledges one of the strengths of their business model (and asset management in general) when he defends El Erian’s lackluster performance on relatively small funds for PIMCO ($10B -which is bigger than most asset mangement firms) by pointing out that they are still able to gather assets. That is the beauty of distribution and PIMCO has great distribution. The author points out that Mr. Gross is a multibillionaire, maybe a germane question would be how much of his net worth is in the fund, especially since he is not a big fan of equities.
I thought the author partially redeemed himself for the cheer leading exhibit in the first half of the article by asking some very great questions that weren’t addressed in the NYT article. Maybe one more to add to the list – how would a completely transparent, exchanged traded derivatives market affect PIMCO’s ability to mange the vast sums of fixed income assets they have?

Posted by CAGR | Report as abusive

How the tech-stock valuation curve inverted

Felix Salmon
Jul 29, 2012 19:03 UTC

Is a bubble bursting in Web 2.0 stocks? The NYT says there is, and says indeed that this implosion is even more dramatic than the one we saw in 2000. In reality, of course, it isn’t.* In 2000, trillions of dollars of wealth evaporated as the share prices of thousands of companies plunged to earth; in 2012, by contrast, we’re talking about a mere handful of companies, including Facebook, which, with its $65 billion market cap, still looks pretty well valued to me.

That said, most of the public self-described “social” companies — with the prominent exception of LinkedIn — have indeed seen their share prices hit hard of late, to the point at which many recent private rounds look decidedly rich. The result is that there’s a pretty strong case to be made that we have what you might call a steep inversion in the valuation curve.

In general and in aggregate, corporate valuations are meant to rise over time. There’s a lot of volatility in the process, of course, and individual companies go bust all the time. But in the Silicon Valley model, companies begin as startups at relatively low valuations, and then as they raise more money in successive rounds, their valuation steadily rises. Eventually, if and when they go public, they’re worth so much that anybody who bought in during one of the private rounds will be sitting on a nice profit.

That’s not just a matter of growth over time, either: it’s also a matter of a much larger investor base. There are only a relative handful of individuals and institutions who buy into private rounds; in contrast, there are millions of investors around the world who can buy stocks listed on public markets. If the number of people bidding against each other to buy equity in any given company suddenly rises by many orders of magnitude, it stands to reason that the price is going to rise as well.

With the latest crop of tech stocks which have gone public, however, that hasn’t been the case — despite what seemed to be enormous appetite, for Facebook stock in particular, from investors all over the world. Instead, even if valuations are still getting steadily richer from round to successive round in the private markets, there’s no a significant drop at the end of the curve — the point where private markets go public.

So what’s going on? The answer, I think, can be found in the psychology of the dot-com bubble. Back then, there were a lot of people making enormous amounts of money by investing in technology stocks. You’d put together a portfolio of tech stocks, the portfolio would rise in value, and you would conclude that you were doing very well, and therefore buy ever more tech stocks. After all, your brokerage statements were proof positive that you knew exactly what you were doing, and were very successful at it. A bull market, especially a soaring bull market, creates confidence and momentum and inflows.

Turn that story on its head, and you wind up where we are today. There are still dedicated technology investors and funds in the public markets, but all the top technology investors have moved, at this point, to the private markets. If you’re in the public markets, your performance has been mediocre for over a decade, and you’re liable to take any brief buzz-induced inflow of funds into the sector as an opportunity to cash out and make a rare and precious profit.

In theory, the fact that the public markets are so much bigger than the private markets should be great for any tech company going public which cares mostly about its valuation. There’s a finite number of shares out there, and the demand for those shares is now vastly bigger than it was. Therefore, price must go up.

In practice, however, it doesn’t work like that. Instead, we have a very small pond of private investors, where valuation momentum can pick up incredibly quickly. But the minute the gates come down and the company’s valuation wave spills into the ocean of the public markets, it just gets absorbed into the broader tech-valuation sluggishness, and disappears.

Yes, Facebook had a very large IPO, but it was always a bit ridiculous to hope that a single offering could change the psychology and momentum of the entire technology sector — even if it had gone well, which of course it didn’t. Stock markets are moody animals, and they don’t like being told how to behave by Sand Hill Road types with an eye to a big payday. The tech sector might turn around and begin a rally at some point. But chances are, that point won’t come until after Silicon Valley’s VCs have been properly chastened.

*Update: I apologize for mischaracterizing the NYT article; it did not say that the current pop was as loud as the one we all heard so loudly in 2000. I misread the article, or read it too quickly. Sorry.


“still looks pretty well valued to me”

Perhaps he meant “pretty richly valued”? Is how I read it, at least.

Posted by TFF | Report as abusive

Counterparties: Low tech

Peter Rudegeair
Jul 27, 2012 21:55 UTC

Welcome to the Counterparties email. The sign-up page is here, it’s just a matter of checking a box if you’re already registered on the Reuters website. Send suggestions, story tips and complaints to Counterparties.Reuters@gmail.com

First, Apple released decidedly “meh” earnings this week for the second quarter. Then, Netflix did, too. Then Zynga. Then Facebook. Not all of these companies are in the same boat: Apple reported strong growth but missed analysts’ lofty expectations; Netflix topped analysts’ estimates but experienced a big slowdown in growth. Still, the stocks of all four companies ended the week down: Apple’s shares fell around 3% on the week; Netflix’s were down 28%; Zynga’s were down 36%; and Facebook’s fell 17%.

Apple’s case is probably the most instructive. Part of what’s going on is the continuation of the trend that Larry Summers picked up on at Fortune’s BrainTech conference last year: that the earnings of tech companies are undervalued relative to the earnings of industrial companies. As he pointed out then, once you subtract Apple’s Scrooge McDuck-size pile of cash, Apple’s price-earnings ratio is only about two-thirds of GE’s. But another part of what’s happening is what Peter Thiel highlighted at this year’s BrainTech conference and that we blogged about last week: big tech companies like Apple, Microsoft and Google have excess cash and a shortage of scalable, innovative ideas worth a chunk of it.

Take Apple’s cash hoard in particular (now over $117 billion). Apple may have just plunked down $356 million in cash in its bid for AuthenTec, but that’s only 5% of the $7.04 billion in cash that Apple accrued since the end of June alone. What Matt Yglesias wrote this week about Microsoft could apply to Apple as well: “Innovation is really hard. Staying on top once your core business has saturated the market is really hard”.

Adam Lashinsky made an observation during Peter Thiel’s panel that there is a notable exception to this trend: “Amazon is the only one, in my mind, of the big tech companies that’s actually reinvesting all its money, that has enough of a vision of the future that they’re actually able to reinvest all their profits”. He was almost spot-on: With heavy investments in its business Amazon was able to eke out a profit of a penny per share this quarter. Barney Jopson had a great piece in the FT earlier this month that detailed Amazon’s capital investments, from its own “digital market place with millions of customers, to petabytes of server space and to state-of-the-art warehouse facilities serving myriad forms of commerce”. Investors don’t seem to mind Amazon’s paltry income for the time being. Although its profit, like Apple’s, came in below analysts’ estimates for the second quarter, Amazon’s shares finished up 4% on the week. – Peter Rudegeair

On to today’s links:

What investors saw and didn’t like in Facebook’s first public earnings release – DealBook

GDP growth slows to 1.5%: The US recovery is now the second slowest since World War Two – WSJ

EU Mess
Yields of 7+ percent too much to bear – Spain discussing full-scale, $366 billion bailout with Germany – Reuters
Draghi made his statement, now he has to back it up – Bloomberg
“Convertibility” and the ECB’s monster challenges – FT Alphaville
The irreversible euro: Did Draghi pull a “the crisis is contained to subprime”? – Tim Duy

“Millions have suffered needlessly” because of the structure of the bailouts – Kevin Drum
Not the strongest argument: “you can screw [management and risk-taking] up at a small bank or a large bank” – Reuters

How one trader tried to blow the whistle on Libor manipulation – and was ignored – FT
How not to rig Libor: the Barclays instructional video – John Carney

Think of the Children
The birthrate is at a 25-year low as Americans put off procreating – USA Today

Good Ideas
Geithner supports the Merkley mortgage refinance plan – Housing Wire
“In many ways … this is functionally equivalent to a principal reduction” – Felix

PR Pushes
What the financial industry needs now: A cheesy promo video with terribly low production values – The Partnership for a Secure Financial Future

“Like Finnegans Wake as drafted by the unicorn debate team … atavistically beautiful, like middle school cave art” – Brian Philips

New Normal
The majority of Americans getting jobs have had to switch industries – WSJ

Data Points
Compared with the Super Bowl, the RNC quadruples earnings for strips clubs – NYT

The NYT is now supported more by readers than by advertisers – NY Mag


I love Amazon on so many levels, but they are a classic case of analysts having been so wrong about the company’s prospects early in their life that they aren’t going to get egg on their face a second time by pooh-poohing either the stock.

When coupled with the small profits narrative that Amazon’s promulgated, and the limited data transparency that Amazon provides investors (under the guise of willing to be misunderstood by investors for long periods of time), the company has a free pass.

All that said, I do think that they are playing retail chess to everyone else’s checkers game; just not at levels disconnected from any market comparable.

Posted by hypermark | Report as abusive