I’m very glad that the WSJ has published today’s debate between Farhad Manjoo and Dennis Berman on the subject of Apple. Manjoo has been writing some very insightful columns about the company, including the one yesterday which explained that Apple has many better options, when it comes to spending its cash, than taking Carl Icahn’s advice and essentially mortgaging the entire pile to conduct a stock buyback.
The Manjoo vs Berman debate displays two important phenomena surrounding nearly all public companies. Firstly, there’s the confusion between a company and a stock; and secondly, there’s the bigger problem with going public in the first place.
Upon going public, every company is doomed to be judged by its share price — and, all too often, it’s doomed for the share price to become more salient, in the public’s mind, than the company itself. Icahn, as a speculative shareholder, has only one interest in this game: he wants the share price to rise, so that he can then sell his shares at a profit. And Berman is, conceptually, on Icahn’s side. He talks about what investors want, and says that if Apple makes a lot of money, “there will be no choice but to give back significant sums to shareholders.” He also likes the idea of Apple racking up vastly more debt than it already has:
Right now, Apple has 30 cents of debt for every dollar it brings in yearly EBITDA. The median figure for the Standard & Poor’s 5000-stock index is $1.90 – or basically six times Apple’s current ratio, according to figures compiled using CapitalIQ. Were Apple to have a median amount, its current debt would move from $17 billion to $108 billion. Is that crazy? No.
In short, Apple’s business model exhibits the rarest traits seen in nature: relatively low capital demands and immense profit generation.
This would be funny, if it weren’t so depressing. Berman concedes that Apple is an extremely rare outlier in the corporate world: it makes a lot of money without having to invest a huge amount up front. Most companies which aren’t Apple, by contrast, have to borrow and invest a huge amount of money before they can start generating earnings. Berman’s bright idea, here, is that if Apple is fortunate enough not to have to go into massive debt to finance its investments, then, er, it should go into massive debt anyway, just because everybody else is doing it.
What good would that huge new debt pile actually serve? Well, it might help increase the share price — or it might not, who knows. (Icahn, for his part, is convinced that the share price will rise either way: he says in his letter to Apple that “the opportunity will not last forever”.) Obviously, it would also burden Apple with billions of dollars of fresh liabilities, in the form of new interest and principal payments. But Berman is unfazed: in his world, liabilities are assets, and assets are liabilities. Seriously: he says, on the liability front, that “the key to keeping Apple sharp will be actually to push more money than comfortable back to shareholders”. And on asset side of the balance sheet, he describes Apple’s cash hoard as “something of a liability”, on the grounds that it is “stranded and unproductive”. (Never mind that even under the Icahn plan, the cash hoard will remain untouched, and be just as stranded and unproductive in future as it is right now.)
This is the mindset of the financial engineer, and while it can make lots of money for corporate raiders, that doesn’t make it a good idea. Berman is a fan of Icahn: “the man doesn’t have stadiums named after himself for no reason,” he writes. Well, yes: the reason is that he spent lots of money to have his name put on those stadiums. He’s a wealthy individual. But Berman seems to think that anything which makes Carl Icahn rich must therefore be the right thing to do.
But here’s the thing: Tim Cook is a caretaker of a company which is designed to be around in perpetuity. Icahn, on the other hand, for all that he claims that “there is nothing short term” about his intentions, still has an exit strategy: he wants to buy low, drive the share price up through shareholder activism, and sell high. Apple should go along with Icahn’s plans only if they increase the long-term value of the company — and it’s pretty obvious that they don’t: Icahn is, at heart, advising Apple to have both large borrowings and a large cash pile at the same time. Which is bonkers.
Manjoo, on the other hand, definitely sees Apple as a company — a company navigating a highly fluid environment, and one where most of its profits come from a single product, the iPhone. Apple needs to stay one step ahead of what consumers want, says Manjoo, and it’s much easier to do that if you’re not saddled with interest payments. Even Manjoo, however, has internalized Silicon Valley’s fetish for endless growth, even when the company in question is already a giant. “What I’m arguing,” writes Manjoo, “is that Apple begin using its cash to act like a different kind of company — that it act like the big-thinking, future-proofing, market-share-buying behemoth it could be… the boldest thing Apple could do with its cash is transform itself into a different kind of company.”
Manjoo’s “different kind of company” is a lower-margin company: one where Apple decides to “give away a lot more free stuff”, and buys market share, or even buys a cellular carrier. This is much less stupid than Berman’s idea. The single most exciting thing about my new iPhone 5s has nothing to do with Apple: instead, it’s T-Mobile’s free international data.
But even Manjoo is working on the assumption that all companies must always want to grow at all times — even if that means becoming “a different kind of company” altogether. Hidden just beneath Manjoo’s writing is a pretty Berman-esque assumption: that the share price should go up rather than down, and that Apple should do everything it can to ensure that outcome. When Manjoo exhorts Apple to “act before trouble hits”, the trouble he has in mind is basically anything which causes the stock price to fall significantly lower than it is already.
So let me put forward an even more radical idea: Apple should just keep on doing exactly what it’s doing. For substantially all of its history, Apple has been a luxury retailer, making beautiful, functional, high-end goods. Its retail stores are in the most expensive neighborhoods, and it never discounts — much like Louis Vuitton. Its products are status symbols. And they can cost eyebrow-raising sums of money: the new Mac Pro, for instance, starts at $3,000 — and that doesn’t even include a screen.
In general, companies are good at doing what they do well, and they’re not good at doing what they don’t do well. That’s one big reason why mergers, and pivots, generally fail. Apple is fantastic at product design, and at maintaining extraordinarily high quality standards on everything it produces. At some points in time, its products touch the public nerve more than they do at other points. No one expects the iPhone’s dominance to last forever: that’s why Apple is trading at about 13 times earnings, while Google’s multiple is more than twice as high. (Don’t even get me started on Amazon.)
Debt makes sense when you need money to invest today, and can repay that money with a substantial future income stream. Apple is in the exact opposite situation: it needs no money to invest today, while its long-term future income stream is quite uncertain. So it makes sense to save up in flush years, like it has been doing. It will continue to create amazing new products; what’s less clear is whether any of those new products will have the ability to become a world-conquering profit monster like the iPhone. The job of the markets is simply to price the shares accordingly; it’s not the job of management to change the deep structure of the company just to make the markets happy.
Steve Jobs always regretted going public. He raised very little money by doing so, and in return he ended up with people like Carl Icahn constantly second-guessing his decisions. Jobs was good at ignoring such gadflies; his successor, Tim Cook, is a little more shareholder-friendly. But shareholders really do nothing for Apple, which hasn’t had a public stock offering in living memory, and which has so much money now that it can pay its employees large amounts of cash to retain talent, instead of having to force them to gamble with restricted stock units.
In other words, Apple should be run a bit like Bloomberg: as a profitable company which pays well, which concentrates first and foremost on making its product as great as possible, and which doesn’t try to be something it’s not, or allow itself to be distracted with financial engineering. Sometimes its stock will go up, and sometimes its stock will go down. But the company, and its core values, will endure.
When 2011 came to an end, the dominance of Chinese artists in the international league tables was clear, if puzzling. Three of the top five artists, in terms of sales, and both of the top two, were Chinese; Zhang Daqian alone managed to gross more than half a billion dollars at auction that year, the first time any artist had come anywhere near that level.
But no one knew what was really going on. One theory — which the peddlers of art-auction data implicitly supported — was that what you saw was simply the facts of the new art world, and that Chinese artists were suddenly on fire. Another theory was that the auction results were real, but that the relative standings of Chinese and western artists were skewed by the fact that Chinese works were more likely to come up for auction, while western works are more likely to change hands privately. And then there were lots of theories about how the numbers couldn’t be taken at face value at all: one oft-cited article from June 2011 talked about the way in which fine art is used in China as a means of “elegant bribery”.
Now, as Bloomberg comes out with a new league table showing that 8 of the top 20 top-selling artists born since 1980 are Chinese (compared to just four who are American), the NYT unveils its latest huge multimedia project: a deep investigation of the Chinese art market, complete with the revelation that the $65.4 million sale of “Eagle Standing on a Pine Tree” a 1946 ink painting by Qi Baishi, never in fact happened. That was the public auction price, but then the buyer never paid — a very common occurrence, it seems, in China.
So, what’s the truth about the Chinese art market, and has the NYT captured it? For one thing, a good third of the public auction-result data should be simply ignored, on the grounds that the pieces in question never actually sold. This includes, ironically enough, the clever interactive chart in the NYT article itself, showing the best-selling artists in the world from 2006 through 2012. Beautifully tractable databases are like that: even when you know they’re deeply flawed, you still end up using them anyway, because they’re the best thing you’ve got.
What’s more, the velocity of Chinese art is vastly higher than the velocity of western art, where paintings very rarely get resold within a few years of being bought. In China, by contrast, a single painting by Qi Baishi has sold four times at auction in the last 10 years, at prices ranging from $30,000 to $794,000.
The result is twofold: firstly, per-artist totals get artificially boosted by the rate at which works are resold. And secondly, the art market becomes a genuinely speculative bubble (unlike its western counterpart), where people buy just because they think they’ll be able to flip their property for a big profit.
Yes, “elegant bribery” happens as well — where a businessman will gift a work of art to some party official, the official will put it up for auction, and then the businessman will buy it at a very high price, after making sure an underbidder is in place to bid up the final amount. But also, in a country with a savings rate of more than 50%, there’s insatiable demand for just about anything which can be considered an investment:
“A majority of Chinese people do not trust the Chinese stock market,” said Melanie Ouyang Lum, a consultant on Chinese art. “The housing boom has slowed tremendously. A lot of people are looking to art for investment.”
But the main phenomenon behind the NYT story, it seems to me, is a weird and uncomfortable marriage between eastern and western conceptions of where value lies in the art market. The western art market emphasizes originality and authenticity, with the result that everybody wants to buy a relatively small number of important works and important artists. If a work is a fake, then it’s worthless, no matter how beautiful it might be.
In China, by contrast, there’s much less of a premium paid on originality, and many masters came up through the ranks by copying the works of their predecessors. That Qi Baishi painting, for instance, dates only to 1946, but could have been painted at any time in the past few hundred years: its style is timeless. On top of that, art is a manufactured commodity in China, where workshops with hundreds of employees churn out copies of the work of the masters. This makes perfect sense, if what you’re doing is creating something aesthetic to go on the wall. The problems start to arise when the art objects rise in value, according to whether or not someone believes them to be authentic.
My favorite story in the NYT article concerns another master, Zhang Daqian, who visited the University of Michigan Museum of Art in 1967 to view an exhibition of the works of Shitao, a 17th-century painter.
His tour guides were proud to show him the works of such a famous painter, who had died more than two centuries earlier. So they were surprised when Mr. Zhang began to laugh and point to various works on the wall, saying: “I did that! And that.”
“That is how Zhang Daqian talked,” said Marshall Wu, a retired professor at the University of Michigan who first met Mr. Zhang in the 1960s. “You never really knew if he was serious or kidding. But he did a lot of Shitao forgeries.”
Don’t think of the “forgeries” here as being a sophisticated con job: Zhang considered it his job to copy Shitao, and seeing his works hung up in a museum as being Shitao’s simply delighted him. If his painting was as good as the master’s, then it was as valuable as the master’s. And of course Zhang’s “forgeries” are far from worthless: in fact, as original Zhang paintings, they might now be worth more than a Shitao.
But in the auction world, no one pays $65 million for a beautiful object: it also needs to be authentic. Hence the predicament in which the Chinese auction market finds itself. Frankly, I would rather see a world where paintings were judged on their inherent aesthetic qualities, and the identity of the painter didn’t matter. After all, even genuine works of the masters are often painted in whole or in part by their assistants. But the present situation in China is clearly the worst of both possible worlds, both incentivizing and demonizing the copying which has been the heart of Chinese art for centuries. One thing is clear: it’s not sustainable, over the long term. Which means that if you’re speculating in Chinese art, you’d better have your exit planned out. Because the bubble is certain to burst, and it could happen at any time.
I spent the past couple of days in Berkeley, participating in a number of events at the inaugural Berkeley Ideas Festival. The highlight for me was interviewing Donald MacDonald, the architect of the new (and magnificent) Bay Bridge. But I was also asked to present a little “provocation” on the second morning, in between heavier sessions covering topics like the effect of 3D printing on the manufacturing workforce and the rise of the plutocracy.
So I thought I’d be a little servicey, and let the audience into a secret: specifically, the secret of how to buy happiness with money.
Berkeley is a fun place to give such a talk, since it’s full of the kind of people who are convinced as a matter of principle that money can’t buy happiness. (Where “money”, much of the time, is code for “San Francisco”.) And it’s also the kind of place where the idea of the hedonic treadmill — the theory which says that we all have our own set level of happiness. Good things can happen to us, which make us happy, and bad things can happen to us, which make us sad, but the effect doesn’t last very long. Even if very good things happen to us, like winning the lottery, or very bad things happen to us, like becoming quadriplegic or losing a spouse, we eventually end up back where we started. (The only reasonably sure-fire way of bringing the set point down, interestingly enough, is becoming and then staying unemployed.)
Now there are things which make us happy, briefly. You might even have heard the saying that “anybody who thinks that money can’t buy happiness, has never bought a puppy“. But every adult also knows that for all their upside, puppies also come with a downside.
So what we’re looking for here isn’t something which will lift the line forever — only spiritual gurus promise that. And it’s not something where short-term happiness ends up being paid for with long-term side-effects. Instead, what we’re looking for is something which will predictably make us happier in the short term, which will have very little in the way of negative long-term effects, and which can be repeated as often as you like. Basically, any time you want to be happier, spend some money on this, and you’ll be happier. And then it’s over, and you can go back to your life, and if you want to do it again, you can.
This is a non-trivial task, because of the way the hedonic treadmill works: you get used to stuff. Remember those lottery winners. People become habituated to nice things: while your bigger house or fancier car can indeed make you happy in the short term, you get used to it pretty quickly, and before long you just become scared to lose it. I was very happy with my living conditions when I was in college, but I’d hate to go back to them now. So if your goal is happiness, you don’t want to wind up in what I think of as the collector mindset: the feeling that whatever you have is somehow incomplete, and that buying new things is a way of temporarily filling a void. We don’t want that: we don’t want something where you’re sad when you don’t have it. We just want something where you’re happy when you do have it. And which you can buy with money.
Now most of the time, in most areas, even if money doesn’t buy happiness, it does buy quality. If you spend $100,000 on a car, it’s going to be a better car than the one rusting away on the second-hand lot which is on sale for $3,500. The positive correlation between price and quality is a basic law of capitalism — but there are exceptions. And one of the main exceptions is wine.
If you study what happens in blind tastings, you get the same result over and over and over again. You can try this at home, if you like; I’ve done that many times, with friends, and it’s a lot of fun. You can do a scientific analysis of more than 6,000 wine tastings, which found a negative correlation between price and quality. Or you can look at the wines which win medals at wine competitions, where it turns out that winning one competition gives you no greater likelihood of winning the next one, and where if you enter the same wine two or three times in the same competition, it can appear all over the place in the final results.
But here’s the trick: if you can’t buy happiness by spending more money on higher quality, then you can buy happiness by spending money taking advantage of all the reasons why people still engage in blind tastings, despite the fact that they are a very bad way to judge a wine’s quality. If you know what the wine you’re tasting is, if you know where it comes from, if you know who made it, if you’ve met the winemaker, and in general, if you know how expensive it is — then that knowledge deeply affects — nearly always to the upside — the way in which you taste and appreciate the wine in question.
Fortunately, nearly all of the time that we taste wine in the real world, we do know what we’re drinking — and we do know (at least roughly) how expensive it is. In those situations, the evidence is clear: When we know how much we spent on what we’re drinking, then the correlation between price and enjoyment is incredibly strong.
The more you spend on a wine, the more you like it. It really doesn’t matter what the wine is at all. But when you’re primed to taste a wine which you know a bit about, including the fact that you spent a significant amount of money on, then you’ll find things in that bottle which you love. You can call this Emperor’s New Clothes syndrome if you want, but I like to think that there’s something real going on. After all, what you see on the label, including what you see on the price tag, is important information which can tell you a lot about what you’re drinking. And the key to any kind of connoisseurship is informed appreciation of something beautiful.
In another session at the Berkeley conference, I interviewed Randall Grahm, the biodynamic winemaker. I love biodynamic wines, even though I think that the philosophy behind them (cosmic rays, etc) is in large part completely bonkers. And I think that a large part of the reason why biodynamic wines taste so honest and delicious is that the discipline of biodynamic winemaking forces winemakers to spend much more effort and concentration on the way they grow and harvest their grapes. Similarly, when you really pay attention to the wine that you’re drinking — something which you’re much more likely to do when you know that it’s expensive — you’re going to be able to discover beauty and nuance which you might otherwise miss.
What’s more, it stands to reason that the more we know about what we’re drinking, the more we’re going to like it. And that if you’re talking about something as complex and enigmatic as wine, the apotheosis of agricultural artistry, then there’s going to be more to find in a bottle of fine Burgundy than there is in a bottle of Blue Nun. After all, the global consensus on which wines are the very best in the world has been remarkably consistent for centuries.
Taste in wine is a real thing, which, while it does change over time, does so much less radically than does, say, taste in furniture. It’s an elusive thing, hard to pin down, and there are many reasons why it’s especially hard to isolate in the artificial environment of the blind tasting. But it does exist, and it’s undeniable that nearly everybody who buys and drinks expensive wine (say, $20 per bottle and over) gets real pleasure out of doing so. (“Real pleasure”, I should note, is a redundant phrase: all pleasure is real, no matter whether its genesis is more likely to be a label or a liquid.)
And here’s the really clever bit: even if you think that this is all just a case of the Emperor’s New Clothes, and that the whole concept of fine wine is at heart a con, the correlation between price and pleasure still holds up. As Daniel Kahneman says, it’s one thing to know your cognitive biases; it’s something else entirely to overcome them.
I, for instance, am absolutely convinced, on an intellectual level, that the whole concept of “super-premium vodka” is basically one big marketing con. Vodka doesn’t taste of anything: that’s the whole point of it. As such the distinction between a super-premium vodka and a premium vodka is entirely one of price and branding. And yet, it works! The genius of Grey Goose was that it created a whole new category above what always used to be the high end of the vodka market — and in doing so, managed to create genuine happiness among vodka drinkers who spent billions of dollars buying up the super-premium branding. But if someone asks me what kind of vodka I’d like in my martini, I still care, a bit. And if I my drink ends up being made with, say, Tito’s, I’m going to savor it more than I would if I had no idea what vodka was being used.
What’s more, you don’t need to spend hundreds of dollars on first-growth Bordeaux for this to work. You just need to spend a little bit more than you normally do — enough that you consider it to be a special bottle of wine. That’s it! When you sit down and pop it open, probably with people you love, in pleasant surroundings, everything is set for a very happy outcome.
And you can do this again and again and again. Spend money on an expensive bottle of wine, open it up, drink it, enjoy it, repeat. I’m not talking about collecting wine, here, that’s a different pathology. I’m just talking about drinking it. There’s really no downside, beyond for the money you’re spending — a single bottle of great wine, shared with a friend or two, isn’t even going to give you a hangover. You can convert money into happiness as often as you like: it never gets old.
This explains, I think, why rich people tend to be so fond of fine wine: it’s the most consistently reliable way that they can convert money into happiness. So if you have a bit of disposable income, get yourself down to your local wine shop. It’ll make you happy, I promise.
I’m reading Megan McArdle’s new book in galleys right now; its title is “The Up Side of Down: Why Failing Well Is the Key to Success”. Given the subject matter, McArdle spends just as much time discussing bad failures as she does discussing good ones — not the things which turned out in the end to be “the best thing that ever happened to me”, but rather the truly catastrophic things which result in wholesale destruction of wealth, health, or people’s lives.
Given the way in which the world is becoming increasingly dominated by complex technological systems, a lot of these failures are going to be technological in nature. Recent publicity, of course, has focused on healthcare.gov — a highly complex website devoted to solving the enormous problem of how millions of Americans will be able to access affordable medical care. And the general tone of the criticism, which is coming from all sides, is that if only the government had ______, then all of these problems, or at least most of them, could have been avoided.
That kind of criticism is always easy in hindsight, which doesn’t make it wrong. Virtually all problems are foreseen by someone, or should have been. But in no organization are all foreseen problems addressed promptly and directly. If they were, then nothing would ever happen. Which means that the real problem is often understood to be a managerial one: the lines of communication weren’t clear enough, the managers didn’t have their priorities right, how on earth could they have been so stupid as to _______.
David Wilson has found a wonderful example in the SEC’s censure of Knight Capital. Knight blew up as a result of badly-designed computer systems, and the cascade of mistakes in this case was particularly egregious: it kept important deprecated code on its active servers, it didn’t double-check to ensure that new code was installed correctly, it had no real procedures to ensure that mistakes like this couldn’t happen, it had no ability to work out why something called the 33 Account was filling up with billions of dollars in random stocks, despite the fact that the account in question had a $2 million gross position limit, it seemingly had no controls in place to stop its computers from doing massive naked shorting in the market, and so on and so forth.
In the end, over the course of a 45-minute period, Knight bought $3.5 billion of 80 stocks, sold $3.15 billion of another 74 stocks, and ended up losing a total of $460 million. Markets were definitely disrupted:
As to 37 of those stocks, the price moved by greater than ten percent, and Knight’s executions constituted more than 50 percent of the trading volume. These share price movements affected other market participants, with some participants receiving less favorable prices than they would have in the absence of these executions and others receiving more favorable prices.
Given the size of Knight’s losses, the only silver lining here is that Knight itself was the main actor receiving less favorable prices, while the rest of the market, in aggregate, ended up making more money that day than it otherwise would have done. But the SEC is right to fine Knight all the same, just as it was right to fine JP Morgan for its London Whale losses: legitimate trading losses are fine, but major risk-management failures are not allowed, and need to be punished by more than just trading losses.
Or, for a smaller-scale example, look at Dan Tynan’s misadventures with Box. Again, there was a series of management and permissioning failures, which ultimately resulted in Tynan’s entire account being vaporized, along with all its content. As he explains:
- Box handed control over my account to someone who was a complete stranger to me;
- They did it because of a one-time association with someone else, who happened to have access to some of my folders;
- They failed to notify me or any of my other collaborators that they were giving control of my account to someone else;
- They failed to confirm deletion of the account with the person who created it (i.e., me); and
- Box.com support was helpless to do anything about it or give me any information. Had I not pulled the journalist card, I’d still be scratching my head over what had happened.
That’s a lot of mistakes; nearly as many as can be seen in the Knight Capital case. But when you see a list this long, the first thing you should think about is Swiss cheese. Specifically, you should think about the Swiss cheese model of failure prevention, as posited by James Reason, of the University of Manchester:
In the Swiss Cheese model, an organization’s defenses against failure are modeled as a series of barriers, represented as slices of cheese. The holes in the slices represent weaknesses in individual parts of the system and are continually varying in size and position across the slices. The system produces failures when a hole in each slice momentarily aligns, permitting (in Reason’s words) “a trajectory of accident opportunity”, so that a hazard passes through holes in all of the slices, leading to a failure.
In other words, we should maybe be a little bit reassured that so many things needed to go wrong in order to produce a fail. The Swiss cheese model isn’t foolproof: sometimes those holes will indeed align. But a long list of failures like this is evidence of a reasonably thick stack of cheese slices. And in general, the thicker the stack, the less likely failure is going to be.
That said, there’s an important countervailing force, which mitigates in favor of more frequent failure, and which is getting steadily larger and scarier — and that’s the sheer complexity of all kinds of information systems. I mentioned this when Knight blew up, quoting Dave Cliff and Linda Northrop:
The concerns expressed here about modern computer-based trading in the global financial markets are really just a detailed instance of a more general story: it seems likely, or at least plausible, that major advanced economies are becoming increasingly reliant on large-scale complex IT systems (LSCITS): the complexity of these LSCITS is increasing rapidly; their socio-economic criticality is also increasing rapidly; our ability to manage them, and to predict their failures before it is too late, may not be keeping up. That is, we may be becoming critically dependent on LSCITS that we simply do not understand and hence are simply not capable of managing.
Under this view, it’s important to try to prevent failures by adding extra layers of Swiss cheese, and by assiduously trying to minimize the size of the holes in any given layer. But as IT systems grow in size and complexity, they will fail in increasingly unpredictable and catastrophic ways. No amount of post-mortem analysis, from Congress or the SEC or anybody else, will have any real ability to stop those catastrophic failures from happening. What’s more, it’s futile to expect that we can somehow design these systems to “fail well” and thereby lessen the chances of even worse failures in the future.
I’ve been a bitobsessed with trying to get a feel for exactly how much money bond funds might go down if and when interest rates start to rise. And now, thanks to the wonderful Jake Levy at BuzzFeed, I can show you, in animated, rubbable-GIF form!
Jake put together two GIFs for me. Both show what happens to a $1,000 bond fund over time: the first one shows the value of the fund at various different durations, and assumes that rates are rising at a modest 0.5% per year; the second one shows the effect of the speed with which rates rise, assuming a constant duration equal to that of the Barclays US Aggregate. If you view these charts at BuzzFeed, on a touch device, then you can click the little hand in the top right corner, drag your finger across them, back and forth, and see how things change.
These charts ultimately come out of a conversation I had with Emanuel Derman, and this clever tool from skewtosis. They’re also purely about interest-rate risk, rather than credit risk: the duration points and initial yields for the first chart correspond to the figures for the 1-year, 2-year, 3-year, 5-year, 7-year, and 10-year Treasury bonds.
As for the lesson to be drawn from the charts, one interpretation is that the big risk to bond funds isn’t rising rates so much as it’s rapidly rising rates. Sure, if rates rise slowly and your fund has substantial duration, then you could lose a bit of money. But if rates rise quickly, you could lose a lot of money. In the BuzzFeed version of these charts, which you can see here, I say that in a rising interest rate environment, it’s possible that bonds could actually be more risky than stocks. But I’m not sure what the implications are for asset allocation. Simon Lack, for one, would say that now’s the time to pretty much get out of bonds entirely, given their large downside and small upside. But I remember that Larry Summers managed to lose a billion dollars using the argument that “rates can’t fall any further”.
So maybe the real lesson here is simply that there just isn’t such a thing as a safe investment. Not even if it’s a Treasury bond.
Are you worried that JP Morgan is being robbed of $13 billion that rightfully belongs to shareholders? Richard Parsons (not the former Citigroup chairman, but rather the former Bank of America executive vice president) is shocked by the size of the JP Morgan settlement, trotting out a line of criticism which is pretty standard in Wall Street circles:
If it is true that J.P. Morgan Chase must pay penalties for mistakes made by Bear Stearns—a firm that Washington encouraged them to take over—then it is likely federal policy makers have actually increased systemic risk to the financial system. In a country that has seen 3,000 banks fail over the past 30 years and more than 12,000 over the past century, it is not difficult to imagine future bank failures…
Little thought seems to have been given to the pursuit of J.P. Morgan Chase over Bear Stearns. Once the government proves itself to be an unreliable “partner” in resolving failed institutions, it will find fewer banks willing to step in next time there is systemic risk to the banking system.
This is doubly false, and no one has done a better job of demonstrating its falseness than Peter Eavis. Back in September, Eavis explained, patiently, that JP Morgan bought Bear Stearns and Washington Mutual with its eyes open. (This isn’t hard to show, when Jamie Dimon was saying, at the time, things like “There are always uncertainties in deals; our eyes are not closed on this one.”) Besides, JP Morgan has made billions of dollars in profit on these deals, even after paying this settlement.
If you have any doubt about this, just look at the accounting. WaMu had shareholders’ equity of some $40 billion, before it was bought, which JP Morgan paid $1.9 billion for. JPM valued that equity at $3.9 billion, so it booked a $2 billion gain the minute that the acquisition closed; it then said that WaMu would contribute about $2.5 billion per year in extra profits going forwards.
The point here is that JPM fully expected that legacy WaMu assets would generate some $36.1 billion in losses. Now that those losses are starting to appear, all that we’re seeing is the arrival of something which was expected and priced in all along.
In reality, Washington Mutual did better than JPM expected: the bank is going to take a $750 million gain this quarter to reflect the outperformance of WaMu mortgages. (I’ll tender a guess, here: underwater mortgages are impossible to refinance, and as a result a huge proportion of JP Morgan’s underwater borrowers are paying well above-market interest rates.)
As a result, there’s no reason whatsoever for JPM to regret playing nice with the government in 2008 by buying Bear Stearns and WaMu. As the WSJ unambiguously reports (emphasis mine):
J.P. Morgan Chase & Co. is willing to pay a steep price to settle with the Justice Department over soured mortgage securities, but it is getting one thing it wanted: It won’t have to pay heavy penalties for the sins of two companies it bought during the financial crisis.
Under the terms of a tentative $13 billion deal that could be finalized in a matter of days, J.P. Morgan will pay roughly $2 billion in penalties that apply to its own conduct during the years before the financial crisis, and not any for problems it inherited from Bear Stearns Cos. or Washington Mutual Inc.
As Eavis explains today, the settlement breaks down into three parts. $6 billion goes to compensate investors for losses on mortgage securities; $4 billion is relief for homeowners; and the remaining $3 billion in fines is specifically targeted only at actions which took place directly under Dimon’s watch.
Despite the concerns that JPMorgan was being unfairly taken to task for the practices of Bear Stearns and Washington Mutual, investigations into the two firms are not expected to lead to any fines. Justice Department lawyers, one person said, decided against allocating fines to those firms because doing so might appear punitive. The government encouraged and helped arrange the two takeovers.
In other words, Parsons’ premise is exactly wrong: JPM is not paying penalties for mistakes made by Bear Stearns. All that it’s doing is making good on obligations of WaMu and Bear related to securities they sold. And it’s inherent in buying a bank that you become responsible for its liabilities as well as its assets.
There is one unexpected wrinkle to this settlement, however. As Matthew Klein point out, some $4 billion of JP Morgan’s non-fine money will go to the taxpayer all the same, in the form of the FHFA, thanks in large part to the dogged efforts of FHFA director Ed DeMarco. DeMarco has been micromanaging Fannie Mae and Freddie Mac for the past four years, which means that he — rather than Fannie and Freddie themselves — has taken the lead in terms of chasing down money the two agencies are owed by the banks from whom they bought mortgage securities.
DeMarco sits in a kind of weird regulatory limbo: technically he only regulates Fannie and Freddie, but because he’s a fully-empowered government regulator, that gives his lawsuits especial force. And so when he sues JP Morgan (and Citi, and Wells Fargo, and other mortgage-bond merchants), the suits fall somewhere in the middle between aggressive regulatory action and a simple civil claim brought by formerly private companies which suffered losses due to miss-sold securities. Most importantly, because DeMarco is a regulator, other regulators, including most importantly the Justice Department, can join in — and, ultimately, settle the whole deal for a huge headline sum.
The best way of looking at this JPM settlement, then, is not as a massive $13 billion fine for wrongdoing. Rather, you should think of it as an upsized out-of-court settlement between JP Morgan and the various private companies which bought mortgage bonds from JPM, WaMu, and Bear. Those companies were mostly Fannie and Freddie, which means that they’re now owned by the government, and so of course lots of other government baggage is being brought in at the same time. But what we’re not seeing is overreach by the SEC, by the Justice Department, by Treasury, or by any other government agency. And we’re certainly not seeing JPM being punished for takeovers which the government asked it to do. We’re just seeing two enormous and bureaucratic systems — the federal government, and JP Morgan Chase — doing their best to disentangle the various obligations that the latter has to the former. It’s opaque, and not particularly edifying. But it’s probably good, on net, for both parties.
Last weekend, at the IMF annual meetings, I moderated an official panel with the snooze-worthy title “Sovereign Debt Restructuring: Lessons from Recent Experience”. But the room was packed, and attention was rapt: everybody wanted to know what the panelists in general, and one in particular, thought about the subject at hand. All eyes were on first deputy managing director David Lipton, who kicked off proceedings with a dry but important speech in which he praised a recent Brookings report as “excellent”.
Lipton’s speech came in the wake of a 49-page paper the IMF released in May, which tried to lay out the issues as seen from Fund headquarters. The paper raised quite a few eyebrows, since it marked the first time in a decade that the IMF has talked in public about changing the international financial architecture around debt restructuring. Its last attempt to tackle the subject, known as the Sovereign Debt Restructuring Mechanism, or SDRM, died ignominiously, bereft of any US support.
What do I think about Lipton’s idea? If you scroll down to the end of this rather long and dense post, you’ll find out. It’s OK, there won’t be a quiz, and you don’t need a detailed understanding of everything I’m going to cover in order to understand my conclusions. But for the suprisingly large number of sovereign debt nerds out there, I’m first going to lay out the issues, as they were presented during the IMF meetings.
Lipton, in his speech, said that he was worried that “official resources, including from the Fund, would be used to pay out other creditors”. He also said that “in cases where the need for debt reduction may be unclear at the outset, in our view the key is to keep creditors on board while the debtor’s adjustment program is given a chance to work”.
This idea is very close to the “standstill” that was originally proposed as part of the SDRM; another name for it is “default”. And as veteran sovereign debt advisor Rafael Molina patiently explained later on in the panel, sovereign debt managers will, as a rule, do anything to avoid defaulting on their debt. As a result, tensions are naturally very high whenever this idea is brought up, despite the upbeat spin that the IMF puts on it in its paper:
The primary objective of creditor bail-in would be designed to ensure that creditors would not exit during the period while the Fund is providing financial assistance. This would also give more time for the Fund to determine whether the problem is one of liquidity or solvency. Accordingly, the measures would typically involve a rescheduling of debt, rather than the type of debt stock reduction that is normally required in circumstances where the debt is judged to be unsustainable. Providing the member with a more comfortable debt profile would also have the additional benefit of enhancing market confidence in the feasibility of the member’s adjustment efforts, thereby reducing the risk that the debt will, in fact, become unsustainable.
Translating into English, the IMF here is essentially saying this: “Sometimes we don’t know whether a country’s debt is too high. We need time to work that out. But if we’re lending, during that period, then while we’re deciding whether or not the country’s debt is sustainable, we’re going to force it to default on its private debt.”
There are two big worries at the IMF, according to Lipton. The first is that the IMF sometimes ends up lending money to sovereigns too late, after the country in question has already racked up an unsustainable quantity of debt. The second is that when the IMF does lend money to a troubled sovereign, that money just turns around and leaves the country entirely, in the form of coupon payments to foreign bondholders. In other words, the IMF doesn’t want to be the last chump lending, even as everybody else is using an IMF program as a path for smoothing their exit out of the country.
Hence the IMF’s latest idea, which is not (yet) a fully-fledged proposal, but which is intended to become one at some point. Basically, if you’re a country with a high and possibly unsustainable debt load, then new IMF loans are going to come with the mother of all strings attached: you’re going to have to stop paying back your existing private creditors in full and on time. Instead, you’re going to have to restructure those loans, somehow — term them out, force them to be rolled over — and in doing so you’re going to see all of the ratings agencies, and all of your CDS contracts, unambiguously declare that you have defaulted on your debts.
In the private sector, such financing is extremely rare: you don’t often see lenders to a company insisting that before they lend, the borrower has to stop paying back its current debts as they come due. There’s really only one situation where that ever happens, which is the case of debtor-in-possession financing after a company files for bankruptcy. So despite the fact that the IMF is adamant that it is not attempting — second time lucky — to create a sovereign bankruptcy regime, it does look as though the Fund is steering in that general direction.
Indeed, it looks like the Fund is aiming for a kind of muddled middle — one which is the worst of both possible worlds. On the one hand, it’s going to force countries to default on their debts; on the other hand, after coming out of default, the countries in question will still have debts which are far too high. The good thing about bankruptcy proceedings is that companies emerge from them in viable form, even if doing so means that creditors are forced to take substantial losses. But if all the IMF wants is “more time for the Fund to determine whether the problem is one of liquidity or solvency” — and if it then makes the determination that the country is actually insolvent after all — then the mild restructuring will have to be followed with a much harsher one. And if defaulting once is bad, defaulting twice in short succession is much, much worse.
The official sector understands this fact about markets, although it has never much liked it. Official-sector creditors, including the IMF and its shareholders, never mark to market: when they make loans, they always keep those loans on their book at par, until such a day as the loans are officially written off. The result is the classic series of Paris Club restructurings, where loans get rescheduled, coupons get reduced, and the present value of the debt continually declines — but not where it matters, on the books of the creditors. If you’re a sovereign creditor, rescheduling debts costs you almost nothing, and so it is indeed a great way of buying time for the debtor.
But the Paris Club, just like the IMF, doesn’t like the idea that its generosity will be taken to the bank by private-sector creditors. As a result, it insists on something called “comparability of treatment”: if a country is getting a good deal from the Paris Club, then it needs to negotiate something similar with its private-sector creditors at the same time. Which might be possible when the private-sector creditors are banks, which can sit down across a negotiating table and hammer something out — especially if the banks in question are able to continue to hold the loans on their books at par, on the grounds that they’re being held to maturity.
When the private-sector creditors are bondholders, however, everything changes. The cost of restructuring bonds — a very public default — is much higher than the cost of restructuring loans. And so there’s a constant tension between the official sector and the private sector when it comes to restructurings. The official sector likes to drag things out, in a series of deals; the private sector much prefers to do a single big deal — what’s known in the trade as “one and done”.
In other words, the noises coming out of the IMF aren’t particularly new: they’re pretty standard official-sector whines. What’s new is that it’s the IMF making them, after a decade of studious silence on the subject.
The Fund is treading much more cautiously this time around than it did ten years ago. It’s listening to just about everybody with an interest in the subject, including the wide range of views represented by its own board. (While creditor countries can see where the Fund is coming from, debtor countries are generally pretty solidly opposed, since they fear that any moves in this direction will only serve to drive up their borrowing costs.) Before my panel, for instance, the Fund hosted a discussion between 20-odd experts from the private sector and academia, with a wide range of views.
I was impressed by the certainty with which the various participants expressed their views, because I have no particular dog in this fight, and generally just find myself agreeing with whoever the last person to speak was. Virtually everybody there had an extremely strong case, despite the fact that many of them were deeply opposed to each other. I’ll try to give a flavor of the full range of views here, since it was hard to do that in the public panel. Obviously, many of these views are mutually inconsistent, but they’re all held by some important constituency somewhere — which should give you an idea of how hard the IMF’s job is, if it wants to achieve any kind of consensus on this issue.
The best place to start, though, if only because the views have names attached to them, is the Brookings report. The lead authors include Lee Buchheit, the dean of sovereign debt restructuring, and lawyer who has represented debtor nations around the world. Also on the lead-author list is Jeromin Zettelmeyer of the EBRD, although he’s at pains to point out that his involvement in the report was personal, and that the report does not necessarily reflect the views of the EBRD. More interestingly still, if you look down the list of other committee members involved in putting this report together, you’ll find the name of the biggest buy-sider of them all, Mohamed El-Erian. From what I can glean, he was not an active participant in the process. But the fact that his name is here at all is noteworthy, since there’s a lot in the report to antagonize the buy side in general.
The report unapologetically uses the b-word in its title, “Revisiting Sovereign Bankruptcy”, and is a pretty radical document, if by “radical” you mean the opposite of “market-friendly”. It says that there’s now “a much stronger case for an orderly sovereign bankruptcy regime today than ten years ago”, and lays out what is referred to by critics as the “Greece and Griesa” argument. Basically, the lesson of Greece — and of the euro crisis more generally — is that sovereign overindebtedness is a much bigger problem than anybody thought it was in 2003. As such, if some kind of sovereign bankruptcy regime helped to constrain the amount that countries could borrow on the private market, well, that might be a good thing, rather than — as people thought in 2003 — a self-evidently bad thing. On top of that, Thomas Griesa, a federal judge in New York, has created a huge precedent with his rulings about the way that the pari passu clause can and should be interpreted in bond documentation. In the wake of those rulings, bondholders are more likely to hold out, rather than tendering their bonds into an exchange. As a result, bond exchanges are going to be more and more difficult to execute successfully, and therefore there needs to be some kind of alternative way to restructure a nation’s bonded debt.
The Brookings paper essentially comes up with two separate sovereign bankruptcy regimes: one for the Eurozone, and one for everybody else. This makes sense to me: a one-size-fits-all solution is never going to be optimal with respect to addressing the very specific and idiosyncratic nature of European sovereign debt problems. In both cases, however, the Brookings paper proposes major new legislative changes: an amendment of the IMF articles, as well as an amendment of the ESM treaty in Europe. And in both cases the amended treaties would set an ex ante level for debt-to-GDP ratios, over which no new official-sector money would be lent without a debt restructuring taking place.
There are obvious problems with using a blunt instrument like the debt-to-GDP ratio to determine whether a debt restructuring is necessary. In fact, the Brookings paper goes in the exact opposite direction to the IMF, which is trying to make its debt sustainability analyses increasingly sophisticated. (For instance, if you look at the debt sustainability analysis on pages 43-45 of the Italy Article IV report, you’ll see a range of scenarios, with associated probabilities, rather than just a simple projection.) Obviously, the simple debt-to-GDP ratio excludes a huge number of very important factors: Japan, with its stratospheric debt-to-GDP ratio, is still vastly more creditworthy than Argentina, whose debt-to-GDP ratio is very low. And more generally, flows tend to matter more than stocks: ceteris paribus, the market will always prefer a country with a 100% debt-to-GDP ratio which is in primary balance, on the one hand, to a country with a 50% debt-to-GDP ratio and a primary deficit of 15% of GDP, on the other.
The Brookings paper argues that trying to put together a more complex threshhold, or even coming up with a bespoke number for every country on a case-by-case basis, is an approach which is certain to be gamed, and ultimately to fail. The point of this proposal is to tie the official sector’s hands — since one of the articles of faith underlying both the current IMF project and the Brookings paper is that the official sector has been too weak when it comes to saying no to countries needing funds. The official sector faces “a simple choice,” says the Brookings paper: “to adopt simple ex-ante rules that constrain discretion when structuring rescues, or to adopt no rules. Given the biases that currently exist against any form of debt restructuring, pure discretion would lead to bigger errors than simple rules.”
This is a highly contentious statement: Much of the buy side, for one, is genuinely convinced that the system isn’t broken, and shouldn’t be fixed. Putting in place a system where official-sector funding requires debt default, they say, plausibly enough, will only make matters worse: any time that a country even thinks about approaching the IMF or the ESM for help, markets will plunge, and bondholders will rush to be the first ones out the door.
Under this view, there are many countries — Brazil in 2002, Portugal and Italy more recently — which are clear success stories thanks to official-sector support, and which would have turned into debt-default failures had this kind of a scheme been in place. Official-sector types, on the other hand, are not entirely convinced that Portugal and Italy really are successes, and they reckon that even Brazil got very lucky with booming commodity prices and extraordinarily low global interest rates.
On the other hand, default isn’t what it used to be. Bond defaults used to be rare, just because sovereign bonds were rare: until the Brady plan in the 1990s, most sovereigns with any propensity to default would simply borrow money from banks rather than attempt to tap the bond market. Once bonds replaced loans, then bond defaults started. At first, they were shocking, but each new default makes them seem less so: statistically speaking, if you have a lot of sovereigns with a lot of debt, then some of them are going to default.
As a result, there’s a significant constituency — including quite a lot of academics looking at things like market access and bond spreads — that has a rather more nuanced view of default than the black-and-white idea that it’s always and everywhere a really bad idea, to be avoided at all costs. Under this view, if you look at successful bond restructurings in the past, then countries do indeed get punished quite harshly in terms of market access and bond spreads if they impose harsh and punitive haircuts on their creditors. On the other hand, if the restructuring is market-friendly and is really more of a reprofiling than an outright haircut, then the country often suffers quite minimal adverse consequences.
Those that see default in shades of gray like to draw distinctions and invent new words: rather than “default”, they say, can’t we use the word “treatment” instead? And in any case, don’t most bondholders, in reality, tend to agree on what needs to be done? After all, the elegance of bond markets is that when a country gets into trouble, the original holders of the debt are likely to sell it at a loss to people who can make a profit, even if (especially if) the country goes through a successful restructuring. Argentina is a particularly contentious outlier: in pretty much every other restructuring, holdouts really haven’t been an issue. And even Argentina can be seen as a success story in one respect: because its default happened so slowly, and was telegraphed so clearly, it had very little in the way of spill-over effects. It’s the sudden defaults, like Russia’s, which are the most dangerous: a clearly-foretold default allows the bonds to be held in large part by speculative investors who might actually make money in the event of a restructuring. As a result, a mild default like the one proposed by the IMF could do wonders in terms of minimizing contagion risks.
This argument doesn’t persuade the more hard-minded market types, who say that if holdouts haven’t been an issue up until now, that proves that the current system is working. What’s more, if the official sector starts bigfooting into the markets and telling countries to default, then at that point you can be sure that holdouts will be an issue — especially since the hedge funds who buy sovereign debt at low prices are exactly the hedge funds which are most likely to hold out. The official sector always seems to want the private sector to take a very large haircut, and restructurings have been successful to date only because the debtor and the markets have had the ability to push back against the IMF. (See, for example, Uruguay.)
Some participants go even further, and say that the current system is already too biased against bondholders. Sure, they’ve done OK for themselves — so far — in Portugal and Italy. But look at cases like Greece, Argentina, and Russia: in those countries, bondholders had to take enormous haircuts, in part because there was so much official-sector financing which insisted on preferred-creditor status. If a country has to pay off its preferred creditors in full, then any given necessary debt reduction is going to fall all the more heavily on the private sector. And if the IMF is going to come up with some kind of system for imposing losses on the private sector, that’s a clear sign that the Fund thinks that the private sector’s losses right now are too small.
Lipton sounds at best overoptimistic and at worst downright disingenuous when he says that “providing the member with a more comfortable debt profile would also have the additional benefit of enhancing market confidence in the feasibility of the member’s adjustment efforts, thereby reducing the risk that the debt will, in fact, become unsustainable.” No bondholders are ever going to actively welcome an IMF program which includes a bond default, even if that default in practice doesn’t involve much in the way of present-value losses. Lipton seems to believe that such a program could cause bond yields to go down; that seems like wishful thinking to me.
So, where do I stand on all this? I’d make three main points.
Firstly, this whole thing looks to me a bit too much like a solution in search of a problem. Hard cases make bad law, and when your entire reason for taking action can be boiled down to Greece-and-Griesa, two cases which are highly unique and idiosyncratic, then you’re always going to run the risk of overreach. The big story in emerging markets over the past decade is that their local debt markets have become much deeper and more liquid, meaning that they’re increasingly capable of funding themselves domestically. And domestic debt is not an issue: any time a government wants to default on its domestic debt it can, or alternatively it can just print money to cover the obligations.
The main exception to this rule is the eurozone, where governments do not have control over their own currency. Which is another way of saying that at heart this is really a European problem, rather than a global one, and that it should be solved at a European level, rather than at the level of the IMF. What makes sense for Ireland is unlikely to make sense for Brazil.
What’s more, in Europe, even more than in the rest of the world, debt restructuring is a very bad way of saving money overall. Sure, you can impose losses on sovereign bondholders — but those sovereign bondholders are very likely to be domestic banks. Which means that for every euro you save in government debt, you’re going to end up spending roughly one euro in bank recapitalization.
So rather than concentrate on bond exchanges, I think the Fund — along with Europe’s technocrats — should think much more about alternative ways of retiring outstanding debt at below face value. Ecuador did this very effectively in its most recent default: it simply used cash to buy up its own debt at a deep discount. And if you look at the amount of money that the official sector ploughed into the Greek exchange, it wouldn’t have taken much more to simply buy up most of the outstanding private debt on the public markets, and get rid of it that way.
I do understand that Greece has worried the IMF — and that Griesa has worried them even more. But it’s crazy to let a single vulture fund — Elliott Associates — effectively set the agenda for the design of the entire international financial architecture. Ten years ago, Anne Krueger was prompted to propose SDRM by Elliott’s shenanigans in Peru; today, Lipton is similarly motivated by Elliott’s successes against Argentina. (Not that Elliott has actually gotten paid, yet.) But if the IMF ends up moving in the direction it’s thinking about, the result could end up being counterproductive for everybody. So let’s think seriously about Europe, first. Only then, and only if a European solution proves obviously successful, should we start considering extending something similar to the rest of the world.
Merrill Lynch closed its Octans 1 CDO in September 2006. By April 2008, a year and a half later, the CDO had completely imploded, inflicting roughly $1.1 billion of losses on its outside investors. Now, five and a half years after that, the SEC has finally got around to launching a lawsuit against the CDO manager, Wing Chau.
If that name seems familiar to you, it’s probably because you read The Big Short, Michael Lewis’s account of the men who made a fortune shorting subprime. The biggest villain in that story was Chau, who went on to (unsuccessfully) sue Lewis and his publisher for defamation. Chau’s complaint was that as a result of the publication of Lewis’s book, his “ability to work in his chosen profession has been severely diminished”. Given that his chosen profession is to manage CDOs, one would think his ability to work there would be severely diminished whether the book had been published or not: there’s precious little demand for such services these days. But in any case, if he retained any kind of professional life at all, this SEC lawsuit is likely to kill it stone dead.
That said, the SEC’s suit is a very weird thing. For one thing, the Octans 1 CDO was constructed and marketed not by Wing Chau but rather by Merrill Lynch. The SEC has been looking into Merrill’s CDO shenanigans since June 2011, but — for the time being, at least — Merrill has escaped any kind of CDO-related litigation, even as Citigroup, JP Morgan, Wells Fargo, UBS, and Goldman Sachs (in the notorious Abacus deal) have all paid substantial fines for such things.
And it’s Merrill’s marketing materials, much more than any action by Wing Chau, which are at the heart of the SEC’s case. The problem with Octans 1 is that a hedge fund called Magnetar had some control over its contents, and Magnetar’s role in helping to shape the contents of the CDO was not disclosed to investors. The SEC’s case rests wholly on the fact that the Octans 1 pitchbook and offering circular made no mention of “Magnetar’s rights in and influence over the collateral selection process”. This may or may not have been a felonious omission, but either way it’s hard to see how Wing Chau is really at fault.
The SEC should know this better than anybody. After all, they’ve been here before. In June 2011, it charged Edward Steffelin, another CDO manager, with basically exactly the same thing as it’s accusing Wing Chau of doing now. It makes sense that the SEC charged Steffelin before it charged Chau, because the case against Steffelin alleged all manner of juicy back-channel dealings between Steffelin and Magnetar:
In a complaint filed against Steffelin, who headed the team at GSC responsible for the Squared CDO, the SEC alleges that Steffelin allowed Magnetar to select and short portfolio assets. The complaint alleges that Steffelin drafted and approved marketing materials promoting GSC’s selection of the portfolio without disclosing Magnetar’s role in the selection process. In addition, unknown to investors, Steffelin was seeking employment with Magnetar while working on the transaction.
Those employment enquiries notwithstanding, however, the SEC’s case against Steffelin was ultimately pretty flimsy, and collapsed, ignominiously, in May 2012, with the SEC dropping all charges. James Stewart had an excellent column, a few months later, laying out the facts:
At first blush, Mr. Steffelin’s case may have looked like Goldman’s. The S.E.C. charged that Mr. Steffelin allowed a large investor in mortgage-backed securities, a hedge fund called Magnetar Capital, to help choose the assets in the C.D.O. that JPMorgan structured and marketed. The commission further contended that Magnetar was betting against some of those securities and that Mr. Steffelin should have disclosed this to investors, but did not.
Among the problems with this theory were Mr. Steffelin’s claim that Magnetar didn’t choose the assets that went into the deal, even if it was aware of some of them (JPMorgan made the final decision); that JPMorgan, not Mr. Steffelin, was responsible for the offering documents and that Mr. Steffelin accurately provided whatever information JPMorgan wanted; and that lawyers for GSC and JPMorgan scrutinized the offering materials and signed off on them, so Mr. Steffelin, who isn’t a lawyer, had every reason to believe they passed muster.
Replace “JP Morgan” here with “Merrill Lynch”, “Steffelin” with “Chau”, and “GSC” with “Harding”, and Stewart could have written exactly the same thing about the current case. Magnetar did not choose the assets in Octans 1: the deal was put together by Merrill Lynch so as to be acceptable both to Magnetar and to Chau. Chau was even more of an active participant in putting the CDO together than Magnetar was. The offering documents were Merrill’s, not Chau’s. And it’s a bit weird to prosecute Chau for failure to make certain disclosures, when firstly he’s not a lawyer, and secondly he wasn’t in charge of what was being disclosed in the first place.
So why is the SEC bringing this case against Chau, when its case against Steffelin collapsed, and the case against Merrill Lynch would appear to be much stronger? (JP Morgan didn’t even fight the Steffelin case: it settled, immediately, for $153.6 million.) Maybe they figure that Chau can’t afford to fight: Stewart reported that Steffelin’s legal fees ended up being more than $3 million, all of which was paid for by GSC’s insurer, AIG. Fresh off one legal defeat, it’s easy to see how Chau might not have a lot of appetite for another big fight.
Maybe it’s just that Chau is one of the few named villains of the financial crisis: if you’ve read one book on the subject, it’s probably Lewis’s, and Chau comes off very badly there. With the SEC looking for a slightly higher-profile individual scalp than Fabrice Tourre, they alighted on Chau. But the fact is that the SEC’s case is very weak, and this case looks not only tardy but also pretty desperate. If Chau has the financial and emotional wherewithal to fight it, I suspect he’ll win pretty easily.
Now that the ban on general solicitation is over, all manner of weird companies are emerging from the nether regions of the internet, trying to persuade people to part with their money in return for a nominal stake in some unlikely investment. One of the glossiest of these new companies is Fantex, which just filed a prospectus for its first athlete-IPO.
Fantex couldn’t have hoped for better press: the NYT covered the story in its Venture Capital section, under the headline “If You Like a Star Athlete, Now You Can Buy a Share”. ESPN, meanwhile, went with “Fantex to offer Arian Foster stock”, while USA Today opted for “Want to invest in NFL’s Arian Foster? Here’s a chance”. Which just says to me that none of the journalists actually read and understood Fantex’s S-1.
The idea here is not a new one; indeed, Michael Lewis wrote about it in depth as long ago as April 2007.
When financial historians look back and ask why it took Wall Street so long to create the first public stock market that trades in professional athletes, they will see ours as an age of creative ferment. They’ll see a new, extremely well-financed company in Silicon Valley that, for the moment, sells itself as a fantasy sports site but aims to become, as its co-founder Mike Kerns puts it, “the first real stock market in athletes.” And they’ll find, in the bowels of the U.S. Patent and Trademark Office, an application from a cryptic entity called A.S.A. Sports Exchange containing a description of a design for just such a market: The athlete would sell 20 percent of all future on-field or on-court earnings to a trust, which would, in turn, sell securities to the public.
Kerns’ cryptic entity ended up being called Protrade, and going exactly nowhere. But Fantex is basically exactly the same thing, just a little bit more complicated and less attractive to investors. With Protrade, you’d buy shares in a trust, which would own 20% of any athlete’s earnings. With Fantex, by contrast, you buy shares in Fantex — a highly risky startup company which is losing money and which has precious little income with which to cover its substantial expenses.
The vast majority of the shares in Fantex — 100 million, to be precise — are closely held by its founders and backers. But another 1 million are being sold to chumps at $10 apiece, to raise the $10 million that Fantex is going to pay Arian Foster, who currently plays football for the Houston Texans. The chumps are buying something called a “tracking stock”, the performance of which is supposed to mirror the economic fortunes of the 27-year-old athlete. And maybe it will. Or, maybe it won’t. The directors of Fantex are under no obligation to pass Foster’s earnings on to shareholders in the form of dividends — even assuming that the contract with Foster does indeed do what it’s meant to do, and result in Fantex receiving 20% of Foster’s earnings, more or less in perpetuity.
The press surrounding Fantex makes it seem as though the biggest risk here is that Foster ends up with a dud of a career — and that is indeed one of the many risks with this investment. But that’s also exactly what Fantex wants you to think: that your stock will go down if Foster does badly, and will go up if he does well.
In reality, however, there are even more non-Foster risks to this stock than there are Foster risks. Your stock, for instance, can only be traded on an exchange which is owned and operated by Fantex. The directors of Fantex can, at their sole discretion and at any time, convert all your Foster shares into common Fantex shares, at any ratio which they determine to be fair. Or, more realistically, they can just go bust: after all, as the prospectus notes, they have no experience in this business. And if they go bust, then the holders of the tracking stock will end up owning about 1% of a bankrupt company, no matter how successful Foster is. As the prospectus says:
While we intend for our Fantex Series Arian Foster to track the performance of the brand, we cannot provide any guarantee that the series will in fact track the performance of such brand. The board of directors has discretion to reattribute assets, liabilities, revenues, expenses and cash flows without the approval of shareholders of a particular tracking series, which discretion will be exercised in accordance with its fiduciary duties under Delaware law and only where its decisions are in the best interests of the company and the stockholders as a whole.
In other words, when the directors decide “to reattribute assets, liabilities, revenues, expenses and cash flows”, their duty is to Fantex, the holding company, and not to the chumps with the Foster shares, who between them account for less than 1% of Fantex’s equity. And in general, as the prospectus also says, “any of our tracking series will be subject to the risk associated with an investment in Fantex as a whole”.
This investment, then, is basically the worst of all possible worlds: if Foster fails, it fails, and if Fantex fails, it also fails. And even if they both do quite well, you’ll only be able to profit on your investment insofar as a completely separate business — the Fantex stock exchange — actually works.
Fantex isn’t looking to raise a huge amount of money here: $10 million should be achievable, given the vast sums bet on fantasy leagues every season. You only need 5,000 chumps investing $2,000 each and you’re there. So Foster is likely to get his cash. But after that, I can’t see this thing going well. Football players are notoriously bad at organizing their finances; is Foster really likely to manage to timely file his mandated Quarterly Report, which “shall detail all Brand Income earned during such quarter, detail the calculation of the Brand Amount for such quarter with respect to such Brand Income, and provide such additional information and certifications required to be included in the Quarterly Report, including such matters as specified in Exhibit E”, within ten days of the end of every calendar quarter, for the rest of his career?
Some time quite soon, Foster is going to receive a $10 million check from Fantex; if he’s typical of most 27-year-old star football players, he’s likely to spend most if not all of that money pretty quickly. But for what will probably be the rest of his life, he’s going to be burdened by what is essentially a private 20% income tax, over and above everything he owes to the government, and to his creditors.
There might be people out there who like the idea of buying and selling stock in Arian Foster — speculating on the fortunes of someone else. But if they stop to think about what they’re doing, they’ll probably realize that it’s pretty distasteful. What they’re trading is the present value of Foster’s future earnings: they’re saying that in many years’ time, long after Foster has left the gridiron for good, they will be sitting there, with their hands out, every quarter, demanding from him 20% of everything he earns. Here’s how the Fantex website puts it:
IT DOESN’T HAVE TO END AT RETIREMENT.
This is a stock linked to the value and performance of an athlete’s brand, not the person. When the athlete retires, their brand may or may not continue to generate income into the future (e.g. endorsements, appearances, broadcasting, etc.). As long as the brand continues to generate income as defined in the brand contract, Fantex, Inc. is entitled to continue to receive payments pursuant to its brand agreement.
This kind of language is deliberately dehumanizing: the athlete is referred to not as a person but as a “brand”, throughout. And the racial overtones are unavoidable: Fantex’s About page features four grinning middle-aged white men, while the man they’re taking 20% of is young and black. This isn’t slavery, this isn’t ownership. But the rich white businessmen are buying something for their $10 million, while Foster is legally binding himself to writing substantial checks to those businessmen, and/or their successors, every three months, for what is quite likely to be the rest of his life.
Before you put any money into Fantex, then, ask yourself two questions. First, do you want to make a really stupid investment? And second, do you really want to buy shares in a company which treats young black men as property to be acquired and then privately taxed? Because that’s exactly what you’re going to be doing.
There’s a strain of triumphalism coursing through the blogosphere today, on the grounds that the bonkers wing of the Republican party is going to have achieved exactly none of its own goals, while inflicting upon itself a massive black eye. The markets are feeling vindicated too: over the past week of DC craziness, the stock market has risen, pretty steadily, a total of about 2.5%. As a trading strategy, “tune out all news from inside the Beltway” seems to have worked very well — it’s a complete vindication of the Nassim Taleb idea that investors shouldn’t read the newspaper. On top of that, the potential debt default was by its nature almost impossible to trade: outside a few obscure instruments like US CDS, it’s very difficult to make money from a trade betting that tails are going to get fatter, for a short while.
But as a feeling of relief courses through Washington and the markets, let’s not get carried away. Yes, as Jonathan Chait says, it’s very good news that the House Republicans’ plan collapsed. But the can hasn’t been kicked very far down the road: we’re going to hit the debt ceiling again in just a few short months. And at that point, one of two things will happen. Either the Republicans, licking their self-inflicted wounds from the current fiasco, will quietly and efficiently pass a bill while getting nothing in return. Or, in the spirit of “if at first you don’t succeed”, they will try, try again.
Joe Weisenthal, like Chait, is hopefully eyeing the first possibility.
If Obama killed the GOP’s revolutionary nihilism, it will go down as the #1 accomplishment of his Presidency.
We can’t be certain Republicans will never hold the debt ceiling hostage again; but Obama has now held firm twice in a row, and if he hasn’t completely crushed the Republican expectation that they can extract a ransom, he has badly damaged it. Threatening to breach the debt ceiling and failing to win a prize is costly behavior for Congress — you anger business and lose face with your supporters when you capitulate. As soon as Republicans come to believe they can’t win, they’ll stop playing.
The problem is that, pace Weisenthal, you can’t just kill someone’s revolutionary nihilism. The Ted Cruz “filibuster” is a great example: it served no actual legislative purpose, and at the end of his idiotically long speech, Cruz ended up voting yes on the very bill he was trying to kill. That’s zombie politics, and the problem with zombies is that — being dead already — they’re incredibly hard to kill.
The point here is that the zombie army, a/k/a the Tea Party, is a movement, not a person — and it’s an aggressively anti-logical movement, at that. You can’t negotiate with a zombie — and neither can you wheel out some kind of clever syllogism which will convince a group of revolutionary nihilists that it’s a bad idea to get into a fight if you’re reasonably convinced that you’re going to lose it. Spoiler alert: it turns out that Ed Norton was beating up himself, all along. When you’re Really Angry, sometimes losing a big fight against The Man is exactly what you feel like doing.
This is why Michael Casey is right: the US should be downgraded. Zombies have taken over a large chunk of the Capitol, and there’s no particular reason to believe that they’re going away any time soon. We will have more sequesters, and more shutdowns, and more debt-ceiling fights, and eventually, in a statistical inevitability, we will fail to find some kind of way through the mess. Besides, as Casey says, even if we do, somehow, manage to muddle through, that doesn’t change the basic underlying fact: “triple-A credits do not behave like this.”
Remember that the sequester was initially put into place as a way to force the hand of any self-interested, logical group of politicians. They had to either come to an agreement — or face an outcome which was specifically designed to be as unpalatable to as many different interest groups as possible. And yet, despite the Sword of Damocles hanging over their heads, the politicians squabbled until it fell. The bigger sword, the debt ceiling, has not fallen yet — but I for one have no particular faith in the ability of Congress to always prevent it from doing so.
Yes, the President has won an important battle against the zombies. But while it’s possible to win a zombie battle, it’s never possible to win a zombie war. No matter how many individual zombies you dispatch, there will always be ten more where they came from. The Tea Party doesn’t take legislative defeat as a signal that it’s doing something wrong: it takes it as a signal that nothing has really changed in Washington and that they therefore need to redouble their nihilistic efforts. Take it from me: come February, or March, or whenever we end up having to have this idiotic debt-ceiling fight all over again, the Tea Party will still be there, and will still be as crazy as ever. A bruised zombie, ultimately, is just a scarier zombie.
Update: Many thanks to Dan Drezner, who has helpfully supplied the soundtrack to this post: