Felix Salmon

The Frannie gamble

Felix Salmon
May 29, 2013 22:55 UTC


This is a three-year chart of Fannie Mae’s common stock, which fell almost 30% today; it’s now at a level not seen since Friday afternoon. You can think of this as shares “getting destroyed” if you want — but really what we’re seeing here is little more than a game of chicken between traders who find it easier to day-trade from their desks than to jet to the 32nd floor of the Galaxy Macau casino for the weekend.

Every so often the financial markets throw up a security which doesn’t make any sense from an intrinsic-value perspective but which traders love to trade anyway. A large amount of cocktail chatter than springs up around the question of whether this is all just a game, where traders try to second-guess each others’ moves, or whether there might actually be some value buried in there somewhere.

Examples are easy to find: AIG stock circa January 2010, for instance, or credit default swaps on the USA a year earlier. For people who have internalized the efficient markets hypothesis, the fact that such things have value means that there has to be a credible story explaining where that value might lie. And sometimes there is: AIG is now a genuinely valuable company, and shares which were trading at a silly $29 in January 2010 are now trading at a pretty sensible $45.

The Frannie trade is interesting because it’s basically a bet on the US government taking pity on various different classes of shareholder. The common stock is pure gamble, but there’s real money being invested in the preferred stock, which is being held by the likes of John Paulson and Jim Millstein, the man who managed to unlock the value in AIG. Millstein explained the bull case to Nick Timiraos:

At some point over the next year, “the government is going to get all of its money back. So the questions for the government are what will, and what can, they do with the excess?” said Mr. Millstein.

Fannie and Freddie, which took around $188 billion from the U.S., will have paid the government about $132 billion in dividends by next month. Investors betting on the preferred shares are taking heart in those improved fortunes.

The problem is that while the government might well get its money back, in nominal terms, from Fannie and Freddie, the $188 billion in debt is still outstanding: the $132 billion in dividends has not paid down a penny of the debt. Since the debt is first in line for any payout from the companies, there’s no particular reason to believe that the preferred stockholders, who are next in line, or the equity holders, who are even more junior, are ever going to see any money at all. The government can keep on dividending out as much money as it likes from Frannie, and still hold onto 188 billion reasons why no one else should ever get anything.

Of course, if the government wanted to recapitalize Frannie and give the companies back to their current shareholders, it always could. But that doesn’t seem likely — especially given how fiscally conscious most of Congress is, these days. And certainly there’s been nothing in recent weeks to justify the massive run-up in the prices of the preferred and the common shares. Rather, what we’re seeing is textbook speculation: people buying shares just because they think a greater fool will be willing to jump onto the momentum trade in the future. If you time it well, you can make a lot of money with that strategy.

There’s another trade here, too, though, which is more distasteful. Timiraos reports that “small investors also have begun to pile in” to Frannie preferreds, and I can’t help but think that they’re doing so for much the same reason that their counterparts a few years ago invested with Bernie Madoff. Back then, it was thought that Madoff was managing to front-run the market, and that his investors were reaping the benefit; now, it is thought that well-connected Washington types like Millstein have inside information about what the government is going to do, and/or are likely to influence the outcome, and that the smart trade is to just follow the insider money.

But that trade — following the smart money — almost never works for retail investors, since the smart money never advertises its exits. If you were lucky enough to be in on this trade a few weeks ago, then you’re sitting on a very nice profit right now. But my guess is that it’s over now, and that if the stock has peaked, the Frannie preferreds aren’t going to stay at their current elevated levels much longer.


The run-up in the common this week was pure momentum players. It had to end badly.

- IF – there is any value in the Agencies, it will be in the pref, not the common. The end result would have to be a conversion of the pref to new common. That would dilute the existing common shares by 5Xs.

Felix points to the Fannie S pref. A better benchmark is the Fannie T, last at $8.

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Don’t fear the bubble

Felix Salmon
May 22, 2013 16:41 UTC

Tyler Cowen has no truck with the Bubble Crew. He aligns himself with Paul Krugman and against Jesse Eisinger; we can add Gillian Tett to Eisinger’s side of the debate, and Jim Surowiecki to Cowen’s.

The bubblista side of the argument, at heart, says that the flood of money being poured into the global economy by the world’s central banks is driving up asset prices to well beyond fundamental valuations, and that if and when valuations revert to sanity, the unwind (the “burst”) could be disastrous in all manner of unpredictable ways.

This is a prediction which is very easy to make, not least because it has no time stamp associated with it. Tett, indeed, says that “these distorted conditions will remain in place far longer than most people expect”, which is little a bit weird: the whole reason why assets are expensive is precisely because, as Krugman says, “long-term rates are low because people, rightly, expect short-term rates to stay low for a long time.” And when long-term rates are low, that doesn’t just affect the price of long-dated bonds; it also drives up the price of stocks, which have infinite maturity.

Still, this is a good place to start, because there does seem to be consensus here: low interest rates, across the curve, are causing asset prices to rise, around the world. Is that prima facie evidence of a bubble? I’d say clearly not. The first job of financial markets is to be a place where you can convert future cashflows into a present-day lump sum, and that lump sum is naturally going to be higher when interest rates are low. Similarly, if and when interest rates start to rise, asset prices may well start to fall. But that’s just what financial markets do: they go up, and they go down. Not every rise is a bubble, and not ever fall is a bubble bursting.

The word “bubble”, at least for me, is a loaded term, with a specific meaning. For one thing, it implies speculation: people buying an asset which is going up in price, just because they think they’re going to be able to sell it to a greater fool at a substantial profit. The dot-com bubble was a prime example of that, with investors jumping onto high-flying technology stocks not because they thought the stocks were cheap but just because they thought the stocks were rising, and that they could make money day-trading these things. Much of the housing bubble looked like that too: you could buy a tract home in Phoenix with no money down, hold on to it for a few months, and then flip it for a substantial payday — even if you never expected to live in it. And certainly the bitcoin bubble fits the bill: pretty much the only reason to buy bitcoins and hold them for more than about 10 minutes is that you think they’re going to go up in value and that you’ll be able to make money as a result.

Is it possible to have a non-speculative bubble? In certain rare cases, perhaps. For instance, there was the market in Impressionist paintings in the 1980s: they went up in value enormously, and then the bubble burst and values came back down again. But people weren’t buying these things to flip them, and — importantly — no real harm was done to anybody when prices stopped going up and started going down. Similarly, in 2007, I said that if Manhattan property prices were in a bubble, then it wasn’t a speculative bubble. And again, whether you call it a bubble or not doesn’t really matter: when Manhattan property prices declined during the housing bust, no real harm was done to anybody.

In any case, the truly defining characteristic of a bubble is surely its bursting. The reason to be worried about bubbles has nothing to do with fear of what happens when everybody is happily making money. Rather, the problem with bubbles is that they burst; bursting bubbles are dangerous, unpredictable things which we should rightly be afraid of. Or, to put it another way: if asset prices simply decline without causing substantial collateral damage, then you weren’t in a bubble to begin with; you were simply in a bull market which then became a bear market.

Looking at the markets today, they show every indication of being bull markets rather than bubbles. For one thing, there’s not much speculation going on: no one’s day-trading junk bonds. Eisinger says that the One Percent are getting wealthier “through speculation”, and cites private-equity firms in the “house flipping” business, but that’s really not what’s going on at all: the One Percent are getting wealthier just because they own stocks and those stocks are going up, while the private-equity firms buying houses aren’t flipping them, but are rather renting them out, as part of their global search for yield. That’s real investment, it’s not speculation. What’s more, when Eisinger points to this chart as evidence that stocks are overvalued, he’s pointing to a chart which shows that — except for a deep “V” at the very height of the financial crisis — shows stocks trading at pretty much their lowest valuation of the past 20 years. Nasdaq 5,000 this is not.

More importantly, investors aren’t leveraged in the way they were during the housing boom: no one’s buying houses with no money down, and no one’s borrowing billions of dollars to invest in super-senior CDO tranches. The dot-com bust wiped out hundreds of billions of dollars of paper wealth, but only caused a relatively mild recession: the reason was partly the fact that Alan Greenspan was able to slash interest rates, but it was also in large part a function of the fact that very little of the dot-com bubble was fueled by leverage.

Today’s markets might well be frothy — but, in the short term at least, that’s a good thing for the real economy. So far this year, we’e seen 1,413 companies issuing stock onto either the primary or secondary markets, raising $288 billion in the process — that’s up 33% from the same period last year. (And remember, the same period last year included the Facebook IPO.) Amazingly and wonderfully, that total includes $74 billion of issuance in Europe, up a whopping 44% from the same period in 2012. Companies don’t generally raise equity capital just to sit on the cash: they raise it so that they can invest the proceeds into their business, thereby creating jobs and economic growth.

Companies are raising equity capital right now because doing so is cheap for them: the higher that stock prices go, the more that we can expect this trend to continue. And that’s good for the economy. And, of course, investors are getting wealthier, which causes some nonzero wealth effect in terms of the amount of money they spend. So, what’s not to like, in terms of markets going up? If it means that the population gets richer and companies have more money to invest in their business, what’s the downside?

Over the long term, expensive stocks are bad for people who are trying to save for retirement: the more you pay for your investments, the lower your ultimate return is going to be. But that’s a relatively minor concern right now. The bubble-worriers have something else on their minds — something more moralistic. They see the rich getting a free lunch: central banks dropping money from helicopters, most of which is going directly into the pockets of the top 1%. That isn’t fair, and they are sure that there’s some kind of cosmic karma which means that wherever there’s a party, there’s bound to be a hangover.

The view that “we have to pay a price for past sins” is nearly always wrong, and in any event the only real sin being committed here is that the rich aren’t sharing their good fortune with everybody else. The stock market is a rising tide which is lifting only the luxury yachts; everybody else is underwater. That is genuinely deplorable. But it doesn’t mean that we’re in a bubble, and it doesn’t mean that if and when the tide goes out, the rest of us are going suffer massive injuries. There are always tail risks, of course: there are always unknown unknowns. But for the time being, the most likely scenario is that when asset prices start to fall, the main people to be hurt will be the ones owning the assets in question. In other words, the people who can best afford it. That’s not a bursting bubble: it’s just a common-or-garden bear market, of the type that all investors should be able to withstand.


Nice comment Ken_G!

Felix, surely it’s got more to do with behaviour and attitude to and perception of risk than it does to interest rates? People are currently falling over themselves to invest right now, and have been doing so in increasing numbers since September of last year. If you remember back to Mario Draghi’s comment about doing everythng necessary to protect the Euro, and that was when confidence returned to the market.

As share prices increased, consumers got more interested and started buying in increasing numbers. Share prices increased further. Despite the sceptics who for years have been berating the rest of us by forecasting nothing but doom and gloom, the Euro didn’t crash and burn, the US economy didn’t collapse under the weight of its rescue plan of QE stimulus, and even the Swiss Franc is now weakening against the USD, the GBP and the EUR as money moves away from safe havens and into areas of higher risk.

It doesn’t seem so long ago you were writing an article about the ever strengthening Swiss France before the Swiss National Bank protected it at a rate of Fr. 1.20 to the Euro; today it has weakened to Fr. 1.24 while yesterday it hit Fr. 1.27 for a time. The USD is now up from Fr. 0.92 to 0.96, and the GBP is up from a low point of Fr. 1.24 to a stronger Fr. 1.45 now.

Yes, there is profit taking, and I guess a lot of options are being cashed in too as they have suddenly become interesting again. As the executives pocket the proceeds of these freebies, they will begin to feel more expansionary in how they look at decisions and I am guessing will psychologically feel more inclined to take higher risks, dipping into their company cash piles and using the money for new projects to generate new profits and new growth.

Happy people invest more, spend more, and the economy benefits as a result. Anyhow, current stock market levels are only just thereabouts as high as they have been before, so how can that be a bubble? Yes, recent growth has been like that out of a recession, but I suspect it has a lot to do with suppressed demand and a wall of money hitting the markets needing a home to go to.

The optimists are returning and the pessimists have been shown up as scaremongers, often with selfish political not economic motivations for their words.

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Why dedecimalization is a bad idea

Felix Salmon
May 14, 2013 16:00 UTC

Dan Primack is excited about a new bill which would give small-cap companies the option to have their stocks be quoted at 5-cent or 10-cent increments rather than the standard one-cent gap. He explains:

Small-cap stocks are trapped in a cycle of arrested development. They are small, so they are ignored by analysts and market-makers. And because they are ignored by analysts and market-makers, they remain small.

The first part of this is surely true: analysts and market-makers do tend to ignore small-cap stocks. But from there on in, things start getting very sketchy. For one thing, there’s no evidence that if you’re ignored by market-makers, your company finds it harder to grow. Even today, in order for a company to grow, it needs more than just a fluffy stock price: it also needs things like increasing profits, or revenues. And while higher profits can feed quite easily into a higher share price, the causality is much harder the other way around — having a high share price doesn’t particularly* help you grow, especially if you’re not interested in acquisitions.

So the premise here is pretty unconvincing to start with: the idea that if we get more analysts and market-makers to cover a particular stock, that will help publicly-listed small-cap companies grow. But there’s a hidden premise here as well, which is even less convincing: that if we allow stocks to be quoted in increments of 5 cents or 10 cents, that will improve the quantity and quality of the market support those companies receive.

One of the good things about the world is that the world of stockbrokers is in secular decline. Americans are — finally — beginning to realize that discount brokers and ETFs and index funds are much more sensible ways to invest than the old method, where a friendly sales guy from Merrill Lynch would chatter away about this stock and that stock and eventually charge you an enormous commission for the privilege of buying or selling at what was invariably exactly the wrong time.

Congressman David Schweikert, who is putting forward the new bill and who represents Scottsdale, Arizona, is puzzled that the SEC has done nothing on tick sizes, despite “overwhelming evidence that wider ticks for small-cap companies will stimulate liquidity, encourage capital formation, and grow jobs”. But I for one haven’t been overwhelmed by any such evidence, and the people pushing it seem to be exactly the industry insiders who would make lots of money from it.

The Schweikert bill is particularly interesting because it doesn’t actually decimalize the small-cap stocks in question. Instead, it quite explicitly just funnels money from small investors to bigger investors and brokerages. Here’s the key bit, with my emphasis added:

The Spread Pricing Liquidity Act allows companies with public float of less than $500 million and average daily trading volume under 500,000 shares to select to have their securities quoted at increments of either 5 or 10 cents, while maintaining trading between the quoted ticks.

Essentially, what this does is disembowel the wonderful NBBO system which has done more to protect small investors than anybody else. NBBO, which stands for National Best Bid/Offer, is the system whereby all of the stock quotes on all of America’s exchanges are aggregated, so that all investors can at any time see the very best bid and the very best offer for any stock. If you’re a small investor, these days, you can pretty much always get immediate execution at NBBO, the best price in the market. The combination of decimalization and high-frequency trading has, in the words of former SEC commissioner Arthur Levitt, “transferred billions of dollars from the pockets of brokers into the pockets of investors;” for the first time ever, small investors get the best execution in the market, rather than the worst.

(This, incidentally, is one of the reasons why it’s hard to write about the problems with high-frequency trading for a generalist audience — there’s no Wall-Street-is-ripping-off-the-little-guy angle, for all that everybody would love to find one.)

Under the Schweikert bill, however, all that goes away. While the brokers and the algobots will still continue to trade in penny increments, smaller investors — and quite possibly bigger investors, too — will only see prices quoted in multiples of 5 cents or 10 cents. For instance, say a stock is quoted at $13.35/$13.40. If you put in a buy order, you’re going to pay $13.40. But the real trading will be going on inside the spread, and your broker can go into the market and snap it up at $13.38, while you still pay the higher price. There’s no way that small investors can possibly benefit from this.

Will brokers take the rents they extract from small investors and reinvest them in deeper coverage of small-cap companies? That’s the hope, but I’m not holding my breath. In a shrinking market, they’re much more likely to hold on to their profits as much as they can. And besides, it’s not like companies need David Schweikert to come to the rescue if what they want is a wider bid-offer spread: all they need to do is have a stock split.

Schweikert was one of the prime movers behind the problematic JOBS Act, where the SEC has done a good job of stalling on various silly yet Congressionally-mandated reforms. This bill seems like a replay: Schweikert wants to force the SEC’s hand on dedecimalization, since the agency is being sensible and dragging its feet. I hope he fails.

*Update: Primack points out that a higher share price can be helpful if companies want to raise subsequent equity rounds, after they’ve gone public.


“Americans are — finally — beginning to realize that discount brokers and ETFs and index funds are much more sensible ways to invest than the old method, where a friendly sales guy from Merrill Lynch would chatter away about this stock and that stock and eventually charge you an enormous commission for the privilege of buying or selling at what was invariably exactly the wrong time.”

Strange that Americans haven’t got richer, with all these great developments, isn’t it? Specifically, the evidence has pretty much piled up that without that friendly sales guy, middle class American saving has absolutely cratered. Non-selling is a much bigger problem than mis-selling, but the regulators never look at that because it’s not a problem that can be blamed on anyone.

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Why CEOs should be rewarded for stock buybacks

Felix Salmon
May 6, 2013 17:03 UTC

Scott Thurm and Serena Ng have an odd piece in today’s WSJ, complaining about executive pay being tied to per-share results rather than overall numbers. Their poster child is Safeway CEO Steven Burd, who has overseen a substantial increase in earnings per share even as sales and profits have gone nowhere, by spending $1.2 billion on stock buybacks.

The implication here is that public companies should be concentrating on growth, rather than on more financial metrics like earnings per share or return on equity. And I think that’s exactly wrong. Not all companies should be growing; some of them, in order to maximize their return on capital, should instead be shrinking. The world’s biggest banks are a good example: most of them are trying to shrink, because doing so will make them leaner, more efficient, and ultimately more valuable.

Stock buybacks aren’t always a good idea: companies do have a tendency to spend far too much money on them at exactly the wrong time, when the share price is high. (There are many examples, but one of the most tragic is probably the New York Times Company, which today is in desperate need of the $2.7 billion it spent on stock buybacks between 1998 and 2004, when the stock was much more expensive than it is now.)

On the other hand, stock buybacks are a very efficient way of returning money to shareholders: they’re basically a pick-your-own-dividend scheme. Many shareholders, especially individual shareholders in high tax brackets, dislike dividends, because they’re taxable income. But if a company takes the money it would otherwise spend on dividends, and spends it instead on buybacks, then shareholders have a choice: they can sell any proportion of their shares back to the company, in line with their liquidity needs, and if they sell nothing then the value of their shares goes up just because the total number of shares is going down. On top of that, companies don’t feel the same need to maintain a steady level of buybacks, in the way that they do feel the need to maintain a steady level of dividends.

If more public companies concentrated on earnings per share rather than overall earnings growth, that would probably be a good thing. Right now, it’s almost impossible to be a successful CEO of a public company whose industry or company is in long-term secular decline. And private-equity companies are well aware of that fact: they love to buy up such firms and extract vast amounts of money from them before they die. Rather than see the spoils of such tactics accrue mainly to the Mitt Romneys of this world, it would be great if the broad shareholding public could also participate in the efficient rotation of capital out of declining industries and into growing ones.

That’s the way the stock market is meant to work, after all: you invest in companies while they are growing, in the hope and expectation that you will be able to make money from their high future cashflows once they reach maturity. But in practice the stock market has great difficulty valuing companies which make large but falling profits, with the result that most of those profits ultimately end up going to private-equity types once the companies are acquired in a leveraged buy-out.

Safeway is faced with a choice right now: it can burn billions of dollars in what would probably be a fruitless attempt to compete with Walmart, or it can return those billions to shareholders, to be reinvested in more promising areas. Safeway’s CEO should choose between those options dispassionately, rather than simply assuming that more investment is always better — and his board should compensate him in such a way that he’s incentivized to make the best decision, rather than always going for growth.

Stock buybacks are an efficient way of returning money to shareholders of a shrinking company, and as such they’re an important part of the public-company CEO toolbox. I’m sure they can be abused at times to manipulate quarterly earnings. But they can also be a pretty efficient way of doing what the stock market is meant to do best: distributing capital to where it can be most effectively deployed. If Safeway has more capital than it can efficiently use, then it should return that capital to the market, where it can be recycled into more promising investments. And in principle it’s entirely reasonable to reward the CEO for doing just that.


Felix, test your take against David Stockman’s, who, after summarizing how Cisco and ExxonMobil have used stock buybacks to enrich senior management, writes:

“The truth of the matter is that the management and board of … most public companies, are addicted to share buybacks. Buy-backs are the giant prop which keeps share prices elevated, existing stock options in the money and the dilutive impact of new awards obfuscated. They are also the corporate laundry where Federal income taxes are rinsed out of top executive compensation through the magic of capital gains.”

David Stockman, “The Great Deformation,” p. 458.

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Apple’s new pitch to investors

Felix Salmon
Apr 23, 2013 22:19 UTC

Today’s earnings report marks the point at which Apple is officially no longer a high-growth tech stock, valued on its monster potential. Instead, it has become a cash cow, valued on its ability to pump hundreds of billions of dollars into its shareholders’ pockets.

That’s the main lesson from the big news of the day, which is that Apple is going to return $100 billion to its shareholders by the end of 2015. By comparison, Apple closed Tuesday with a market capitalization of $380 billion. And its $145 billion cash pile isn’t going to get any smaller: the newly-announced program merely brings its dividend and share-repurchase expenditures up to roughly the level of its current free cash flow. Apple will still have more than enough money to invest as much money as it likes in anything it likes, even its new headquarters.

Apple says that its new capital-return scheme “translates to an average rate of $30 billion per year from the time of the first dividend payment in August 2012 through December 2015″; it’s pretty hard to imagine that number falling thereafter. If you assume fungibility of dividends and share repurchases, then you can express that number as an effective dividend yield: a $30 billion dividend, divided by a $400 billion market cap, works out to a yield of a whopping 7.5%. No wonder the stock market is welcoming the news.

In order to be able to continue to return $30 billion per year to shareholders in perpetuity, Apple is going to have to become a more conservative and predictable organization than it has been until now. Which brings me to the chart that Jay Yarow published yesterday:


As Yarow says, this chart shows the effects of Apple’s stated intention to be more realistic about its earnings guidance. And today’s earnings continued the pattern: EPS beat guidance by 7%, while revenues beat by 4%. Those numbers are decidedly modest compared to the kind of beats we saw in 2010-11.

But at the same time, we’re also seeing the law of large numbers in this data. Let me present Yarow’s revenue data in a slightly different way, adding in today’s latest datapoint:


It’s pretty clear that the massive beats, here, took place at times of massive growth: all corporate numbers are hard to predict, even internally, when they’re growing at 73% a year, like Apple’s revenues did in 2011. This quarter’s revenues are still substantially higher than the same quarter’s last year: they’re up 11%. But earnings per share are actually down by 18% from the same quarter last year, and when you’re a manufacturer making $10 billion a quarter on revenues of more than $40 billion, and when you’re as ruthlessly efficient as Apple is, you’re not likely to have a lot of big surprises any more.

Apple is trading at an astonishingly low valuation, with a p/e ratio in single digits, because it has now become that animal investors like least: a slow-growing tech stock. Either one is fine on its own, and both slow-growing stocks and fast-growing tech stocks can support much higher multiples than Apple is seeing right now. But conservative investors, who like slow-growing stocks with high dividends, are constitutionally uncomfortable with the volatility inherent in the tech world. And technology investors, who are happy taking that kind of risk, want to see substantial growth. Apple, notwithstanding the fact that it’s one of the most valuable companies in the world, is falling through the capital-markets cracks.

All of which perhaps explains the other part of today’s announcement: that Apple is going to start leveraging itself, and taking on debt. Apple’s debt will provide a safe low-yielding investment for conservative investors; and while it will increase the earnings volatility seen by shareholders, the fact is that Apple clearly hasn’t seen any valuation benefit from seeing its earnings volatility come down, so it might as well artificially bring it back up again. If its current capital structure is attractive to no one, maybe its new capital structure will have something for everyone.


Two questions:

1) When Apple posts another few quarters with 50%+ growth in the next few years, what will happen to its share price?

2) What makes Apple’s dollar of revenue, with ~40% gross margin worth about as much as Amazon’s, with single digit margins (if that)?

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Where banks really make money on IPOs

Felix Salmon
Mar 11, 2013 06:22 UTC

Every time an IPO has a big pop on its opening day, the same tired debate gets reprised: did the investment banks leading the deal rip off the company raising equity capital? The arguments on both sides are well rehearsed — I covered them myself in no little detail, for instance, after LinkedIn went public, in 2011.

Back then, I had sympathy with the bankers:

If the large 7% fee does anything, it aligns the banks’ interests with the issuer’s. If the banks felt they could make millions more dollars for themselves just by raising the offering price, it’s reasonable to assume that they would have done so. I’m sure that the institutions which were granted IPO access are grateful to the banks for the money they made, but that gratitude isn’t worth a ten-figure sum to the ECM divisions of the banks in question.

Today, however, I have to take all of that back. And it’s all thanks to Joe Nocera, who has a great column this weekend, where he uncovers a bunch of documents in one of those interminable securities lawsuits against Goldman Sachs. The documents should have been sealed; they weren’t. And now, thanks to Nocera, we can all see exactly where Goldman makes its money, when it comes to IPOs. (It’s fantastic that he put those documents online, although it’s hard to read them in the browser; here’s the download link which the NYT weirdly removed from its own site.)

The lawsuit in question concerns the IPO of eToys, back in 1999. The company sold 8.2 million shares, raising $164 million; Goldman’s 7% fee on that amount comes to $11.5 million. If Goldman had sold the shares at $37 rather than $20, it would have received an extra $10 million — and what bank would willingly leave $10 million on the table?

What Nocera has discovered, however, is that Goldman was not leaving $10 million on the table. Instead, it was making more than that — much more — in kickbacks from the clients to whom it allocated hot eToys stock.

Goldman carefully calculated the first-day gains reaped by its investment clients. After compiling the numbers in something it called a trade-up report, the Goldman sales force would call on clients, show them how much they had made from Goldman’s I.P.O.’s and demand that they reward Goldman with increased business. It was not unusual for Goldman sales representatives to ask that 30 to 50 percent of the first-day profits be returned to Goldman via commissions, according to depositions given in the case.

eToys opened at $78 per share, which meant that Goldman’s clients were sitting on a profit of $475 million the minute that the stock started trading on the open market. In most cases, the clients cashed out — which was smart, because eToys didn’t stay at those levels for long. But if Goldman got back 40% of those profits in trading commissions, then it made $190 million in commissions, compared to that $11.5 million in fees.

If Goldman had raised the IPO price to $37 per share, then yes its fee income would have gone up by $10 million, to $21.5 million. But — assuming the stock would still have opened at $78 — its clients’ opening-tick profits would have come down to $336 million, and Goldman’s 40% share of that would also have come down, to $135 million. Total income to Goldman? $156.5 million, rather than $201.5 million. If the IPO price were higher, Goldman’s total take would have gone down by about $45 million.

All of these numbers are hypothetical, of course, but the bigger point is simple: if Goldman manages to get kickbacks, in terms of extra commissions, of more than 7% of its clients’ profits, then it has a financial incentive to underprice the IPO. And Goldman’s clients were desperate to give it kickbacks: they didn’t just route their standard trading through Goldman, since that wouldn’t generate enough commissions. Instead, they bought and sold stocks on the same day, at the same price. Capstar Holding, for instance, bought 57,000 shares in Seagram Ltd at $50.13 per share on June 21, 1999 — and then sold them, on the same day, at the same price. Capstar made nothing on the trade, but Goldman made a commission of $5,700. Capstar’s Christopher Rule says that in May 1999, fully 70% of all of his trading activity “was done solely for the purpose of generating commissions”, so that he could continue to keep on getting IPO allocations.

Goldman, of course, revealed none of this to eToys. Instead, they pitched eToys with a presentation saying, on its first page, in big underlined type, “eToys’ Interests Will Always Come First“. On the page headlined “IPO Pricing Dynamics”, they explained that the IPO should be price at a “10-15% discount to the expected fully distributed trading level” — which means not to the opening price, necessarily, but rather to the “trading value 1-3 months after the offering”. After all, this was the dot-com boom: everybody knew that IPOs were games to be played for fun and profit, and that the first-day price was a very bad price-discovery mechanism.

If you look at the chart of what happened to the eToys share price in the first few months after the IPO, the price fluctuated around $40 a share — which means that by Goldman’s own standards, it really ought to have priced the IPO much closer to $37 than to $20. And this was no idiosyncratic mistake on Goldman’s part: Goldman’s other IPOs all fit the same pattern. For instance, look at the three deals run by Lawton Fitt, the Goldman executive in charge of the deal, before the eToys IPO. First was pcOrder, which went public at $21 and opened at $55.25. Then there was iVillage: that went public at $24, and opened at $95.88. Finally, there was Portal Software, which went public at 414 and opened at $36. When eToys went public at $20, Fitt knew exactly what was going to happen: indeed, she bet her colleagues that eToys stock would hit $80 on the opening day. She knew her market: it actually traded as high as $85.

Some big names jump out from the documents here — none more so than Bob Steel, who was then Goldman’s co-head of equity sales, and who went on to put out financial-crisis fires for Hank Paulson at Treasury before going on to become the CEO of Wachovia. Steel wrote a detailed email to Tim Ferguson, the chief investment strategist at Putnam Investments, saying that he would try to help Putnam out “with regard to IPO allocations”. At the same time, however, he added that “we should be rewarded with additional secondary business for offering access to capital markets product”. Which, in English, means that if Putnam got access to Goldman’s IPOs, it would have to steer more soft-dollar commissions to Goldman.

Meanwhile, if you didn’t toe the investment banks’ line, they would cut you. Toby Lenk was the CEO of eToys, and in a 2006 deposition he was asked whether he ever “voiced any displeasure” with Goldman about the fact that they left so much money on the table. He said no — and added “a little story” about why it was never a good idea to annoy a big investment bank. In 2000, Lenk explained, when eToys was desperate for money, it raised some cash through a convertible debt offering:

We initially selected Merrill Lynch to be our lead convertible debt underwriter, and Goldman Sachs came in and put a strong foot forward to take that away, and Merrill Lynch we kept as a secondary underwriter in the secondary position and kept them in the deal. They were in the deal, and I believe it was the morning of the deal going into the marketplace, or the night before, or right around that time, Merrill Lynch’s lead internet analyst, Henry Blodget, downgraded our stock as that was going into the marketplace, and made it extremely difficult for that placement to happen.

The investment banks have punitive power over us. We need them to raise capital. You don’t go complaining to investment banks because they will crush you, and that is a perfect example. We got penalized by Merrill Lynch. We got slapped hard, and it nearly sank that offering, and I can tell you that nearly sank the company.

This is just the flipside of pumping up companies in order to get investment banking business: if you lose that business, then you do the opposite, and downgrade the company just when doing so causes the most pain. As a result, as Lenk says, you didn’t cross the bankers — and you certainly didn’t cross Goldman.

All of which puts Goldman’s 7% fee into very interesting perspective. Goldman likely made much much more money on the eToys IPO from its buy-side clients than it did from eToys itself. Indeed, it could have offered to run the IPO for free, the IPO would still have been very lucrative for Goldman. But of course eToys would never have given Goldman the IPO mandate if Goldman had offered to run it for free — because then it would have been obvious where Goldman’s loyalties resided.

The real purpose of the 7% fee, it seems, was to make eToys think that it had hired Goldman and that Goldman was working for eToys — and also to tie eToys into a close relationship with Goldman. (Lenk, for instance, became a personal client of Goldman Sachs shortly after the IPO.) As Andrew Clavell once put it:

If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t. Hang on, I hear you shouting that you’re actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don’t. Know.

The 7% fee is a very large shiny object, which diverts everybody’s attention from where the real money is made — or at least did, back in 1999. Have things changed since then? Here’s Nocera:

The documents are old. Some will dismiss them as relics of another era. But I continue to believe that the mind-set created by the I.P.O. madness of the late 1990s never really went away. To this day, an I.P.O. with a big first-day jump is considered a success, even though the company is being short-shrifted. To this day, investors know that they are expected to find ways to reward the firms that allocate them hot I.P.O. shares. The only thing that is truly different today is that few on Wall Street are so foolish as to put such sentiments in an e-mail.

That’s the one point at which I’m willing to disagree with Nocera. Nothing ever changes much on Wall Street, including the degree of professional foolishness. I’m sure if a determined prosecutor went hunting for similar emails today, she could probably find them. But I don’t know what the point would be. Because there’s nothing illegal about asking buy-side clients to send commission revenue your way — or even about explaining to them how much money you’ve helped them make. eToys’ creditors might ultimately win this case against Goldman, or they might not, or the two sides might settle. But whatever happens, the implications for sell-side equity capital markets desks will be minuscule. Because the amount of money they’re making right now will always dwarf any potential litigation risk 15 years down the road.



interesting analysis. Could you elaborate a little on how you got to the 40% on trading commissions?


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Why analysts should not be investors, Andy Zaky edition

Felix Salmon
Mar 7, 2013 07:53 UTC

Back in October, Andy Zaky put out his sixth “buy” recommendation on Apple stock. The first five — in July 2006, November 2008, August 2010, June 2011, and May 2012 — all did spectacularly well, and all hit his price target within the time span he specified. Zaky was a first-rate Apple analyst, quoted by me and many, many others; as Philip Elmer-DeWitt says, he had “a series of spot-on predictions”, of everything from Apple’s earnings, to its iPhone sales, to — of course, its stock-price movements.

Smart and accurate Apple analysts are in high demand, and Zaky, quite sensibly, decided to monetize his gift. In June 2011 he put his blog behind a paywall, charging first $49 per month and then, in June 2012, $200 per month. With 700 subscribers, that meant a six-figure income per month, just by selling access to his detailed Apple analysis and trading recommendations.

Unlike most analysts, however, Zaky soon discovered* that his subscribers actually followed his recommendations — to the letter, in many cases. They weren’t using his analysis to inform their own decisions, they were outsourcing all of their decision-making to Zaky, simply placing the trades themselves. And so Zaky made a fateful decision: in that case, he might as well start his own hedge fund.

Bullish Cross Asset Management was launched in late 2011, and by November 2012 some 28 investors had invested a total of $10,607,815 with Zaky. And had lost it all. For Zaky, it turns out, was a truly dreadful fund manager: the kind of guy who not only put all his eggs in one basket, but the kind of guy who would also desperately double down upon incurring trading losses. With that kind of a trading strategy, even someone who’s right 85% of the time is going to blow up pretty quickly.

Zaky of course feels bad about this, and says he wants to make his partners whole, and “make things right”. But that would involve investing money, and investing money is clearly something Zaky is incredibly bad at. It’s easy and facile to sneer at analysts, saying that if they were actually any good at their jobs, they’d be making ten or a hundred times as much money by actually investing, instead of just putting out recommendations. But the fact is that analysis and investing are two very different skillsets, and while Zaky was very good at the former, he was very bad at the latter.

There’s no particular shame in that; sometimes you only learn your limitations by trying and failing. But the most astonishing part of the Andy Zaky story is not that he set up a tiny hedge fund which failed. Rather, it’s the lemming-like way in which the subscribers to his newsletter lost a mind-boggling sum of money — quite possibly well over $1 billion.

Elmer-DeWitt has heard from 36 former subscribers to Zaky’s newsletter; between them, they lost a whopping $92.5 million. Just one of them claims to have lost $50 million, or five times the total assets of Zaky’s hedge fund. If you ignore that one outlier, the rest of the subscribers have still lost an average of $1.2 million apiece — vastly more than the $380,000 or so invested by the average partner in Zaky’s hedge fund. And if you include the $50 million outlier, then the average loss rises to $2.6 million. Multiply either number by 700 subscribers, and it’s easy to see how total losses could reach the billion-dollar mark.

Reading Elmer-DeWitt’s original story, it’s clear that many of those investors were incredibly unsophisticated. And probably their self-reported loss estimates should be taken with a pinch of salt: they’re probably calculating their losses from their mark-to-market high point, rather than from the amount of cash they invested into trading Zaky’s recommendations. Still, this story is clear proof, in case any were needed, that you don’t need to qualify as a sophisticated or wealthy investor in order to engage in ridiculously risky trading strategies.

The Zaky story is depressing for another reason, too. The subtitle of his blog is “The Power of Compounded Returns in Holistic Quantitative Modeling” — it looks impressive, but it’s ultimately meaningless, and it naturally appeals to the ignorant. It can’t have taken Zaky very long to work out, on a subconscious if not a conscious level, that the best way to develop a reputation, and to build up his subscriber base, was to be as aggressive as possible in his calls, and to try to maximize both returns and risk. No one was going to pay him $2,400 a year to outperform Apple stock a little bit: these people were greedy, and wanted to shoot the moon. As such, they only have themselves, rather than Zaky, to blame for their losses. In fact, by creating a strong incentive for Zaky to ramp up the risk quotient in his calls, they probably helped turn a first-rate analyst into a busted investor: Zaky’s behavior, in some sense, was his subscribers’ fault.

Zaky, it’s clear, had much more value to the world of investing when he didn’t have skin in the game than when he did. That might be hard for a former trader like Nassim Taleb to understand, but the fact is that investing creates all manner of psychological feedback loops, which have to be managed with discipline. If you can’t manage those feedback loops, you’ll blow up — but at the same time, absent those feedback loops, you can still be a very perspicacious analyst.

Why did people take money they couldn’t afford to lose, and invest it in high-risk options strategies playing a single stock? Why did one person invest 50 million dollars in such strategies? And why did any of them trust a kid with no investing track record? It seems incomprehensible to me. But as Larry Summers famously said, “there are idiots. Look around.” You think a billion dollars is a lot to lose on Apple stock? Well, Macau’s casinos took in $3.4 billion of gambling revenues just last month. There will always be gamblers, and gamblers will always lose money. But it’s easy to see why Apple’s executives have historically paid as little attention as possible to the antics of the stock market.

*Update: Mick Weinstein points me to an unbelievably hubristic Zaky post from October 2011, which helps explain why people were following him so slavishly. There’s a whole section called “Bullish Cross Model Portfolios: The Importance of following our Models to the Letter”:

We’ve repeatedly mentioned over and over again that closely following the various Apple-based model portfolios to the letter is very key. That when we make a decision with regards to these portfolios, that decision is very carefully calculated and delicately executed to contemplate nearly every scenario that the market can throw at us. If you decide to deviate from the model, you’re likely to run into problems…

I could put out 10,000 pages of material and that wouldn’t even come close to scratching the surface of what goes into my decision making process. There is no way for me to practically reduce all of my knowledge, experience or reasoning abilities to the written word…

It is completely unreasonable to expect me to reduce every single thought or reason behind every decision we make to the written word. No one could do that… There is so much in terms of experience that there is simply no practical way I can teach people everything.

The equity markets is very much as complicated as the human body and it would be like asking a physician to teach you to practice medicine in a few months. When we make a decision, we try to do the best we can to give the core reasons behind that decision. But you should understand right now that (1) there’s very little that is lost on me, (2) there’s very little that you’ve thought of that isn’t already on my mind.

For 95% of people, this kind of thing is a huge red flag, saying “stay well away from this guy”. But for the other 1%, it’s weirdly comforting.



The most peculiar part of his list activity was the period during which he would brag about customizing a Bentley he was ordering.

Posted by Rohinga | Report as abusive

Why Apple should ignore its shareholders

Felix Salmon
Feb 12, 2013 00:30 UTC

Allan Sloan neatly divides the world of Apple obsessives into two types of people:

For most people, Apple mania means buying the company’s products and playing with them. But for us financial voyeur types, the fun comes from watching the lunatic lurching of Apple’s stock price.

Financial journalists love any stock doing the lunatic-lurching thing, because that creates an easy heroes-and-villains story. Were you bearish at the top? You’re a genius! Were you bullish throughout the fall? You’re a goat!

James Stewart has a classic example of the genre this weekend, putting on his straightest face and contriving to be shocked — shocked! — that Wall Street was bullish on Apple stock during its recent decline:

Fifty of 57 analysts rated it a buy or strong buy; only two rated it a sell. Apple shares continued their plunge, and this week were trading at just over $450, down 36 percent from their peak.

How could professional analysts have gotten it so wrong?

It wasn’t supposed to be this way.

This is very, very silly: the clear implication here is that the analysts following Apple should have seen the fall coming. But you can’t time an individual stock like that: no one can. Especially when there was nothing — no thing — which caused the stock to fall. Apple stock was going up, and then it was going down. That happens with stocks: they’re volatile things. But you can’t expect anybody, no matter what their job is, to be able to anticipate all those fluctuations.

Instead, analysts generally do something else. At heart, they’re fundamental analysts: they look at a company’s numbers, and decide how much they think the company should be worth, given its revenue and profitability and prospects. Even at its peak, Apple was trading at pretty low multiples — and on top of that, it had a lot of upwards momentum. So it makes perfect sense that most analysts had “buy” ratings on the stock, with price targets somewhere north of $700. And given that nothing fundamental changed in the past few months, it would be weird for one of those analysts to suddenly slap a “sell” rating on the stock just because the ratios are becoming even more attractive as the stock gets cheaper.

With any stock, there’s always a bear case, and Stewart lionizes the one bearish analyst he managed to find, Carlo Besenius of Creative Global Investments. But even with hindsight, Besenius’s bear case doesn’t seem particularly compelling, based as it was on squishy things like “concerns about product quality and innovation”. You can always have “concerns about product quality and innovation”, and you can always be uncomfortable with “Apple’s arrogance”. But those concerns would have left you out of one of the greatest bull runs that the stock market has ever seen, over the past decade or so.

Similarly, Bethany McLean’s case for Apple being a $200 stock doesn’t actually include any ratios, or any calculation which comes to that number. Instead, she simply asserts that “built into Wall Street’s stock price targets was the expectation that the iPhone would rule the world” — and that therefore any future world which isn’t dominated by the iPhone must have Apple trading at a much lower level than those price targets.

The problem with this argument, of course, is that it’s far from clear that the price targets did incorporate global domination. It’s entirely possible that she’s right, of course, along with other bears like Jeff Gundlach, whose big Apple short last spring looked horrible for a while but now looks much smarter. But at heart, the bear case on Apple is one based on gut feeling: that the company has had its day, that its greatest glories are behind it, and that Tim Cook is not going to be able to continue Steve Jobs’s string of astonishing successes. It’s a perfectly reasonable gut feeling to have. But it won’t tell you when Apple stock is going to drop, and it won’t give you a level at which to exit your position. (McLean’s arguments, for instance, could be used to justify a $100 target, or a $200 target, or a $400 target.)

Meanwhile, the highest-profile Apple bull right now, David Einhorn, is arguably even worse than the bears. He has loads of clever ideas in the realm of financial engineering, whereby the issuance of new classes of stock would efficiently funnel money to shareholders like himself and thereby make them happy. It’s the kind of Clever Idea that activist hedge-fund managers like Einhorn and Bill Ackman often have, but it’s fundamentally a distraction in terms of Apple’s core job, which is to make insanely great products. Basically, everybody knows nothing, when it comes to the famously-secretive Apple, and it would be crazy for someone like Tim Cook to pay much attention to such ignoramuses.

Apple did spectacularly well, for most of the past 10 years, ignoring shareholders completely; at one of its competitors, Michael Dell is so sick of them he wants to buy them out and make them go away entirely. If Einhorn got his way, there might be a short-term boost in the stock, Einhorn would take his profits, the people who invest in Einhorn’s funds would make money — and Apple would in no way be better positioned for the future than it is today.

The day that Apple starts embarking on elaborate financial engineering in order to placate hedge-fund investors is the day that it loses sight of its core mission and starts turning into a mess like Hewlett-Packard, constantly trying to “deliver shareholder value”, whatever that might mean. When Tim Cook became CEO, he was given a restricted stock grant of 1 million shares, which don’t fully vest until 2021. The point was to keep him focused on a time horizon much longer than anything David Einhorn might be thinking about, and the message was that he shouldn’t worry about the stock price fluctuating up one month and down the next: so long as he builds an excellent permanent franchise, he will end up hugely wealthy. Apple listened to shareholders before, when it fired Steve Jobs and brought in John Sculley. It won’t make that mistake again.

Therefore, to use Sloan’s distinction, Cook rightly belongs with those of us who are interested mostly in buying the company’s products and playing with them, rather than those of us glued to the gyrations in the corporate share price. Let Wall Street worry about the Apple share price: very little harm is done to the company if it’s low, and Apple is so incredibly profitable that it has zero need for Wall Street or any kind of outside investment.

Apple shares are an interesting speculative vehicle, in which a lot of money can be made and lost. But they don’t help shape the fortunes of Apple itself — not any more. A close reading of the stock price might tell you something about herd mentality among mutual-fund managers, and the problems of being so big that people feel forced to buy your stock. But the share price has never been particularly useful in terms of being able to predict what’s going to happen next to Apple the company. Let New Yorkers worry about the stock: in Cupertino, they have much more important things to do.


“So, what is the point of owning stock again?
No claim on current profit, no claim on retained earnings.
Is the hope that you find a sucker or sell before management does actually crater value?”

Didn’t some economist win the Nobel prize for explaining this? Was it Modigliani? It’s all beyond me.

Posted by Kaleberg | Report as abusive

Why Dell is going private

Felix Salmon
Feb 5, 2013 15:38 UTC

Why are Michael Dell and Silver Lake taking Dell private at a valuation of $24.4 billion? Christopher Mims explained his theory a few weeks ago: it’s all about a company that Dell acquired last year for roughly $500 million. Wyse makes PCs-on-a-USB-stick: everything is in the cloud. According to Mims, if you combine Wyse’s technology with Dell’s ability to talk the kind of language that corporate IT buyers love, Dell is now well position to disrupt itself:

A privately held Dell, shielded from the pressure to post continual growth on a quarterly basis, could refocus itself on thin clients and cloud computing, which could set itself up for a breathtaking turnaround.

This raises an interesting question. Right now, Dell has about $9 billion of debt; that number is going to rise substantially post-buyout, with a $2 billion loan from Microsoft and a $15 billion financing package from Wall Street. The cost of servicing all that debt is going to weigh heavily on any company trying to grow fast in the highly competitive and extremely capital-intensive world of cloud computing. Wouldn’t it be easier to just stay public, announce a new cloud-based strategy, let the stock find its level, and then execute with an eye to the long term?

After all, private equity shops like Silver Lake have a clear time horizon and exit strategy: they want to come in, turn the company around, and then sell out at a substantial profit within 5-10 years. Public equity, by contrast, is permanent capital, and has an infinite time horizon — in theory, it should be better suited for people with a long-term vision.

But two things are going on here. Firstly, Dell is incredibly cheap. It has revenue of roughly $60 billion per year, gross profit of almost $14 billion, and net income of more than $2.5 billion. That means Silver Lake is paying less than 10 times earnings for the second-biggest PC manufacturer in the US, and the third-biggest in the world. And secondly, debt is incredibly cheap as well. Financing terms haven’t been disclosed, but I doubt Dell is paying more than 6% for its money. 6% of $15 billion is less than $1 billion a year, which still leaves a lot of money left over for investing in the cloud.

Winning a significant share of the cloud-computing pie is not going to be easy: both Google and Amazon are formidable competitors. But I can absolutely see what Silver Lake is thinking here. For many years, the big money in technology has been in fast-growing early-stage companies — but those companies are being increasingly boxed in by a few large firms who each hold key patents in just about every area. Dell has patents — it acquired more than 180 of them with the Wyse acquisition alone; it has the ability to invest and to reach enormous numbers of customers; and it also has a large number of boring-but-viable business units which can be sold off to generate even more capital if needed.

The valuation curve in the technology space has never been as steeply inverted as it is right now: while there are dozens of billion-dollar startups with negligible profits or revenues, the giants in the sector are trading at a significant discount to the stock market as a whole. For a company like Silver Lake, which is based in Silicon Valley and exists to turn around mature technology companies, this can be seen as a once-in-a-generation opportunity combining cheap debt with low valuations and enormous upside potential if they get it right. Frankly, if Silver Lake didn’t buy Dell at this point it should probably just pack up and liquidate.

This buyout might well fail — private equity is an inherently risky business. But it’s pretty obvious that Silver Lake has a much greater risk tolerance, right now, than the public equity markets have. If public shareholders don’t want to touch Dell, and Silver Lake sees an opportunity, then it makes perfect sense for Silver Lake to buy the company — especially since they get to keep Michael Dell himself as a key partner in the deal. If you’re a big company wanting to take big risks in technology, it seems, these days you have only three choices. You can be Amazon, you can be Google, or you can go private. Dell’s choice was clear.


I think fxtrader7 has the right take on this. Basically, it’s a liquidation play. Dell, for all its flaws, is an operating company with decent financials. Sucking the life out of it and leaving an empty husk is good business.

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