Banking Sector Band-aids Just Won't do It

We all know by now that the U.S. banking sector is badly broken. The real question is what to do about it. I think a few core principles need to be followed when devising a plan for healing the banking sector:

1. The plight of equity-holders should be ignored;
2. Long-standing rules governing bank ownership shouldn't be compromised in a panic; and
3. Bank balance sheets won't heal unless deep pain is felt, and preferably as quickly as possible.

Bank Equity Holders: Out of Luck

Investors in junior securities, be they common shares, preferred stocks or subordinated debt, enjoy premium returns in the good times and bear disproportionate risks in the bad. They should not have a seat at the table in a bail-out scenario. When considering the plans put forth for rescuing the GSEs - Fannie Mae and Freddie Mac - I do not want to see Treasury Secretary Paulson spending my tax dollars propping up existing equity holders. This is money that should go to restoring liquidity and order to the mortgage market and enabling debt holders to get their money back. Equity holders - they should be wiped out. GSE equity holders have long enjoyed the benefit of a guarantee off the backs of the U.S. taxpayer; now the tables are turned and it's payback time. If you want the potential returns to equity, then you need to shoulder the risks to equity. And those risks have been borne out. And you are busted.

Now, this is an issue separate from fraud. If it turns out the disclosures were improper and that equity holders did not have the information necessary to make an informed investment decision, then by all means file a class-action lawsuit and seek appropriate remedies. But this is also part and parcel of being an equity holder. Bad things can and do happen. It's high time that equity investors understood this. And I'm not the only one to have this view: consider the words of David Einhorn, manager of the widely-respected hedge fund Greenlight Capital, from his book Fooling Some of the People All of the Time:

The truth is that investors in corporate securities are risk takers managing investments of risk capital. One risk is fraud. The best way to discourage fraud is to actually enforce the penalties for fraud. If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said. And, because their money is at stake, investors will allocate their capital more carefully.

Exactly.

Don't Play Games With the BHCA

2. The thought that bank ownership rules should be relaxed because of the need to attract liquidity into the sector is deeply misguided. While there are plenty of rules and regulations with which I disagree, but the long-standing Bank Holding Company Act rules make a lot of sense to me. Banks play a special role in the fabric of our economy, from money creation and credit to safety and access to liquidity. These are not areas to be trifled with. Further, I think proposed rule changes really cloud the issue. If the sector needs more capital, then the question needs to be asked; what can be done within the existing rules and regulations?

We have the example of TPG/WaMu, which, I'm afraid, is not a template for bringing capital into the sector. This was a deal done behind closed doors, at terms that frankly illustrate why the sector is so badly damaged. TPG wanted lots of cushion in order to do a deal, because of a high degree of uncertainty surrounding the investment portfolio. It presumably took large deal fees. The structure was also massively dilutive to current shareholders, and further provided anti-dilution protection against subsequent capital raises at prices lower than its deal price for 18 months. I'd be willing to wager that this is one anti-dilution feature that will surely end up in-the-money. Not bad, TPG. But to be fair, if I was TPG I'd have pushed for the same deal. Why? Because almost every large financial institution in the U.S. is made up of two institutions; a good bank and a bad bank.

Good Bank/Bad Bank as a Way to Move Forward

The good bank is a bank we can understand, analyze and readily price. The bad bank, well, is bad for a reason. It contains a large number of very complex, hard-to-value instruments. Mortgages. Illiquid derivatives. Leveraged loans and loan commitments. So an investor in such a combined good bank/bad bank entity is likely to pay a sharply discounted value for the good bank because the bad bank is so bad, or at least it's potential losses are so unclear.

What I believe we really need is a good bank/bad bank approach to the current banking sector woes, causing all banks to shrink by offloading their bad bank instruments into either a bank-specific vehicle (like Citi taking its bad assets and selling them into a "Citi Bad Bank") or a series of pools organized by asset type (similar to the Super SIV idea, except separate vehicles for mortgages, derivatives, leveraged loans and unfunded commitments). The instruments to be marked-to-market upon transfer and funded by private capital, which will now demand a return in line with the risk without placing unnecessary downward pressure on the valuation of the good banks that remain. And if private capital wishes to fund the good banks who now have clean balance sheets and are ready to expand but are short on capital, they will receive a return commensurate with healthy, good bank growth capital. This approach does not require a change to the Bank Holding Company Act, but it does require bank managements to take big hits to equity - now -  in order to lay a strong foundation for future growth.

Note to Bank Managements: Take the Medicine - Now

3. Bank management's steps towards fixing their balance sheets has been a slow, painful process, which is likely to be played out over even longer periods of time. This, in my opinion, is a huge mistake. It is both costly to their firms and for the economy, as the pervasive lack of confidence in our financial institutions will remain until the problems are cleaned up. But healing can only happen if investors have greater transparency into the future of these firms, which means really understanding the risks embedded in their asset books. And as it stands today, there are still way too many unknowns to make financial commitments to the sector. Those who did so early got smoked, and others, like TPG, received deals that ultimately hurt the bank and its shareholders and don't address the issues of transparency. Mr. Paulson should devote more calories to this issue and less to bailing out the GSE's and protecting their common stockholders. Yes, the GSEs are hugely important, don't get me wrong. But the larger banking sector needs fixing, and it appears that a little prodding is in order.

Without the health of our banking sector, I do not see a foundation for recovery. The Treasury, the Federal Reserve and bank managements need to wake up. An incremental approach to rebuilding financial strength, trust and confidence is a fool's game. Get to it.

Monitor110: A Post Mortem

Turning Failure into Learning

Writing a post mortem is hard, particularly when the result is failure: a failed deal; a failed investment; a failed concept. That said, without a post mortem, without deep reflection, honesty and introspection, how can we get better and do better the next time? Quite simply, we can't. My involvement with Monitor110, as an investor, Board member and leader, was one of the most interesting and informative experiences of my life. I learned about areas I never dreamed of. I worked with a terrific group of young, exceptionally bright people who believed in the vision. Ultimately, we failed. But why did we fail, and what could we have done differently?  Some of the stuff is pure 20:20 hindsight. These observations aren't worth much. But the interpersonal dynamics, the issues of organizational structure, the need to change strategy in light of new information, the relationship with key investors, all of these are very instructive. I will endeavor to be as honest and candid as possible.

Let me say that I deeply respect everybody involved with Monitor110 from the original founder, Jeff Stewart, to our investors, employees and customers. Everyone tried very hard to make things work, and this post is not an indictment of anyone. There are no "bad actors" in this story. But a confluence of factors made success an uphill struggle.

The Seven Deadly Sins

While we certainly made more than seven mistakes during the nearly four-year life of Monitor110, I think these top the list.

1. The lack of a single, "the buck stops here" leader until too late in the game
2. No separation between the technology organization and the product organization
3. Too much PR, too early
4. Too much money
5. Not close enough to the customer
6. Slow to adapt to market reality
7. Disagreement on strategy both within the Company and with the Board

A Little Background

I was initially approached in early 2005 by Jeff Stewart, who had the original idea for Monitor110. It was a compelling idea. The thesis: more and better information is being put out on the Internet every day, information that can be valuable to Institutional investors who are constantly looking for an edge. And these investors were not very sophisticated about how to best access this information; Monitor110 would use technology to help them get that edge. Jeff and a few guys had hacked together a version 1.0 of the system, which was based on a boolean matching engine with rules corresponding to each company and investment theme. It was fast. It worked ok. We spent some time working with PubSub, who had built a scalable matching engine but was not focused on the financial services industry.

By mid-2005 the system worked, but spam was becoming more prevalent and caused the matching results to deteriorate, e.g., too much junk clogging the output. Around the same time we started to dig into natural language processing and the statistical processing of text, thinking that this might be a better way to address the spam issue and to get more targeted, relevant results. This prompted us to not push version 1.0, instead wanting to see if we could come up with a more powerful release using NLP to mark the kick-off. In retrospect, this was a big mistake. Mistake #5, to be precise. We should have gotten it out there, been kicked in the head by tough customers, and iterated like crazy to address their needs. Woulda, shoulda, coulda. Didn't.

An Unusual Leadership Structure

The idea was that Jeff was the technology guy and I was the business guy. Jeff focused on technology and product and I focused on fund raising, HR, controls and client access (given my Wall Street and hedge fund rolodex). On paper, made sense. Jeff was a successful three-time entrepreneur, I was an experienced senior Wall Street executive. The problem was, however, that when it came time to make hard decisions the two-headed structure really didn't work. It was a technology company working to solve a complex problem, and ultimately technology dominated the discussion. Ultimately, we ended up building something that the business side was not happy with, which made selling it difficult. An indication of Mistake #2. Neither Jeff nor I had the power, real or perceived, to simply change direction. The Board was supportive of this management structure. This was also a mistake. Mistake #1.

A Real Product versus a Science Project

We talked about "release early/release often," but were scared of looking like idiots in front of major Wall Street and hedge fund clients. Is it better to wait a bit before releasing to have a more compelling product or to begin getting feedback on a less impressive offering? We chose #1; in retrospect I think we should have chosen #2. By choosing to wait we lost our intimacy with the customer (Mistake #5 again), falling into the classic (as a "green" entrepreneur I didn't know this, but as a seasoned four-year venture investor I know this now) trap of pursuing a "science project," not building a commercially salable product. Dumb. Another problem: technology and product management were effectively bundled together, with the same decision-makers for both. This was another crucial error, #2 again. Instead of having product management as the advocate for the customer and the product evangelist, we had technology running the show in a vacuum. Huge mistake. This allowed us to perpetuate the science project for much, much longer than we should have. There were no checks-and-balances built into the system. This was a recipe for failure. I intuitively knew it then but as an inexperienced entrepreneur didn't feel empowered to act. Really, really stupid. After 20 years of making consistently good business decisions why didn't I throw a fit and and be more assertive in communicating my concerns? No good answer here.

And these bad behaviors were reinforced by an unplanned event that sharply impacted our psyche: being on the front page of the Financial Times. It is hard to call it a mistake since we didn't seek to get such exposure, but I put it down as Mistake #3. To be honest, this single fact was a very meaningful factor in our failure. It raised the level of expectations so high that it made us reluctant to release anything that wasn't earth-shattering. It was also catalyst for us raising our last and largest round of capital. So the net effect was that it enabled to raise all this money that kept us far from the customer. Truth be told, we were probably afraid of customers at this point because we didn't want to disappoint them or look bad. Oh, we'd build something they'd love. We just wouldn't show it to them until it was done. Ugh. Just so stupid.

Too Much Money

Too much money is like too much time; work expands to fill the time allotted, and ways to spend money multiply when abundant financial resources are available. By being simply too good at raising money, it enabled us to perpetuate poor organizational structure and suboptimal strategic decisions. Mistake #4. We weren't forced early on to be scrappy and revenue focused. We wanted to build something that was so good from the get-go that the market would simply eat it up. Problem was, with all that money we hid from the market while we were building, almost ensuring that we would come up with something that the market wouldn't accept. And then there were technology issues that came up along the way, very substantive issues, that because of so much money we simply didn't face into nearly fast enough. And this drove a wedge in the company between those that were more plugged into the market (and felt we weren't building the right thing or addressing the data issues the right way) and those who were building the product (and felt very convinced that what they were building was responsive to the market). I would almost argue that too much money enabled the other six mistakes to be made again and again and again. Seems counter-intuitive, right? It's not. And believe me, I am super sensitive to this issue now as an investor. If a company wants to raise significantly more money than I think they need to get to revenue, I push back. Hard.

Investor Expectations versus Market Reality

We raised money based on a vision of a scalable web portal, a tool that would eventually be the web-enabled side of Bloomberg. We never believed we'd replace Bloomberg, Reuters or Thomson for market data and mainstream news, but that we'd eventually become a necessary part of the Institutional investor research mosaic. We were positioned as a technology company, not as an alternative research provider or a services business. And it was the deep belief in Monitor110 as a pure technology company that created a rift between the business side of the company and powerful members of the Board. Mistakes #6 and #7, as you'll soon see.

We did an angel round in the latter part of 2005 followed by an institutional round early in 2006, enough money, we thought, to help us build the new version 1.0 of the product. We then did another institutional round in Q3 2006 to further execute against this vision, because the money was offered to us on a pre-emptive basis and around six months earlier than we were planning to do a raise. The new release would be whizzy, fast, comprehensive and use all that neat technology to analyze unstructured data in real time, and to score each data element by reputation and relevance. Easy to filter, discover and analyze. Super cool, right? Sure. Problem was, we started out trying to analyze most of the dynamic web (probably up to 100 million sources by now) in real-time, and using technology (NLP, pattern matching, etc.) to do the filtering, indexing and categorization. This was no mean engineering feat. We had a very, very large and complex back-end. And even with this, the quality of the data coming through to the end-user was just not that good. Too much spam, still. Duplicate posts. Sometimes mis-categorized. Difficulty applying our reputation algorithms. Not good.

Those closer to the customer wanted to effectively chuck this approach and to build up a high-value corpus of data from the bottom up, using our deep knowledge of the source universe to assemble a body of data from publishers of high reputation. Really more akin to a "Bloomberg for the Web" than the original product, as the sources would be of high-quality and indexed correctly. They also wanted to build a research capability, where a desk could generate customized reports for clients leveraging our technology and data. But making this fundamental change to our approach towards data and the business model resulted in a fight. Almost a jihad, where certain parts of the company were vehemently in favor of changing our approach while others said "improvement to the current system is right around the corner." This could only happen because of Mistakes #1 and #2, where nobody could pound the table and say "this is the way we're going to do it and here's why," nor could the business side simply say "this is what our clients want. This is why we should do it." We were one big, passionate, driven, dysfunctional family. This argument played out over months and months, and cost us an enormous amount of money. Eventually we did change our approach to data, but it was a fight that spiritually damaged the company and morale and had a financial impact that substantially depleted our coffers.

And in Conclusion

The good news for me personally is that I now invest in a way that actively seeks to avoid the seven deadly sins listed above, and the performance of my portfolio companies bears this out. But I simply wasn't smart enough or experienced enough to see all of these mistakes or to feel empowered to do something about them until it was too late. I would like to thank all of our investors for having the confidence in us to pursue the Monitor110 vision, and I'm sorry that we weren't financially successful. I'd also like to thank the people with whom I worked during my tenure at Monitor110. Not a bad apple in the lot. Smart, hard-working, highly motivated professionals. They will invariably do extremely well in their post-Monitor110 lives.

The market for alternative information and tools is very, very challenging, and the current market environment isn't making it any easier. But there are clear needs out there that should and will be addressed. I will write a post on the alternative information market at a later time. Thanks for listening.

Monitor110: Closing a Chapter

Some of my friends and readers have already heard the news, that the Board of Monitor110 has decided to cease operations. It was a hard decision and certainly a sad one at that. Monitor110 was one of my first early-stage investments, and one which I spent a lot of time trying to make work. Mistakes abound, mistakes that I wouldn't make today having become a much more experienced investor and entrepreneur since my original investment and involvement. To say that I learned a lot from the experience is the understatement of the century, and I will write a series of posts outlining my learnings, the good, the bad and the ugly, from every facet of the company's conception, rise and fall.

My life changed dramatically through Monitor110, due to the people I met (employees, investors, customers, advisors, other entrepreneurs and vendors), the things I did (raise money, structure deals, recruit, do business development deals) and the lessons I learned (too numerous to detail here). It also was an engine to get me even more involved in early-stage investing and advising, an activity that has become my principal vocation over the past three years. It also spurred me on to blogging, enriching my life as an outlet for self-expression, idea sharing and as tool for meeting amazing people, seeing deals and building community. As disappointing as failure feels, my life is permanently changed for the better due to my involvement with the company and its constituencies. I am a better investor, a better adviser and perhaps better in touch with my own strengths and weaknesses as a result.

More later. And thanks to all those who have sent me kind notes of support. I really appreciate it.

An Open Letter to the Next U.S. President

Dear Mr. President:

It has been my view for quite some time that the U.S. is in pretty bad shape. From the deteriorating economy to the questionable integrity of our financial institutions, from the faulty regulatory frameworks to the dumbing down of American culture, from our bankrupt policy towards the U.S. dollar to a deepening malaise from Wall Street to Main Street, things are looking quite bleak. But all is not lost; we are Americans. We are innovative and entrepreneurial. We can be tough (if pushed). We can come together (if compelled). And now is the time for us to be tough and to come together in order to rebuild our country, a country whose promise is far greater than the one I see today.

I think the most important thing you can do as President is to help us feel better about ourselves, and to help the world feel better about us. And I believe these two goals are pretty closely related.

What is hurting us now? Fear of inflation, stagnant economic output and joblessness. Nobody wants a replay of the 1970s. Or the 1930s, for the matter. One area that has gotten little press that threatens the future of our country and its prosperity is our crumbling infrastructure. A recent story in the Economist provided some startling and scary statistics: "In 2005 the American Society of Civil Engineers estimated that $1.6 trillion was needed over five years to bring just the existing infrastructure into good repair. This does not account for future needs. By 2020 freight volumes are projected to be 70% greater than in 1998. By 2050 America’s population is expected to reach 420m, 50% more than in 2000. Much of this growth will take place in metropolitan areas, where the infrastructure is already run down." And the picture just gets worse over time. This is kind of like Social Security, in which our leaders have chosen to defer pain to future generations, without thought of how it might effect our children and grandchildren. The issue with investing in infrastructure is that it is an investment in the future, yet with benefits that can and will be enjoyed today. A massive program to rebuild roads, bridges and subway systems, to upgrade and expand airports, ports and waterways, would provide hundreds of thousands of good-paying jobs and drive local economies across the country. Such a program would have massive ripple effects on the retail sector, putting money in people's pockets that is not driven by home equity loans but real, productive jobs. Further, such a program would lay a solid foundation for future growth, growth that if it were to happen in the absence of these infrastructure investments would put us on track to have conditions akin to a third-world country. These jobs would be a mix of manufacturing and service jobs, supporting our still-significant heavy industries with real work. Needed work.

Now all this investment takes money, and as you know, we are already burdened with a staggering external debt. This debt is particularly unpleasant because of the sharply falling dollar, which makes our creditors less likely to continue extending credit. But you know what - I bet that you could raise the money to do these investments without even batting an eye. Why? Because all of these investments make the U.S. a better - not a worse - credit risk, as it immediately stokes the engines of growth and further lays the foundation for continued healthy growth in the future. Invest today, get a lot more back tomorrow. But for this to fly, you need to keep your wits about you and keep taxes low, encourage capital investment. resist any protectionist tendencies and to foster good relationships with our trading partners. Any backsliding in this area and the whole thing will backfire on you. You can easily sell this to both Congress and the American people. And selling the bonds to finance such an endeavor won't be much more difficult to our well-heeled, cash flush trading partners. Well, maybe a little more difficult, unless...

We do need to make some cuts to help finance this historic rebuilding initiative, to show our creditors that we can make tough decisions when necessary. What we don't need is to cut spending on education, science and math programs, early-child support and core programs in the arts that help keep us rounded as human beings. We also need a cogent policy on supporting intelligent investment in alternative energy. What we do need is to cut military spending - dramatically. Not because we don't need a strong military, but because we don't need to be and shouldn't attempt to be the moral compass for the entire planet. The previous administration drove a stake through the heart of our military, leaving an overextended, demoralized, undermanned, disorganized and fractured institution in its wake. Our massive overseas troop deployments and ongoing presence in Iraq is costing us hundreds of billions of dollars a year, dollars much better spent at home supporting the programs I outlined above. Are we really better off because of such policies, especially in a newly multi-lateral world?  I think you'd be well advised to consider a different mission for our military, one that puts it in the role of protector of U.S. interests, narrowly defined. We can't turn back the clock on China - they have a role to play as a global force and will not be denied. Then you have Russia, India, the Middle Eastern economic powers and others wanting their seat at the table. We need to become a leader of, but also a true part of the global community. This requires a level of humility, poise and perspective we haven't seen in a long, long time. This means sharply scaling back legacy military involvements that have their roots in World War II, and bringing lots of our fine men and women in uniform home. It also means rebuilding the command structure and morale of our troops, who have spent too much time fighting questionable battles that have left our proud nation poorer, weaker and more isolated than it has in generations. Our nation and our military deserves better.

I believe these policies will play well with the rest of the world, Mr. President. Not because it shows us in a position of weakness, but because it shows that we can take care of business at home, business that is key for the economic and political functioning of the world. We've been off the rails, and our enemies and allies alike have been acutely aware of this. It is time to reverse this perception, because the status quo is simply not sustainable. I do not wish to live through a slow, grinding decline of the U.S. as a superpower, both economically and militarily. You alone are in a position to stop this from happening.

I know this will be hard to pull off, Mr. President. Let's face it; no matter what, you are leaving office with a trillion-dollar deficit and a global stage still in flux. The real question is how you are preparing our nation for the future. You will either be remembered as someone who had an historic opportunity in a rapidly changing world but chose to do nothing with it, or to make the hard decisions, stare fear and uncertainty in the eye and say "I am embracing the future. Not everybody will be happy today but subsequent generations will benefit from my bold actions." I sincerely hope you choose the latter, Mr. President.

Best regards,

A Proud but Concerned American

Straight-talk on FAS 157: Blackstone and their Banker Buddies Have it Wrong

There have been some rumblings over the past several months about accounting rules being a key contributor to the banking sector meltdown, and I've let it slide. But now that  Steve Schwartzman and Tony James of Blackstone have publicly stated their views that FAS 157 - or Fair Value Measurement rules in normal-speak - is perhaps even dangerous, I have to put my blogging hiatus to the side. Because this view is so myopic, slanted and not acknowledging of the complexity of the issue that some additional (and more detailed) perspective is warranted.

I've always felt that primary responsibility of bank leadership was to maximize return while managing risk to an acceptable level, and in a financial firm this really comes down to the concept of gap management (the difference between the duration of assets and liabilities, or the net interest rate sensitivity of the firm). Before the rates thrifts could pay for deposits was de-regulated, they had a wonderful business of lending long at comparatively high rates (principally in residential mortgages) and borrowing at comparatively low rates (via core deposits). Because rates were undifferentiated core deposits were very "sticky," as there wasn't a price motive to switch from one thrift to another. Therefore, the implied duration of its loan book was long while the implied duration of its core deposit base was long as well, giving them a matched book and a steady stream of earnings. Now this is a simplified view of things but you get the point. When this came to a screeching halt in 1982 and thrifts needed to compete more aggressively for both mortgage assets and deposits, that nicely managed gap widened dramatically. Assets were still long-dated, but lower yielding than before due to competition. Liabilities were now more expensive and of a much shorter duration, causing a massive funding mismatch that contributed to the S&L crisis of the late 1980's.

Why my little walk down memory lane? Because my thesis is that we are pretty much experiencing the same phenomenon today. Assets whose duration have unexpectedly lengthened due to lack of liquidity, while most banks have funded themselves in a seemingly opportunistic but highly risky way through repurchase agreements, asset-backed commercial paper and other short-term financing instruments. And when the music stops and investors stop wanting to lending short? The predictable cash crunch ensues. This is a classic failure of gap management, the key building block of running a successful financial firm. Some may throw up smoke and say "Well, the trading risks of investment banks are much more complicated than the simple mortgage loans of the 1980's. This is totally different."

Bull. Trading risk becomes liquidity risk when you can't trade. If you can't finance a book to take into account the vagaries of different market (read: liquidity) scenarios, then nothing else matters. Just ask Bear Stearns. So, if you are a prudent gap manager and operating in a FAS 157 world, what would you do? Do real stress-testing of liquidity scenarios and construct a capital structure that address much of the liquidity risk posed by non-standard assets. Because in an adverse scenario where liquidity dries up, there is a flight to quality and spreads blow out, the bank will experience a large mark-to-market gain on its liabilities, both avoiding a huge hit to equity and mitigating the need to run out and secure costly financing under highly adverse circumstances (like Citigroup, Merrill Lynch, Lehman, Washington Mutual and the rest of them). This could have prevented a lot of pain to a lot of shareholders. Sure, they might not have ridden as high during the up-market, but they would been more than compensated with downside protection. It's called volatility reduction. Or prudent gap management.

By way of background, let me share some of the Financial Accounting Standards Board's summary of what FAS 157 is intended to do:

The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability.

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This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability.

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This Statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine.

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This Statement clarifies that a fair value measurement for a liability reflects its nonperformance risk (the risk that the obligation will not be fulfilled). Because nonperformance risk includes the reporting entity’s credit risk, the reporting entity should consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value under other accounting pronouncements...

I think this stuff is pretty straightforward and reasonable but hey, that's just me. Messrs. Schwartzman and James, however, feel quite differently. From today's New York Times:

But Mr. Schwarzman is convinced that the rule — known as FAS 157 — is forcing bookkeepers to overstate the problems at the nation’s largest banks.

“From the C.E.O.’s I talk with,” Mr. Schwarzman said during an interview on Monday morning, “the rule is accentuating and amplifying potential losses. It’s a significant contributing factor.”

Some of his bigwig pals in finance believe that Wall Street is in much better shape than the balance sheets suggest, Mr. Schwarzman said. The president of Blackstone, Hamilton E. James, goes even further. FAS 157, he said, is not just misleading: “It’s dangerous.”

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The idea seems noble enough. The rule forces banks to mark to market, rather to some theoretical price calculated by a computer — a system often derided as “mark to make-believe.” (Occasionally, for certain types of assets, the rule allows for using a model — and yes, the potential for manipulation too.)

But here’s the problem: Sometimes, there is no market — not for toxic investments like collateralized debt obligations, or C.D.O.’s, filled with subprime mortgages. No one will touch this stuff. And if there is no market, FAS 157 says, a bank must mark the investment’s value down, possibly all the way to zero.

That partly explains why big banks had to write down countless billions in C.D.O. exposure. The losses are, at least in part, theoretical. Nonetheless, the banks, in response, are bringing down their leverage levels and running to the desert to raise additional capital, often at shareholders’ expense.

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Of course, Mr. Schwarzman’s theory only holds up if the underlying assets are really worth much more than anyone currently expects. And if they are so mispriced, why isn’t some vulture investor — or Mr. Schwarzman — buying up C.D.O.’s en masse?

For Mr. Schwartzman’s part, he says that the banks haven’t been willing to unload the investments at the distressed prices. Besides, the diligence required for most buyers is almost too complicated.

I think Steve and Tony are only looking at half the problem. In a mark-to-market world, you can't only look at the asset side, you need to look at the liability side as well. And, oh yes, there is also that niggling issue of liquidity. As Mr. Schwartzman says, "...the banks haven't been willing to unload (the) investments at distressed prices..." Well, a firm earns that right by having a capital structure and funding plan that can support a long-term hold strategy. Otherwise, they should suffer the vagaries of the market. But this is an issue simply not addressed by the bright men of Blackstone or their Wall Street buddies.

So why do risk managers and bank managements' so consistently make bad decisions? Probably because there is an over-reliance on measures that are seemingly quantifiable. They can measure delta. They can measure vega. They can measure theta. They can measure gamma (or at least they think they can). They can estimate credit loss ratios. But what about liquidity? When you are quantifying factor exposures, how exactly do you model liquidity as other risk factors change? It is a very, very hard question. Sometimes risk management requires judgment beyond computers, which is hopefully one of the biggest take-aways from the current credit melt-down. My sense is that there is currently a fear to manage without a machine telling you what to do. It is kind of like the drunk looking for his lost keys by the streetlight, simply because this is where he can see. But the likelihood of his keys being within the illumination of the streetlight is very, very low. Some of the best risk managers, guys like Gus Levy of Goldman Sachs and Ace Greenberg of Bear Stearns, didn't rely on computers but relied on instinct, savvy and experience. We need more of this. It's called leadership. Let's not cloud the issue. It's not about FAS 157 or any other accounting rule. It has been and always will be about management. 

Anschutz as Icarus: Flying too Close to the Sun

The variable prepaid forward contract, without question one of the most popular transactions on corporate and high net worth derivatives desks on Wall Street. Every firm has their own brand name for it, but the bottom line is always the same: helping a company or a wealthy individual protect the value of a concentrated stock position and generate liquidity from the position without paying taxes currently. In essence, getting all the benefits of a sale without the costs associated with a sale. An article in today's Wall Street Journal highlighted the structure and provided an example of its being pushed to the limit, so much so that the favorable tax treatment generally associated with the strategy is being challenged by the IRS. These strategies in other forms have not drawn the IRS's ire, but why?

First some historical perspective. In a perfect world, derivatives professionals and their clients would like to figure out how to sell an appreciated asset and not pay taxes - ever. Historically there has only been one foolproof way to accomplish this feat - by dying (with your heirs getting a stepped-up basis in the appreciated stock to fair market value at the time of death, enabling a sale without ever paying capital gains taxes on the position). Most clients and their advisers prefer a somewhat less draconian vehicle for accomplishing this, and the easy answer used to be the "short-against-the-box" trade. This involved simply borrowing stock against an appreciated stock position and selling it, posting the sale proceeds as collateral against the short position and perfectly hedging the value of the appreciated shares. This deal worked for a long time, until the IRS determined that if a transaction looked like a sale and smelled like a sale then it probably was a sale, and eliminated the tax deferral associated with the strategy. So smart derivatives practitioners then asked themselves the question - if a "short-against-the-box" transaction eliminated too much risk to warrant a tax deferral, then exactly how much risk needed to be taken in order to secure the more favorable treatment?

Financial engineering then gave us the variable prepaid forward and its variants (collectively 'VPF"). Essentially, you can think of a VPF as a kind of private mandatory convertible, similar to the instruments sold to raise capital for banks and corporations. Put another way, a client using a VPF to hedge a stock position is:

• Selling their stock forward (agreeing to sell at a future date for a pre-agreed upon price, generally 3 to 7 years foward);
• Buying a call option struck at the current stock price; and
• Selling a call option (or in some structures .833 of a call option) at 120% or more of the current stock price.

And once the hedge is put in place, the client can receive the present value of the future cash flows upfront, which is generally in the range of 80-85% of the current fair market value of the hedged position.The net effect of all this is to give the client significant liquidity, protect the full downside of the hedged position at the current stock price and to defer payment of capital gains taxes until the expiration of the hedge.

• Question: why does the IRS deem this not to be a constructive sale for tax purposes while the short-against-the-box is treated as a sale?
• Answer: because of the variability of future outcomes associated with the hedged position, the measure of which is the spread between the call option bought and the call option sold (in the above example a 100% call bought and a 120% call sold for a 20% spread) as well as the length of the hedge.

What are two ways to make the above hedge more "sale-like" and therefore blowing the tax deferral in the eyes of the IRS?

1. Make the call strikes closer, e.g., a 100% bought call and a 110% sold call; or
2. Make the maturity longer, e.g., 10 or more years.

The best measure of "stock-likeness" is embodied by the concept of delta. Per Wikipedia:

The delta measures the sensitivity to changes in the price of the underlying asset. The Δ of an instrument is the mathematical derivative of the option value V with respect to the underlyer's price.

Think of it this way: owning stock has a delta of +1. Selling stock has a delta of -1.  The hedge is the synthetic selling of stock. So if the delta of the hedge is too high (meaning the call spread is too tight or the maturity is too long), there won't be enough retained risk or variability of potential outcomes to cause the IRS to allow tax deferral. And while Congress hasn't enacted concrete rules that govern these strategies, the IRS has issued "private letter rulings" to law firms and banks on the topic that pretty much support what I've written above (or at least they did when I was in the business). But what was always an issue, a niggling little issue that sometimes found its way into certain of these hedging contracts, concerned the issue of stock borrow. And this is where the wealthy and generally fortunate Mr. Anschutz might be in a bit of trouble.

In order to execute one of these VPF deals, stock needs to be borrowed and sold to establish the short position. The Wall Street bank is the one who does this. But in the hedging contract, it has to be stated who bears the risk of a stock borrow being "called in" (meaning you've got to give the shares back to the stock lender and the transaction gets unwound). While there are lots of shades of gray (e.g., the stock can go "on special" and the borrow simply gets more expensive but doesn't go away, but someone has to incur the higher borrowing costs), someone is taking the borrow risk. So far we're ok as far as the IRS is concerned.

But where it used to be fuzzy prior to 2006 (but now is not) was when the Wall Street firm had the ability to borrow the shares held by the client in the event of a short squeeze or if there was not sufficient borrow available to get the hedge off in the first place. I looked at this feature many, many times and spent countless hours with counsel trying to get comfortable with this but never could. In the late 1990s/early 2000s during the Internet bubble, it was often very difficult to source enough borrow to execute a big hedge on a recently IPO-ed stock, and borrowing the client's shares would have been the ticket to millions in fees. But sadly, a prudent man's view of the facts and circumstances left these deals to be done by others or none at all. Don't shed too many tears, however: there were plenty of liquid stocks to hedge where this issue never came up, but in some cases it did and some decided to roll the dice.

Enter Mr. Anschutz. Now, according to the WSJ article, these transactions were entered into during 2000 and 2001. But they provided the counterparty, DLJ, with the ability to borrow the shares held by Mr. Anschutz. So think about this. Mr. A has shares. He posts them as collateral to DFJ for the hedging transaction. They sell those exact same shares as part of the hedge. Seems like a sale, right? This is the IRS position. The IRS formally shut the door on this type of deal back in 2006, a full 5-6 years after Mr. Anschutz put his hedges in place. Clearly his counsel will argue that such transactions should be grandfathered as they were entered into before the rules were clarified. But some of us saw these deals during the same time period and concluded that they were simply too dangerous. The benefit of an 8-year tax deferral like the one contemplated by Mr. Anschutz's hedges are very valuable. But the terms of his particular agreements are yet another example of something we see on Wall Street time and time again: flying too close to the sun.

 

Bank Holding Company Stockholders: Even Greater Dilution Awaits

During my years as a derivatives and capital structuring professional, I spent a lot of time working with my teams to develop versions of the "holy grail" - tax-deductible equity. In short, when corporations are seeking to raise funds, the goal is to receive equity credit from the rating agencies while incurring a financing cost more akin to debt. And this is nowhere more important than with regulated financial institutions, which have mandated minimum capital ratios which are heavily scrutinized by both regulators and the analyst community. Bank holding companies have been on the leading edge of so-called "hybrid" equity issuance, and have historically been among the largest issuers of such paper.

Without question, hybrid paper has created a form of both regulatory and economic arbitrage, where "equity" can be issued at debt rates. This has been courtesy of bank regulators, ratings agencies and the IRS, from whom opinions are sought to ensure the amount of equity credit received and the tax-deductibility of the structure. It could only be that such an arbitrage opportunity could exist when three different bodies are involved in the treatment of such instruments.

There is a limit to this nirvana, however: only so much of this paper can count as equity before the regulators and ratings agencies call bullshit. And if you believe the story line in a recent Wall Street Journal article - and I do - then this breaking point has pretty much been reached:

U.S. banks and brokers trying to raise capital with hybrid securities have turned to issuing the instruments so frequently they risk losing the securities' capital-raising benefits.

If the banks decide to sell more of these securities, which are a blend of equity and debt, they may not be considered capital by rating firms. That in turn could limit financial firms looking to raise more funds to bolster battered balance sheets.

The companies are then likely to tap other avenues that pose their own disadvantages, such as selling common stock -- which current shareholders wouldn't welcome.

The real issue here isn't that the banks are opportunistically trying to raise cheap capital and get equity credit, though this has been the "sale" from Wall Street firms to the banks during calmer times, but that banks need to raise equity, real equity - and fast. Damaged balance sheets face banks of all sizes across the U.S. the UK, and they either need to massively shrink their assets and de-lever (which causes a flood of paper to further depress asset prices), raise real equity capital or both. And it appears that the equity issuance side of the equation will become more costly, and greater numbers of these sales will be in the form of expensive and dilutive common stock. This is clearly not good for existing common stockholders, who will bear the brunt of this change in issuance strategy. Whether it is through public market issuance or via private sales akin to Washington Mutual's deal with TPG or the announced Bradford & Bingley transaction in the UK, common stockholders will be hurt - badly.

It brings me back to my early days at Citibank when Prince Al-Waleed spent a cool $590 million to buy up what turned out to be one of the best investments of all time (even in light of current problems). We have only witnessed the tip of the iceberg.

 

Yes Ben, the Dollar Does Matter

The weak dollar has been a source of much consternation, at least for me, over the past year. There are those who say "Who cares; a weak dollar helps exports," and "You need to keep pushing down interest rates until the economy recovers and we work through this crisis." My position has been pretty clear: a weak dollar is bad, not in and of itself, but because of the knock-on effects of such a policy. Why? Consider just a few reasons:

• The U.S. is a debtor nation. We rely on foreign governments to finance our deficits. If the value of those dollar-denominated holdings keep falling, at some point they will either stop buying or demand an increasingly high interest rate to offset currency losses;

• The U.S. financial system is in a badly weakened state. We need both onshore and offshore sources of capital to bolster bank balance sheets burdened with busted ABS and retained LBO loans. If foreign investors lack confidence in the dollar, this erects an extremely high barrier for investment.

• The U.S. imports a lot of stuff. Paying for this stuff with depreciated dollars means only one thing - rising prices. A weak dollar is fundamentally inflationary and something that could bring us back to a time we'd all rather forget - the 1970s.

But for most of the time I've been writing about my frustration with Fed policy, Mr. Bernanke has been turning a deaf ear to my pleas. But now it appears that we've reached a tipping point in Ben's mind, a point that has prompted him to sing a somewhat different song; here are his comments during yesterday's speech at the International Monetary Conference in Barcelona:

In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets.  The challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation.  We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations.  Over time, the Federal Reserve's commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy--including flexible markets and robust innovation and productivity--will be key factors ensuring that the dollar remains a strong and stable currency.

Price stability? Maximum sustainable employment? Flexible markets? Hmm, not sure we've done such a good job on these fronts. Productivity, yes - so far. Mr. Bernanke is focused on the right goals to be sure. It's just that it has taken him a while to get there. And now he has to follow through with actions to back up the words. Clearly in his calculus he viewed the need to push down rates regardless of the impact on the dollar as critical in order to help repair the broken U.S. credit markets. It is hard to fault him for his intentions, though one can argue that pain taken quickly and sharply is, in the long run, a better policy than death by a thousand cuts. And given that the impact of Fed policy has a lag associated with it, are inflationary forces already unleashed in the system too far advanced for tighter monetary policy to tame them? Are we destined to suffer higher prices and higher interest rates due to the Fed's slowness in reining in liquidity to stem a plunging dollar? This is the $64,000 question. And given the way things are looking, I'm not sure I want to know the answer.

Hedge Fund Fees and Liquidity - Setting it Straight

The current fallout associated with DB Zwirn is causing a renewed focus on both mark-to-market practices and, by association, pay-for-performance practices. The way it's being depicted in the media it's almost as if someone woke up and realized, "Hey, if hedge funds have illiquid investments kind of like private equity firms, then shouldn't they get paid like private equity firms (e.g., upon realization)?" 

I've been beating this drum for a long, long time, because if you've spent much time in the industry and have experience with both liquid and illiquid assets it becomes very clear, very quickly that there is an inherent conflict. How, exactly, can a manager justify a quarterly mark on a fundamentally illiquid position and deem it fair to get paid on an upward revision in value? You can't eat that revision, you can't monetize it, yet somehow you should get compensated for it? Interestingly, these are often the same managers who squawk about being judged on a quarterly basis when their strategy is fundamentally long-term. Why should one really be surprised about this asymmetry - heads I win, tails I don't lose. It is this ego and greed that drives many - but clearly not all - good hedge fund managers.

I actually think I wrote a pretty good post on this issue last year, with the following paragraphs being particularly relevant to the current media frenzy:

If positions are held for trading, meaning that short-term assets are being funded with short-term liabilities, then you've got to use either market prices or prices privately received from, say, five dealers, who are quoting based upon taking the bid (or at least the mid) side of the trade. And these are the prices that should be used for both NAV and performance fee calculations for funds, and carrying values for banks and other kinds of asset managers. Let me repeat: if the asset is a trading asset funded with short-term trading liabilities, then you need true marks. No marking to model. Period. Because as we all know, models don't begin to reflect the realities of financial distress, and are inevitably skewed in favor of the manager, if not intentionally then at least subliminally because managers, by definition, tend to love their positions.

Conversely, if positions are held for investment, it must be demonstrated that such investments are funded with liabilities of like or longer duration. This way, an investor can take comfort in knowing that while the values used might not be market-based, the manager can ride out adverse market conditions and not be forced to liquidate at the worst time. However, investment assets should not attract performance compensation until they are sold, and Management must provide clear documentation as to the process used to value these assets for NAV calculation purposes. This necessarily sets a higher return threshold for investment assets relative to trading assets, as should be the case: if one is giving up liquidity and the ability to collect quarterly performance compensation, then the expected return on these assets better be huge. This is where Management's view comes into play. This approach treats investment assets as if they were private equity in nature, being funded with long-term liabilities and attracting performance fees only when sold.

It all seems brutally straight-forward to me. It always has. But in an industry where the words "hedge fund" have come to mean a fairly standard set of terms and conditions - 2% management fee, 20% performance fee, fees paid quarterly - investors have gotten locked into a compensation paradigm that no longer fits portfolios that have become increasingly chocka-block with illiquid assets. Theoretically, in a perfect world, I'd argue that managers should get paid on positions as they get closed out, whether they are held for one day or five years. This eliminates the impact of marks on compensation, offers 100% transparency and truly aligns the motives of managers and investors. Sure, record keeping would suck, but this can be figured out. I'd be interested in the arguments contrary to this position, except those which say "The best managers simply won't accept this." Over time things can change but it depends upon investor resolve and insight, two things that have clearly been lacking in this latest wave of hedge fund melt-downs.

The Inevitable Growth of Derivatives Exchanges

The World Of Derivatives Has Changed

Derivatives exchanges for the trading, clearing and settlement of options and futures is nothing new; they've pretty much been a fact for over 30 years. And volume growth at these exchanges is exploding, regardless of the venue - ICE, ISE, NYMEX, CME, etc. They are all flourishing amidst rising market volatility and rising transaction volumes in general. That said, exchanges continue to miss an enormous part of the derivatives trading and hedging activity that happens in the over-the-counter (OTC) market. Back when I was a derivatives structurer and marketer, the OTC market was THE place for derivatives transactions, particularly in the fixed income, foreign exchange, credit and commodities markets. But today things have changed. The meteoric rise of the OTC credit derivatives market has caused many market watchers to question both the degree and extent of this largely unregulated activity, and recent crises that have involved credit default swaps (CDS) and the like are raising questions about issues of transparency, counterparty credit risk, broker/dealer market exposure and documentation.

Why OTC Markets are Still Enormous

Even in light of the clear benefits of exchanges - transparency, standardized documentation, centralized credit, clearing and settlement functions - the OTC markets have continued to thrive. But why?

• Customization: Whether for risk management or for speculation, the standardized (or lightly customizable) contracts offered by the listed markets simply don't meet the needs of many market participants. Whether for a corporation issuing a bond that wants to precisely hedge a recent issuance (e.g., by swapping a bond with a fixed coupon to floating rate), a project financing vehicle that needs to protect a series of highly variable and choppy cash flows or a speculator that wants to express a particular view through a basket of credit swaps and equity positions, the OTC market is able to address and and all requirements on a highly customized basis.

• Lack of transparency: Let's face it, banks want as little price discovery as possible because it leads to more generous pricing opportunities. Especially if a hedger or speculator wants to put on a non-standard position, banks stand to make the lion's share of their profits relative to facilitating large numbers of exchange-traded instruments with razor-thin margins. This is just reality.

• Potentially better terms: This transcends pricing, as bank counterparties may be easier on collateral requirements and credit terms than exchanges. It is in a bank's interest for derivative counterparties to honor their agreements over their life, and have been known to do unnatural things to keep a derivative counterparty alive for the duration of the agreement.

Rising Volumes Make All The Difference

When I marketed and structured derivative solutions customization was the key driver, as tailored solutions that better met a client's needs also provided the opportunity to make more money. It was effectively the synthesis of an investment banker and a Sales & Trading professional, offering strategies and counsel in order to deliver the right OTC or public capital markets solution. This was pretty cool. The transactions got papered right, the appropriate credit was approved and the necessary ISDA Master documentation was in place. But maybe I did 50 transactions a year. This is a very different situation than we have today where tens of thousands of credit derviative transactions and trillions of dollars of notional value get done annually.

Risks Of The OTC Documentation Blizzard

Further, prime brokers and their broker/dealers were nearly in crisis around undocumented trades, particulary in the 2004-06 time frame, so much so that the SEC had to step in to force banks operations areas to clean up their act - or else. Imagine a situation where a major institution fails with tens of billions of outstanding CDS' written on its bonds, and thousands of unconfirmed trades spinning a tangled web of relationships among investors, speculators and hedgers all over the world. It would be a bonanza for litigators but a nightmare for financial market participants and those for whom they manage money. Not a scenario I want to imagine.

Exchanges Are Designed To Help

So what is the answer? Getting the leading derivatives originators to agree on a standardized template for CDS trades, interest rate swaps and the other building blocks of the OTC market, and creating enough degrees of freedom in the contracts such that there is some ability to customize without losing the liquidity of the instruments. The central exchange function is simply so valuable in an a world of exploding volumes and numbers of counterparties, and can serve as a mechanism to ensure best practices with respect to transparency, credit provision and documentation. I am not one to bang the drum for excessive regulation, but by pushing as much trading volume onto exchanges as possible I believe the likelihood of market dislocations will be minimized and "unexpected" crises in the wake of credit and performance defaults will be substantially reduced.

The Inexorable Shift Towards Exchanges

I find it useful to think about ideas by stressing the extremes, e.g., how did things used to be and how might they look at infinity? And to me it is inevitable that, at infinity, almost all transactions will be done on exchanges. Why? The benefits simply outweigh the costs, and there are a number of catalysts in place to support this conclusion: increasingly global and liquid markets; inexorably rising transaction volumes; much larger credit exposures; the difficulties with counterparty credit review; increasingly intertwined financial systems; and the blizzard of paper required to trade OTC with more and more counterparties. Over time, the inefficiency of the OTC market will cause it to take a back seat to the exchanges, and this is a trend that will build momentum over time. Think about Toyota versus GM. Who could have imagined Toyota's success three decades ago? And now they are pulling away. This is how I think of the exchange model versus the OTC model. The changing of the guard is inevitable. Just wait and see.