Wednesday, January 28, 2009

Madoff's Mistake

One of the inevitable consequences of bear markets seems to be the bust of Ponzi schemes. The explanation seems to be that Ponzi schemes are quite prevalent in our society but can remain undetected during good times. In other words, during good times people seem to have the risk appetite to believe that it is easy to make money consistently without risk of permanent loss. Under this psychological predisposition one presumably can entice his neighbors and friends (all of the caught schemers so far have been men, so women are either better at it or they do not run Ponzi schemes) into believing in unsustainable stories.

The scariest part of the explanation I just used is that, not only applies to "12% return no volatility" (lets call it the "Madoff scheme"), but also to "we only buy growth (i.e. very high p/e) companies" (which we may call the "Internet scheme").

If you think the analogy is preposterous, consider the plight of a tech and/or internet portfolio manager in, say, 1999. His entire portfolio consisted of stocks with high p/e. Sure, many of the companies had been growing at double digit rates, but even a tech manager knows that most companies cannot maintain such growth rates indefinitely. Yet, our manager kept accepting subscriptions, and with the subscriptions bought more of the same expensive stocks, which pushed the price of his portfolio higher making his investors happy. The only difference between this scheme and Madoff's is that it had a chance of succeeding... As much of a chance as Madoff's, that is, who in the absence of a bear market could have kept the system going until his death. Also, since many tech portfolios corrected at least 90%, we can say the result was essentially the same.

In fact, if you think about it, Madoff's scheme had a better chance of outlasting and Internet fund (as it did) because it was not bound by exogenous events like company earnings. His only potential enemy was massive redemptions triggered by a generalized panic which his strategy could have never caused.

As smart as he was, or perhaps because he was never a true manager, Madoff missed one obvious recourse that could have prolonged his tenure: gating.

In case you didn't know, every hedge fund has a clause that allows the managers to reject redemption requests in order to "protect other investors." Of course, the definition of who do you think you protect and against what is in the eye of the beholder. Furthermore, I am sure that many people reading this are cringing at the comparison between a smart-money hedge fund and a run of the mill Ponzi scheme. However, consider the reasoning behind the gate clause: "If I sell to give you your money back I drive the prices down hurting people who do not redeem (including your manager)." If that is the case, then the prices depend on my actions? If they do, what is the exit strategy? Also, what was the effect of my buying on the way up and what performance fees did I pay while I pushed the prices higher?

Of course, if one wanted to speculate (a term seldom used in the Hedge Fund world), one could say that maybe the managers are concerned about losing the 2% fixed fee they continue to charge for managing the assets they cannot sell. Not to mention those managers who have invoked the gating clause because they "...refuse to be the industry's ATM" (true quote from a well know fund manager which implies that they could return your money, they just don't want to).

In summary, I consider a Ponzi scheme any investment were the return depends on successfully attracting new investors. Conversely, if the exit of investors permanently destroys the value of the investment, then it must be some kind of Ponzi scheme as well.

In the end, if Madoff had rejected the redemptions invoking some kind of obscure clause, he would probably still be in business today, even without an auditor.

Friday, January 16, 2009

Time to choose: The Country or the Stock Market

Americans love the stock market. If you say "the Dow", everyone knows what you are talking about, and the index is prominently mentioned in every news broadcast in all sorts of media. You can say that the equity culture is as American as the fireworks on the 4th July, both may have been invented elsewhere, but they have never been as adored as they are here.

An why not? The stock market is supposed to be this wonderful mechanism that allows anyone to become rich and pursue lofty goals like giving to charity and paying for our kids' education. In addition, the stock market can give us the sense of being wise investors like Warren Buffet or those guys from Yale.

Anyone who thinks a bad year can change this fails to understand the profound optimism embedded into the American psyche. "Stocks always come back," say the experts, leaving out the fact that they could take 30 years to come back and that statement would still be true.

Bonds? nobody buys bonds, unless you are some kind of insurance company. Most people who own bonds through some kind of mutual fund don't even know that they do.

The problem is that, over the past 25 years, we have taken this approach to the extreme. Employees at every level have gotten used to being compensated with stock and/or options. This in turn means that management is more concerned with "the stock" than with the long term viability of the business. In addition, "the market" gets its information about the companies from "the analysts" who mostly extrapolate management assumptions using Excel.

This fixation is now leading our government to the utterly nonsensical behavior of using your money to bail out every kind of company without first wiping-out the equity. The managers, who usually hold large amounts of equity and options are very happy with this. If the company survives, they may be able to recover their wealth. In the meantime, they can keep collecting their large salaries (and bonuses) and, maybe, issue themselves more stock and options at current prices. Meanwhile, the American public, is treated to the argument that "letting [insert bailout recipient] FAIL would be worse for all of us."

Forgive me for pointing out the obvious, but erasing GM or Citigroup's common and preferred equity in exchange for backing up all or part of their debt WOULD NOT hurt the company in any way. Not only that, but it would restore in the public mind the sense that people who made lots of money in the past by riding the credit-driven bull market can lose money by the unraveling of the same market. The latter is not a minor point if we want to entice people to invest in the future as a general sense of a rigged game does not generate confidence in the average investor.

It is time the politicians realize that our money is a scarce resource. If we need to put a safety net under a few companies to save jobs, so be it. However, insisting on saving the equity will not only discredit our financial markets, but significantly increase the size of the total bailout. They can't save everyone so it is time to choose.

Wednesday, January 14, 2009

Latest dividend information from the "big 8"

Bank of America (BAC).....10/16/08.....$0.32..............6.4B
Bank of NY (BK)................1/13/09......$0.24..............1.15B
Citigroup (C)....................9/29/08......$0.16..............5.5B
Goldman Sachs (GS).........12/16/08......$0.47..............442M
JPMorgan Chase (JPM)...12/09/08......$0.38.............3.7B
Morgan Stanley (MS).......12/17/08...... $0.27.............1.0B
State Street (STT)............12/18/08...... $0.24.............432M
Wells Fargo (WFC)...........10/22/08...... $0.34.............4.2B

According to my calculations, that is a total of $6.6 billion only considering the last declared dividends. Keep in mind that BAC and WFC declared theirs before receiving the money from the government.

Source: Bloomberg

How they spend the TARP Money

div·i·dend (div- i-dend')
1. Mathematics A quantity to be divided.
a. A share of profits received by a stockholder or by a policyholder in a mutual insurance society.
b. A payment pro rata to a creditor of a person adjudged bankrupt.
a. A share of a surplus; a bonus.
b. An unexpected gain, benefit, or advantage.
[The American Heritage Dictionary, 4th ed.]

If you read the financial press you may think there is something wrong with the venerable Citigroup. They seem to imply that the recent government investment in Citi is some kind of “bailout”. In addition, the press insists in propagating malicious rumors about Citi desperately needing new capital. According to these rumors, Citi would be ready to sell asset at “fire-sale” prices. In fact, they are even trying to portray Citi’s latest strategic move, the new joint venture with Morgan Stanley, as a desperate move to raise the pittance of $2.7 billion.

Fortunately for us, firm believers in the infallibility of financial markets, there is plenty of evidence that Citigroup is as strong as ever. How do we know? As any financial text will tell you, there is no stronger signal to a company’s health as its dividend to common stock. Citi, of course punctually paid a $0.16 per common share on xx/xx/08. In fact, according to their quarterly cash flow, Citigroup paid $6 billion in the three quarters to 9/30/08 ($10 billion in 2007, if you care), more than twice what they will receive in cash for 51% of Smith Barney.

Do you think that the brightest bankers in Wall St. would pay $6 billion in dividends if they needed cash? In fact who in their right mind would pay such a large dividend while raising equity? Not Citi, unless you count the $4 billion of common equity they issued in 1Q08. Wait! Issuing equity to pay dividends sounds like a Ponzi scheme. Well, only if you think money is fungible.

This begs another question, if Citi needs taxpayer money, where do they get the money to pay dividends? Better yet, why do they continue to pay dividends given that they are desperate enough to need taxpayer money? If I were Citigroup, I would stop paying dividends to conserve cash. After all, dividends are discretionary payments which means I can cut them zero. Likewise, if I was the US Treasury or the Fed, who are supposed to look after the public funds they dispense, I would ask Citigroup NOT to pay dividends while they owe me money. Otherwise, it may look to “The American People” like they are using taxpayer dollars to satisfy someone’s fetish for a predictable dividend stream.

So long as we are on the subject, have you asked yourself who gets these dividends, which lately seem to come from taxpayers dollars? Citigroup shareholders, of course, which include, as far as I know, a member of the Saudi Royal family, several institutions around the World, and Citigroup employees.

The last group deserves special attention. If I am not mistaken, Wall St. banks like to compensate their employees with restricted stock. I think restricted, in this context, means that they can not sell the stock for a period of time. However, I do think they collect the dividend. That means that the money, if fungible, goes from the taxpayer to the accounts of the holders of restricted stock some of whom are responsible for setting dividend policy. As the Church Lady would say, “isn’t that special”

In the United Kingdom, a similarly structured allegedly capitalist society, the government also had to make a “capital infusion” to shore up the banks. The first thing they did was to abolish dividend payments.

If you think Citigroup is unique, I suggest that you take a look at any American bank receiving public funds. According to the US Treasury, if forced to forego dividend payments, many banks would not “participate” (meaning they would not accept the bailout money.)

There you have it, these guys are so smart that they have convinced the US government that they need to be enticed to accept a bailout. Sweet!

Tuesday, January 13, 2009

First Amendment to the United States Constitution

"Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assemble, and to petition the Government for a redress of grievances."