Andy Kessler

NPR: Navigating Wall Street's Lexicon

http://www.npr.org/templates/story/story.php?storyId=96557570
1:02 mark
"The last fund manager or the last set of individuals out in the marketplace, have they given up hope, have they just said, 'you know what, sell everything,' and just en mass, people are  puking out stocks, that would be capitulation, that is what forms a bottom."

Chris Arnold, NPR: "Nice image."

WSJ: What Paulson Is Trying to Do

http://online.wsj.com/article/SB122402984044334627.html
Less than two weeks into it, the $700 billion Troubled Asset Relief Program (TARP) is stuck between a rock and a hard place. Next week, several hundred billion dollars of credit default swap (default insurance) payments on Lehman's debt default are due. No one quite knows who owes what and if they're good for it. Hence the urgency in Henry Paulson and Ben Bernanke's plan to inject $250 billion directly into bank balance sheets, which seems a necessary evil to get capital to the right place and help weaker banks save face. The credit markets agree -- so far.

Wall Street and banks live by short-term loans. But as a loan shark might say, right now, nobody wants to lend to nobody. The rate that banks charge each other, the London Interbank Offered Rate (Libor), has been trading so high above three-month Treasury-bill rates (on Monday it was 4.75% vs. 0.11%) that no one is lending. This so-called TED spread -- the difference between what banks pay and what the Treasury pays to borrow for three months -- signals the health of credit markets and has rarely been over 1% since the 1987 crash. The Treasury is clearly focused on this metric and needs to get it down to historic spreads. First it has to change the current mentality of "who wants to lend to the next Lehman or Wachovia?"

The original TARP plan was to buy all the bad loans, mortgage-backed securities and collateralized debt obligations (CDOs) currently weighing down bank balance sheets. That is still the right (and profitable) thing to do. History shows that well-capitalized banks eventually do lend since hoarding doesn't make money.

But here's the current dilemma: If Treasury pays more than market price for these distressed securities, it would look like a taxpayer gift to Wall Street. That's politically unfeasible. So Treasury has to pay the current distressed prices. (Despite this week's stock-market bounce, prices are still dropping on toxic CDOs.) But if Treasury pays current, fire-sale prices, it would lead to major write-downs at banks. Since most of these securities are collateral for other loans, and regulators force banks to have minimum capital requirements and cash on hand, any write-down in value immediately means new capital needs to be raised.

Is this the right thing to do? Probably not…But it's the only thing to do at this stage.

And then who would throw good money after bad? Sovereign wealth funds have already been burned. Dubai invested in Citigroup less than a year ago via preferred shares that convert into Citi stock at $32 to $37 per share. Citi is now around $18.

Other banks are still scrambling. Morgan Stanley's shares bottomed under $7 last Friday on fears that Mitsubishi UFJ Financial Group, a Japanese bank with $1.8 trillion in assets, would pull out of a previously announced deal to buy 21% of the company for $9 billion. Luckily for Morgan Stanley, the Japanese think long term and did the deal anyway, even though it makes no economic sense at the moment. Other U.S. banks wouldn't be so lucky.

So here we are with no interbank loans and no equity financing. Treasury would bankrupt banks if TARP buys securities at market prices, forcing them to do the impossible task of raising capital in an ugly environment.

The direct capital injection is a way to get unstuck. In effect, first Treasury injects money into bank's balance sheets, then buys the toxic loans at market prices. Even if there are write downs, banks will have enough capital to live. What about healthy banks like J.P. Morgan, Bank of America and perhaps Goldman, which don't need capital? They get it too. The Treasury is forcing every top bank to take the government investment. Why? Because if they didn't, the ones that do take the capital would look weak and loans to them would remain dry.

Is this the right thing to do? Probably not. Despite some limits on compensation, bad management stays in charge. Government investment in financial institutions will raise a gazillion temptations and conflicts of interest. Politicians won't be able to help themselves and will inevitably meddle. Just look at the pork loaded into the TARP bill. But it's the only thing to do at this stage. Next stop is full nationalization and no one wants that. Already the TED spread is coming in, dropping to 4.36 from 4.64. The market likes the plan, at least for now.

One concern: Won't cranking the monetary printing presses to finance all this lead to runaway inflation? Probably not. Remember that after the 1929 market crash and subsequent bank runs, 10,000 or roughly 40% of banks failed, $2 billion in deposits were wiped out and 30% of the money supply disappeared. So did a similar percentage of GDP. Today, bank deposits are mostly safe, but with $1 trillion in bank and Wall Street writedowns taken or soon to be taken on bad real estate securities, some multiple of that in money supply will vanish with the stroke of an accountant's pen. Restarting bank lending is the only way to top it back up.

Many questions remain: When will Libor rates and the TED spread go back to normal so lending can restart? Then, when does the government sell the preferred shares so we can return to a market economy? Can we put an expiration date on government programs? (Most New Deal institutions are still around.) Furthermore, what do we do with the returns on investment?

Thanks to deposit insurance, there are no huge bank runs going on. There is, however, a "loan run," meaning no one will lend to weak banks. Yes, it's distasteful for government to own any private enterprise, especially in finance. But if you hold your nose, the new TARP seems like a way to end this loan drought. There is no economy until this is fixed. Then we can start arguing about the inevitable reforms to come.

Forbes.com - New Life

Thank you, sir, may I have another? As the stock market gets spanked,down 40% in a year and a day, there is a silver lining. We Americans get our lumps out the way, and start a new life. Much has been made of the "mark to market" rule and its role in the credit crisis, but it probably has saved us from 10-plus years of gloom and doom.

Mark to market just accelerated the inevitable, the write-down of bad loans.

Google the number 157 and the first result that comes up is the Financial Accounting Standards Board (FASB) statement on fair value measurements. It's way too boring to read, but what it says is that if a bank or investment bank has a security that trades at 62 cents on the dollar, you have to carry it on your books at 62 cents on the dollar. Pretty simple. You may think it's worth more--well, of course you do, or else you would have sold it, dummy--but the market says it's only worth 62 cents, so quit arguing.

The problem is that many markets, especially those for the now-toxic mortgage-backed securities and collateralized debt obligations (CDO), are thinly traded. This means, the argument goes, that they don't reflect true value. Devious evildoers can set the price wherever they want it. And since these securities are the collateral for short-term loans that the entire financial system is built on, they are subject to manipulation.

Like this: A hedge fund shorts a bank stock, then bids down the thinly traded value of an AAA-rated CDO, a collection of mortgages from, say, the second half of 2006, which is sitting on the books of said bank. Because of FASB 157, the bank has to "mark to market" at the lower price, write down the difference as a loss and raise more capital, and its stock goes down as previous shareholders get diluted. It's one of the reasons the Security and Exchange Commission halted shorting financial stocks, a Band-Aid on a bigger problem.

Well, boohoo! They shouldn't have owned these crappy securities in the first place. Mark to market just accelerated the inevitable, the write-down of bad loans. For the system as a whole, it is always better to take your lumps post-haste. Get it out of the way. Dow down 45%? So what? It was going to drop that much anyway, and one fell swoop beats the Chinese water torture--drip, drip, drip--of a decade of daily declines. And yes, even if it means losing a few companies.

For me, even a flawed market price is better than no market price at all. On paper, Wachovia  has a book value of $75 billion and is being bought by Wells Fargo  for maybe $15 billion. Not sure exactly what they're marking to.

To better understand a world without mark to market, go read Gillian Tett's 2003 book Saving the Sun. A quick summary: Japanese banks made all sorts of horrendous loans in the 1980s. Many, and maybe most, of the loans stopped paying interest after the Japanese bubble burst in 1990. Banks' balance sheets were stuffed with non-performing loans (NPL). Instead of writing them down, marking to market, they just sat there gathering dust on their books. The banks stayed in business, but stopped writing new loans, the result being Japan's Lost Decade. By the late 1990s, the Nikkei 225 index had basically dropped by half.

Anyway, one Japanese bank, Long-Term Credit Bank, finally collapsed in 1998. The Japanese government allowed an American buyout firm, Ripplewood, led by J.C. Flowers & Co., to come in, buy the bank, rename it Shinsei (or New Life) and write down as many NPLs as they could with the government taking the loss. This was around 2000. The bank started lending again and generating profits. So successful was this deal that Shinsei went public in 2004, clearing a $6 billion gain for Ripplewood.

It may have been catastrophic if, like Lehman Brothers  in 2008, Long-Term Credit Bank had failed in 1991, with reverberations throughout the Japanese financial system and probably the world. Their stock market may--would--have crashed, dropping, uh, 50%. But the government could have bought the bad loans, recapitalized the banks themselves and not lost the last 18 years of global growth to China.

So as hard awful as a Dow dropping like a safe onto Wall Street and Main Street is, cheer up. It's almost over. The gunk is getting cleared out. No pain, no gain.

By the way, as a not-quite-amusing epilogue to the Shinsei story: Like many other banks around the globe, it was buying subprime securities over the last few years. Late in 2007, J.C. Flowers had to put more money into the bank to shore up its finances. Maybe this time they will do the write-downs a little quicker. New Life, indeed.

New York Magazine: Why Wall Street Will Prevail

Why Wall Street Will Prevail
Things are bad now, but the world will never out-finance us.

http://nymag.com/news/intelligencer/51168/

With the stock market tanking and Wall Street’s top firms either vanished or trembling under the skirt of commercial banks, is finance as we know it over? Will the Credit Crisis of 2008 turn New York dominance into submission—to London, Shanghai, Dubai, or even Moscow?

Not a chance. First, globalization has proved itself out. Some schmuck defaults on his 3,000-square-foot exurban dream home, and Fortis Bank in Belgium gets nationalized. It wasn’t just Wall Street buying stupid toxic securities—everyone was. Right now, nearly $200 billion is trying (unsuccessfully) to prop up Russian markets, hundreds of billions of euros are trying to resuscitate European banks. Wanna bet over/under on Chinese financials next year?

Second, when you think of markets, remember this saying: Money sloshes around the globe seeking its highest return. You would think that it ought to be sloshing away from the U.S. But it isn’t. If anything, it’s sloshing toward us, buying into the safety of U.S. Treasuries. So much so that they’re sold out. Short-term rates are almost negative. The dollar has been on a tear against all but the Japanese yen. Weird, I know, but we are the port in the storm, even though the storm started in this port.

Third, we make valuable stuff. One cause for alarm, even before the financial meltdown this year, is that the U.S. has gone from around a third of world economic output to something closer to a quarter, at the same time that the BRIC (Brazil, Russia, India, and China) have doubled their share to about 16 percent. But that doesn’t tell the whole story. It’s not so much what your output is, it’s how much you profit doing what you do. The Chinese make us stuff at very low profits, while India answers our customer-support calls. Apple makes more money selling iPhones than any subcontractor in these two countries. And a rising Russia was based on over $100-a-barrel oil, probably a thing of the past, with perhaps a similar future for Brazil’s output of less and less valuable sugarcane and soccer players.

Sure, China and South Korea and the entire Middle East sheikhdom community are sitting on trillions of our dollars, from years of reckless trade and fiscal deficits. But it’s not where the money sits that’s important—it’s what you do with it, where you turn it into more. The U.S. is the largest-valued market, with the most wealth: approximately $50 trillion in financial assets vs. $30 trillion in the eurozone and maybe $2 trillion in China. Innovation remains America’s biggest export—in the form of software, network equipment, pharmaceuticals, search engines, and the next wave of funky energy products—and productivity is the only thing that leads to long-term wealth. Wall Street is not the stock market; it is the gatekeeper for great and future great companies that want to tap it for growth capital. Oddly, it’s what happens outside New York that will keep New York the financial capital.

Will the Credit Crisis of 2008 turn New York's dominance into submission?

And finally, the U.S. dollar still rules. Our accounting is legit, more so post-Enron, and years of regulation mean that corporate numbers are, for the most part, transparent. Investors know what they are buying. Not true with Gazprom or even Daimler. Remember all those companies that did their IPOs (initial public offerings) in Europe, on the AIM (Alternative Investment Market)? They all learned their lesson the hard way. They went public in name only. Few shares traded, prices were suspect, and you could never really sell any shares. A word of warning. Policy is the one thing that can screw up Wall Street. Tighter regulation is in the air. Some will be good, like higher reserve requirements for banks, and some will be awful, like restricting short selling or guaranteeing mortgages. New York will remain the world’s financial center—but beware that its biggest risk is just a three-and-a-half-hour Amtrak ride to the south.

Weekly Standard: What is Wall Street these days, anyway?

http://www.weeklystandard.com/Content/Public/Articles/000/000/015/654vucfz.asp

Before the last of Wall Street gets sold off as day-old fish on Fulton Street or washed into the East River altogether it’s worth asking, what is Wall Street these days anyway?

Thanks to Dick Grasso and CNBC, most of us think of Wall Street as balding men in ugly solid-colored suits yelling at each other and throwing litter on the floor of the New York Stock Exchange. Not even close. They might as well be holograms from Disneyland’s Haunted Mansion, just a hangover of years gone by. Or maybe Wall Street is stockbrokers, calling you at dinnertime, trying to put you into a few shares of some hot IPO. Or sleek bankers, guys (mostly) in gray Armani suits, blue shirts with white collars, and Hermès ties, jetting off to London to close some important deal. Not anymore.

Thanks to Dick Grasso, most of us think of Wall Street as balding men in ugly solid-colored suits yelling at each other and throwing litter on the floor of the New York Stock Exchange. Not even close.

So what is it? From 40,000 feet, Wall Street is about access to capital. The stock market trades every weekday, and sometimes slowly, sometimes violently, picks the economy’s winners and losers. Actually, it’s not the market, it’s you and me, our mutual funds and pension plans, the collective “we,” that do the picking via our buying and selling. It’s nice to be needed. You may not even realize it, but magically, the value of companies with great prospects goes up, meaning they can raise capital much more cheaply to hire smart programmers or build another solar panel factory. The flip side is that the price of companies doing all the wrong things (think General Motors and now Lehman Brothers) goes down, starving them of capital, a punishment for screwing up, until they disappear or do something to turn themselves around. The stock market, which is really you and me, does the dirty work of hiring and firing managers and green-lighting or killing projects. Pretty cool.

On the street level, of course, Wall Street is a lot nastier. After 20 years in the business, when I think of Wall Street, I think of alpha dogs generating revenue however they can: getting deals done, fighting for market share against all the other firms, and then at the end of the year, on the inside of their firms, unsheathing the political knives to carve up the ever growing bonus pool, and maybe also carve up each other. Wall Street is really just a compensation scheme. Firms generate sales, and employees get half the money. Yes, half. The rest, after expenses goes to  shareholders. Sweet deal.

Back in the days of private partnerships, White Weld or Brown Brothers or even Morgan Stanley, that was fine. They traded stocks and made good money. They offered advice on mergers and acquisitions and got paid handsomely. But in August 1983, the stock market and the U.S. economy took off. So did mutual funds. And Silicon Valley. And biotech. And a massive service economy. More capital was needed to fund the growth of great companies Think of all the technology companies that didn’t even exist in 1983. Wall Street partners had to pay for memberships in Greenwich country clubs, so partnerships couldn’t retain much earnings. They needed to tap those same public markets, and so went public to raise huge buckets of capital to help their clients. What a great 25-year run!

A very subtle change ruined the party. The same PC and Internet technology that was sweeping corporate America and getting rid of tellers and travel agents and secretaries and typesetters was also invading Wall Street. No one needed a broker anymore—you could do it all online. Traders at firms were being replaced by electronic trading systems that were faster, cheaper, and don’t show up late for work after taking clients out to Smith & Wollensky’s.

By 2002, Wall Street firms, despite being flush with huge balance sheets of capital to generate returns with,  were no longer making money in their bread and butter business of stock and bond trading, investment banking, and money management. The one group making money were these weird guys with math Ph.D.s creating exotic securities, derivatives, pieces of paper backed by pools of assets, maybe airplane leases, or home mortgages. The neat thing about derivatives is that no one but the person who created them knows what they’re worth, so you can sell them at huge markups. Woo-hoo. Mammoth departments were created all over Wall Street to securitize everything that moved. With the Fed forcing low interest rates in 2002-2004, the higher the yield the better.

Subprime home mortgages, because of higher risk (ooh, don’t say that word), had high yields and moved to the top of the list. When not enough of these loans could be bought from banks, firms like Bear Stearns and Lehman set up entire loan-origination subsidiaries, and in true Wall Street style were aggressive and rose to the top of the market-share tables. If you want to know why Wall Street CEOs made so much, it wasn’t from trading your 1,000 shares of Apple stock.

Still, those profits weren’t enough. Their customers were making great money buying Wall Street’s derivatives. But why should banks and pension funds and hedge funds have all the fun? What a perfect use for all that capital on their huge balance sheets and cheap financing from low interest rates. Wall Street, en masse, started buying all these high yielding derivatives for their own account. They ate their own dog food, if you will.

It was the easy trade. Borrow at 3 percent and make 6 percent or 8 percent or 10 percent. They liked it so much, they levered up. Meaning instead of just borrowing a dollar for every two dollars of assets they owned (which by the way, thanks to the 50-percent margin requirement, is the amount of leverage that you and I are allowed to buy stocks from these same firms), they borrowed 20 to 1, 30 to 1, and even 50 to 1, if they could get away with it. And man, it was a lucrative trade. So why not?

I’ll tell you why not. Because all of a sudden, Wall Street is no longer a business of traders or stock brokers or investment bankers, it’s a giant hedge fund. And they have no idea what they are doing. None. I ran a hedge fund for a lot of years and learned rather quickly that if a trade was too good, if everyone was doing the same trade, then I should absolutely turn around and run for the hills. But no one on Wall Street did. The spreadsheets fl ashed green. Risk was a four-letter word best not said in polite company. Wall Streeters became hedge fund cowboys and loved the spoils, until a tiny little downturn in housing sent everyone rushing to get out of the pool at the same time. Deleveraging a balance sheet leveraged at 30 to 1 is not easy or pretty when everyone is doing it along with you. And this is not the customer panic-selling and paying fees to Wall Street, it’s Wall Street doing the selling, pushing prices into the irrational range and turning companies belly up overnight.

Bear Stearns gone. WaMu too, into the belly of J.P. Morgan. Wachovia into Wells Fargo (or is it Citi?). Fannie and Freddie are the new U.S. Department of Mortgages and are closing their K Street offices. Lehman is dust in the wind. AIG in the penalty box. Merrill Lynch is a subsidiary of Bank of America, which barely survived their purchase of Countrywide Mortgages and, the word is, they won’t change their name to Lynch America Countrywide. They should.

And horror of horrors, Goldman Sachs and Morgan Stanley are now bank holding companies. Yeah sure, free toaster jokes are flying, but the net effect is they will now be restricted to 10: or 12:1 leverage, instead of 30.

There is plenty of finger pointing to go around. You can blame the Fed for low interest rates, rating agencies for putting AAA ratings on garbage loans, the SEC, short sellers, monoline debt insurers, lying borrowers, mark to market accounting—heck, let’s blame the Chinese for lending us our own dollars.

When running money, I bought plenty of stocks only to see the company screw up and the stock drop. I could try to blame the company, but my investors would blame me. And rightly so. It was nobody’s fault but mine. The buck stops at the management of these firms for chasing a bad trade and not sticking to their bread and butter businesses.

Is this the end of Wall Street? More like the start of a new one. At the end of the day, Wall Street is not about the names on the door, it’s about the people inside. There were great people at Lehman and Enron, Bear Stearns and AIG. Those who have a nose for making money will join other firms, or hedge funds, or start their own shop. Still, I’m pretty sure that half of those employed on Wall
Street in 2007 will be doing something else by January.

And the new Wall Street? There’s only one direction. It’s back to basics. Not quite back to the old white shoes blue blood partnerships of the past but certainly that business model. With a lot less capital, sit on the edge of the stock market and provide access to capital for the next set of great companies. Take ’em public, bank ’em, and grow with ’em. It may not be as exciting as the last few years, but it beats getting dumped in the East River. ♦

Radio, Radio: NPR and Rush

Doesn't get much different than these two radio outlets!

NPR Morning Edition September 16, 2008

http://www.npr.org/templates/story/story.php?storyId=94658913

Investors Feel the Pain of Lehman Bros. Collapse by Chris Arnold

At 2:00 mark:

“This happens every cycle and I used to work on Wall Street and I competed against Drexel Burnham and Shearson and Dean Witter and EF Hutton and they’re gone. Each of them made one mistake or another along the way. This is nothing new. I don’t think we’ve entered a new era of the 1930’s and the Depression.”

 

“At the end of the day, no one really misses them. Because someone else steps up and takes over their business. And quite frankly, a lot of the people that work at these firms, the better of them get jobs across the street.”

NPR Morning Edition September 19, 2008

http://www.npr.org/templates/story/story.php?storyId=94795760

Financial Sectors' New Buzzword Is Deleverage by Chris Arnold

At 2:05 mark:

“Wall Street was borrowing at 30 or 35 to 1 so all you needed was a slight little downtick in home prices, which were backing up these sub-prime loans, and you completely wipe firms out.”

Who Do You Trust? Conservatism.
September 25, 2008

http://www.rushlimbaugh.com/home/daily/site_092508/content/01125108.guest.html

RUSH: Now, I went and grabbed a piece today in the Wall Street Journal, and it happens to end up being one of the most persuasive pieces I have read in all of this.  It's by Andy Kessler, a former hedge fund manager, and he's the author of How We Got Here, published in 2005.  Let me join his column in progress: [Quotes from column]

Now, I have some thoughts on this because this piece makes it clear this is not a bailout.  It's a rescue.  Now, these things still have some value.  I don't know what the value is, and they haven't been foreclosed on.  They're pretty close to worthless, but it's not technically a bailout.  And of course you're hearing all these warnings if we do this then there's not going to be any credit.  Okay, now, what does that mean?  ...  Okay, here we go. The piece I just read to you, Andy Kessler, I should give you the headline.  "The Paulson Plan Will Make Money for Taxpayers."  He's a former hedge fund manager, and that's how he analyzes this. He's one of these economists that has commuter models and he's run some projections.  Now, if this guy is right -- and who knows?  See, we don't know who to trust, and we don't know who's going to end up being right.  Our experienced is, "I'm from the government and I'm here to help you," means we're going to get screwed.  And we know there's not one single person involved in this I trust with that prediction. There's not a Ronald Reagan here.  If a Ronald Reagan was saying, "We gotta do this," I would believe it.  There isn't one of those.  So you've gotta scrounge around.  It's actually a great educational process.  
 
Snerdley came in today and said, "I have never worked harder in my life trying to understand this financial thing.  I've been spending more time this past week working on trying to understand this. 'Cause this is all Greek, all this lingo jingo they use, talking about these derivatives and the credit swaps," but it has been an amazing educational exercise.  But if this guy, Mr. Kessler, is right; it underscores points made prior to today by me on this program. Number one: that the federal government is nationalizing the financial markets.  I don't care what anybody says, this is nationalizing the financial markets.  Number two: these loans (he makes it clear in this piece) have not yet defaulted, even if they are risky.  Number three: when the market recovers, the federal government will be able to make lots of money selling the undefaulted loans back to the private sector. Even if they're sold below their original value, it will be more than the government paid to take them off the hands of the financial institutions today.
 
It's made clear by Mr. Kessler in his piece.  Also we can conclude since he's a former hedge fund manager and he likes this, that Wall Street's desperate for this to happen so that these financial institutions that are in need of cash can get it and get it fast, whatever price they have to sell their loans for.  Cash is king right now, they don't have any, and they need it.  They can't borrow. They can't lend. They can't do diddlysquat.  The federal government, as Mr. Kessler makes clear, will have a windfall of potentially trillions of dollars -- which, experience tells me, will be used to expand the size of government.  ...   Does it contain a lot of golden opportunities for people to take some of this stash and enrich themselves personally?  Now, these are the kind of rules there are going to have to built into this.  I'll tell you, as you go through this and you understand it, what becomes clear to me -- and I said at the beginning of this hour, "Who do you trust?"  I trust conservatism.  Conservatism and free market economies work.  It is based on growth.  ... The federal government, as Mr. Kessler, Andy Kessler of the Wall Street Journal today makes clear, the federal government will have a windfall of potentially trillions of dollars if his computer models are accurate -- which they will, I think, use to massively expand the federal government.  I have yet to see a massive pile of money show up that was unexpected that's either given back to us or used to reduce debt.  ...  We have far too many people who are becoming rich from government policy rather than the give-and-take of the free market.  So put simply, based on this article I read in the last hour from Andy Kessler in the Wall Street Journal, the federal government appears to be the only entity capable of coming up with the enormous amount of money it's going to take to take over these loans -- which have not failed yet but which the government itself requires these banks to devalue as assets.  Now, they are required to base their value on current prices.  This is what mark to market is. 

Read entire transcript here.

WSJ: Clean Up Print

http://online.wsj.com/article/SB122230704116773989.html

In 1992, hedge-fund manager George Soros made $1 billion betting against the British pound. In 2007, John Paulson's Credit Opportunities fund correctly bet against subprime mortgages, clearing $15 billion for the year and $3.7 billion for him. Warren Buffett is now hoping to make big money on Goldman Sachs.

What pikers. These are small-time deals. My analysis suggests that Treasury Secretary Henry Paulson (a former investment banker, no less, not a trader) may pull off the mother of all trades, which could net a trillion dollars and maybe as much as $2.2 trillion -- yes, with a "t" -- for the United States Treasury.

 

Here's what's happened so far. New technology like electronic trading meant that Wall Street's bread-and-butter business of investment banking and trading stocks stopped making much money years ago. So investment banks took their enormous capital and at first packaged yield-enhanced, subprime mortgage loans into complex derivatives such as collateralized debt obligations (CDOs). Eventually and stupidly, these institutions owned them for themselves -- lots of them, often at 30-to-1 leverage. The financial products were made "safe" by insurance products known as credit default swaps, a credit derivative from companies such as AIG. When housing turned down, the mortgages and derivatives were worth a lot less and no one would lend Wall Street money anymore.

Treasury Secretary Henry Paulson (a former investment banker, no less, not a trader) may pull off the mother of all trades, which could net a trillion dollars

Then the piling on started. Hedge funds could short financial stocks and then bid down the prices of CDOs stuck on Wall Street's balance sheets. This was pretty easy to do in an illiquid market. Because of the Federal Accounting Standards Board's mark-to-market 157 rule, Wall Street had to write off the lower value of these securities and raise more capital, diluting shareholders. So the stock prices would drop, which is what the shorts wanted in the first place. It was all legit.

There is a saying on Wall Street that goes, "The market can stay irrational longer than you can stay solvent." Long Term Capital Management learned this lesson 10 years ago when it got its portfolio picked off by Wall Street as its short-term financing dried up. I had thought the opposite -- hedge funds picking off Wall Street -- would happen today. But in a weird twist, it's the government that is set up to win the prize.

Here's how: As short-term financing dried up, Fannie Mae and Freddie Mac's deteriorating financials threatened to trigger some $1.4 trillion in credit default swap payments that no one, including giant insurer AIG, had the capital to make good on. So Treasury Secretary Henry Paulson put Fannie and Freddie into conservatorship. This removed any short-term financing hassle. He also put up $85 billion in loan guarantees to AIG in exchange for 80% of the company.

Taxpayers will get their money back on AIG. My models suggest that Fannie and Freddie, on the other hand, are a gold mine. For $2 billion in cash up front and some $200 billion in loan guarantees so far, the U.S. government now controls $5.4 trillion in mortgages and mortgage guarantees.

Fannie and Freddie each own around $800 million in mortgage loans, some of them already at discounted values. They also guarantee the credit-worthiness of another $2.2 trillion and $1.6 trillion in mortgage-backed securities. Held to maturity, they may be worth a lot more than Mr. Paulson paid for them. They're called distressed securities for a reason.

Now Mr. Paulson is pitching Congress for $700 billion or more to buy distressed loans and CDOs from the rest of Wall Street, injecting needed cash onto balance sheets so that normal loans for economic activity can be restored. The trick is what price he will pay. Better mortgages and CDOs are selling for 70 cents on the dollar. But many are seriously distressed (15-25 cents on the dollar) because they are the last to be paid in foreclosures. These are what Wall Street wants to unload the quickest. Traders call this a "Clean Up Print".

Firms will haggle, but eventually cave -- they need the cash. I am figuring Mr. Paulson could wind up buying more than $2 trillion in notional value loans and home equity and CDOs for his $700 billion.

So the U.S. will be stuck with a portfolio in the trillions of dollars in bad loans and last-to-be-paid derivatives. Where is the trade in that?

Well, unlike Mr. Buffett or any hedge fund, the Treasury and the Federal Reserve get to cheat. It's not without risk, but the Feds, with lots of levers, can and will pump capital into the U.S. economy to get it moving again. Future heads of Treasury and the Federal Reserve will be growth advocates -- in effect, "talking their book." While normally this creates a threat of inflation and a run on the dollar, and we may see dollar exchange rates turn south near term, don't expect it to last.

First, with Goldman Sachs and Morgan Stanley now operating as low-leverage bank holding companies, a dollar injected into the economy will most likely turn into $10 in capital (instead of $30 when they were investment banks). This is a huge change. Plus, a stronger U.S. economy, with its financial players having clean balance sheets, will become a safe haven for capital.

Europe is threatened by an angry Russian bear. The Far East, especially China, has its own post-Olympic banking house of cards of non-performing loans to deal with. Interest rates will tick up as the economy expands -- a plus for the dollar. Finally, a stronger economy driven by industry instead of financials means more jobs, less foreclosures and higher held-to-maturity payouts on this Fed loan portfolio.

You can slice the numbers a lot of different ways. My calculations, which assume 50% impairment on subprime loans, suggest it is possible, all in, for this portfolio to generate between $1 trillion and $2.2 trillion -- the greatest trade ever. Every hedge-fund manager will be jealous. Perhaps Mr. Buffett is buying a small piece of the trade via his Goldman Sachs investment.

Over 10 years this could change the budget scenario in D.C., which can also strengthen the dollar. The next president gets a heck of a windfall. In the spirit of Secretary of State William Seward's purchase of Alaska for $7 million in 1867, this week may be remembered as Paulson's Folly.

Forbes.com: Lehman = Pan Am

Not to sound harsh, but Lehman Brothers reminds me of Pan Am Airlines. No one (well, beyond their employees) is going to miss them. There are plenty of others to take their place.

In the '70s and '80s, a deregulated airline industry grew beyond its means, was stuck with bad assets, prices dropped and consolidation became inevitable. Pan Am was an early innovator, flying seaplanes into previously unreachable Caribbean Islands. They eventually flew everywhere, competed with everyone, stretched their balance sheet so it was as inedible as the mystery meat they served on flights and then one day went ... Poof!

The true money-makers on Wall Street all find jobs elsewhere. The worker bees in the middle tier see disruption, but are eventually absorbed. The bottom tier goes to work at Foot Locker

Analogies only go so far, but Wall Street got caught in the same wringer. Deregulated since 1975, balance sheets grew and grew as money got thrown at the profitable business of trading stocks and bonds, investment banking and money management. In the cheap-money period of 2002 to 2007, Wall Street’s thirst for capital saw no limits.

Inevitably, too many players and a bit of technology in the form of electronic trading squeezed the profitability of Wall Streets bread-and-butter businesses.

Forbes.com: Google's Offensive Strategy

Back in 1983 on the hit TV show The A-Team, George Peppard's Hannibal said to Mr. T's Bad Attitude Baracus, "There's an old saying: 'The best defense is a good offense.'"

Mr. T replied,"You got that wrong, man. A good offense is the best defense."

Then they wrestled pythons or something.

Make no mistake: This is not about browsers

On Tuesday, Google  let word slip--while showing off a comic book, of all things--about its new browser technology, code-named Chrome.

Was it offense against Microsoft's  Internet Explorer? Defense against Apple's  iPhone browser, Safari? A fight for the great network operating system in the sky? All of the above?

Tech Ticker: Is It Safe?

ABX Indicator

Click on ABX-HE-AAA 06-2 for the chart.

WSJ: The War for the Web

Microsoft was smart to walk away (for now) from its $44 billion bid for Yahoo. It's never good to overpay. But the software giant – whose stock has flatlined for eight years – was onto the right strategy in looking to the Web for growth.

Can't Microsoft build something on its own? Why the rush to pay billions for Yahoo? The simple (and wrong) answer was that adding Yahoo's 20% Web search market share to Microsoft's 10% meant that it could compete against Google's 60% share. Technology changes too fast for that to make sense except on paper. Programs run anywhere these days – on your desktop computer, on servers in data centers, on your iPod, cellphone, GPS, video game console, digital camera and on and on. It's not just about beating Google at search, it's about tying all these devices together in a new end-to-end computing framework.

With the Microsoft/Yahoo deal breakdown, everyone assumes Google walks away with the prize. Not so fast. This contest is just starting. For Microsoft or Google or anyone else to win, they need four key elements of an end-to-end strategy:

- The Cloud. The desktop computer isn't going away. But as bandwidth speeds increase, more and more computing can be done in the network of computers sitting in data centers – aka the "cloud."

There, search results can be calculated, companies' payrolls processed, even the complex graphics for video games can be drawn. But it's not cheap. These clouds are multibillion-dollar investments. Google spent $842 million in the last three months on servers, data centers and fiber optics.

Not only hasn't the Internet yet matured, it's becoming an ever-more high stakes game

Today, there are several major clouds: Google, Yahoo, Microsoft, Amazon and smaller players IBM and Sun. Can there be more? Sure, but it would require a business model that could not only pay for it, but could rip it out every few years and modernize it. Google's $20 billion Web advertising business gives it the cash flow to do so. Advantage Google.

Tech Ticker: The Woz

Part 1 - Get Ready for the Woz!

Part 2 - Creating the Computer of My Dreams

Part 3 - Today's Young Innovators

Part 4 - Favorite Gadgets (yes, he packs a laser)

Part 5 - Stock jock/news junkie

Part 6 - Segway Jousting

NYT: QOTD

Huh?

Tech Ticker: Working Hard and Playing Hard

Carbon Fiber Lifestyle...

NYT: Tough Times for Buyout Lords

I don't normally post these, but I couldn't resist.

http://www.nytimes.com/2008/03/08/business/08mogul.html

Tight Credit, Tough Times for Buyout Lords

By LANDON THOMAS Jr.

Published: March 8, 2008


...
“The crowds are smaller at cocktail parties, the aura is stained, but there still is the letter B, as in billionaire, next to their name,” said Andy Kessler, a former hedge fund executive who has written books about Wall Street. “They may still have halls named after them at universities, but the idea that these guys are the kings of investing, that time has passed.”

UPDATE March 10: A $100 million Donation to the N.Y. Public Library. That was fast. "Stephen A. Schwarzman Building ...the name to be etched on the building." Schwarzman wants his legacy etched in stone and protected by lions.

Tech Ticker: Why Everyone Works So Hard in Silicon Valley

WSJ: Internet Wrecking Ball

Imagine a town that has all sorts of gasoline pipelines running by it but only one gas pump. Rationing is inevitable. So are price controls.

Everyone gets equal amounts, except of course first responders like police and ambulances, which should get all the gas they want. And, well, so should the mayor. And if you can make a good business case that you work 60 miles away, you can file paperwork and perhaps pull some strings for more gas. How about those kids hot-rodding around town who can't drive 55? They get last dibs, and maybe we can sneak in some gas thinner to slow down their engines and not waste gas.

You can do all that and constantly update the gas neutrality rules -- or you can just open another gas station across the street. Or one on each corner.

The trick to an open and innovative Internet is not sneaky technical fixes nor more rules and regulations and bureaucracies to enforce them. The Internet will only expand based on competitive principles, not socialist diktat.

This is the essence of the Ed Markey's (D., Mass.) Orwellian-named Internet Freedom Preservation Act of 2008, which would foist network neutrality on the wild and woolly Internet. The Federal Communications Commission is holding a public hearing today at Harvard Law School in Cambridge, Mass., to build the case for the ill-conceived idea of preventing, as Mr. Markey's bill would, network operators from using technologies that may favor one application over another.

It's a bad idea because the only thing Mr. Markey's bill will preserve is mediocrity via the lack of competition, and full employment for regulators micromanaging a business whose very innovation comes from the lack of rules. With net neutrality, there will be no new competition and no incentives for build outs. Bandwidth speeds will stagnate, and new services will wither from bandwidth starvation.

The idea of network neutrality is that all of our Internet packets are equal, and that the spirit of the Internet and its ability to create wonderful new applications like Google, MySpace and Facebook is predicated on open (albeit limited) access for all. Yet, despite an overabundance of bandwidth pulsing throughout the U.S., we are still stuck with rationing to our homes. Haven't we learned that advancing technology is never served by arbitrary rules to divvy up scarce resources? Look at the dearth of good cell phone applications. Rules make incumbents lazy.

Tech Ticker: The Game Changer

Tech Ticker: Soap Opera

Tech Ticker on Yahoo Finance launched today. Enjoy.

WSJ: What's Next for the Banks

If you want to know what's going to happen to the big banks and investment banks, you've got to go back to early 2003, when the seeds of destruction were planted.

It had been a year or so since a couple of trillion dollars of investor wealth had been wiped out. The Dow was 8000 and dropping, and the stocks of big institutions from Citi to Merrill Lynch to Morgan Stanley were at multiyear lows. Bank lending was down, but no one was really worried. The old "borrow short, lend long and pocket the difference" game had been around for millennia, and banks had weathered worse than this mild economic slowdown.

What was not at all clear was how investment banks were going to make money going forward. Wall Street had piles of capital and no place to go. Stock trading and large parts of bond trading had gone electronic. Decimalization of the stock market wiped out markups. IPOs were down, mergers were down and, gasp, bonuses were way down.

Stocks were out and investors wanted yield -- safe, predictable returns -- but there wasn't much profit in that. Some, especially hedge funds and international investors, insisted on even higher yields than plain old government bonds.

So Wall Street, as it always does, gave investors what they wanted -- excess yield in the form of derivatives, asset-backed, mortgage-backed, collateralized debt obligations (CDOs), basically funky amalgamations of lots of other pieces of paper. Done right, no one but you knew how to value these exotic instruments, so you could mark them up way more than a penny and generate huge fees, profits and bonuses. Win-win.

I Still Hate Dividends, Professor Siegel

Wharton Professor Jeremy Siegel is much revered. His students sing his praise, his books are best sellers, the press adores him. I’ve heard him speak and he is very engaging, even convincing. He is also totally wrong. About dividends. About ETFs based on dividends. Enough to lose you money.

A few years back I wrote an op-ed for the Wall Street Journal Op-Ed page about dividends. Specifically, that I hate dividends. You can read it here. Stocks trade on their prospects for earnings. Dividends are just a bribe to get you interested in slow growing companies who can’t be bothered to reinvest their earnings in something useful. In the past, when companies paid out 100% of their earnings to shareholders, well then dividends mattered. Today, no one pays 100%, so dividends have limited say in the value of a company. In fact, they sucker you in with attractive “yields” right before they consider cutting the dividend. Citigroup anyone?

as persuasive as arguments may sound, the hard evidence proves otherwise.

Sadly, to academics such as Professor Siegel, this is heresy. He was nice enough to write a letter to the editor about my piece saying that I was completely wrong. He is entitled to his opinion, of course, as I am entitled to hold a grudge. He even took a swipe at me in his March 2005 book, The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New, (although he called me Arthur Kessler, nice fact checking, Professor Seagull). And I quote,

“As persuasive as Kessler’s arguments may sound, the hard evidence proves otherwise…Average returns on older firms surpassed the returns on the newer firms…Technology stocks, which pay the lowest dividends have scarcely been market beaters.”

Like, say, Apple. Don’t bother with the book, it is backwards looking twaddle.

TCS: Cali Cupcake Cops

I tried. I really tried. But it took all of a few days with the kids back in school before I ran into the new "policy" that finally pushed me over the edge.

Look, school is hard, starting with no buses. Yeah sure, a good cardio workout in the morning for my massively helmeted and biking boys is just the ticket to put on an attentive face as the day and their teachers drone on. Never mind that their backpacks are heavier than our troops' patrolling the Sunni Triangle. Biking builds character. Or so I've been told. I'm OK with that.

Gosh, I hope that mother with the pig-tails and hairy legs uses hot water.

And I've caved on the whole paper plate and plastic cup thing. Classes are now stocked with real plates and cups (donated, of course) and us eco-squirrels take turns bringing home the dirty dishes, washing them and returning them to the class. Gosh, I hope that mother with the pig-tails and hairy legs uses hot water. Don't you dare try to load the plates in supermarket bags, paper or plastic, for your awkward bike ride home. No, no, no. Go online and find the same unbleached burlap sack I found and you'll get the clucks of approval you are after. Yeah sure, second graders make a real mess and the dishes smell worse than a chemistry experiment gone wrong, but I'm OK with that.

Weekly Standard: YouTube U.

http://www.weeklystandard.com/Content/Public/Articles/000/000/014/250klogu.asp

Without much fanfare, college lectures are being put online, for free. MIT lectures can be downloaded from iTunes University, and you can watch Cal professors pontificate on your computer via YouTube. Is this some new trend? Do colleges feel threatened by Wikipedia? Something funny is going on. No one gives anything away for free without some ulterior motive.

Now you can sleep through lectures in the comfort of your own home

I mean, don't they know college is big business? Right now, 17 million students are involved in higher education, some higher than others. As a business, college is growing faster than sales of multicolored Crocs. Since 1980, the population of students under 25 has grown 40 percent--and for those over 25, it's up even more at 52 percent. Is this what your neighbors are doing during the day? Could be. Even better (for colleges, anyway), since 2002 tuition has jumped 35 percent in real terms (that's adjusted for inflation, for you French-lit majors). And while financial aid is available, there is some $85 billion in student loans outstanding. Who is going to break the news to these kids that they could have bought a Mustang and watched that physics class for free on their laptop between shifts at Dunkin Donuts (which isn't even spelt right)?

Wallstrip Interview

WSJ: Blackstone's World of Cash

Will the private equity party -- this week's Blackstone IPO is icing on the cake -- end with a bang or a whimper? Let's recall that on Friday, Oct. 13, 1989, the almost $7 billion employee-led buyout of United Airlines fell through, a bookend on a wild 1980s of junk bond-led takeovers. The Dow dropped 190 points that day, almost 7%. That's 1000 points today. Ouch. Could it happen again?

Sure. The money involved here ain't small potatoes. Private equity funds raised $221 billion last year, up from $33 billion 10 years ago. There are now over 170 private equity funds with more than $1 billion in assets. The value of deals done last year was $475 billion, up from $37 billion five years ago. Most of it was taking public companies private -- Equity Office, HCA, Harrah's Clear Channel and on and on.

What's fueling the boom? With the Dow over 13,000, it's not like there's lots of cheap companies just begging to be bought and turned around. Rather, the world has been awash in cash. The money supply has been growing like a weed at the same time that the federal deficit is shrinking -- $148.5 billion through the first eight months of budget year, down 34% from last year. As our trade deficit with China grows, they keep buying our long-term bonds. Add to that the Japanese carry trade (borrow in Japan at negligible interest rates and invest elsewhere), and you get distortions -- especially from fixed income investors such as banks, insurance companies, pension funds and hedge funds, all chasing higher yields.

WSJ: A Future For Newspapers

New technology is mucking up the media, and newspapers seem to be taking the brunt of it. Craigslist and eBay took away classified ad sales, direct advertisers are allocating budgets to search engines and circulation is receding faster than Bruce Willis's hairline. Investors seem to prefer the safety of television broadcasters and cable companies, with their nice, government-mandated franchises and pipes that reach directly into homes.

Media, after all, is about owning a pipe -- some conduit between the creation of news or entertainment and the eyeballs that consume it. Media companies sell the owners of those eyeballs lots of things we weren't even sure we needed. The higher the ad rates, the better the business. The pipe reaches the consumer directly, keeping competition at bay. The tighter the pipe, the less the competition.

For broadcasters, the pipe is spectrum given or bought from the Federal Communications Commission under the guise that spectrum is scarce. For cable operators, it is often the sole cable franchise in a town. For phone companies, it's those regulated copper wires, some of which are so old they have Alexander Graham Bell's teeth marks in the insulation.

And newspapers? Where's the pipe? What conduit to readers do they control? Well, there is the guy that drives up and somehow misses your driveway every morning. Or the sidewalk newspaper dispenser where the homeless man buys one copy and steals the rest so he can peddle them on street corners. So unless you are the only paper in town (ask Warren Buffett how much he makes on monopoly papers like the Buffalo News), there is not much of a pipe to control. Instead, reputation, quality news gathering, trust and credibility maintain the franchise, something The Wall Street Journal and the New York Times enjoy on a national level and the Washington Post and others have locally.

NYT: Trust Me

Is there trust anymore? We are caught between Obi-Wan Kenobi saying, “Let go, Luke. Luke, trust me,” and Eric “Otter” Stratton in Animal House declaring, “You [Delta House language] up. You trusted us!” Heck, the civilized world still shakes hands to show we aren’t packing daggers. In business, “trust me” often turned out to be the two most dangerous words in America.

Joe Nacchio is the latest trust-destroying manager, convicted on 19 counts of insider trading and dumping Qwest stock while smiling to shareholders. Names like Ebbers, Kozlowski, Skilling, and Martha are now synonymous with fraud, scandal and even in polite conversations are likened to the thin film that covers standing ponds. (I did meet Martha once, and she gave me a recipe for flourless waffles, so let’s give her a pass, shall we?)

Wall Street research was long ago disgraced, but add to that mutual fund late trading, options backdating, onerous interest ratings and insurance premium overinflating, and what you have is a lot of folks whose reputations have been shredded into scraps finer than Arthur Andersen documents. And the government? Given all the lying in D.C. on both sides of the aisle, you would think Scooter Libby’s defense would have been selective enforcement.

So here I am at my Carrie Bradshaw moment: Will we ever trust anyone again?

NYT: Blank Slate Hedgies

As heard on TV one morning while shaving:

Morning Show Talking Head: So tell us what drives hedge fund managers?
Hedge Fund Dude: It’s just never ending. Thinking about what is going to work next. I have a friend who is worth $150 million who is working some new ideas for a fund.
Talking Head: If I had $150 million, the last thing I would do is start a hedge fund.
Hedge Fund Dude: That’s why you don’t have $150 million.

What exactly is a hedge fund? It’s nothing more than an investment vehicle that can buy and sell almost anything. Unlike mutual funds that just charge 1 to 2 percent of assets as a fee no matter how they do, hedge funds get to keep 20 percent (and often more) of their investment gains. It’s an incentive for their managers to lead bizarre lives and suffer from mental anguish. You think they should go crazy for free?

According to Hedge Fund Research, $1.568 trillion dollars is now managed by hedge funds. This isn’t small potatoes. Who are these masked men and women? And how is it they make so much money, some of them hundreds of millions of dollars a year, for themselves?

While capital sloshes around the globe seeking its highest returns, most money is slow, almost sedentary, kind of meandering around like a humpback whale looking for easy pickings. Hedge funds, on the other hand, are playing a game of Whac-a-Mole. Whenever anything with a potential return pops up its head, young cobras staring at multicolored screens blast the mole into submission, quickly buying underpriced shares or dumping overpriced ones. How do they know what is over- or underpriced? That’s their dirty little secret. There is no one answer.