Oh Sh*t...Even Index Arb Isn't Safe

When it rains, it pours so it is said. And indeed it does according to Kaminsky et.al's 2004 paper on the relationship(s) between capital flows, macro policies and the business cycle. It also duly applied in 2002 when dozens of double-digit billion corporations 'fessed up to various forms of malfeasance from diddling and manufacturing bogus research, looting the kitty by backdating options, re-striking awards at lows and so forth, to the outright fraud on a scale that would have made te likes of Alan Bond and Juergen Schneider blush.

And while the scale of AIG (it WAS a fraud!!), Madoff, and more recently Stanford Fincl might have sent even adventursome investors running for the safety of the Index Arbitrage bunkers, today, we are told by Reuters that even Index Arbitrage offers offers no comfort, with the arrest of Walsh & Greenwood for nothing less than getting caught with their snouts in their clients cookie jar, much like Pooh Bear's head was stuck in the honey pot.

The pair are accused of nothing less than "appropriating" client funds for personal use. More than 80% of assets it is believed. Undoubtedly, few will have heard of WG Trading, but like Madoff they've been around for decades, had a fine reputation believed to be running a respectable Index Arb shop. It seems however, they were buying racehorses, paying alimony, funding the remodeling at Le Cirque, buying big digs in fashionable neighborhoods, hot wheels, and everything else a Would-be Wall Street Entrepreneurial Titan should be seen to be spending it on. We know not if either had a Net-Jets fractional, or a lease on a jet-powered titanium tube with wings of their own.

Now, like Madoff, there perhaps should have been some red flags and by way of disclosure, I have no inside information or special knowledge of WG. But it is common knowledge that no one has made money out of index arb in the USA since the 1980s. Certainly not enough - after management fees to fund a Larchmont-lockjaw lifestyle of thoroughbreds, polo, and rare Aston-Martins. Index arb was a means of getting cheap stock loan inventory, having inventory (before the downtick rule) to sell long when it was in spirit, a short-sale, and having a position to to use at expiration to manipulate prices for associated option trades as necessary. It has been, in short, a dealer business since anyone who was not doing all three (like most of the broker-dealers in might now be termed "The Glory Years") wouldn't get a proverbial word in edgewise since those that had the natural axe would inevitably be better offered on the way in, and better bid on the way out. And like Madoff, when the tide went out, it became impossible to answer the questions regarding the ability to competitively fund positions as a non-bank, non-deposit-taking, non-prime-brokering institution in an era of balance-sheet reduction. Or perhaps they just burned the balance of their clients money, quite literally, on hay.

And so due-diligence just got a whole lot harder - both for investors and managers. Now, Mr Hedge Fund Manager, Mr Investor (or Mr Kroll on his behalf) will be poking around in YOUR rubbish bins. Like the French Fisc, they will be evaluating your lifestyle and working backwards to see whether or not YOUR income is commensurate with your returns. NOW, Mr Investor will want to see the audited accounts of not just the Fund, but the investment Management company. And there will be no excuse (except the embarrassment of riches) to deny such access. Mr Investor will want to know - in fact will need to know - about messy divorces and spiteful wives from hell. Yes, life in the future will be whole lot different after this one...

What Price For Market Liquidity?!?!?

What is the price for equity market liquidity in size? Anyone who has any doubts about what the precise number should or might beat present need only look at Phil Falcone's (Harbinger) sale of it's Fortescue (hey John H, read this!) stake to China's Hunan & Valin Iron & Steel group at 20% BELOW the so-called market, according to a Bloomberg news report.. And Fortescue is reasonably liquid, but apparently not liquid enough.

When I see such a tangible tell-tale of market-structure reality (typically the result of filings), I think of several topics that the thoughtful practitioners should ruminate upon:

(1) What is the meaning of this for the accrual and payment of performance fees upon "Last Market-to-Market" valuations? Seems Mr Falcone pocketed 20% of all the market impact on the way up.

(2) What does this say about the true value of certain activists true portfolio liquidation value, particularly those like Warren Lichtenstein's Steel Partners Japan Fund where the positions are equally large if not larger, but the turnover but a fraction of that in something like FMG.

(3) Audits should almost certainly carry serious caveat warnings about liquidity-adjusted valuations. I've raised this with senior audit partners at financial practices before and they've looked at me like I was the Devil incarnate. Yet their opinions are qualified regarding hundreds of minute details, yet it disregards perhaps the most important: mark-to-market is fallacy where positions are large and liquidity constrained.

(4) IF disposing of a 10% position requires a 20% discount, then imagine the intentional market-impact one can generate on the way in (both on long and short positions) which again is the cornerstone of incentive fees, and should highlight for allocators and investors the large potential for abuse, and near-certainty that before this is over, ALL peformance fees will be paid on a new industry standard of some kind of rolling three or five year window.

(5) Systemically, this is instructive on the essential need to avoid liquidation. Not avoid longer-term deleveraging, but wholesale point-in-time Mellon-like liquidation. Imagine for a moment that "failing banks" (currently insolvent, or near-insolvent) are liquidated, and the extreme market impacts of their sales upon asset prices will of course force others into insolvency merely exacerbating the situation. Th LTCM managed unwind is a reasonable model here. Warehouse the risk, unwind it orderly in due time. For forcing systemic liquidation does not equate to market efficiency. Price discovery in illiquid markets is likely to result in overshoot, and exacerbate systemic difficulties. This doesn't mean that said asset prices warehoused are over, or undervalued, but that selling position to make position is merely systemically sub-optimal with real negative cascade impacts upon employment and output.

Frankly Mr Shankly...

How did I miss this?!!? It was outside my realm of consciousness...until Thursday. But it's fabulous - both musically and lyrically, and it's been ricocheting non-stop off what few neurons I've left since Thursday eve. I know the song is quite to parochial to Morrissey, but I can't help feel there is a some greater macro relevance within. Perhaps it is the derisory view of dishonesty. Perhaps it's the Faustian bargain. Perhaps it's the suspicion that our Mr Shanklies are writing piss-poor poetry too. Perhaps it's the scathing coda...

An Excellent Read...

Silence due to travel, family business and obligations, all have taken precedence. Lots to say, just no time to say it, as the ratio of drafts to posts continues to increase uncomfortably.

Yet, amidst the decided market gloom, extreme pessimism of real economy data points, to the ultra-tail of pessimism (note: don't read this if you can't handle it), former bank analyst, John Hempton has prepared a fine and measured multi-dimensional analysis of systemic solvency in Bank Solvency and The Geithner Plan that is a must-read. It is not that it is optimistic. It isn't. But in comparison to tin-foil hat brigade's offerings, it is a welcome bit of sobriety. I am not alone in thinking this, as Dr James Hamilton at Econobrowser used Mr Hempton's post as a basis to Meditate on The Prospects for the US Banking System. It is, in any event, a welcome change from contemplations of a return to a neolithic existence, a Mad-Max or Blade-runner-esque future imminently awaiting us. So enjoy, and if you;ve comments, do please post them directly to the original post at Bronte Capita, or the link at Econobrowser where they'll be in better company and receive due review. In the meantime, I'll return to my Campari & Soda and the arcane study of French Property Law.

Pundit Rage

There is always a bull market somewhere so goes the old saw. Despite the sorry state of markets far and wide, and even sorrier state of the real economy that is lagging the former, a week of traveling, planes, trains, and hotels with attendant over-indulgence in popular newspapers, television and radio has revealed the latest rip-roaring and snorting bull-market: simple-minded interviewers wheeling out pedestrian interviewees from any remotely-related tangential financial discipline - most with paltry knowledge and understanding of the current economic crisis, economic history, and financial markets but all who are recriminating, pontificating, moralizing, wagging fingers, o denying and defending in a blind-leading-the-blind retributional media-equivalent of road-rage. If ever there were a moment to turn off the sound on the stupid-box, change the radio station to the local university's 24-hour indie music station, use the newsprint (FT excepted) for kindling or bog-roll (a Daily Mail recession-fighting tip?!?), limit one's consumption to the coterie of fine balanced and thoughtful blogs, or just read a book, preferably one written more than a hundred years ago, now is precisely the moment to do so. And like most bull-markets, this one too will eventually fall-in on itself out of internal fatigue, or perhaps more, optimistically through a mass-epiphany by their consumers that such simplified uninformed demagogic treatment is one of the reasons why we are here in the first place.

(inset pinched from an old Big Picture borrowing of the original screen shot)

"Camille's Reclining" Declining

Contrary to momentum investor hopes, buying high, or recent highs, can be perilous to your financial well-being for a very very long time, in nominal terms but more acutely in real and relative terms. Such an emblematic example was reported in Bloomberg yesterday:

Feb. 4 (Bloomberg) -- A Claude Monet painting of his wife Camille reclining in a flower-strewn meadow sold tonight at Christie’s International in London for 11.2 million pounds ($16.2 million) with fees.

It was bought by a Paris-based representative of Christie’s, taking instructions over the telephone.

The 2-foot 8-inch wide canvas, dating from 1876, had been estimated by the auction house to fetch 15 million pounds, making it the most valuable estimated work offered in London’s February series of Impressionist and modern art sales. Its final price was less than a bronze version of Degas’s best-known “Little Dancer” sculpture that sold yesterday at Sotheby’s for 13.3 million pounds.

The Monet’s price history reflects historical demand from art collectors. It had last appeared on the auction market in November 1999 at Sotheby’s New York, where it sold for $15.4 million.

In June 1988, at the height of the last art market boom, the painting sold for 14.3 million pounds with fees at Sotheby’s in London.

Twenty years, and nominally one hasn't made a penny!! And the real-term returns would undoubtedly be more negative than -50%, an astronomical difference between even something pedestrian like T-bills. Of course one presumably has had the privilege of Camille Monet's two-dimensional company for the duration which may be some consolation to those prefering Monet to say, Leroy Neimann. Van Gogh's "Dr Gachet" (see post) hardly fared better only coming back into the money 18 years after Daishowa's Saito rang the bell, and then only briefly, for today, Ken Griffin is no longer "bid", and impressionists, while still eye-wateringly expensive for mere mortals, are clearly no longer be the store of value in real terms previously believed.

So yes, price matters. Homes bought in hot markets this decade, tech stocks, EM bonds and stocks bought mid-decade, US Bonds and perhaps Gold bought now, are also reasonable candidates to suffer Dr Gachet's curse.

Simon Cowell is a D*ck

Simon Cowell is a d*ck. I don't think there is a more pleasant or articulate word to describe him, without referring to or repeating this base American expression. Maybe I haven't expended enough energy upon the task. Maybe Joyce, had he been alive, also would have arrived at the same place in the dictionary. Gore Vidal might do better, but it is his job, and he's paid for such eloquence.

That said, I actually like Simon Cowell. I admire his perception of, and focus upon, the clear and present reality of his "contest". He refreshingly cuts to the metaphorical chase. He is cringe-ingly honest. Cruel, yes indeed, but honest. And rarely wrong in his area of expertise, though needless to say I would hesitate to consult him on issues relating to good-banks and bad-banks, or the relative virtues of The Taylor Rule. Daresay I am no expert on things Idol (or X-Factor for those on the receiving end of Jim Rogers latest abuse). But, I will admit (somewhat ashamedly), that I have paused during occasional channel surfing sojourns, and watched his spectacle with a rubbernecker's combination of morbid fascination, bewilderment and bemusement.

While I suspect there is something unsavourily dishonest about the antics of some of the contestants who willingly submit themselves to the inevitable ridicule and abuse, beyond the strange desire for a few moments of celebrity, there appears to be (if my bullshit detectors are in order) a far greater number of contestants who are genuinely confused, surprised, not to mention seemingly devastated by the reception they receive from those on the far side of the judge's table. These people genuinely seem NOT to understand that their perception of reality (often longly and dearly held) is, and has been, continents apart from, not just the cruel, critical, honest eyes of the panel, but of - and I hesitate before invoking the phrase - the world of objective reality. Perhaps as a result of overly-sympathetic and/or sensitive friends and family, an overly-supportive "everyone's a winner" culture, or their own denial, they are, in a single word, clueless.

And as I am watch yet another now-teary-eyed hopeful [if not rightfully then accurately] crucified by Mr Cowell, I cannot help myself from making the comparison to American's similar bewilderment over the causes of the current crisis, and economic state which they collectively find themselves. They too, don't have clue and quite genuinely seem not to understand what has happened, what they did wrong, what got them here, or there, as if the words "reflection" or "introspection" were entirely foreign from the English language on these shores of the Atlantic. This reveals itself in the pronouncements from lawmakers, interviews with ordinary people, selective lynchings by the media without the wholesale indictment of the hand that feeds them.

Yet sober-minded people DO exist in America. It was thirty years ago that Jimmy Carter donned a cardigan and spoke of malaise, it's causes, and proposed solutions, (thrift, parsimony, hard-work, sustainability, quality vs. quantity, replacing the emptiness of consumption with more spiritual things, faith, morality, optimism). Little of said redemption recipe was heeded despite the inherent correctness of his advice. And for twenty-five subsequent years to the present, rather than seeing the wisdom in his words, America as seen them as sanctimonious choosing instead the absurdity of renting the public interest for parochial gain, worse-than-neglectful energy policy, managed healthcare, unrelenting geographic sprawl, the dismissal of pricing negative externalities, rights without responsibilities, self-regulation, ballooning expansion of credit without any reasonable tether to sustainability, billions in bonuses coincidental to negative-billions at the bottom of the income statement, sub-prime lending, LBOs, SIVs, ZIRP, internet bubbles, housing bubbles, commodity bubbles, government bond bubbles, persistent half-trillion-a-year current account deficits, lending to a borrower to withdraw equity leaving a wafer-thin margin upon an illiquid depreciating asset that recently doubled or tripled, the packaging of non-recourse under- or un-secured loans-to-already-indebted people without a Plan-B and calling them 'AAA', leaving the lights on everywhere when no one is around, electing a President (twice!) whose unashamed objective was to terrorize the Public Interest, or building low quality 2x4 wooden homes in hurricane alley on a floodplain is almost beyond comprehension. And undoubtedly one could add their own litany of petty tyrants that offend any semblance of prudential decency or common-sense. And while this is going on, lawmakers and The People occupied themselves with steroid use in professional sports, how to insure prophylactics and birth-control pills receive second billing to abstinence, the un-sanctity of gay marriage, 10 things not to do with a cigar, amongst others trivial pursuits.

But now, America has finished performing. Now, Simon Cowell-The-market has harshly declared judgment. It isn't kind. It isn't nice. It stings and hurts. But it is truthful and honest and correct. Yet it remains almost unfathomable that they still cannot see its own culpability, despite it cutting wide and deep into each and every crevice of the Polity - in media, in government, in individuals, in academia. There's anger. There's disbelief. Dreams have been shattered. The tears are coming. But please, don't beg. Don't cry. Stoically face up to it. Affirm culpability. Introspect. Deal with reality. And most importantly, learn from your mistakes...

Inflation(ists) vs. Deflation(ists) - Part II

I want to follow-up last week’s Inflation vs. Deflation post since the debate is of the utmost importance, financially, socially, and politically. Not that there are quick, microwavable answers. But I appreciate everyone's attempts so to all who contributed their opinions, be they intellectually-argued, divinely-inspired, dogmatically-held or viscerally-based, thank you.

This is admittedly a bitchy post. Gore Vidal bitchy. I don’t know why. Perhaps it is because when the camps are clearly drawn, caricatures and archetypes are easily derived. Yet we all fight against our biases, so bitchy as it is, I hope sensitive souls will take barbs and less-than flattering generalizations merely as a call to examine our biases and predispositions.

Here is what I've garnered from on and off-line comments after distilling them down;

1. Liquidationists - contrary to Hayek himself (tnx Sean!) - probably underestimate just how unpleasant and un-civic unfettered unwinding of current untethered debt-to-GDP ratios would be. I wouldn’t be surprised to discover that liquidationists are more predominant in "safe” jobs, or perhaps no jobs. They have a sense of moral outrage at [other] people gaming the system (which I share) that exceeds their moral outrage at the human cost of unemployment, chaos, lawlessness, and mob-rule (which I do not). But interestingly, amongst the ranks of the liquidationists are those that have themselves gamed the inflationist system, but like Mark Cuban, have abandoned the carousel and now wish to protect their gains against dilution so are pleased to maximum pain. They may call themselves deflationists, but they shouldn’t be confused with them since this lot has a parochial interest, be it morally-driven spitefulness or relative financial gain from finally being rewarded for their prudence and parsimony…provided the system doesn’t implode too too much.

2. Inflationists are buffeted by a determinism of actions and events; cause and effect - a sense of inevitability that is - I will posit - seductive like a Caribbean beach, Marx’s manifesto, or in hypothesizing a closed-form solution (without proving it) in having conjured logically plausible answers, but without (it seems to me), the intermediate-term lattice. “We ARE going to point "C" (Zimbabwe) from point "A-and-one-half" (where we are now) because of this and that, (always involving a moon-shot for Velocity) but point "B" is under-explored whether because it’s been assumed out of existence by adopting jump functions, or multiple paths that lead to the same place. But as an investor, first and foremost, I am terribly interested in point B which is actually more important [to me] than point-C, as many-a-hedge fund manager (and their investors!) with the long leveraged correlated complex of anti-dollar trades has learned in Q3 and Q4. Interestingly, many in this camp are NOT economists, which given the record of economists, I do not hold against them. But there is something admittedly cult-like about The Movement and its members. Not that it makes them wrong, or less likely to be right. It may make them more likely to be right for I may be confusing that thing which is akin to Mormon certitude, the tsk tsk tsk head-shaking by The Faithful at The Sinners, for what may be simple visionary-ism.

3. True deflationists, to some extent, have the easier path to defend since they will be right sooner or later, as even hyperinflation will "bust" eventually yielding to the very deflation authorities tried to avoid. Cheating (i.e. leaving the forecast period open) apart, deflationism CAN defensibly share reality with eventual inflation, though the hyperinflation feared by some is more difficult to reconcile with the “big-D”. But timing IS everything, and the shorter odds of the deflationists IMHO result from the inflationists might easily being off by a factor of several years - longer than one can continue to continuously post variation margin, longer than counterparties can remain solvent, and not before the assets expressing the pure and extreme view halve again (note: that is an alternative scenario – not a prediction). Which in almost any book, particularly a trading book, would make it wrong. They try to be agnostic (vs willfulness of liquidationists) this is not their true way. For most deflationists are, it must be pointed out, pessimists by nature. Maybe they are not perma-bears (not that there is anything wrong with that in Japan), but for many of the deflationists, have been waiting for this since 1987 .... and 1994.... and 1998....and 2002. You don’t even need to have the sound on when a deflationist comments for their body language gives away their inherent sense of worry. Their brows are more furrowed. Skin more pitted. They would never be caught dead in a bow-tie. And so one wonders: are they right in spite or because of themselves?

4. There are nuances. I am what [astute] reader-commentator (and unabashed inflationist) David Pearson terms "a deflationist overshooter". This is articulated or perhaps only implied in the original post, and reckons that: the weight of de-flation (de-leveraging, de-risking, precipitously de-clining core asset prices, de-capacitating financial system distress, de-employment shocks, secular de-consumption (savings) ratios, even demographics) trumps any triage, stitching or even bionic limb replacement conjured by central banks and Keynesian stimuli, by a large magnitude. And, this view conjectures, that by the time even the most interventionist authorities comprehend this, it will be too late for the inflationist "V" to ripen. AFTER that (two years?!? three?!?) when the majority of purge may be complete, and only then (year prior to re-election year 2012?) will the drastic measures be taken, which will be overkill and could very well/will lead to above trend inflation. Not hyperinflation. Above-trend inflation. It understands – as Jeremy Grantham suggested last weekend, that solutions will - like reducing greenhouse gases - likely require multiple types of adjustment including falls and write-downs in asset prices (particularly debt); debt-for-equity swaps, copled with some rise in nominal incomes and price indices. But like the deflationists, this view is predicated upon tinder being too wet to combust (again thanks David for the correct terminology), and authorities – in this new paradigm – having the impetus and fortitude to “do the right thing” in the heat of the moment, which, if recent history be the example is as likely or difficult as it is for one party living up to pre-coital promises in another universally-known heat-of-the-moment act.

5. Most comments have been yankee-centric - perhaps mirroring readers interests and geography. I can warm to risk appetites returning when Global ZIRP arrives and begins to push the mountains of cash investors hold, further out on the risk curve. And global fiscal packages diminish the nominal falls and begin - not necessarily to get traction - but just stabilize things. NOT intermediaries, or leveraged punters, but owners of capital whose initial forays will resemble a tug-o-war with the ongoing deleveragistas, happy to finally catch a bid in something. Don's comment was a good one. It highlights the historical assumption that the developed world would eventually close in on us, by rising to our level - not by dragging us down. But globalization is at least partially about convergence, and the leverage in the west papered over fundamental unsustainabilities about such rosy western convergence notions that must be confronted in the absence of cold-nuclear fusion, flux capacitors and unlimited resources.

We are between the proverbial rock and hard place; Scylla and Charybdis; or a fat arse and an cement park bench, and so there are no good solutions…only less bad, and probably more socially expensive ones.

I Won!!!

Damn those 419 scammers are good! I received this one (revealed below) today, slinking its way through spam filters, and I was soooo ready to claim my winnings. Yes, they are enterprisingly quick to embroider reality to catch a sucker, though I am not sure which is more surreal, or fanatstic...

UNITED STATES TREASURY
SWEEPSTAKE LOTTERY DIVISION
NATIONAL PROMOTION/PRIZE AWARD DEPT.
REF: SSL/61-ILGI0509/45
BATCH:SSL/15/096/GCO

DATE: 26/01/2009

RE: WINNING FINAL NOTIFICATION

Dear Winner,

This is to inform you of the release of the US Treasury’s Sweepstakes “Everyone Is a Winner Lottery” Promotional Program (part of the US Congressional Legislation entitled the “No Household Left Behind Act of 2009) held on the 26th January, 2009 in which your ticket number: 212005600545188 with Serial number: 4888/02, an entry automatically attached to your SS number, which drew the Lucky numbers: 41-6-76-13-45-8, consequently won the lottery in the Second category of the year 2009. You are therefore approved for a lump sum payout of USD10,000.00 (TEN THOUSAND US DOLLARS ONLY) in cash accredited to file reference number: KPC/9080333308/03 from a total cash prize of USD 1,600,000,000.000.00(ONE THOUSAND SIX HUNDRED BILLION USDs ONLY) to be shared amongst among the One hundred and sixty million households automatically enrolled winners in this category. Your funds are now deposited in a security company with your prize money insured in your email.

Due to the mix up of some email addresses, we ask that you keep this award from public notice until your claim has been processed and money remitted to your account as this is part of our security protocol to avoid double claiming or unwarranted abuse by Financial Institutions of this program by participants as it has happened in the past.

All participants were selected randomly from Social Security Rolls through a computer draw system and extracted from all households. Subject to economic conditions and Government solvency, this promotion will take place annually to complement existing US Treasury policy.

To file your claim, you can contact:

United States Treasury
Mr Timothy Geithner
Tel: +202-781-2200
Email: tim.geithner@ustreasury.gov

Or for more rapid (and recommended) disbursement, please contact our approved agent:

Union Bank of Nigeria
Mr Amos Mugambo
Tel: +234-1-8507693
Email: a.mugambo@hotmail.com

who will process your claim and insure remittance of your prize money to a designated account of your choice. Remember, for most rapid disbursement you are to contact our agents by email and within One Month of receiving this notice. After this date, all funds will be returned to the United States Treasury as unclaimed. For further processing and remittance of your winning funds you are fill and forward to our claim agent, the completed processing verification form below:

(1)NAME OF BENEFICIARY
(2)ADDRESS
(3)TELEPHONE
(4)DATE OF BIRTH
(5)OCCUPATION
(6)NATIONALITY
(7)COUNTRY
(8)TICKET NO.
(9)MODE OF PAYMENT(Bank Transfer or Certified Cheque)
(10)SS NUMBER

To avoid unnecessary delays and complications, please quote your reference/batch numbers in any correspondences with your recommended claim agent. Congratulations once more from all members and staffs of this program.

Yours Sincerely,
/signed/
Timothy Geithner
Lottery Director

(lest my cred suffer, for the avoidance of doubt, I have admittedly embroidered my actual Spanish Lottery Win ;)

Oh, and John, surely a "Lottery" would be more fun than Helicopter Drops, no?

Semantic Losses

I couldn't help noticing a contributed post to Albourne Partners's Village which was [somewhat imprecisely] entitled "Majority of Hedge Funds and FOHFs Lost Money in 2008". Being pedantic, and a stickler for accurate semantics, the headline should have read: Majority of Investors in Hedge Fund and FOHFs Lost Money On The Investments Last Year". And this is part of the industry's asymmetric problem, no? Few managers and even fewer FOHFs "lost" money in their management companies (excepting those perhaps with large incentive-fee deferrals invested in their Funds , though with post-redemption and shrinkage, this too will change in 2009.

Inflation v. Deflation

Dear Diary:

For the record, on the Inflation vs. Deflation debate, I know that you know that I've personally held the view that since core asset prices began to slide in 2007, that deflation was more likely than inflation. We predicted the demise of commodities (fully requited) and the diminuation in precious metals (partly requited) too, that disinvestment would trump investment implying further destruction of core asset prices. We believed this for the simplistic reason that we believed we'd witnessed "Peak Credit", causing such massive destruction in core asset prices (particularly real estate, and equity) combined with destruction of wealth and bank capital from paper backed by these real estate (and other unsecured and poorly-secured consumer-related) assets was, and would continue to be far greater than any measure of recapitalization or monetary conjuring the authorities could implement or that lawmakers could politically countenance. This was the crux of a debate with Steve Waldmann at Interfluidity last Spring, and has continued on-and-off with the inflation-fearors - most passionately the Austrians - through to the present.

It was, I believe a contrarian view until Q3 08, when the world seemingly en-masse discovered revulsion, risk-aversion, and wholesale fears of deflation - fear not seen since Q3 02. Despite the swinging of the pendulum towards the deflationary outcome, chatter amongst sound money types (of which I AM one though our concept of sound money was collectively one which would have insure we were never in this situation in the first instance) has remained decidedly critical of Bernanke, and the Fed, and all official attempts to ameliorate the collapse of the financial system as we know it, on moral, philosophical and financial grounds, the latter being mostly predicated present or future inflation risks. The derision is shared by many I respect such as Willem Buiter, and Martin Wolfe, not to mention a number of Austrians with whom I correspond off-line.

As much as I agree philosophically, I am more forgiving and sanguine - of both the the authorities modus operandi and at least in the near and medium-term, of the consequences since I believe that with the money markets seized as they were, and after the Lehman lessons, letting any large financial institution liquidate at THIS time, into a disorderly market - i.e. not guaranteeing all deposits, and senior bank debt, and probably most junior albeit with possible haircuts, would entail unmentionable panic, bank runs, and unspeakable systemic dislocation as EVERYONE withdraws deposits and tried to sell bank debt in lieu of government securities, further complicating adjustment, and reinforcing the most pernicious of deflationary forces. Such an outcome in my opinion is wholly untenable, and probably even unnecessary. This doesn't mean I agree with TARP or asymmetrical Treasury initiatives to help friends of Hank , or their methods, but it does mean that I am not nearly as harsh on the Fed for ballooning its sheet, attempting to do what it can in the immediate term, and again, sanguine about it's ultimately inflationary impacts. Of course, I believe the authorities should have contemplated the inevitable arrival at this point in time when when they unleashed these forces, and dismissed the germanic disdain for unbridled credit growth. But the key point is that I've viewed efforts as band-aids and non-inflationary since they are merely triaging the hemorrhaging of asset prices and capital THAT ARE ALREADY OUT THERE - houses already built, capital already expenditured and consumed. As result of this, no one is going to build new housing, time shares or officer buildings, plant & equipment or such. No American consumer is going to be permitted to become more indebted or consume much beyond what he takes in. No financial institution is going to expand their balance sheet when everyone and everything is deleveraging from Peak Credit. And in any event the official sums proposed are too small in relation to that which has been destroyed, and will continue to be destroyed as assumptions about debt service, future growth, consumption and asset prices reverts to long-term means. Moreover, there should be no shock whatsoever that consumption has fallen off a cliff. It is not mysterious, but merely a return to that which the people can afford sans Refi and HELOCs, sans tax-cut, sans expanding credit, sans increasing vendor financing, sans rising asset prices. It seems to me I can recall others than myself who saw the faux-prosperity and faux-recovery from 03-07 for what it was: massively-goosed by non-extrapolatable, non-recurring items that would.. inevitably.. unwind.

But that was then. And this is now, and I still find few of those skeptical financial calvinists I respect articulating a similarly sanguine view, excepting Dr Roubini who seems to favor the bold actions without fearing the inflation that so many others seemingly fear. Recently I came across a post about the ballooning Fed balance sheet in Doc Hamilton's post (tnx NT!), he does a super job of teasing out the costs and benefits of Fed actions, and proposes modification by eliminating the payment of interest on reserve balances. There follows a super exchange in the comments section on the mechanisms of inter-CB swaps, and other exchanges about the inflation-deflation debate. Buried in there were some comments by Dr Perry Mehrlingat Columbia (who Capital Chronicle has pointed out has a CV with esteemed accomplishments of a length approaching Tolstoy's War&Peace), who finally articulated the 1,000,000,000,000-dollar question that has been on the forefront of my mind:

Everything in the post is correct, and very much on the minds of every Fed watcher. The question is, what does it mean? I have what may be a contrarian view.

It seems to me that what we are seeing is simply the balance sheet consequences of the Fed's decision to take the wholesale money market onto its own balance sheet. Banks (and other entities) that used to lend to one another, are now lending and borrowing through the intermediation of the Fed. This is so not just domestically but also internationally (the huge swap line), since foreign banks used to fund dollar asset holdings in the dollar money market.

In this view, inflation seems much less likely. Why not? If the original wholesale money market borrowing and lending was not inflationary, then why should its substitute be inflationary? Indeed, the real question is whether the expansion of the Fed's balance sheet is keeping pace with the contraction of money market credit more generally. If not, then the consequence may be deflationary.

Posted by: Perry Mehrling at December 22, 2008 05:12 AM

So finally, I see what I feel intuitively in words. They look right. And I want to know: If this is NOT right, why not? If inflation is just around the corner, how and in what form will it emerge? Who's balance sheet will expand to create the money sufficient to offset the destruction in already-consumed asset prices and consumption beyond one's means that is, by all accounts, unfinance-able at this and probably future points in time. If there is a plausible alternate reality, please paint it for me here and now, both technically and anecdotally.

Yours truly,

Cassie

P.S. - Diary, you haven't told anyone about my secret fondness for Mr Trichet, have you? He needs a hug I think....

Heaven Sent?!?

With Tim Geithner, who it must be said, I like and respect, having some "issues" of his own at the moment, it might be appropriate for him to pull "a Richardson" and excuse himself to avoid further taint and embarrassment to the incoming administration so that someone, anyone, can take the fiscal helm.

This may very well send the Obama team back to the so-called drawing board to find someone who can pass my Ethics Exam with a "Spitzer-score: or better, and inspire a more positive leadership image in the eyes of the public.

Fortunately, I believe that I have solved the conundrum, or rather it may, indeed have solved itself as only miraculuous events can. For the quite obvious answer, has, quite literally descended upon us from the heavens, to America's financial center in New York. Mr Obama, meet Mr "Sully" who would make a great Treasury Secretary, if he could do for the national 747 Jumbo what perhaps only a skilled pilot such as he can to safely crash-land our vessel...

Ethics Exam

I have often wondered (never having been to business school myself) what happens in the interim between one's MBA ethics classes and the real world execution of fraud, cheating and malfeasance. Does one's conscience (if they ever had one) merely extinguish one day under the incessant pressure of keeping up with the Paul Tudor-Jones', Blankfeins and Fulds or does it die a slow but tortured death under the weight of repeated terms of Miss Porter's fees, and one's wife's Bergdorf Goodman bill?

Fortunately, Psycho-Ethical Testing Associates has been hard at work developing an Ethical Assessment Examination that they believe predicts the relative predisposition to the erosion of one's ethical values, with obvious use by boards and (D&O Underwriters!)in assessing the risk of future malfeasance.

I have been lucky enough to obtain a copy of their beta-examination (tuned for the financial sector) which I re-print for your perusal below.

Ethical Assessment Examination:

Instructions: Please read the questions thoroughly, and circle the letter of your chosen response. And NO CHEATING!!

1. A mortgage broker known to you only as "Big Mo'" offers you a package of loans for your securitisation operations. Your wife is high maintenance, and your kids' Exeter fees are due next week. Select the statement that best identifies your first sentiments

(a) "AIG will insure it for WHAT?!?!"
(b) The spotty kid at S&P says they're AAA.
(c) "How close are we to our budgeted P&L"
(d) "Who did the property valuations, how were they compensated, what percentage of the purchasers actually have jobs, who will these be on-sold to, and what representations will be made?"
(e) "Has anyone aggregated the retrospective underlying values over the past decade?


2. The Head of Investment Banking has asked the Director of Research to ask the Senior Energy Co. Analyst to ask you prepare an upbeat research report on "Blackhole Oil Exploration Ltd.", a company you've discovered is owned by the brother-in-law of the IB Head's sister, and which his wife is an interested party. Which statement best summarizes your sentiments:

(a) "Hellooooo promotion!"
(b) "Will my Porsche be "Fire-engine red" or or Silver like my words?"
(c) "This will make a great short for my brother's Hedge Fund - let me call him now"
(d) "Ummmm, wasn't this the guy who received the Wells Notice from the SEC?
(e) "The Peace Corps in Bangui or Ouagadagu would be a welcome change"


3. For your summer job, you have secured a gig selling ice cream on a three-quarter-mile-long beach. The position is "mobile" meaning you get to set-up whereever you want and you get a share of the profits above the cost of the goods. There are two other ice-cream sellers from other competing companies also permitted to sell on the beach. Where would you choose to locate?

(a) adjacent to the other ice cream sellers in order to collude and fix the highest tenable prices with the minimum amount of walking.
(b) nearest to the hippies to whom you might flog some higher-margin "weed"
(c) nearest to the group of sorority girls sunbathing by the entrance
(d) closest to the crowds to achieve highest volumes
(e) keep moving to stay fit and provide the best service for potential customers


4. You are a wealth manager. You discover that even when you're late putting in buy or sell orders for certain mutual funds, your orders are accepted - even AFTER the cutoff time which is meant to protect existing investors from being predated by new investors taking advantage of market-moving information. What is the best course of action?

(a)Set up a hedge fund to exploit the opportunity until it goes away.
(b) take advantage of the loophole infrequently, but in a big way, so you can profit but at the same time maintain plausible criminal deniability.
(c) trade frequently and in smaller size so as to not attract undue attention, but allow you to profit continuously.
(c) Anonymously inform the SEC to assuage your conscience, while simultaneously doing it from time to time.
(d) Just say No!, but don't be a whistle-blowing sissy.
(e) Call a reporter at the Wall Street Journal with a scoop.


5. You are a small-cap fund manager running a reasonably large-sized fund with a 60-odd stock portfolio. Many names are less-liquid and trading activity definitely impacts the price due their small cap and prodigious front-running by market-makers and micro-structure "arbs". Every month, quarter and year-end, you observe that many of your holdings, being value or contrarian plays, suffer from getting "whacked" and smashed into these critical valuation periods, causing your performance to be elevated during mid-month, but unnecessarily hurt during the times that matter causing your firm to lose bragging rights, and you, to lose performance bonus. Do you:

(a) use your power to buy more and attempt too offset the selling pressure
(b) ramp other stocks you hold to offset the negative performance of the ones being smashed
(c) Leave large "market-on-close" sell orders with several of your brokers and then cancel them 25 minutes before the close.
(d) Join the Pat Byrne Anti-Short-Selling Holders Organization for Long Equity Speculators (acronym =....)
(e) Don't sweat. Be content with being honest and poorer for it.


6. As a retail stock-broker you are paid a percentage of your customers transactions, and trailing commission of varying degrees depending upon what you flog and at what price. Your mother-in-law, who is objectively an unpleasant person, is looking for a conservative large-cap growth fund. You have 25 different funds to choose from. What do you recommend to her?

(a) The Smithfield New Century Growth which has bottom quartile performance over ten years but a 5% load of which you get 2.5 PLUS a 1% trail ad infinitum.
(b) The Fidelity Benchmark-Hugger Fund which has a reasonable trail, AND 50th percentile performance, for which your mother-in-law cannot find additional fault with you for in the future.
(c) A Fairfield-Sentry (Note: her house is fully-paid off and won't need to move in with you)
(d) You offer to manage it yourself (note: equal to 3 or 4% per annum in self-generated commissions)
(e) Vangaurd Windsor no-load 30bp mgmt fee, low expense ratio, but no trail.

(7) You are a senior trade-executor at a large buy-side money-manager. Your trades are often of significant size, and as such have enormous value to anyone apprised of them such as executing brokers who can front-run them or quietly pass the information to other hedge fund clients who pay premium commissions to the broker precisely for such information. Which statement best summarizes how you know your broker is being honest with your orders?

(a) He was a fraternity brother. He would NEVER do that.
(b) He allocated me lots of Hot Issues during the boom-times.
(c) He scored Miley Cyrus tickets for my daughter's birthday party in the Deluxe Box and even arranged pony rides for them IN THE BOX!.
(d) I've got dirt on him like the photos from that time he showed-up with those Russian hookers...
(e) We have our own post-trade analytics that factor-analyze the outcomes.


(8) Imagine you are a Fund-of-Funds manager, and you have the good fortune to get in early on "great" manager who has demonstrated stable returns and who is so amicable and magnanimous that he doesn't even charge management or performance fees despite his libor + 600 record. Even though you originally invested in good faith, you begin to suspect that all may not be as it seems. However, you get a 5% load on every new investment, and seemingly quite "real" management and performance fees of $182,000,000 PER YEAR. Yes, PER YEAR!!, for doing precious little. What is the best course of action for your suspicions?

(a) Never admit to suspecting anything. There is a statute of limitations and they won't be able to take all of it from you.
(b) Act surprised. Make sure you've the BEST lawyer on retainer.
(c) Payout as much as possible to family and friends as payroll for work undertaken. It will be hard to get that back.
(d) Kill the Golden Goose, and insure, at least, you won't go to the Big House.
(e) Seppuku with one of the samurai swords you've been collecting


9. As the Senior Manager of a large and highly profitable debt trading group within a bank, it is November and you discover an error in one of your traders pricing models and the accounting system that tracks it, causing it to overstate profit by a large margin. It is the same model and trader that was responsible for your $12mm bonus last year and the year before, and one you've been a champion of at the firm. With bonus season almost here, do you:

(a) Stay quiet. Take the money. Resign for "personal reasons"; Hire a good lawyer.
(b) Express shock and indignation and blame it on someone else.
(c) Express shock and horror when its discovered and take responsibility.
(d)'fess-up, take the lumps, claim you "lost" the money on the ponies.
(e)'fess-up, take the lumps, give back the money from prior years


10. As a successful hedge fund manager, you made 100% gross last year with leveraged concentrated bets in risky securities. Your family, friends, and alma-mater (whose new building at the business school is named after you) are invested. You collected NINE-DIGIT compensation (through a Cypriot holding company of a Maltese offshore Trust) tax-free. This year however, you were down 65% - not only wiping out all the "gains" but incurring significant losses. You've decided to liquidate the fund since the high-water mark is so far away, there is little motivation to make the journey from CT to NYC and since YOU don't want to be left with the illiquid crap you can't sell after you open the gate. Should you rebate investors the "performance" fees you earned last year, since, philosophically speaking, you didn't really earn them?

(a) No way Jose. My kids, and my kids' kids will forever fly private!
(b) No, last year was LAST year. THIS year. And in any event, it wasn't my fault, it was "a perfect storm".
(c) maybe, ummmmm, dunno really.
(d) Yes, but only to family, friends, and perhaps alma-maters.
(e) Yes. because kharma's a bitch if not properly tended.


11. As the Chief of a Global Insurance concern that you've built with sweat and cunning, you're company is very profitable. But, despite strong feelings to the contrary, you are not God, you cannot control the fact that occasionally "shit happens" that will negatively impact P&L. You've had a good run and your shareholders have come to love your above-average returns. They value stability, even if manufactured. You've had an embarrassingly good year on the heels of several prior outrageously good years. Do you:

(a) call an ART specialist and ask him to help you keep some for a rainy day?
(b) get a subordinate to do it with no audit trail to you, and deny all knowledge if depositioned?
(c) do nothing, and blame "a perfect storm" if the shit hits the fan?
(d) reserve as aggressively as possible within plausible limits of scrutiny?
(e) in the event "shit does happen", take your lumps and try to communicate to shareholders, as diplomatically as possible, that elevated returns come with elevated attendant risks?


12. You are the CFO of a profitable software company. The market has always valued your shares highly due the firm's attractive returns on equity and stellar growth. As a result, the company's shares remain eye-wateringly expensive, though according to bulls "justified" due to growth prospects. All the senior management team (who are your friends too) have large soon-to-vest options in addition to large additional stock option awards pegged to your firm's EPS growth. You foresee small delays in new a product launch that you forecast will cause the company to be light for the quarter causing the shares to torpedo, and for your award grants to be be reduced, and net-worth halved. Which of the following most closely describes the best course of action?

(a) Obviously implement an aggressive stock buyback plan to squeeze the float to make your numbers.
(b) offer aggressive discounts as required to "channel stuff" in order to crystallize awards and give management time to sell stock
(c) hedge by structuring a "collar" on your holdings to lock-in outrageously valued paper wealth bypassing SEC filing requirements
(d) To be safe do A, B & C, then phone a friend (from a payphone) at a hedge fund in which you are invested.
(e) Do nothing and update your CV.


13. As the COO of a bulge-bracket firm who makes copious amounts of money from securities lending and prime brokerage, the CEO is demanding growth growth growth. One of your MDs has pointed out that the "uptick" rule is real nuisance, and that its abolition would increase turnover, short balances and net profits to your firm. How do you proceed with this apparently savvy observation?

(a) enagage powerful lobbysists to campaign for repeal or amendment of historical "impediments" to maximizing profits
(b) increase campaign contributions to friendly lawmakers who can turn the screws on the SEC
(c) both A & B
(d) Let your customers know, off-the-record, you will no longer be policing current regulations
(e) Let independent unbiased academic researchers have access to all your (and exchange data) and let good science assist in the making of public policy.


14. You are a well-connected CEO and CIO of a major-league hedge fund. Your circle of influential and important friends extends far and wide, so you are privileged to much material non-public information about takeovers, business prospects, and other market-moving news. You take your responsibility of delivering above-market returns to your investors very seriously. Your firm has acted on such information and profited handsomely as a result, but insider-trader investigations have caused the regulators to begin asking uncomfortable questions. Do you:

(a) Publicly deny and dismiss any and all allegations
(b) Instruct staff to destroy email records
(c) Call Bill to call Charlie to have him call off the dogs
(d) Hire a former senior SEC counsel with dirt on the investigators to head your newly-beefed up Compliance Department
(e) Admit unintentional transgressions, pay the fine. Be more careful in future.

(15) You are the manager of a large and successful hedge fund. As a result you are one of the most important customers of a bulge-bracket firm with whom you prime, and can always be counted on to trade upon their ideas, where such ideas are based upon reasonably sound information, generating commissions for the brokerage firm, increasing debit balances, and contributing further to the fund's returns that will attract new subscriptions, and virtuously increase the debit balances and commissions at the brokerage firm. (Note: some of the employees in the brokerage firm also invest personally in the fund). One day, you receive a call saying one of the brokerage firm's less important, (and admittedly more embarrassing) clients) is **highly** leveraged, and concentrated in a handful of long and short names which they (wink wink nod nod) kindly supply to you. Do you:

(a) "gun them hard", pushing the market-to-market on positions through the margin threshold, forcing liquidation which the broker then kindly offers to you to close out your shorts
(b) "gun them hard", pushing the market-to-market on positions through the margin threshold, forcing liquidation which the broker then kindly offers to you to close out your shorts
(c) Both A & B
(d) thank them politely, but do nothing.
(e) thank them politely, call the FSA, who will do nothing and think about retirement.

Scoring:
Calculate your total using a=5 b=4 c=3 d=2 e=1

Ethics & malfeasance forecast potential:
15-17 = Very Low - Dalai Lama, Mother Theresa, Bishop Tutu etc.
18-20 = Low - Eliot Spitzer (Do as I say, not as I do...)
20-30 = Medium - Ken Lay (Who knows what one will until faced with the heat of the moment)
30-35 = Elevated - Bernie Ebbers cellmate potential
35-45 = Very High - I **heart** Jeff Skilling!

An Idea Crunch

Sitting in my now-emptier-than-usual coffee shop, drinking my filter coffee (cappuccino's are too expensive!), I had an investment epiphany, or rather several. I thought to myself, "why not take my capital and build a new office building?". Yes, it's true there are half a dozen nearby still under construction, and the existing class-A space has ballooning vacancies and plunging rents, but I'll get the jump on the next cycle..right? Or, why not buy those 3 acres near the water and put up some condos on spec? If that doesn't work I can always turn them into time-shares, right?? Or maybe I should buy the 500 acres of under-utilized farm land and build an auto-assembly plant? Or a disc-brake manufacturing plant? Or an air-bag igniter operation? 250 room businessman's hotel, that does wedding on the weekends? Or I could build a new shopping mall, replete with swank boutiques and over-priced kitchen stuff and of course, a food-court. If that is too low-rent given the income inequality and distress at the lower-income end, I could build a designer-brand factory-outlet shopping center, since the nearest one is more than twenty-five miles away!! We could put a "Hooters" in the vast, usually empty, car-park which would draw the punters and happy-hour crowd. How about an independently-owned coal-fired power generation station? Nahhh, NIMBYs would handcuff me for years and the demand outlook remains tepid at best. Perhaps I could turn the currently disused, former discount store with large empty parking lot on the national highway into a logistics center, by expanding the loading bays at the back, and by putting a "Hooters" in the corner of the front parking lot? I know, maybe I should build a new municipal stadium with all the attendant concessions and super-boxes, and then I can lure a professional football or baseball team here? Perhaps a disc-drive plant? A credit-card operations center? A mortgage origination and processing center? What about a pilot fitness center of a chain that I will take nationwide? A supermarket? A car-dealer? A lawn & garden center? A new subdivision of 4000sq ft "luxury" homes squeezed onto 3000sqft lots with gallery ceilings? A new community bank? A coffee shop? A lumber mill? A factory for making paper-making felts? A community newspaper? A building materials supplier? Open a new hedge fund? OK maybe none of these qualify as epiphanies. Maybe for any of these, I couldn't even find the finance I needed it despite my equity. But upon closer inspection, maybe credit crunch is wrong description. Maybe it's a actually a useful productive idea crunch. Maybe, we are - for the moment - overbuilt, over-satiated, over-consumed, and just full-up. And that is before we ask anyone for credit. Certainly not everyone, for there is obvious dire need on the north and east sides of town, Am I am crazy to even be thinking about making useful productive investments? Maybe not, but I think back to Yossarian of Joseph Heller fame, refusing to fly more missions, so he's protesting naked in a tree, and sent to the army shrink.

Doc Daneeka: So I understand you don't want to fly any more missions.
Yossarian: Yes that's right
Doc Daneeka: Why not?
Yossarian: Because there's lots of young people my age, back home, going out, getting drunk, having a good time, and that's what I should be doing
Doc Daneeka: But were at war, with a brutal and merciless enemy. What if everybody felt as you do...?!?
Yossarian: Then I'd be a fool to feel any different.

Yea, maybe I'm not crazy, but I'm probably a fool...

An Indecent Proposal Indeed

Oh it's late, but reader 212213 has brought to my attention Warren Lichtenstein's proposal (as reported by Reuters) to float "his" Steel Partners II Fund in order to errrr ummm attempt to do something redeeming. No... redeeming is not the correct word for that is what most of his investors would like to do following their 40% smelting. Irredeeming is perhaps the more apt term. For it would seem that the hedges so carefully and scornfully explained to dear Cassandra in the comments section of this post perhaps by Mr Lichtenstein himself (or one of his soon-to-be unemployed lackeys) would seem not to have quite worked out the way Mr Lichtenstein (or lackey) suggested they would. But the Lord workeths in strange and mysterious ways. Particularly the God of the Old Testament who was forever smiting that which wasn't entirely kosher and even some that were. Ignoring that, Mr Lichtenstein's fate should come as no surprise to readers of this blog, or anyone with even a double-digit intelligent quotient, for rarely was there a more cockamamied harebrained and self-serving basis for an investment fund than this one. And now, having left investors exposed to the elements and rusting; now, with only Pig Iron left of the Steel, Mr Lichtenstein would like a vote of confidence that would in effect grant him permanent capital in order to lighten his Limited "Partners" of yet more money.

I admit that I haven't seen Steel's letters to investors explaining recent performance or proposing a solution to the situation highlighted by Reuters. But I can tell you with certainty that a perfect storm was NOT responsible, but near-fraud, and almost-certain neglectful misrepresentation and stupidity are to blame. Strong stuff, yes, but below are the posts - most which in hindsight were reasonably prescient - which detail what in my market vernacular is a more cynical form of ponzi for it attempts to justify the scheme with bullshit bullshit bulllshit, to veneer over the S.O.P. of using the weight of NEW INVESTOR money to buy monstrously concentrated positions in illiquid securities at higher and higher prices. And as much as I hate reading old posts, it is worth trolling through these for the record.

Be Careful What You Wish For
December 27th 2005. Ruminates upon the differences between American and Japanese systems, introducing Activists (and Steel) as forces to be evaluated (then dismissed).

New Shock & Horror: Livedoor Fraud!! January 17 2006 Near-fraud and market manipulation discussed as adjunct to Horie's Livedoor shocker (or not).

Pirating Buccaneering and Steeling October 4th 2006 Detailed analysis of Tom Hudson's (Cap'n Hook?) bizarrely hilarious problems and activism in Japan. I think this was a great post, (please read!!) which foretold with uncanny accuracy The Great Unraveling of activists. Yet sadly all it achieved were two Spammer comments. Ummm I guess the Fund of Funds and Steel investors' missed this one...

Bully Steels Candy From Baby November 29, 2006 Brief discussion of the "sacrifice" of Myojo Foods, forcing its sale to Nissin (#2897), and paying the greenmailer Stel, rather than letting the unworthy carpetbaggers get their smelly paws on one of the crowning achievements of the corporate food industry in Japan: Instant Noodles!

How Do You Hide An Elephant?!? December 22 2006 Analysis of large-shareholder reporting shenanigans in japan. Porsche must have read this one...

Man of Steel May 8th 2007 See them here!! Photos of the camera-shy activist in Korea taken from the sacking of KT&G meeting. How tall is he?!?!

9513 to TCI: "......"%#&k &##" ! June 4th 2007 Like the waves of cannon fodder in WW1, yet another foreigner storms the fortress. Forecasts [correctly] the travails of TCI, and Steel.

When You Wish Upon A Star June 6 2007 Included some mention about Steel Partners and Tokyo Hostess Bars

Reprint of Bulldog Sauce Letter to Steel (In Full) June 12 2007 Very funny (at least I thought so, but no one else commented!) reprint of mock-letter from Bulldog telling Mr Lichtenstein to "Please Fuck-Off" [again]...

Team Japan 1 - Activists 0 June 30 2007 Detailed look at the implications of TCI vs Japan Power suggesting patience will be the victor. Remember Muhammad Ali's famous rope-a-dope?!?!

Megan's Law For Activists in Japan
July 19th, 2007 Comment on the labeling of Steel as "An Abusive Acquirer..."

Team Japan 3 - Carpetbaggers 1 July 24 2007 Yet another hostile acquirer rebuffed. Score now? See the board....

The World in 2008 - A Sneak Preview December 17 2007 My forecasts for 2008 including the demise of Steel Partners. Pretty damn good overall (Naked Capitalism highlighted it because of the unrequited forecast that Condi Rice would leave like a rat on a sinking ship. The one I am most proud of: "The best investment in 2008 will be disinvestment..." Need I have said more?

A Kindler Gentler Kind of Greenmailer May 6 2008 Recap of late-innings desperation by Steel to be nice and ask kindly for management to b uy their large unmarketable stakes in highly illiquid enterprises. Foretold of doom to come....and now arrived. I think this one was VERY funny, but as with most of the things I think are VERY funny, few others do...at least judging by the comments

A Bad Hair Day For Aderans' Management May 29, 2008 This is was one that jerked the chain of someone in Steel's organization. He rudely and amateurishly tried to argue the case, and then finally shut-up at the suggestion that Steel be transparent and show the time sales & prices to dispel the notion that it was a market-impact trade on illiquid securities. THIS IS A MUST READ IF ONLY FOR THE EXCHANGES IN THE COMMENTS.

Effingly Absurd Efforts July 22 2008 Effingly amusing post actually about home grown Steel imitator Effissimo, rooting for the lions to finish Steel off and put them out of their misery.

So where does the proposal leave investors? Between a rock and a hard place. Vote to float, and the ingrate who got you there is rewarded. Redeem, and you will get royally buggered on the exit, or perhaps pursuant to the fine-print, payment-in-kind which would be a rag-tag-bag of illiquid stakes in cheap-for-a-reason enterprises.

But the audacity of the suggestion is what should incense investors most of all. It would be like being a customer at a restaurant where you've been very obviously poisoned by the appetizer and main courses, so much so, that you've bee rolling and vomiting all over the floor and now are dry-heaving bile, when the owner personally comes up to you and smarmily asks what you'd like for dessert, and whether you'd like to reserve the same table next week, same time.

The Directors should fire Mr Lichtenstein and appoint a new manager to unwind the book WITHOUT FURTHER ENRICHING THE EXISTING MANAGER. Someone errrr like me!??!? Well, at least I would charge reasonable fees, be trying to figure out how to get my investors out of the Steel Partners Hell-hole rather than partying with Denise Rich in St Tropez, and not be self-serving other than put a bit of grub on my family's table, and perhaps most importantly, I would - as I have always been in the past - and contrary to current management, be a true and proper fiduciary.

The Enigma of Martin Armstrong (revisited)

Martin Armstrong's name is surfacing once again, as cyclically recurrent as perhaps predicted by his theories. One would be forgiven for possibly attributing this to the recent revelation that another Ponzi (Mr Madoff's) was surpassed that of his own. Or it might be that people were having second thoughts on the veracity of his theories given the state of the financial system and the bucking of the asset-price destruction trend by Gold, much the same way the Hebrews turned to golden calfs after dessicating in the desert for a while. Or it might be that Mr Armstrong has been writing again, (though this time from behind bars), and that it has received some traction by goldbugs, still enamoured by errrr ummm that about him they find attractive. Whatever the reality, Mr Armstrong is the nexus between them, and so I thought it opportune to re-post (with a few editorial clean-ups) an old post from Aug 2006 entitled "The Enigma of Martin Armstrong".

Anyone with anything to add (for the Record) on the specifics of PEI, it's trading, Japanese Repair Bonds, Cresvale, Marty's affiliation with Magnum "scion" Dion Friedland, should feel welcome and encouraged to do so here. Read on....


Monday, August 21, 2006

The Enigma of Martin Armstrong

Some memories fade, but are never entirely forgotten. The same holds true for certain personalities, particularly the bizarrre and eccentric. One such notorious individual is Martin Armstrong a.k.a. Princeton Economics a.k.a. self-professed expert in the history of money and things gold, and in keeping true to my theme, of things Japanese. He was accused of a large Ponzi fraud, of hiding the alleged spoils, and of being the purveyor of the notoriously unvaluable "Cresvale Bonds" that besotted Japanese corporate investors and populated their portfolios, much to their eventual chagrin. Coincidentally, as a result of some inexplicable synchronicity, I was wondering only a few weeks ago what's become of Mr Armstrong and was preparing a post to that affect, so it is timely coincidence indeed that, after languishing for six-and-a-half years in a Manhattan jail cell, he finally pleaded guilty to charges of "fraud" on Thursday, August 17th 2006.

For those unfamiliar, or too merely too young to know, Martin Armstrong was a confidence trickster, if not an outright fraudster for which he was accused. Martin Armstrong was also a Bad trader. A very VERY Bad (note upper case "B") and inept trader. And it is reasonably certain Martin Armstrong committed fraud to cover up his very bad trades. And then he committed more trades in an attempt to cover up his fraud on a hope and prayer all would eventually come good. Most of these were in Nikkei and in Gold. Contrary to the laughable ineptitude with which he implemented his "strategies", by most accounts he was smooth, suave and authoritative, in a way that encouraged people to entrust to him their money. Which he then duly lost. Many many hundreds of millions of US dollars. Perhaps billions of US dollars, but we don't know precisely because Mr Armstrong has not spoken other than (until this week) to deny his accused. The official court dockets (available on-line) from his 1999 indictment in the Manhattan district of US Federal Court read like a Shakespearean comedy. The more he traded, the more he lost. So much and so bad were his trades that his colleagues, and brokers mercilessly joked about it behind his back. He was, according to the same court docket, so consistently wrong-footed in his punts that he would have done far better flipping a coin to decide whether or not to be long or short. Or use the infamous "Ask the 8-Ball" Method. Or consult Nancy Reagan's financial astrologer, or even seek the advice of Anatole Kaletsky. Anything but use his own judgement.

Though his company, Princeton Economics, had head offices in the US, he traded from Tokyo in an office overlooking the gardens of the Imperial Palace. For Japan had a special place in his scheme. You see, ironically, the Japanese too, in undertaking their own form of financial-speculation-gone-awry known as Zaitech, had lost billions in late 80's and early 90's on dubiously-thought-out wrong-footed speculation and stock-market investment. Like Martin Armstrong, shell-shocked by large lossess, they were too ashamed and/or embarrassed to tell their shareholders that they had punted wrongly, or in UK football vernacular, scored the financial equivalent of an "own-goal". Not willing to come clean, they found themselves with a serious problem and yearned for a clever and tidy solution that would absolve them of the thing they feared most, which was NOT the losing of the money itself, but accepting responsibility for it, a dilemma not unlike that faced by I. Lewis "Scooter" Libby.

Enter Martin Armstrong and the almost forgotten Cresvale Securities. He too had a problem since his golden-tongued investment plans, proved rather less robust than hoped [and promised] and resulted in large trading losses for his clients. It seems from the prosecution's accusations that he was able to continue his scheme (until this point) and make payments to the clients who redeemed by using the proceeds from new investors. This, however was proving more difficult as losses mounted, and so he desperately needed new clients. Big clients. Well-heeled clients who wouldn't be asking for their money back any time soon. Such as money from the trust of someone deceased. Better yet, a dead-pet trust!!. Or even better: a Japanese corporate client that themselves had a big dirty secret to hide.

And so they found each other: the companies, like an inveterate gambler, desperate for an investment saviour who with promises of high returns - would, over time, regain their previous losses, rescuing them from certain the humiliation and shame that they most dreaded (not to mention a demotion to the Corporate Travel Office, or Janitorial Services Dept.) and Armstrong, now with a fresh load of clients, and more importantly, their cash. In between them stood Cresvale Japan, the securities firm who brought them together, gave legitamacy to both their pursuits, and took nice fees out of the middle in the process, and in so doing torpedoed themselves out of existence.

The scheme ( I am conjecturing here) worked something like this: Japanese Corporate 'Y' perhaps had lost $100,000,000 speculating through a subsidiary, selling say Nikkei Put Options or buying boatloads of overvalued shares after consulting with Madame Inoue's Buddhist toad (tip: this is one of my favorite posts!!). They were able to hide this financial pustule for a while by playing "pass the parcel". perhaps between offshore subsidiaries with different year-ends. Thus their consolidated accounts still showed these losses as assets at their full value on their balance sheets. So Armstrong/Cresvale proposed they swap $50,000,000 of new money for a "repair bond" with a maturity value equal to the full $150,000,000 ($100mm of losses + $50mm of new money) and then let Magic Martin do his thing. Here, they might have been sweet-talked, or they might have seen it more cynically as a win-win for If things went right, they would make their money back and everyone wins. If something went wrong, well they can blame the investment losses on Armstrong, call it fraud, and take write-offs, without having to take responsibility in the first instance. (note: this is sketch of the essence, not the actual details).

This is all interesting, but what really fascinated ME about this story is that in the mid-90s, certain un-named American value investors had eyed a number of Japanese companies that they believed "cheap" because they seemed to have large amounts of un-specified cash & marketable securities reported on their balance sheets, relative to their now-diminished market capitalizations. In some cases these balances were in excess of the firm's entire market capitalization. Many reasons were put forth explaining the phenomena such as: "empire building"; "small-float and closely-held"; "saving for a rainy day"; "deflation"; "management conservativeness"; "investor pessimism"; "adverse taxes upon large distributions"; "legal inability to conduct share buy-backs" etc. All these seemed somewhat plausible. Conspicuous by its absence, except as speculated by the most hardened, battle weary cynical gaijin observers was: "because it doesn't exist".

But clearly some people HAD to know about their losses. For other foreign banks (Paribas, Lehman, etc.) were in the so-called "repair bond" business. Other financial institutions had been counterparties to their sales of embedded Nikkei Put options. And many of the companies themselves were household names. Maybe their businesses were not as fraudulent as Armstrong's, but nonetheless their audited accounts and subsequent actions foraying into esoteric transactions were meant to deceive shareholders by masking losses and allowing them be amortized over many years.

Since I am here, writing this, readers must suspect that none of these things went according to plan. When the Armstrong fraud broke, many of the guilty Japanese Corporates had to come clean. Sort of. They claimed they were victims of fraud (and perhaps some truly were unsuspecting purchasers of Cresvale Bonds), but the "repair Bond" concept and angle was often lost on most external observers. Yakult Honsha (TSE#2267) was said to have $1bn of losses alone from their Armstron-relatedg assiociation, as well as engineering firm Chudenko (#1941); specialty chemcial maker Gun-Ei Co. (#4229) pharma co's. Kissei (#4547), and Towa Pharm (#4553), machine-tool giant Amada Corp (#6113), pneumatic specialist SMC (#6273), eletronic parts mfgr Alps Electric (#6770) advertising agency Asatsu (#9747), office furniture maker Itoki Crebio (#7972) and more than 50 other firms were deemed to be "stung" in the Ponzi's unraveling. Yakult's losses were apparently so big that they couldn't blame Armstrong for all of them with a straight face, but many other co.s did, and [perhaps as planned] were "absolved" of culpability for their original sins.

The epilogue was that Armstrong, accused of Fraud, sat in jail for contempt of court, and was not brought forth to trial for his alleged failure to turnover evidence and in particular, to tell authorities the whereabouts of $15mm of gold and silver coins and bronze statues he'd reputedly squirreled away. It was the longest such languishment for contempt in United States history. All the while, he's claimed that he was innocent of the fraud itself. I make no judgement here, but it seems likely from the court documents and testimony of accused accomplices at HSBC he that committed fraud in the form of the ponzi that used new proceeds to pay old losses. His brokers, Republic Bank, (now the behemoth HSBC) coughed up nearly USD$600mm for their part in not alerting authorities to the potential wrong-doing, which court documents allege, they were well aware. That said, a good portion of the suspected so-called "losses were not "embezzlement" or "theft", per se, as the newspapers and Japanese Corporates would have readers believe, but out-and-out ineptitude and shitty trading. The subsequent deceit and using proceeds of one investor to pay another, and, well, we know what that is called.

His reversal and decision to enter a guilty plea may reflect that Armstrong the man met Armstrong the fraudster. Or it may reflect Armstrong's understanding that having spent six years in jail, an admission of guilt might allow him to squeeze a few years of freedom in his (no pun intended) "Golden Years".

For investors, the only the protection they can afford themselves is doing appropriate due diligence and being highly skeptical of anything that purports to be "too good to be true", or turn base metals or paper into errrrr ummm gold.

And The Largest Fraudulent Conveyance Recipient Is...

Today, there are far more experts on the subject of Fraudulent Conveyance than there were several weeks ago. And rightfully so, since it is a fascinating concept - particularly in the $50bn case of He Who I've Promised Not To Discuss as one of my year's resolutions, and one that in days of old might have merited a lively discussion in the The Talmud. Roger Ehrenberg at Information Arbitrage discussed the perils in this case. It generated many passionate comments, yet, missed one of the most fascinating and salient aspects of the case which was kindly highlighted by reader "Shairon The Parliamentarian" (profile sadly unavailable):

Perhaps the singularly largest beneficiary as a recipient of fraudulently conveyed funds was the United States Government since many of the redeemers will have paid capital gains taxes upon the BLM redemptions with fraudulently conveyed funds. As a result, it will be incumbent upon them to disgorge said tax receipts back to the administrator for ultimate redistribution. Given the length of time many investors were "in", the capital gains, and thus the taxes thereupon would, one might assume, be very large.

Nothing like kicking someone when they are down! And it gets worse for Uncle Sam since (as has been widely pointed-out) the investment losses will offset investment gains for many taxpayers (only of course if ever again investment gains outside the US Govt Bond market resurface again within the statute of limitations for their carry-forward) for years to come.

Farewell, then 2008...

So, farewell then
two-thousand
and-eight -
end of Bush-folly
and the Bubble Of
The American Way.

To some
you were
eponymously
known as the
Year of The Rat.

To others
you were
just as aptly
annus horribilus

Volatility,
asset price destruction,
fear, greed, hubris,
fraud, collapse,
deleveraging and
revulsion were your
catch-phrases.

'Tis astonishing
what it takes to
convince The People
to live within
their collective
means.

I Am Shocked That You're Shocked...!!

The name Bernard L. Madoff has been upon everyone's lips of late - even those who know nothing about finance, hedge funds, or the subtleties regarding how to execute a good Ponzi. And I can understand the awe at the numbers - even though $50 billion is on the high side given its compounding of non-existent returns, for one cannot lose what they never had. Yet, despite the size, I remain shocked that industry people are "SHOCKED" or even just "shocked. While I will admit to being surprised that of all the possible Ockham-friendly explanations, Ponzi was the culprit, I can say with certitude that it was "relief" rather than "shock" that I felt, since the revelation finally solved a long-outstanding and personally troubling market non-sequitir.

Yet through all the analysis, uproar, indignation, and financial horror, I AM shocked that the media and commentators of all persuasions have left untouched the details that I find most fascinating. These pertain to contemplating Mr Madoff's inner monologue throughout, his relationship with his wife, how (if you believe the sons) he managed to avoid discussing the sordid details in conversations with his sons over Mom's Sunday-evening pot-roast and egg-noodles (did she cook or merely press her speed-dialer to book tables at Le Cirque and Daniel???) . Perhaps this is because I have never taken the study of psychology to any depth; perhaps it is because I myself am such a pathetic liar I cannot countenance a serious confabulation, but neither deters my morbid fascination with what Mr Madoff must have been thinking at various crossroads during the swindle, such as when he went for a slash in the mens room after delivering a congratulatory address to the Hadassah who were amongst the very people he was taking to the cleaners!! Did Mr Madoff go to Synagogue? Might there not have been moments during the one solemn service or another where he felt deep remorse and regret to such an extent he would end the charade there and then? And how many times did his inner-self feel near collapse as the proximity of discovery approached during the numerous occasions over the fifteen years - be Long-Term Capital (many industry redemptions), the Tech Wreck, or the publishing of the Barron's article. How much time did he put into contemplating what P&L would be contextually acceptable...in other words: did he agonize over whether -0.09% would be more reasonable than -0.12%? Did anyone help him in these ruminations? Did he devise a method for fabricating returns in the positive months - e.g. the way Luke Rhinehart did in The Dice Man?? Did he keep a little Black Book of all the lies and half-truths he told to various people in order to keep them straight? Is it really possible that FG's Walter Noel, Andres Piedrahita and Jeffrey Tucker REALLY didn't know what was up? Did he despise himself even more when he read about the "honest" Wall St. fortunes made by Dr Simons and David Shaw? What went through BLMs thinning head when another $100mm hit his account from the wire? Was it celebratory (popping a vintage Krug) or merely a sigh of relief at living to fight another day, to have another pedicure, another meal at Boulud's place, another massage (happy ending?) almost Sisyphusian given the lack of meaning for whatever meaning there might have been (family, love, tzedakah, good works?) would pale in comparison to the scale of what awaited just around the around the corner that would surely shred whatever meaning he might have self-deceived himself into thinking his life possessed.

Perhaps, though, I am getting too cerebral here. Perhaps a sociopath is entirely self-delusional. Perhaps the sociopath believes he has achieved what he has merely conjured and is an equal to Dr Simons and Mr Shaw. I do not know. But I continue to wonder...