Monday, April 24, 2017

Ralph Lauren Still Paying $68K Per Day Lease On Closed NYC Flagship (RL)

$68,493 per day for 39,000 square feet?
We may have found one of the problems with retail. Back in 2011 Airbnb was offering Liechtenstein for $70 thousand per night, links below.

From the New York Post:

Ralph Lauren still paying rent at abandoned former flagship store
For passersby on Fifth Avenue on Thursday, there was no evidence that legendary American designer Ralph Lauren operated a grand flagship store at 55th Street.

The royal blue awnings are gone and the flagpole, which once proudly flew a banner with the fluttering image of a horse and polo player, stands naked.

And just as important, there is no new tenant setting up shop and, according to sources, no broker has started marketing the 39,000-square-foot space that has been dark since the designer shut off the lights one last time on Saturday.

The only constant, it appears, is that Ralph Lauren Corp. continues to pay rent of nearly $70,000 a day.

“That gives you a good indication of how poorly they were doing at that location that they are paying rent there on an empty space rather than stay open until they find a new tenant,” said one real estate expert, who did not want to be identified.

The stunning and sudden departure of the retailer after just two years on the most famous shopping corridor is unprecedented, said Tom Cusick, president of the Fifth Avenue Business Improvement District. “I don’t recall any company pulling out of a location with a long-term lease after such a short time on Fifth Avenue.”

The iconic fashion house, which has been fighting sagging sales and has closed 50 other stores, signed a $400 million, 16-year lease for the flagship store in 2013. That rent averages $25 million a year, or $68,493 a day....MORE
The graphic the Post chose to illustrate the story:
Ralph Lauren's Fifth Avenue store is some white elephant - the lease 
isn't up for about 13 years at an eye-popping rate of $68,500 a day.

Meanwhile in comparisons, we linked to a post in June, 2010 that may have given someone an idea

"Snoop Dogg tries to rent entire country of Liechtenstein"
From Foreign Policy's Passport blog:
In a too-good-to-check item, the Daily Mirror reports that rapper Snoop Dogg recently attempted to rent the entire nation of Liechtenstein for a music video:
The request surprised authorities in the state of Liechtenstein - population 35,000 with an area of 61.7 square miles between Switzerland and Austria.
Local property lease agent Karl Schwaerzler said: "We've had requests for palaces and villages but never one to hire the whole country before.">>>MORE
which was followed a few months later by a story in the Guardian:

Liechtenstein for hire at $70,000 a night
Liechtenstein rental scheme includes customised street signs, temporary currency and accommodation for 150
Vaduz castle in Liechtenstein. Photograph: Paul Trummer/Getty Images 
Executives with cash to burn traditionally hire luxury yachts, secluded villas or expensive hotel suites to impress clients. Now they can take corporate hospitality to a new level by hiring an entire country, albeit a small one.

The principality of Liechtenstein has decided to make itself available to private clients, from $70,000 (£43,000) a night, complete with customised street signs and temporary currency. It's a big step for the country best known for its tax-haven status and exporting false teeth: last year Snoop Dogg, pictured, tried to hire it to use in a music video, but received a stern refusal from authorities.

Since then they have woken up to the marketing opportunities of their mountainous landscape. The price tag includes accommodation for 150 people, although the 35,000 inhabitants would remain.

Any personal touches, such as an individual logo created out of candle wax or a customised medieval procession, come at an extra, undisclosed cost.

Upon arrival in Liechtenstein, visitors would be presented with the symbolic key to the state, followed by wine tasting at the estate of the head of state, Prince Hans-Adam II. Other options include tobogganing, fireworks and horse-drawn carriage rides through the capital Vaduz....MORE
So what's the all-in price for an après-wine-tasting tobogganing outing with the Prince?
Under the fireworks, natch.
While throwing temporary currency to the Liechtensteiners (who suffer GDP envy re: Monaco)
With Ralph Lauren steering the toboggan.

Platts: "Why the crude rally has fizzled: Market analysis series" Part II

Our intro to to Part I, April 20, 2017:

Here's the last year of WTI prices via FinViz:

$51.34 up 49 cents, last.
Currently $49.32, down another 30 cents.
From Platts' The Barrel blog:
This is the second of a three-part look at why oil prices have failed to rally despite OPEC’s best efforts at managing supply cuts. Read part 1 here.

So, why is everyone so bullish?

Many oil analysts take as a fait accompli that OPEC-led production cuts thus far are key to balancing the crude market. If this is the case, though, why hasn’t it happened yet?
But the bulls say give it time. In the long run, the market will balance.

Everyone knows what Keynes said about the long run (that we are all dead).

That the market is prime for a rally has become gospel truth. But isn’t something so paradigmatic just a little bit risky?

“Oil prices will get better, and you can take that to the bank,” David Purcell, head of macro research at Tudor, Pickering and Holt, said at a recent Dallas conference.

“The market is under-supplied, inventories are back to normal levels by the end of the year, and if you guys don’t drill the Permian too fast, we’re okay,” Purcell said.

But drilling too fast is just what drillers have been doing. According to Platts Analytics RigData, active Permian horizontal rigs now stand at 280, 40% of all US horizontal drilling. The number of US horizontal rigs will likely break above 700 soon, revisiting a number last seen in April 2015, when Permian rigs made up just 25% of the total.
Permian looking increasingly profitable
Calling for $60/b by the year’s end, FGE Chairman Fereidun Fesharaki said at a Fujairah bunkering conference last month that recent price pessimism was overdone and that financial players in the short term were misreading the market.

Many of the banks have been driving this home as well.

While Credit Suisse analysts earlier this month conceded that both Atlantic Basin and Asia-Pacific crude markets are suffering from oversupply — widening price discounts for Asian grades like Russia’s ESPO Blend and Qatar’s Al-Shaheen can attest to that — they also say that it is too early to ditch the idea that just because prices have struggled, the market isn’t rebalancing....MUCH MORE

Capital Markets: "Dramatic Response to French Election"

I have a sneaking suspicion that gap is going to fill:
$1.0891 last.

From Marc to Market:
The results of the first round of the French election spurred a dramatic response in the capital markets. Our thesis that there is no populist-nationalist wave sweeping the world is supported by the previous results in Austria, the Netherlands, and now France. The AfD in Germany is wilting in the polls, and there too the center will hold. The populist-nationalist wave seems a result of the Anglo-American two-party system in which the center-right party adopted part of the populist-nationalist platform.

The euro gapped higher in pre-Pacific trading. It had finished the week in North America a little below $1.0730 and jumped to almost $1.0860 on its way to nearly $1.0940. However, it drifted lower in Asia and steadied in Europe around $1.0850. The gap is found between $1.0738 (Friday's high) and $1.0821 (today's low). The immediate issue is what kind of gap it is? The longer it is unfilled, the more bullish are the implications.

There are some events that are the week that could challenge it. The ECB meeting stands out as a risk. The March meeting was seen as hawkish, and this does not seem to be Draghi's intent. Draghi's comments before the weekend reiterated the line about rates being this low or lower. The ECB's Nowotny explained that policy for 2017 has already been set, and a decision about 2018 will be made in the second half.

Meanwhile, as President Trump's 100-day in office approaches, there seems to be a push to make something happen, but this could be a dangerous game if the inflated expectations are not satisfied. In particular, there has been the suggestion that a vote on health care reform could be held this week, but it does not look ready. Trump reportedly will make an announcement on tax reform (Wednesday), but this is likely more of a wish list that detailed proposals. Reports suggest that it will not include the controversial border adjustment tax.

Also, some measure must be passed before the end of the week on the spending authorization of the federal government. Some sort of short-term extension rather than a real solution is likely. It is what has happened to the debt ceiling as well. The Treasury Department has already begun taking extraordinary measures, including reducing its cash balances at the NY Fed, which some have linked to reducing the cost of dollar funding in the cross currency swaps.

Investors' sight of relief at the results of the French election is the main driver today. It is sufficient to overwhelm the decision by Fitch before the weekend to downgrade Italy's sovereign rating to BBB from BBB+. Italian 10-year bond yield is off six basis points, while the German 10-year yield is up nearly 10 bp. Spain's 10-year yield is down five basis points. France is off 10 bp.

In recent weeks, the fund trackers have reported strong demand for European stocks. European bourses are sharply higher today. The CAC leads the way with a 4.4% advance that has lifted the benchmark to its best level since 2008. The DAX's nearly 3% gain lifts it to a new record high. While sterling itself is marginally firmer, the FTSE 250 is up nearly 1% to a new record high. The Dow Jones Stoxx 600 is up almost 2%, led by the financials, industrials, and telecom. None of the major industry groups is up by less than 1%.

Asia-Pacific interest rates and equity markets rose. The MSCI Asia Pacific Index rose 0.4%, for a third consecutive advancing sessions. The Nikkei advanced more than 1% for the second consecutive session, something not seen since January. Chinese shares were not invited to the party. The Shanghai Composite lows 1.4% amid reports of a regulatory crackdown. It was the largest decline of the year. It is off nearly 5% since the 15-month high was set two weeks ago....MORE

Crispin Odey: "It Feels Lonely Being Bearish"

From ZeroHedge, April 20:
In Crispin Odey's latest letter to investors, the billionaire hedge fund manager laments "how quickly everything has changed", notes that "without the reflation fireworks, equity markets feel vulnerable", and concludes that while a year ago it was easy to be bearish - China was slowing, world trade was creaking, Europe was not recovering and the oil price was hitting new lows - "a year later to be bearish feels lonely, despite the fact that the reflationary story of the past year looks difficult to sustain and auto loan lending has joined a long list of risks along with Trump and Brexit."
 And yet, unlike Horseman, he is not throwing in the towel just yet: "Money creation alone has taken markets to all-time highs but what strong arms take, strong arms must defend. Valuations demand that they do."

And while Odey's trenchant appeal that "when we look back at this madness, some people will feel ashamed" is accurate however, considering his YTD P&L of -4.9%, following a 1 year drop of 33.7% (and more than half over the past 3 years), Odey may not be among those looking back.
Full letter below:
Look how quickly everything has changed. Trump, defeated over the Obama Healthcare reform has, as it were, retreated into an aggressive foreign policy which is almost the opposite to the Monroe doctrine which he was adopting earlier. Bannon is on the back foot. In the absence of a corporate tax cut or any kind of VAT tax reform, the US economy is succumbing to an overvalued dollar and a growing crisis in subprime lending, centred on the second hand car market. The government bonds have already guessed Yellen’s mind. No more rate rises. We are now just waiting for the Fed to set up a lending business, loaning 5 year old cars to people who can neither drive nor borrow. That is what they need to do to stop the subprime losses ballooning.

Last year what bailed everyone out after the bad first quarter was China and the oil price. Despite China pumping in 40% of GNP in new lending, the statistics are revealing. The economy grew nominally 7½%. Consumption of steel grew by 2%, despite steel prices rising 60%, and the auto market started to weaken (by 2.5%) in the new year after being driven up by the size of the support exercise. For this year, it is going to be difficult for China to even continue its recovery. The chances have to be high that we have just witnessed a giant rally in a bear market for commodities. Where is Trump’s massive infrastructure boom?
Without the fireworks, equity markets feel vulnerable. The Great Reflation was responsible for a re-rating of stock markets. If all we have left is the Central Bank’s bond bubbles, that may not generate enough growth to support prices.

Whilst undoubtedly bonds were in bubble territory last year as evidenced by the fact that the only way a buyer could possibly make money was by selling the loss making asset to a bigger fool, the equity market did become compliant in the game. Companies learnt to pay out dividends with borrowed money and became very adept at using shares as dividends – so called scrip. Very popular with corporates.

Several of our favourite shorts have shown a tremendous appetite for scrip. Intu Properties, the largest shopping mall owners in the UK are valued at £8bn EV, not surprisingly when they received £447m in net rent and £408m in EBITDA in 2016. They paid out £240m on interest and hedging costs (year end LTV of 44%), needed to spend £121m in capex to keep the tenants happy and so shareholders got £183 million in dividend of which £29m was in scrip (£73m in scrip the year before). The problem with scrip is people are starting to find that it is not worth the paper it is written on. Intu this year say they will  spend not £121m but £297m to keep tenants happy. In a world where scrip is no longer being appreciated that leaves a £300m shortfall after £230m interest payable, capex and dividend. Whoops!

With the subprime problem emerging in the used car market, remember that this is nothing but a can (car) kicked down the track some years ago. In 2012, with the compliance of the Fed, leases on cars were extended from 3 years to 5 years with a residual value of 20% of the new at the end of the 5 years seeming reasonable given that cars last 10 years. The result was a 30% increase in demand for new cars on the back of a 30% decline in cash costs. Five years later, with subprime in the USA some 2.3x larger than it was in 2008/9, these second hand cars are not attracting bids at or above the residual prices built into the leases. At present, prices are just 7½% below the expected price. Dangerous but not critical. What frightens everyone is who is going to buy so many second hand cars for cash over the next few years? A change to the new leasing price now needs to be made. Just when sales have already been weakening.

Another inadvertent child of QE has been the rise of disruptive technologies – Amazon, Uber, Tesla, Artificial Intelligence, ViaSat. All promise to undermine incumbents and most importantly the current assets employed by the incumbents, lent against by the banks and the corporate bond market. Paradoxically it is also the reason that productivity is falling – losing income earners are not easily found, equally well paid jobs. It is putting pressure on property prices in much the same way as it is hitting second hand car prices.

Unless we are happy to see the Fed and other central banks extend their remits drastically these new developments must have repercussions in the capital markets. The unwillingness of investors to discount this, has made stock markets both so resilient and so difficult to read.

The Bank of England, under Carney, have taken this further than most, presiding over personal savings rates falling from 12% in 2008 to 3.5%. At a time of uncertainty of trade terms, the UK is reliant on credit equal to 5% of GNP. With inflation rising thanks to the fall in ster-ling towards 4% and short rates at 0.25% and 10 year bonds yielding 1%, prices are not that tempting. No wonder that foreign investors have been selling down their gilts. The optimist will tell you that sterling is 25% too cheap ‘on the Big Mac Index’ and is due a bounce. But a bounce presupposes that individuals will start to save again. With all interest rates negative they seem intent on borrowing and spending. When we look back at this madness, some people will feel ashamed. Twisted facts and twisted logic may be met in the quiet of the night by reality.

A year ago it was easy to be bearish. China was slowing, world trade was creaking, Europe was not recovering and the oil price was hitting new lows. A year later to be bearish feels lonely, despite the fact that the reflationary story of the past year looks difficult to sustain and auto loan lending has joined a long list of risks along with Trump and Brexit. Money creation alone has taken markets to all-time highs but what strong arms take, strong arms must defend. Valuations demand that they do.
* * *
Finally, as per his position breakdown, we may have identified one of the biggest cable shorts. In light of recent events, it appears that Odey's losses are set to continue....MORE

Sunday, April 23, 2017

HBR: "The Trade-Off Every AI Company Will Face"

There is a phenomena is science known as simultaneous discovery or simultaneous invention. The two most famous examples are probably calculus and evolution but there are dozens if not hundreds of cases.

Here's another one.

From the Harvard Business Review, March 28:
It doesn’t take a tremendous amount of training to begin a job as a cashier at McDonald’s. Even on their first day, most new cashiers are good enough. And they improve as they serve more customers. Although a new cashier may be slower and make more mistakes than their experienced peers, society generally accepts that they will learn from experience.

We don’t often think of it, but the same is true of commercial airline pilots. We take comfort that airline transport pilot certification is regulated by the U.S. Department of Transportation’s Federal Aviation Administration and requires minimum experience of 1,500 hours of flight time, 500 hours of cross-country flight time, 100 hours of night flight time, and 75 hours of instrument operations time. But we also know that pilots continue to improve from on-the-job experience.

On January 15, 2009, when US Airways Flight 1549 was struck by a flock of Canada geese, shutting down all engine power, Captain Chelsey “Sully” Sullenberger miraculously landed his plane in the Hudson River, saving the lives of all 155 passengers. Most reporters attributed his performance to experience. He had recorded 19,663 total flight hours, including 4,765 flying an A320. Sully himself reflected: “One way of looking at this might be that for 42 years, I’ve been making small, regular deposits in this bank of experience, education, and training. And on January 15, the balance was sufficient so that I could make a very large withdrawal.” Sully, and all his passengers, benefited from the thousands of people he’d flown before.

The difference between cashiers and pilots in what constitutes “good enough” is based on tolerance for error. Obviously, our tolerance is much lower for pilots. This is reflected in the amount of in-house training we require them to accumulate prior to serving their first customers, even though they continue to learn from on-the-job experience. We have different definitions for good enough when it comes to how much training humans require in different jobs.
The same is true of machines that learn.

Artificial intelligence (AI) applications are based on generating predictions. Unlike traditionally programmed computer algorithms, designed to take data and follow a specified path to produce an outcome, machine learning, the most common approach to AI these days, involves algorithms evolving through various learning processes. A machine is given data, including outcomes, it finds associations, and then, based on those associations, it takes new data it has never seen before and predicts an outcome.

This means that intelligent machines need to be trained, just as pilots and cashiers do. Companies design systems to train new employees until they are good enough and then deploy them into service, knowing that they will improve as they learn from experience doing their job. While this seems obvious, determining what constitutes good enough is an important decision. In the case of machine intelligence, it can be a major strategic decision regarding timing: when to shift from in-house training to on-the-job learning.

There is no ready-made answer as to what constitutes “good enough” for machine intelligence. Instead, there are trade-offs. Success with machine intelligence will require taking these trade-offs seriously and approaching them strategically.

The first question firms must ask is what tolerance they and their customers have for error. We have high tolerance for error with some intelligent machines and a low tolerance for others. For example, Google’s Inbox application reads your email, uses AI to predict how you will want to respond, and generates three short responses for the user to choose from. Many users report enjoying using the application even when it has a 70% failure rate (i.e., the AI-generated response is only useful 30% of the time). The reason for this high tolerance for error is that the benefit of reduced composing and typing outweighs the cost of wasted screen real estate when the predicted short response is wrong.

In contrast, we have low tolerance for error in the realm of autonomous driving. The first generation of autonomous vehicles, largely pioneered by Google, was trained using specialist human drivers who took a limited set of vehicles and drove them hundreds of thousands of kilometers. It was like a parent taking a teenager on supervised driving experiences before letting them drive on their own.

The human specialist drivers provide a safe training environment, but are also extremely limited. The machine only learns about a small number of situations. It may take many millions of miles in varying environments and situations before someone has learned how to deal with the rare incidents that are more likely to lead to accidents. For autonomous vehicles, real roads are nasty and unforgiving precisely because nasty or unforgiving human-caused situations can occur on them.
The second question to ask, then, is how important it is to capture user data in the wild....MORE
Coming in at a less oblique angle of attack and with a topical/timely hook, FT Alphaville:
Tesla says this is not the vaporware you are looking for

A Deep Dive Into What Elon Musk Is Up To With His Neuralink Company

From WaitButWhy:

Neuralink and the Brain’s Magical Future
Last month, I got a phone call.
Okay maybe that’s not exactly how it happened, and maybe those weren’t his exact words. But after learning about the new company Elon Musk was starting, I’ve come to realize that that’s exactly what he’s trying to do.

When I wrote about Tesla and SpaceX, I learned that you can only fully wrap your head around certain companies by zooming both way, way in and way, way out. In, on the technical challenges facing the engineers, out on the existential challenges facing our species. In on a snapshot of the world right now, out on the big story of how we got to this moment and what our far future could look like.

Not only is Elon’s new venture—Neuralink—the same type of deal, but six weeks after first learning about the company, I’m convinced that it somehow manages to eclipse Tesla and SpaceX in both the boldness of its engineering undertaking and the grandeur of its mission. The other two companies aim to redefine what future humans will do—Neuralink wants to redefine what future humans will be.
The mind-bending bigness of Neuralink’s mission, combined with the labyrinth of impossible complexity that is the human brain, made this the hardest set of concepts yet to fully wrap my head around—but it also made it the most exhilarating when, with enough time spent zoomed on both ends, it all finally clicked. I feel like I took a time machine to the future, and I’m here to tell you that it’s even weirder than we expect.

But before I can bring you in the time machine to show you what I found, we need to get in our zoom machine—because as I learned the hard way, Elon’s wizard hat plans cannot be properly understood until your head’s in the right place.

So wipe your brain clean of what it thinks it knows about itself and its future, put on soft clothes, and let’s jump into the vortex.
Part 1: The Human Colossus
Part 2: The Brain
Part 3: Brain-Machine Interfaces
Part 4: Neuralink’s Challenge
Part 5: The Wizard Era
Part 6: The Great Merger
Notes key: Type 1 are fun notes for fun facts, extra thoughts, or further explanation. Type 2 are boring notes for sources and citations.

Part 1: The Human Colossus
600 million years ago, no one really did anything, ever.
The problem is that no one had any nerves. Without nerves, you can’t move, or think, or process information of any kind. So you just had to kind of exist and wait there until you died.
But then came the jellyfish.
The jellyfish was the first animal to figure out that nerves were an obvious thing to make sure you had, and it had the world’s first nervous system—a nerve net.
The jellyfish’s nerve net allowed it to collect important information from the world around it—like where there were objects, predators, or food—and pass that information along, through a big game of telephone, to all parts of its body. Being able to receive and process information meant that the jellyfish could actually react to changes in its environment in order to increase the odds of life going well, rather than just floating aimlessly and hoping for the best.

A little later, a new animal came around who had an even cooler idea.
The flatworm figured out that you could get a lot more done if there was someone in the nervous system who was in charge of everything—a nervous system boss. The boss lived in the flatworm’s head and had a rule that all nerves in the body had to report any new information directly to him. So instead of arranging themselves in a net shape, the flatworm’s nervous system all revolved around a central highway of messenger nerves that would pass messages back and forth between the boss and everyone else:
The flatworm’s boss-highway system was the world’s first central nervous system, and the boss in the flatworm’s head was the world’s first brain.

The idea of a nervous system boss quickly caught on with others, and soon, there were thousands of species on Earth with brains.

As time passed and Earth’s animals started inventing intricate new body systems, the bosses got busier.
You won't believe how much more


"5 Neuroscience Experts Weigh in on Elon Musk's Mysterious "Neural Lace" Company"
Questions America Wants Answered: Would Elon Musk's Neuralink Solve All of Accounting’s Problems?
"Elon Musk launches Neuralink, a venture to merge the human brain with AI" UPDATED
"Too Funny: Reporting On Elon Musk's New Brain Implant Company, The Nerds at Boy Genius Report..."
In other news...

But what about rockets? For the asteroid mining cancer cures? 

Saturday, April 22, 2017

Don't Fear the (McCormick) Reaper

I too have fallen under the spell of the reaper's song. Links below.
From The Conversable Economist:

Don't Fear the (McCormick) Reaper
The McCormick reaper is one of the primary labor-saving inventions of the early 19th century, and at a time when many people are expressing concerns about how modern machines are going to make large numbers of workers obsolete, it's a story with some lessons worth remembering. Karl Rhodes tells the story of the arguments over who invented the reaper and the wars over patent rights in  "Reaping the Benefits of the Reaper," which appears in the Econ Focus magazine published by the Federal Reserve Bank of Richmond (Third/Fourth Quarter 2016, pp. 27-30). Here, I'll lay out some of the lessons which caught my eye, which in places will sound similar to modern issues concerning innovation and intellectual property.

The reaper was important, but it didn't win the Civil War
The reaper was a horse-drawn contraption for harvesting wheat and other grains. Rhodes quotes the historian William Hutchinson who wrote: "Of all the inventions during the first half of the nineteenth century which revolutionized agriculture, the reaper was probably the most important," because it removed the bottleneck of needing to hire lots of extra workers at harvest time, and thus allowed a farmer "to reap as much as he could sow."

But somewhere along the way, I had imbibed a larger myth, that the labor saving properties of the reaper helped the North to with the Civil War by allowing young men who would otherwise have been needed for the harvest to become soldiers. However, Daniel Peter Ott in a 2014 PhD dissertation on " Producing a Past: Cyrus McCormick's Reaper from Heritage to History." Ott traces the claim that the reaper helped to win the Civil War back to some  promotional materials for the centennial celebration of the reaper in 1931 produced by International Harvester which included this statement:

"Secretary of War Stanton said: ‘The reaper is to the North what slavery is to the South. By taking the place of regiments of young men in western harvest fields, it released them to do battle for the Union at the front and at the same time kept up the supply of bread for the nation and the nation’s armies. Thus, without McCormick’s invention I feel the North could not win and the Union would have been dismembered.’"
Ott argues persuasively that this quotation is incorrect. Apparently, Edwin Stanton was a patent attorney before he became Secretary of War for President Lincoln, and he was arguing in court in 1861 that McCormick's reaper deserved an extension of his patent term. Ott quotes a 1905 biography of Edwin Stanton, written by Frank A. Flower, which included the following quotation attributed to an 1861 patent case, in which Stanton argued:
"The reaper is as important to the North as slavery to the South. It takes the place of the regiments of young men who have left the harvest fields to do battle for the Union, and thus enables the farmers to keep up the supply of bread for the nation and its armies. McCormick’s invention will aid materially to prevent the Union from dismemberment, and to grant his prayer herein is the smallest compensation the Government can make."
There doesn't seem to be any documentary evidence directly from the 1860s on what Stanton said. But it appears plausible that the he argued as a patent attorney in 1861 that the McCormick reaper deserved a patent because it could help to with the Civil War, and that comment was later transmuted by a corporate public relations department into a claim that Secretary of War Stanton credited the reaper with actually winning the Civil War.   

New innovations can bring conflict over intellectual property
Oded Hussey patented a reaper in 1833. Cyrus McCormick patented a reaper in 1834. By the early 1840s, Hussey had sold more reapers than McCormick. But the idea of a mechanical reaper had been in the air for some time. Joseph Gies offered some background in "The Great Reaper War," published in the Winter 1990 issue of Invention & Technology Gies wrote:
"In 1783 Britain’s Society for the Encouragement of Arts, Manufactures, and Commerce offered a gold medal for a practical reaper. The idea seemed simple: to use traction, via suitable gearing, to provide power to move some form of cutting mechanism. By 1831 several techniques had been explored, using a revolving reel of blades, as in a hand lawn mower; a rotating knifeedged disk, as in a modern power mower; and mechanical scissors. Robert McCormick had tried using revolving beaters to press the stalks against stationary knives. Cyrus McCormick and Obed Hussey both chose a toothed sickle bar that moved back and forth horizontally. Hussey’s machine was supported on two wheels, McCormick’s on a single broad main wheel, whose rotation imparted motion to the cutter bar. Wire fingers or guards in front of the blade helped hold the brittle stalks upright."
Hussey and McCormick then both argued in 1848 for their patent rights to be extended for a first time. By 1861, at the time patent attorney Stanton made his comments about the importance of the reaper, Hussey's patent rights had been extended for a third time, and McCormick wanted his patent rights extended, too....MORE
In the words of The Bruce Dickinson:
"I mean, really.. explore the space. I like what I'm hearing. roll it."
Way back in May of 'aught-seven we took the reaper as our hook for some posts on trading government policy:

Global Warming, Politics, Laws and Opportunity
Climateer Investing readers will be well served if they keep track of the various bills currently in Congress, or alternatively if they check in with CI from time to time (he said modestly).

We have entered the political (money) phase of the climate change discourse. So of course I am going to write about wheat.

I first became aware of just how much money can be made by paying attention to what the politicians are up to when I re-read the story of Cyrus McCormick and his Reaper twenty years ago. Most of what I knew of the story turned out to be wrong. On Monday evening I dug out my 1961 edition of "Historical Statistics of the United States" for some backround.

First off the reaper was probably invented by Cyrus' dad: The great demonstration of 1831 was done just six weeks after Robert McCormick's failed demonstration. Second, McCormick's version was not the first patented. Third, the invention was a commercial failure (at first).

There have been many reasons put forth to account for the eventual success of the machine. At a 1931 ceremony marking the centennial of the first test a former governor of Virginia said:
Rather jocularly speaking, he was possessed of a combination of qualities which have at all times proved invincible. He was a Virginian, he was a Democrat, and he was a Presbyterian; and so God blessed him with success because he deserved it.
Invented in 1831 and patented in 1834, McCormick didn't sell a single machine until 1840. The sales figures for the early years are debatable but these are the best I could put together:

1840------- 2
1843------ 29
1844------ 50
1845------ 58
1846------ 75

External factors played a part: Florida, Texas and Iowa were admitted to the Union in '45, '45 and '46 respectively.

Miles of railroad trackage, 2818 miles in 1840 increased to 4633 in 1845 and 9021 in 1850.
The nation's asset base grew e.g. life insurance in force went from $4.7mm (face) in 1840 to $97.1mm in 1850. The country was growing pretty fast.

On the corporate level, McCormick was a pioneer of installment sales.
The company moved to Chicago in 1847. Contrary to what this wonderfully illustrated 12 page history says:
It was not until 1847, when he built his own factory in Chicago, that he was able to sell a significant number of machines.
the salesmen's order books were filling up prior to the move.

This is getting to be a long post. I think I will serialize and show the opportunity created by laws and politics in the next posting....

Global Warming, Politics, Laws and Opportunity--Part II

To summarize part I (below) the McCormick family invented the reaper, sales in the first nine years were zero and in the next seven averaged 31 per year. They then exploded to 800 machines in 1847. What happened?

As reported by The Economist May 16, 1846, the British House of Commons had repealed the "Corn Laws", eliminating the tariff on imported wheat, the day before. Corn in this usage is not maize but rather is generic for grain. Prime Minister Peel won the battle but lost his premiership, the quote of the day was "Peel and repeal."

Some historians have argued that Peel's motive for this early example of free trade was the ongoing famine in Ireland, Peel himself had raised the issue in an earlier speech. This idea is patently false as Ireland's landlords continued to export food throughout the famine, with the dead Irish (est. 800,000 although some historians put the number at two million) being replaced by 977,000 head of cattle.

In his May 15, 1846 speech Peel said: "But let me say, altho it has not been brought prominently under consideration, that, without any reference to the case of Ireland, the working of the law, as far as Great Britain is concerned, during the present year has not been satisfactory."

According to "Historical Statistics of the United States:" wheat exports from the U.S. to the U.K. more than doubled from 1846 to 1847 and the McCormick family fortunes were assured....MORE

If you ar going to take this approach to investing, especially as my-little-crony direct investment rather than on a portfolio basis,  always, always, always heed the words of our first inductee into the Climateer Hall of Fame, the 26th Secretary of War, Democrat and Republican (!) Senator from Pennsylvania, Simon Cameron:
Our Hero
Simon Cameron
"The honest politician is one who when he is bought,
will stay bought."

Paul Tudor Jones Apparently Hit A Nerve With His Dire Warning (Asness, Fischer et. al.)

Yesterday the FT's Izabella Kaminska directed our attention to this article:
Of course the timing of the toppy trigger getting pulled will be very news driven, French election outcomes, for example, could be the rationale for a 5% up-move or a 15% drop in developed country indices.
Just as interesting is the scalded-cat reaction of some folks to what Jones said.

First up, the article that started it all, from Bloomberg April 20 with an update April 21: 

Paul Tudor Jones Says U.S. Stocks Should ‘Terrify’ Janet Yellen
  • Says U.S. market cap to GDP ratio highest since 2000
  • Stocks could rise higher after next month’s French election
Billionaire investor Paul Tudor Jones has a message for Janet Yellen and investors: Be very afraid.
The legendary macro trader says that years of low interest rates have bloated stock valuations to a level not seen since 2000, right before the Nasdaq tumbled 75 percent over two-plus years. That measure -- the value of the stock market relative to the size of the economy -- should be “terrifying” to a central banker, Jones said earlier this month at a closed-door Goldman Sachs Asset Management conference, according to people who heard him.

Jones is voicing what many hedge fund and other money managers are privately warning investors: Stocks are trading at unsustainable levels. A few traders are more explicit, predicting a sizable market tumble by the end of the year.

Last week, Guggenheim Partner’s Scott Minerd said he expected a “significant correction” this summer or early fall. Philip Yang, a macro manager who has run Willowbridge Associates since 1988, sees a stock plunge of between 20 and 40 percent, according to people familiar with his thinking.

Even Larry Fink, whose BlackRock Inc. oversees $5.4 trillion mostly betting on rising markets, acknowledged this week that stocks could fall between 5 and 10 percent if corporate earnings disappoint.

Caution Flags
Their views aren’t widespread. They’ve seen the carnage suffered by a few money managers who have been waving caution flags for awhile now, as the eight-year equity rally marched on.

But the nervousness feels a bit more urgent now. U.S. stocks sit 2 percent below the all-time high set on March 1. The S&P 500 index is trading at about 22 times earnings, the highest multiple in almost a decade, goosed by a post-election surge.

Managers expecting the worst each have a pet harbinger of doom. Seth Klarman, who runs the $30 billion Baupost Group, told investors in a letter last week that corporate insiders have been heavy sellers of their company shares. To him, that’s “a sign that those who know their companies the best believe valuations have become full or excessive.”...MORE
This was followed by the Vice-Chairman of the Federal Reserve Board saying on CNBC:
"Fed's Fischer: Stock market volatility doesn't terrify me"

Back to Bloomberg, who also caught the Fed man's comments,  

Quants Fire Back at Paul Tudor Jones After His Attack on Risk Parity
  • Macro manager sees strategy as driver for next stock selloff
  • Risk parity didn’t dump all stocks in last correction: AQR
Paul Tudor Jones says automated trading strategies are poised to blow up the market when volatility returns. That’s not going over well at one of the biggest quant shops on Wall Street.

Speaking at a closed-door Goldman Sachs Asset Management conference earlier this month, the billionaire hedge fund investor said that a portfolio strategy known as risk parity will eventually act as “the hammer on the downside” when turmoil returns to equity markets.

For AQR Capital Management LLC, a giant in the risk parity field, the concerns are overblown, with any selling forced by the strategy having an “utterly trivial” impact on the $23 trillion U.S. equity market.

“There are scenarios in which risk parity funds sell equities, but the possible magnitude of that is very small,” said Michael Mendelson, a risk-parity portfolio manager at AQR.“Some reports have grossly exaggerated the potential impact.”

Jones, who oversees $10 billion in his Greenwich, Connecticut-based Tudor Investment hedge fund, is the latest active asset manager to whip up fears surrounding the automated strategies that were a favorite target of bank researchers during the selloffs in August 2015 and early 2016. The strategy has less than $150 billion invested in it, according to data provider eVestment, most of at AQR and Bridgewater Associates’ All Weather Fund.

That’s significantly lower than the roughly $500 billion that some have estimated. And of that total, only around a third is investing in equities, Mendelson said. That compares to the nearly $2 trillion in market value that evaporated from U.S. equities during the last stock market correction.
“Even on a sharp move in the stock market, the positioning changes would be utterly trivial and would have about zero impact,” Mendelson said.

A spokesman for Paul Tudor Jones did not immediately respond to an email request seeking comment.

Cash Fleeing
Risk parity bases its allocations to different asset classes on risk rather than capital, as in the typical 60-40 stock-bond fund. So, for example, U.S. Treasures and international government bonds often play a larger role in risk parity funds than in other asset pools, while stocks usually take up a smaller slice.

In addition, money has fled risk parity funds in seven of the past nine quarters, for net outflows of more than $16 billion among funds tracked by eVestment....MORE
Finally, ZeroHedge who had posts on both Bloomberg stories has this interesting note:
...To be sure, Qian did hit Jones where it hurts: right in his performance, or lack thereof. “First you had Leon Cooperman and now it’s a hedge fund guy,” said Qian. “Any time performance isn’t doing well, they just blame risk parity.”

That however, does not change the fact that both Kolanovic and Jones are right (for more details see "One Year Later, This Is What Would Prompt Another "Risk-Parity" Blow Up"). And since volatility now appears to be rising, and sharp moves in both equities and bonds are likely on the immediate horizon, we present one of our favorite charts: the risk parity deleveraging sensitivity analysis. As BofA showed last summer, the most risk of deleveraging from vol controlled risk parity funds comes when both volatility and correlation of the underlying components rise together (i.e. quadrants 2 and 3 in the chart below).
In other words, a day which sees a -4% SPX drop and +1% bond rally (good diversification) would generate no selling pressure, "underscoring the critical role played by bond-equity correlation in governing the severity of risk parity unwinds." However, a troubling scenario is one where even a relatively benign 2% selloff of the S&P coupled with just a 1% selloff of the 10Y could result in up to 50% deleveraging, which in turn would accelerate further liquidations by other comparable funds, and lead to a self-fulfilling crash across asset classes.

We look forward to those two market conditions being met and watching the market's response as only that "experiment" will finally resolve the debate over whether risk-parity is the market's most pressing, imminent time bomb.

Also at ZH: "Fed's Fischer Responds To Paul Tudor Jones"

"Insurance and Nakedness": The Guy Who Saw the 2007-2009 Meltdown Coming and Described Exactly What Would Happen

Fifteen years ago today, April 22, 2002 I printed this amazing prognosis.
The whole thing is genius but just a single comment on GAAP vs. non-GAAP accounting makes it worth the price of admission:
Pro forma, I'm Miss America
A repost from Tuesday, February 16, 2010:

I collect prognostications.
This weekend I was going through a file of forecasts that various people had made from 2000 through 2005 and saw one that I had printed out on April 22, 2002.
Truly amazing.
Insurance and Nakedness

Before I get to the title of this piece, I'd ask you to take a short quiz -- two questions. I'll be referring back to these two items later in this article. First question: What are the odds of someone winning the lottery?
If you're like most people, you answered something like, "they're very low." But that would be incorrect, because you answered a question that I didn't ask. The question you likely answered is the one that you're most familiar with: What are the odds that you (or another specific person, named in advance) will win the lottery?
But rather than looking at it from the point of view you're used to, look at the lottery as a whole. That's the question I asked. Someone usually does win the lottery. In fact, the point can be made even more plainly if we take the example of a charity raffle. You've probably been to one of these. Everybody buys a ticket and someone will win the prize. If the first winner isn't there, they pick another ticket out of the fishbowl. They keep doing it until someone wins. We don't know who will winin advance, but there's a 100% chance that someone will win.
Hopefully, you'll see my point later on and not think it's just a stupid question where I could say, "Fooled ya! Fooled ya!" But first, lets get to the second question which is more straightforward and rhetorical:
If a company has 90% market share of a market that is mature and is not growing, and the company isn't expanding into any other lines of business, how much more can the company grow?
Probably not much. In fact, the things that can happen are mostly bad. There's 10% more upside, but a whole lot of potential downside. A new competitor might undercut on price or on service and take away 10-15% of the market. Somebody might give away your product or service as a loss-leader to get the customer's business on something else. Another product or service might displace yours or make it obsolete, etc., etc. The point being, there is a time when the market becomes saturated and the risk becomes greater than the reward.
Hereafter, I'll be referring to these two items as the lottery example and the 90% problem.
Is Everybody Already Into The Pool Of Available Buyers?
In a previous piece, I asked a question that I'll put to you again: name an asset that you cannot buy with 100% financing. There are very, very few. Ironically, stocks are one of the few I can think of. Cars, boats, houses, furniture, stereos, you name it -- 100% financing is available. And that's a stingy deal. Nowadays it's no down, no payments, and no interest for a year or two. Greater than 100% financing on houses is often available. Twenty years ago, it was not like this. Even ten years ago it wasn't like this. The increase in credit availability is the reason for much of the increased demand in certain sectors of the economy.
The ability to purchase an asset on credit creates a huge additional demand for the asset because it increases the pool of available buyers. If we all had to pay cash for cars, let's say $30,000, the pool of available buyers would be small because many people have very little in the way of savings. But if the car can be purchased for a payment of several hundred dollars a month, the pool of available buyers increases dramatically. That's wonderful as the credit availability is being increased. But if it decreases, it also takes away potential buyers.
As an investor in assets, of course, you want the pool of available buyers to be small -- less competition. The time to buy real estate, for example, is when interest rates are 12-13%, no banks will lend money anyway, and nobody has cash. Nobody but you. Conversely, when lenders are offering easy credit, 125% financing, the lowest interest rates in 40 yrs, etc., this is about as big as the pool of available buyers is going to get. No one knows where the exact saturation point is, but it will come.
As discussed last time, much of the credit creation in this current bubble has taken place outside of the banking system itself. Now I'll invoke the lottery example and suggest that again we need to look at the whole -- the total amount of both money and credit available -- not just one specific part of it. Rather than looking at just the official banking numbers (M1, M2, M3, MZM, etc) for signs of an increasing money supply as we may be used to doing, we must also look at the increase in credit outside the banking system. It has exploded. Credit can affect asset prices just as much as real money. But, alas, at some point the market will get saturated with credit (whose payments still must be made), as the borrower simply cannot afford more payments given his current income. Then there are no new buyers, asset prices begin to fall, credit becomes less available, and the entire scheme goes into reverse.
Debt, Derivatives, SPEs, SPVs, and SUVs
It's quite possible that much of this credit has been effected because of a single faulty premise. If you think that's not possible, let's remember it was a very short time ago that almost the entire internet bubble was brought about by the single flawed premise that advertising would cover the costs of running a web site. Sure, you had some retailers and other businesses trying to sell stuff, but by and large everybody thought they could provide content for free, and make money from advertising. Almost everyone involved with the internet believed that faulty premise.
Where credit creation is concerned, that flawed premise may be the concept of financial insurance. Of all the "financial insurance" products, credit insurance is among the most worrisome. Think of credit insurance as being a bit like co-signing on a loan. If the borrower can't pay, you're on the hook. It would obviously be much riskier to cosign for an irresponsible teenager than for a reputable, able, qualified borrower. However, able borrowers obviously don't need a co-signer.
But Wall Street would have us believe something different. They would have us believe that you can take a bunch of sub-prime auto loans, consumer loans, or mortgage loans, etc., place them into an SPE (Special Purpose Entity) or SPV (Special Purpose Vehicle), slap a credit insurance product on them to turn them into AAA-rated paper, and the risk is somehow hedged away and just magically disappears into the system.
This is nonsense. I contend that not only is credit insurance not an insurance product, but the risks cannot be hedged away, and, in fact, the very existence of such "financial insurance" products is almost destined to bring about the very type of conditions that will expose their speciousness.
The '87 Crash Revisited
If there are two things that we should have learned from the stock market crash of 1987, they are these: (1) portfolio insurance was a flawed concept that served as nothing more than a giant stop-loss order, and (2) writing naked puts on the stock market seems like a great idea when the market is flat or going up, but you can get wiped out in a hurry when there is a large move down.
Now, in my opinion, Wall Street has combined these two great flavors to give us the new and improved concept of credit insurance. I want to make clear that when I speak of credit insurance I'm talking about the type of insurance used during the last 5-7 years (during the boom) in conjunction with the "structured finance" products: asset-backed securities, mortgage-backed securities, collateralized debt obligations, et al. This entire industry, in it's current form, is extremely young -- maybe 10 years old. It is a boom-time creation.
Credit insurance, as a concept, began by companies insuring municipal bond obligations. That, I consider to be a different and legitimate business. You're dealing with a municipality who has taxing authority and is providing a necessity to the citizenry. But then the industry began to expand into insuring other products to the point where in the last 5-7 years, I believe they are taking ridiculous risks in the structured finance area.
An insurable event must be random and mutually exclusive in order for an insurer to be able to pool a number of insureds, do the actuarial calculations, and charge an appropriate premium. Usually an insurable event is one that is mutually exclusive by geography, and/or demographics, and/or industry, and it is also not possible for the events to be contagious or interconnected, etc.
The point can be made clear with an example. An automobile insurance company, for example, may insure drivers in Dallas, Los Angeles, Denver, Omaha, etc. A car accident in Dallas is not going to cause one in Denver. Sure, accidents will happen at the same time in different cities, but it is all more-or-less random, whether happening to a 36-year-old or a 57-year-old, male or female, working in pharmaceutical sales or as a homemaker.
But now lets take that same concept and apply it to one type of financial insurance: stock portfolio insurance. None of the randomness and mutual exclusivity is there. All of your insureds are all taking part in the same event (in this case, a stock market downturn), which is cyclical rather than random. Imagine the CEO of a stock portfolio insurance company boasting, "We have a diversified insurance portfolio. Diversified geographically: we insure against stock losses in Dallas, LA, New York and Omaha. Diversified demographically: we insure people from age 28 all the way up to age 75 against stock losses. We're also diversified by industry sector, insuring against stock losses in the financial, retailing, real estate, and manufacturing sectors. We're very well diversified."
Obviously, such a portfolio is not diversified at all. The losses will come to all of your insureds in one fell swoop when the stock market heads down, regardless of their location, their age, or their industry. Attempting to write insurance for something cyclical is not insurance. It's guaranteed losses at some point, the only question is when.
Self-Fulfilling Problems
But it gets even worse than that. The very existence of financial insurance for something cyclical will almost certainly lead to a boom followed by an inevitable bust -- the very thing the "insurance company" cannot withstand. Just so that we don't over-use the stock market as our only example of "insuring" a cyclical event, let's "insure" against a downturn in the semiconductor industry. What will happen? A boom. It's almost guaranteed. With "insurance" available, every semi manufacturer would go out and build as many new plants as possible in order to gain market share. After all, its losses are limited -- it's got "insurance." Every semi company would do the same. There would be a temporary boom. And the ultimate liabilities for the insurer would only get bigger as the boom grew. You'd get massive over-capacity that would lead to a huge bust in the industry, and huge losses for the insurer. The existence of the insurance product brings about the very bust it cannot withstand.
There is no way you could charge enough for the product because every semiconductor company will have losses. Even if you knew in advance that there would be $5 million in losses for one company, you'd have to charge more than $5 million for the "insurance" policy, because all of your other insureds would have losses too. There are no offsetting "unharmed" insureds (whose premiums you get to keep) to make up for the claims you have to pay out. Everyone would be hit. Everyone would have a claim. Any attempts to hedge the risk dynamically would mean selling into a declining market and would only exacerbate the problem.
Much like insuring against a downturn in the stock market or in the semiconductor industry, the credit insurers are really insuring against a serious downturn in the economy. Loans everywhere will all go bad at the same time. And just as the semi manufacturers thought they could build with reckless abandon because they have "insurance," the purchasers of all this credit are willing to buy with abandon because the securities they are purchasing are insured. They're AAA-rated.
So it seems to me that this type of "credit insurance," can only exist for one of two reasons: (1) it is either massively under-priced and the under-pricing will be exposed during a significant downturn, or (2) it is properly priced and the buyers are stupid to buy it. Personally, I'd lean very heavily toward thinking it's number one. There is huge risk out there somewhere. As we've witnessed with recent events, these things can be hidden for some time. The credit insurers boast of very, very small losses. So small that one wonders why anyone would pay premiums for their products.
Much of the credit creation in the economy has occurred because there are ready buyers of this credit. The purchasers of these structured securities are buying them because they are AAA-rated. This is only possible because of credit insurance. If that insurance becomes too expensive or goes away because the insurers start suffering large losses or receive credit downgrades, etc., the AAA-rating would also go away, meaning the purchasers of these securities would disappear, and much of the credit creation could seize up very quickly. Thus, a significant portion of the money supply could contract, quickly. This is why I do not discount a financial accident scenario. Not to say that it will happen, only that it could.
Many of the hedge funds and leveraged speculators playing the chase-the-yield game and buying these asset-backs and mortgage-backs, et al, could go broke very quickly. Banks could be on the hook for loans to many of those hedge funds. The entire area of structured finance, in its current form, is new and untested by a significant economic downturn. It is a chain of many weak links. Debt, derivatives, credit insurance, hedge funds, special vehicles, banks, etc., are all interconnected. The losses can be contagious. Another LTCM-type debacle is not out of the question. We seem to just keep ignoring these head-on collisions and keep speculating wildly as though nothing happened. Just hose the blood off the dashboard and let somebody new start driving the car.
The Availability Of Financial Insurance Can Disappear Quickly
Interestingly, one of the reasons Kmart cited for having to file bankruptcy when they did was the "evaporation of the surety-bond market." I heard an analyst say that the potential losses from the surety companies on Enron transactions alone (we haven't even discussed the potential for fraud, which tends to be rife during bubbles) could amount to something like 75% of all surety premiums collected by all surety companies for the year.
Many money market funds are dropping default insurance because premiums have soared. USAA, Fidelity Investments, and Putnam Investments, have all dropped insurance. Vanguard and others are considering doing so. Those funds just got a lot riskier. One has to assume they weren't blowing the shareholders' money on insurance for no reason. Now it's no big deal?
My personal belief is that the puny additional yield in money market funds is no longer worth the risk.
If there are huge losses out there, they are likely to show up without warning. Take seriously the fact that money market funds are not federally insured. I will be keeping any uninvested funds in things that are federally insured or direct obligations of the US government. Because yields are so low (another unintended consequence of cramming interest rates down), many money funds are already absorbing expenses so investors don't take losses. There's the potential for funds to take additional risk to chase yield. We should also remember that money market funds are susceptible to the equivalent of bank runs. Obviously not in the sense that there are fractional reserves like at a bank, but in the sense that too many withdrawals could force funds to go bankrupt. Just because this has rarely happened before does not mean the risk isn't there.
Mortgage insurance is another financial insurance product of dubious nature. The Japanese mortgage insurance companies are still suffering to this day, requiring further injections of capital. Many analysts say our property bubble isn't nearly as bad as Japan's. Maybe they're right . . . but maybe not. Before it crashed, we also heard the Nasdaq wasn't a bubble and wouldn't collapse like the Nikkei.
Now, the main argument used to explain that we don't have a housing bubble is that there is no oversupply. There was no oversupply of telecom equipment either. . . . until there was. Companies couldn't keep up with demand. Remember those days? Easy money produced a temporary over-demand of telecom equipment that brought about the oversupply. When the easy money disappeared, the oversupply was exposed. In housing, I believe easy credit has made for a temporary over-demand of housing. When the easy credit disappears, there will be an oversupply.
In a recent article, Joe Birbaum, an executive retiring from Mortgage Guaranty Insurance Corp, urged caution in home lending. That's good. Except we read this, "His definition of high-risk: loans exceeding 100% of a home's value or beyond 103% for low-risk borrowers rolling closing costs into the loan; and deals requiring more than 41% of borrower income for the mortgage payment." So apparently, he thinks 100% loans are not high risk. That's scary.
Structural economic problems are often not readily visible; they're not peeling paint. The building just collapses, seemingly unexpectedly, and for no visible reason. If we have a serious economic downturn, the mortgage insurers will suffer mightily.
Good Times, Loose Morals
Keep in mind, everything gets loosey-goosey when times are good. "Close enough. Let it go through. Big fees riding on this." Normally, when a company sets up an SPE or SPV they must obtain a "true sale" opinion from a law firm, indicating that this really is a sale and not some sort of sham transaction. Stop and think about that concept for a minute. You're selling to such a closely related party that you have to get a law firm to step in and say, "Yeah, this is really a sale, not just two guys pushing paper back and forth to steal money." That's not to say such a structure can't be used legitimately; it's just to point out that this is obviously a very, very close relationship.
Now the bad news. Enron had "true-sale" opinions from a highly respected law firm. We now know that these were anything but true sales. Might there be more out there? If Wall Street is good at one thing, it's making a cookie-cutter and doing the same thing over and over. Everyone's morals become a little looser when easy money is at stake. These types of structured finance transactions have yet do go through a major economic downturn. If large losses are suffered by SPVs, do you think maybe the investors from two different entities might bicker over how the deal was set up? Or might bicker over the remaining assets? Or might sue the deep pockets (the insurers)?
The other day I saw a press release stating that a company had sold a series of AAA-rated sub-prime loans. Only on Wall Street could such an oxymoron be seen as financial genius. But somehow, turning sub-prime paper into AAA-rated paper doesn't sound risk-free to me. Somebody is holding that risk. The credit insurers claim they hedge this risk away dynamically. I don't see how this is possible. Who takes the other side of that trade? They might do it once, but once they take big losses, they won't do it again. The liquidity for such a market will disappear. Many of these SPVs also have a built-in liquidation feature where if the losses get to a level that is to great, the entire thing will be liquidated. "To whom?" one might ask. Liquidity is a coward; it disappears when things get tough.
So to use a stock market analogy, I contend that the purchasers of such credit insurance products are buying something akin to portfolio insurance, and they are buying the insurance from someone who is essentially writing naked, out-of-the-money puts on the economy. Neither is a smart thing.
[And similarly, with the bankruptcies of Kmart, Enron, Global Crossing, et al, many of the large banks are discovering that those credit lines they handed out so freely during the boom, are the equivalent of writing naked, out-of-the-money LEAP puts on a given company: very small fees collected in return for the risk of huge losses in bankruptcy. Worse, they can't "buy back" these LEAP puts in the open market. They just have to sit there and take the pain.]
Enron = MicroStrategy
MicroStrategy was the company that got everyone looking at the dubious accounting of many of the tech stocks. Everyone looked at tech revenues and earnings with a much closer eye after MicroStrategy blew up in March of 2000, if I recall. Enron will likely be the siren to go off for the larger companies and the market as a whole. Bond rating agencies will take a much closer look at companies now. We may now see a race to downgrade as none of the big three wants to be responsible for triggering credit clauses in loan agreements, or derivatives, or off-balance-sheet entities. The accounting will likely get tougher, as the accounting firms don't want to have to pay out huge lawsuit settlements.
We now find out that Enron was recording its revenues much like Priceline was. And the earnings were, well, non-existent. The self-dealing off-balance-sheet partnerships had plenty of profits, however. (It's ironic to see the Federal government, a big abuser of off-balance-sheet accounting itself, sit in judgment of Enron.)
Enron was supposed to be The World's Greatest Company. It now seems Enron's only claim to fame can be that it was Texas' biggest innovator in creative finance since Anna Nicole Smith's groundbreaking work in pioneering the viatical marriage. (In case you're not familiar with the subject, Ms. Smith, a Playboy playmate, married an octogenarian billionaire. Though men often describe her as a woman of "ample personality," whenever I see Ms. Smith on television I immediately become concerned that I may have over-inflated my tires.)
It seems Enron was over-inflating things too. But who hasn't been? And it doesn't have to be fraud. If we just counted stock options as compensation and caused them to be expensed as they should be, earnings would probably fall another 8-15% at most companies. At some companies the earnings reductions would be much, much greater. Employee stock options are basically just another type of OTC derivative. When there is no regulated exchange to establish a market price, the company sort of gets to decide what they're worth. "Uh, we'll choose zero." Fox guarding the hen house. Mark-to-market accounting and gain-on-sale accounting for OTC derivatives work much the same way. "Mark-to-meet-earnings-estimates" may be a more appropriate term.
Pro-Forma, I'm Miss America
Lets pad the top a little bit and pretend that I have long, flowing, blond hair rather than a graying, balding pate. Take a few decades off my age, and cap my teeth while you're at it. Then, imagine my excessive nose and back hair isn't really there. Ignore my pot belly. Strip away the male genitalia (ouch). And finally, make believe my disgusting toenail fungus isn't as hideous as it really is. Do all these things, and you'll see that I'm actually an incredibly attractive, slender, leggy, 21-year-old female who has some very important views on world peace, plus I have the ability to keep every single one of my beautiful teeth exposed while excitedly uttering the phrase, "I'm majoring in COMMUNICATIONS!"
The gap between GAAP earnings and pro-forma earnings has never been greater. The one-time charge is now something that occurs approximately every three months. Big bath quarters, goodwill "cookie jar" reserves, off-balance-sheet transactions, aggressive pension assumptions, revenue swapping, etc., are all part of the game. Companies are not earning as much money as they are saying. It's that simple.
This leads us to a question.
New Economy Or Embezzlement?
The sole purpose of all these financial shenanigans is to make a company appear to be worth more than it really is.
If the company were private and management owned all the stock themselves, they would never report earnings to themselves this way.
It is clearly an attempt to mislead the public into bidding the prices of shares up to higher and higher levels so that insiders can sell out. At its worst, it can become the financial version of e pluribus unum. Roughly translated: from many Global Crossing shareholders. . . . to Gary Winnick.
I believe it was Teddy Roosevelt who said, "A man who has never been to college might steal a railroad car, but a man who has been to college might steal the whole railroad."
Embezzlement means to willfully take or convert to one's own use, another's money or property, of which the wrongdoer acquired possession lawfully, by reason of some office or employment or position of trust.
Not accounting for stock options, misleading accounting, etc., fits the definition of embezzlement, in my opinion. Let's call it what it is.
Employee stock options should either be accounted for fully as expenses, or outlawed for public companies. One or the other. Otherwise it's embezzlement.
Microsoft recently traded at 60 and the Jan '04 calls with a strike price of 60 were trading for 14. Think about that. At-the-money options with less than two years to expiration trade for 14, but employee options expiring in ten years are free, according to the income statement.
If we go the route of expensing options, perhaps we should consider having publicly traded 10-year LEAP options on all companies that issue employee stock options. That way, the market, not some formula, would determine their value. The more glowing hype that management spews about their company, the pricier their 10-year LEAPS would become in the market, and thus, the more expenses the company would have to deduct for new option grants. They would have to pay a current price for offering ridiculously rosy future scenarios.
Employees would not be allowed to speculate in the LEAPS. (And why are employee options for 10 years anyway, with no cost of capital factored in?)
Alternatively, outlawing option grants for public companies is also worth looking into. Contrary to popular belief, I believe options do far more to pit management against shareholders, rather than put them in the same boat. Extensive use of options is only a couple of decades old (coincidentally, the same decades that stocks went up the most in history -- at least partially because of false, overstated earnings; victims are left holding the bag).
Options do much to encourage management to make money off the shareholders, rather than with them. Management has an incentive to issue bad news and drive the stock price down right before the option grant in order to get themselves a lower strike price. Options also encourage unhealthy risk-taking to get the share price up. They provide motivation for accounting chicanery and setting up structures that may be good for a few years (long enough for insiders to sell out) and then blow up later on, a la Enron. They encourage a company to engage in risky vendor financing to prop up sales and earnings short term. The list goes on. They provide much temptation for management to act in an immoral manner. What corporate board is going to vote against an option plan when they get some to? (Even when options "work," money has still been taken from shareholders because they are having to pay a higher price for the stock than it is really worth if all expenses had been accounted for.)
Private startup companies, often short on cash, could still issue whatever options they want. This would also encourage companies to stay private until their house is in order. The big risk-taking would be done in private companies and not with the public's money. But for public companies, pay management in cash after they have produced cash earnings. That way all the expenses will be accounted for. Then let the management buy stock at the market price if they want, so they are in exactly the same boat as shareholders rather than getting free lottery tickets. No sweetheart deals for management. That's the whole idea of being a fiduciary.
Officers are fiduciaries of the shareholders, meaning they are supposed to put the shareholders' interests ahead of their own, not the other way around. They are supposed to watch out for shareholders, not conceal expenses from them.
At the very least, options almost guarantee that at some point the most aggressive accounting possible will be used in order to get the stock price as high as possible. Innocents will get sucked in to purchasing at a falsely inflated price.
Now, consider reading the following headline in your local newspaper:
Strong Sex Drive Leads To Poor Punctuation Study, Says
In other words, sometimes the statement itself gives you some unintended insight into the person making it. This brings us to General Electric. GE is a large company very representative of the economy as a whole. GE's CEO Jeff Immelt recently admitted that he does not see a recovery in 2002, but at the same time announced that earnings would increase by up to 18% in 2002. Not that they might, or that they could, but that they would. Ponder that one. He's telling you the earnings will be up, even before the results have come in. That should tell you something. No executive should be making that kind of statement. If I'm not mistaken, Mr. Immelt's predecessor once remarked that they could grow earnings in any economic environment. A ridiculous statement, unless you know you're going to torture the books until they tell you the number you want.
GE's financing arm can do lots of things to make earnings look better than they are. I have no idea what GE is really earning. I don't think anybody does. Oh, I know what they're reporting, I just don't know what they're earning. I don't know the risks they're taking. But something is very fishy when the CEO announces earnings a year ahead of time.
What Can Get Better?
While many people are saying that the worst is all behind us, I don't see it that way at all. The 90% problem discussed earlier is something we face in many areas of the economy. Companies are already as aggressive as they can be with their accounting. Options aren't being accounted for. P/E ratios are either very near, or way above, all-time highs depending on whose figures you use. Unemployment is still ridiculously low for a recession. Energy prices are back down. Home ownership is at all-time highs. Home equity is at all-time lows even as home prices are at all-time highs. Interest rates are at 40-year lows and everybody has already done a ReFi on their house. Credit is available everywhere. The savings rate is nil. Consumer debt is at all-time highs. Gas is around a buck. Everybody's driving a new car they don't need but got for 0% financing. The dollar is still amazingly strong, even though the trade deficit is enormous. On and on.
What if just a couple of these things start going in the other direction? What if many of them do? Things are already leveraged to the upside in nearly every way. But you can only leverage-up once. After that, what do you do for an encore?
Isn't the risk to the downside much greater than the potential upside?
"Looking Beyond The Valley"
Every time the market rallies, we continually hear stock salesmen tell us that investors are "looking beyond the valley" to the imminent recovery, the improvement in earnings, and the inevitable increase in stock prices. This phrase paints a wonderfully rosy picture. It suggests we are standing on one high point, looking across to another high point (you can't be in the valley and looking beyond it). We aren't even in the valley yet, you see, but once we get there it's going to be so shallow, that it's not really even worth thinking about.
This reminds me of a passage in the book Cadillac Desert (a history of the American west's water resources) that has always stuck with me:
In 1539, Don Francisco Vasquez de Coronado, a nobleman who had married rich and been appointed governor of the Guadalajara by the Spanish king, set out on horseback from Mexico with a couple of hundred men, driving into the uncharted north. . . . .A few of his party on a side excursion discovered the Grand Canyon, but they were unimpressed by its beauty, and guessed the width of the Colorado River far below them at eight feet or so.
This was the biggest bubble in financial history. Step back and have an appreciation for what we're looking at.
If you're "looking across the valley" and plan to journey there, be sure you have a realistic assessment of how wide the valley is, how steep and lengthy the descent into it is, how arduous it may be to get across the valley, and how painstakingly slow and difficult the climb up the other side may be.


Pretty good writer eh?
Remember, that was written in February 2002, Enron was all over the headlines and the market was still eight months from the October 8, 2002 bottom that set up the five-year speculative frenzy that topped out on October 9, 2007.
The author is a fellow named Tim Picks who used to write for Gold-Eagle.
Here's the index of his essays for their site. He seems to have dropped out of sight in 2004.