Posts Tagged ‘Investment Banks’

Paul Krugman: Lest We Forget

Monday, December 1st, 2008


Paul KrugmanPaul Krugman opines that financial reform and regulation of the shadow banking system cannot wait:

Paul Robin Krugman (pronounced /ˈkɹuːɡmən/; born February 28, 1953) is an American economist, columnist, author and intellectual.[2] He is a professor of economics and international affairs at Princeton University, and a columnist for The New York Times. In 2008, Krugman won the Nobel Memorial Prize in Economic Sciences “for his analysis of trade patterns and location of economic activity”. Krugman is well-known in academia for his work in international economics, including trade theory, economic geography, and international finance.


Lest We Forget, by Paul Krugman, Commentary, NY Times: A few months ago I found myself at a meeting of economists and finance officials, discussing — what else? — the crisis. There was a lot of soul-searching going on. One senior policy maker asked, “Why didn’t we see this coming?”

There was, of course, only one thing to say…: “What do you mean ‘we,’ white man?”

Seriously, though, the official had a point. Some people say that the current crisis is unprecedented, but … there were plenty of precedents… Yet these precedents were ignored. And the story of how “we” failed to see this coming has a clear policy implication — namely, that financial market reform … shouldn’t wait until the crisis is resolved. …

Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories?

Why did so many people insist that our financial system was “resilient,” as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world?

Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?

One answer … is that nobody likes a party pooper. While the housing bubble was still inflating, lenders[, investment banks, and money managers] were making lots of money… Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?

There’s also another reason the economic policy establishment failed to see the current crisis coming. … [T]he crisis of 1997-98… showed that the modern financial system, with its deregulated markets, highly leveraged players and global capital flows, was becoming dangerously fragile. But when the crisis abated, the order of the day was triumphalism, not soul-searching.

Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers “The Committee to Save the World”… who “prevented a global meltdown.” In effect, everyone declared … victory…, while forgetting to ask how we got so close to the brink in the first place.

In fact, both the crisis of 1997-98 and the bursting of the dot-com bubble probably had the perverse effect of making both investors and public officials more, not less, complacent. Because neither crisis quite lived up to our worst fears,… investors came to believe that Mr. Greenspan had the magical power to solve all problems — and so, one suspects, did Mr. Greenspan himself, who opposed … prudential regulation of the financial system.

Now we’re in the midst of another crisis, the worst since the 1930s. For the moment, all eyes are on the immediate response to that crisis. … And because we’re all so worried about the current crisis, it’s hard to focus on the longer-term issues — on reining in our out-of-control financial system, so as to prevent or at least limit the next crisis. Yet the experience of the last decade suggests that we should be … regulating the “shadow banking system” at the heart of the current mess, sooner rather than later.

For once the economy is on the road to recovery, the wheeler-dealers will be making easy money again — and will lobby hard against anyone who tries to limit their bottom lines. Moreover, the success of recovery efforts will come to seem preordained, even though it wasn’t, and the urgency of action will be lost.

So here’s my plea: even though the incoming administration’s agenda is already very full, it should not put off financial reform. The time to start preventing the next crisis is now.

Go to Source

More on this topic (What's this?)
The Great Fractional Reserve Banking Scam (Contrarian Profits, 11/28/08)
"Deflation has become inevitable" (naked capitalism, 12/12/08)
Russian Banking System Teetering, Accelerated Withdrawals Underway (naked capitalism, 10/16/08)
Read more on Banking, New York Times Company at Wikinvest

People who read this post also read these:

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,
Posted in Markets | No Comments »

Bill Ackman: Pershing Square Q3 2008 Letter

Thursday, November 27th, 2008


Bill Ackman, Pershing Square Capital Management

Pershing Square Q3 2008 Investor Letter
by Bill Ackman, November 15, 2008 at 11:44 pm

These are extraordinary times particularly for active participants in the capital markets. While I do not normally choose to write about macro and regulatory events, I thought it would be useful for you to understand how we think about recent events and their impact on our portfolio.

We are currently witnessing the greatest deleveraging event in history. What began as a credit bubble bursting has now spread to the equity markets as banks, investment banks, hedge funds, structured products, mutual funds, pension funds, endowments and other leveraged and unleveraged market participants have been forced to liquidate assets by their counterparties, leverage providers, redeeming clients, and as a result of downgrades, other debts or other commitments that need to be funded.

These actions have led to forced and indiscriminate selling in security markets around the world, which in turn has caused other investors to panic or simply to sell, to get out of the way of other forced sellers.

As a fund which is generally substantially more long than short, we have also suffered large mark-to-market declines in our long investments. Year to date, however, our performance has substantially exceeded that of the broader equity markets, which at this writing have seen a more than 34% decline. Our outperformance is largely due to large gains on our investments in Longs Drugs and Wachovia Corporation as well as profits on our credit default swap and other short exposures. Our market losses have been further mitigated because we operate unleveraged and have substantial cash balances. Currently, we have cash and near-cash (Longs Drugs and Wachovia/Wells Fargo long/short) equal to approximately 39% of our capital.

When, you might ask, will the selling end? While I don’t proclaim to be a market prognosticator, I will make a few observations. Unlike the deleveraging that takes place when banks and other financial institutions sell assets to meet regulatory requirements, which is typically a longer term process, the forced deleveraging that is now taking place in the equity markets is being implemented largely by the prime brokerage firms and margin account managers at broker dealers around the world. Prime brokers are not known to be laggardly in their approach to liquidating an account that no longer meets margin requirements. This is likely to be even more true in the current environment. As such, it may be reasonable to conclude that the forced liquidation that is now taking place may not be a prolonged process.

Security prices around the world have come down tremendously. In the larger capitalization U.S. markets, which are the focus of our strategy, the reductions have been substantial. As of the market close on October 31st, the S&P 500 is down 34.0%, year to date, and down by 37.5% from its high on October 31, 2007; and this is after last week’s rally in which the S&P 500 rose more than 12% from the lows. Unlike the bear market of 1973 and 1974, in which stocks declined by 45% from the highs, this bear market was not preceded by the “Nifty 50″ bubble in which large capitalization growth stocks traded at extraordinary valuations. While valuations were not cheap one year ago, in a long-term historical context, the market as a whole (particularly if one were to exclude financials) was not particularly expensive either.

As such, in today’s market, we are finding extraordinary bargains, the kinds of opportunities that are normally associated with market bottoms. While there are still weak and poorly capitalized businesses that are likely still overvalued, the high quality, well-capitalized, larger capitalization businesses which are the focus of our strategy look very cheap to us.

While this means that now is likely to be a much better time to be a buyer rather than a seller, it does not mean that the market will not continue to decline, even substantially, from current levels, particularly in the short term. In fact, because of tax-loss selling over the next 60 or so days, there will likely be additional selling pressure. At some point, however, the forced selling will come to an end. Large amounts of cash are sitting on the sidelines waiting to be deployed when investors feel the coast is clear. In the event the market were to start to rise again, it would not be a surprise to see institutional, retail, and hedge fund investors rapidly deploy capital so as not to miss a, perhaps, explosive market rally.

What does this all mean for Pershing Square? Despite the fact that we occasionally have an opinion, we spend little time trying to outguess market prognosticators about the short-term future of the markets or the economy for the purpose of deciding whether or not to invest. Since we believe that short-term market and economic prognostication is largely a fool’s errand, we invest according to a strategy that makes the need to rely on short-term market or economic assessments largely irrelevant.

Our strategy is to seek to identify businesses and occasionally collections of assets which trade in the public markets for which we can predict with a high degree of confidence their future cash flows - not precisely, but within a reasonable band of outcomes. We seek to identify companies which offer a high degree of predictability in their businesses and are relatively immune to extrinsic factors like fluctuations in commodity prices, interest rates, and the economic cycle. Often, we are not capable of predicting a business’ earnings power over an extended period of time. These investments typically end up in the “Don’t Know” pile.

Because we cannot predict the economic cycles with precision, we look for businesses which are capitalized to withstand difficult economic times or even the normal ups and downs of any business. If we can find such a business and it trades at a deep discount to our estimate of fair value, we have found a potential investment for the portfolio. Next we look for the factors that have led to the business’ undervaluation, and judge - based on our assessment of the company’s governance structure, management team, ownership, and other factors - whether we can effectuate change in order to unlock value. When the price is right, the business is high quality, the management is excellent, and there are no changes to be made, we are willing to make a passive investment.

Our assessment of the short-term supply and demand for securities plays almost no role in our determining whether to invest capital, long or short. If we believed that it was possible to accurately predict short-term market or individual stock price movements and we had the capability to do so ourselves, we might have a different approach. Below I quote Warren Buffett in his 1994 Letter to shareholders where he perhaps says it best:

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results…

Stock prices will continue to fluctuate - sometimes sharply - and the economy will have its ups and down. Over time, however, we believe it is highly probable that the sort of businesses we own will continue to increase in value at a satisfactory rate.

I believe we will look at the current U.S. stock market valuations for high quality mid and large capitalization businesses as presenting perhaps the best investment opportunities of our lifetimes.

Portfolio Update

The last quarter and, in particular, the last few weeks have been an extraordinarily busy and productive time for Pershing Square. During this time, we have made considerably more buy and sell decisions than usual, taking advantage of the liquidity of our holdings, the enormous volatility of the market, and new opportunities that have presented themselves in recent weeks.

In the third quarter, we disposed of our investments Cadbury PLC, Canadian Tire, and Austrian Post at prices generally higher than current levels. We also disposed of the substantial majority of our investment in Sears Holdings. We hold a residual interest in Sears (which represents approximately 1.5% of fund capital) as its price declined to a level at which it made no sense to continue to sell. We redeployed the capital from these sales into Wachovia Corporation, which I will discuss further below, as well as a new investment in which we are in the process of accumulating a position.

We sold these positions not because we thought they would be poor investments, but rather because we believed that we could redeploy the capital in investments that offered a more attractive risk-reward profile. As we have often stated, we are always willing to sell an existing holding at a profit or a loss, if we can find a better use for the funds. For our taxable investors, sales at a loss have the additional benefit of offsetting taxable gains.

Our sales were also motivated by the fact that three of the above companies - Sears, Canadian Tire, and Austrian Post - each have a controlling shareholder. Because we believe that one of our important competitive advantages is our ability to effectuate change at companies in our portfolio, other than in special circumstances, we do not expect to make investments in controlled companies in the future.

As a result of recent changes in the portfolio and strategic developments with respect to Longs Drugs and Wachovia Corporation, our long portfolio is now comprised of higher quality, more economically resilient businesses, companies for which we can be a catalyst to create value, and a large amount of cash and soon-to-be cash that we can redeploy in new opportunities.

On the short side of the portfolio, we have been opportunistic in unwinding single-name credit default swaps in cases where spreads have increased significantly, and have covered certain short positions where stocks have declined substantially as a result of company-specific as well as market-related events. We recently repurchased CDS on the investment grade credit index as certain technical factors have made this investment/hedge attractive once again.

Longs Drugs

In last quarter’s letter, I alluded to a new position on which we expected to file a Schedule 13D shortly. That position was Longs Drugs, a West Coast based drugstore retailer. While Longs’ was valued in the market as an underperforming drug store retailer, we valued the business based on its component parts which included: (1) owned and long-term, below-market, leasehold real estate, (2) RxAmerica, a rapidly growing pharmacy benefit manager (”PBM”) which generated more than 20% of the company’s trailing operating income, and (3) an underperforming, low-margin drugstore retailer. At our cost, we believed that Longs real estate value alone more than covered our purchase price and we were getting the PBM and the retailer for less than free. We estimated the fair market value of the company to be $85 to $95 per share assuming each of the company’s assets was sold to the buyer who could pay the highest price.

Unlike many of our previous active investments, we concluded that Longs had reached the end of its strategic life and should be sold to one of its larger competitors, namely CVS or Walgreens. While it has been rare for us to buy a stake in the company with a view that a strategic sale was the right exit opportunity, we have done so in the past. For example, our original investment in Sears Roebuck & Company was predicated on a strategic outcome at the company which was ultimately achieved when it was acquired by Kmart.

In the current weak (to use a euphemism) credit environment, we are particularly wary of investments which are predicated on a sale. However, in this case, we were comforted by the fact that Longs Drugs would be a must-have acquisition for CVS and Walgreens and that both companies, which are many times the size of Longs, could easily finance the acquisition. Even in the event a sale did not go through, we had purchased Longs at an attractive price which offered a substantial margin of safety against a permanent loss of capital.

Within one week of our 13D filing, Longs announced that it had entered into a transaction to be sold to CVS for $71.50 per share in a cash tender offer, an approximately 44% premium to our average cost. While we were happy with the deal, we were somewhat unhappy with the purchase price, particularly when we learned that the company had not run a competitive auction. Thereafter, we hired the Blackstone Group with whom we have worked successfully in past transactions in an attempt to achieve a better outcome for all shareholders.

We and Blackstone were successful in attracting a bid of $75 per share from Walgreens; however, the greater regulatory risk and potential time delay in a transaction with Walgreens led Longs’ board to reject the transaction in favor of the CVS offer. Walgreens subsequently withdrew its offer citing market conditions, and a day later, the CEO of Walgreens stepped down. We anticipate that we will be fully cashed out of our investment in Longs’ by the close of trading today.

Wachovia Corporation

Wachovia is a good example of the types of opportunities that have emerged in the current highly volatile environment. On Monday morning September 29th, Wachovia Corporation announced that it had entered into an agreement in principle to sell its banking subsidiaries to Citigroup. The transaction was structured in an unusual manner. In the deal, Citi was paying $2.1 billion of its own stock to Wachovia Corporation (the publicly traded holding company for the Wachovia banking subsidiaries) and assuming $53 billion of senior and subordinate holding company debt in addition to the debt and other liabilities of the Wachovia banking subsidiaries. The description of the transaction was limited to a several paragraph press release and a conference call presentation by Citigroup that morning. Wachovia stock opened later Monday afternoon at approximately $1.80 per share, down 82% from Friday’s close.

The market’s reaction to the Citi transaction was severe, particularly as the transaction was announced only four days after Washington Mutual’s subsidiary banks were seized by regulators and sold to J.P. Morgan. In that transaction, WaMu’s holding company filed for bankruptcy, wiping out shareholders and materially impairing holding company creditors.

The Wachovia transaction, however, was structured in a materially different manner from the WaMu seizure. It appears that the government, in order to protect bank holding company bondholders from losing their investment and perhaps to avoid triggering a CDS credit event, structured this deal so that Citi would assume the holding company debts. Interestingly, as part of the Citi transaction the government provided an excess-of-loss guarantee on Wachovia mortgages to protect Citi, which the government could likely have avoided if it had not required Citi to assume $53 billion of holding company debt. It appears that the government had concluded that additional bank holding company debt defaults would create systemic risk or reduce the ability for bank holding companies to access this important source of capital, and therefore chose to protect the Wachovia banking subsidiary and the holding company bondholders.

The unusual structure of the transaction created an interesting investment opportunity. By removing the holding company debts, Wachovia Corporation, now orphaned from its bank subsidiaries was left with some very attractive assets. Based on our reading of the public filings, conference call transcripts, and internet research over the course of Monday morning and afternoon, we estimated that Wachovia was left with the following assets: approximately $2 billion or more of cash, $2.1 billion of Citigroup Stock, the Wachovia Securities wealth management operation, A.G. Edwards (which had been purchased one year ago for approximately $7 billion), Evergreen Asset Management (a mutual fund manager with $245 billion in assets under management), Wachovia Insurance Services, and other ancillary assets.

In light of the Citi debt assumption, the only material liability of Wachovia Corporation was $9.8 billion of non-cumulative, perpetual preferred stock. Because this preferred is both non-cumulative and perpetual, Wachovia has no obligation to ever pay a dividend on these securities making these liabilities effectively a free form of equity financing. These types of preferred securities are typically structured to qualify as an attractive form of bank holding company equity which gets favorable regulatory and rating agency treatment. Now that they were orphaned by the transaction, at best these liabilities were worth less than 50 cents on the dollar.

We also determined that the structure of the transaction would create a large tax asset for the holding company. By selling the bank subsidiaries for less than their net tangible asset value, we estimated that a $26 billion tax loss would be created. This tax loss could by carried back two years enabling the holding company to recover approximately $7.5 billion of cash taxes that had previously been paid.

Our conservative estimate of value of New Wachovia was in excess of $8 per share even assuming that the preferred stock was redeemed or valued at par. We began buying the stock shortly after it opened on Monday afternoon. My instructions to our traders Ramy Saad and Erika Kreyssig were to buy every share we possibly could, including pre- and post-market trading. They did a superb job.

Between Monday afternoon and late Thursday we acquired 178 million shares, or approximately 8.3% of the company, at an average price of $3.15. On Friday morning before the open, Wells Fargo announced a definitive agreement to acquire Wachovia for 0.1991 shares of Wells common stock, or more than $7.00 per share based on Friday’s trading price. We began selling our Wachovia stock on Friday. We could not, however, hedge the Wells Fargo stock price because the short selling ban was still in effect.

Citi, which thought it had an exclusive to complete the transaction with Wachovia, brought litigation later that Friday to enjoin the Wells Fargo deal. By late the following week, Citi, likely as a result of pressure from the government, had agreed to allow the Wells transaction to go forward while retaining their lawsuit for damages against Wells Fargo.

As of this date, we have hedged 100% of our exposure to Wells Fargo shares, and have been opportunistic in unwinding a substantial portion of the position. Assuming we waited until transaction closure and taking into consideration Wachovia shares already sold, we have locked in a 67% profit on this $560 million investment.

The government and all of the parties appear to be doing everything they can to consummate the transaction promptly. The transaction received HSR approval in one day and the Treasury and banking authority approvals over the following weekend. Wells has been issued 39% of the voting stock of Wachovia and transaction closure is anticipated by year end. The transaction requires the recently filed form S-4 to be approved by the SEC and the completion of the mechanics of the shareholder meeting in order to be consummated. It is an excellent deal for Wells Fargo and for Pershing Square.

A Mistake

While most of our long investments are comprised of great businesses or assets at fair prices with a catalyst to create value, we occasionally are willing to invest a small amount of fund capital in situations which offer the potential for a many-fold profit at the risk of a large or near-total loss of capital invested. I typically call these investments mispriced options. Our CDS investments fit this profile. While not all mispriced options will be profitable for the funds, I expect our collective experience in these commitments to be quite favorable over time.

We purchased stock in American International Group, Inc. (AIG) after the announcement of the government bailout. In summary, we did so because at the price paid, we purchased AIG at a substantial discount to book value, and we believed that book value was a conservative estimation of the value of AIG’s underlying businesses net of derivative losses. We also believed that there was the potential for a renegotiation of the government’s extremely harsh financing commitment to AIG which provided for 80% dilution, enormous commitment fees, and a high interest rate.

In particular, we believed that if AIG could pay back the government promptly through a combination of asset sales, termination of certain CDS contracts at potentially less than fair market value, and equity investments from existing and potentially other investors, that there was a chance to renegotiate the 80% zero-strike warrant package to the government. If the warrant dilution could be mitigated, it would be possible for AIG shareholders to make a many-fold return on investment. Initially, we believed that the potential for return outweighed the risk of loss. Because of the inherent leverage of AIG, the risk of a permanent loss of capital on this investment was material. As such, we limited the size of our investment to 2.5% of fund capital.

After acquiring our position, we met with other large holders, policymakers and contacted Berkshire Hathaway and other potential investors about a proposed recapitalization of AIG. Unfortunately, the collection of shareholders that were attempting to restructure the government deal was exceedingly disorganized and some large holders were conflicted by a desire to buy certain assets from the company.

We ultimately concluded that the return on invested brain damage from this investment exceeded the probability-weighted opportunity for profit, and we decided to fold the tent. We sold our stock and incurred a modest loss to the funds.

Our Business Model

In order to achieve long-term success, Pershing Square must make good investments and operate with a robust business model. With much media attention focused on hedge fund failures, I thought it would be worthwhile reviewing the characteristics of our business model and explaining why we will withstand industry-specific and overall environmental threats to the investment and hedge fund businesses. The principle factors which contribute to the robustness of our business model are as follows:

* Our portfolio management approach is inherently low risk (where risk is defined as the probability of a permanent loss of capital), particularly when compared with other hedge fund business models. An important distinguishing factor about Pershing Square compared to most other hedge funds is that we do not generally use margin leverage in our investment strategy. The lawyers prefer that I put in the word “generally” to give us the flexibility to use margin to manage short-term capital flows, but, to-date, we have not used any but an immaterial amount of margin, and only for a brief period of time, and we have no intention of changing this approach,
* We generally invest in higher quality businesses with dominant and defensive market positions that generate predictable free cash flow streams and that have modestly or negatively leveraged (cash in excess of debt) balance sheets. We buy these businesses at deep discounts to our estimate of intrinsic value giving us a margin of safety against a permanent impairment of capital. I say “generally” again here because we do make exceptions in certain limited circumstances; that is, we may buy a more leveraged or lower quality business if we believe the price paid sufficiently discounts the risk.
* We often seek investments where we can effectuate positive change to catalyze the realization of value. This serves to accelerate the recognition of value, helps us avoid “dead money” situations, and protects us somewhat from managerial actions which can destroy value.
* We are diversified to an adequate but not excessive extent. This has further benefits for risk and operational management which I will discuss below.
* There is an inherent balance to our long/short investment approach. Historically, when equity or credit markets weaken, our shorts become more valuable, and occasionally materially more valuable, offsetting somewhat the mark-to-market declines in our long portfolio. If we choose to unwind these short positions during market downturns, we can generate capital to invest in a now less expensive market. These short investments generally stand on their own in that they do not typically require a stock market or credit market decline to be successful. That said, they have served as a useful hedging tool during periods of dramatic market declines.
* We have been paranoid about counterparty risk since the inception of the firm. First, we trade with counterparties which we believe to be creditworthy. Second, we have negotiated ISDA agreements which provide us with daily mark-to-market cash and U.S. Treasurys equal to the previous day’s market value of our derivative contracts. In cases where we are required to post initial margin and therefore have some exposure beyond the market value of our derivative contracts, we have typically purchased CDS on our counterparties to further mitigate counterparty risk. While our approach to counterparty risk has protected us from any counterparty losses to date, please be forewarned there is no perfect approach to avoiding counterparty risk.

Our simple approach to investing also allows us to avoid complicated approaches to risk management. Our investment strategy does not require us to open offices all over the globe. As such, we don’t need traders working around the clock. We can go to sleep at night and sleep. Our weekends are largely our own (Ok. I admit it. I am writing this letter in the office on Sunday.) Our risk management approach is to: (1) put our eggs in a few very sturdy baskets, (2) store those baskets in very safe places where they cannot be taken away from us and sold at precisely the wrong time due to margin calls, and (3) to know and track those baskets and their contents very carefully. We call this approach the sleep-at-night approach to risk management. If I can’t, we won’t.

I am extremely skeptical of more automated, algorithmic, Value at Risk, and other business school sanctioned approaches to risk management. None of these approaches saved Lehman, Bear Stearns, Fannie, Freddie, AIG, WaMu, Wachovia or any of the other institutions that used these and other ostensibly more sophisticated risk management strategies.

Our investment strategy and approach to counterparty risk serves to limit the risks inherent in our individual investment selections, our counterparty risk, and the portfolio as a whole. There are, however, other important risks to our business, principally operational, reputational, and regulatory risk.

Operational Risk

Our investment approach is largely straightforward and relatively simple. This, coupled with the concentrated nature of the portfolio, allows us to run our business with a limited number of personnel. We have five senior investment professionals including myself. Shane Dinneen, still officially a junior investment professional, is fast earning his stripes as an eventual senior member of the team.

We could manage our portfolio with less human talent than we have. For members of the investment team reading this letter, don’t be concerned because I have no intention of shrinking the team, but I make the point nonetheless. Simplicity in our investment approach allows for a simpler back office and a smaller overall staff. We have 31 people total at Pershing Square. It could be fewer, but one of Tim Barefield’s (our COO) important risk management principles provides for back-up talent for every role in the firm.

Our Noah’s Ark approach to personnel duplication makes for a good analogy for the ship we have designed. We have worked hard to build a business that can withstand the Great Deluge, and this goes beyond counterparty risk. For example, it is not yet clear this year whether there will be any incentive allocation to be shared at the firm. That said, whether or not the funds’ finish the year in the black, it will be extremely unlikely that a member of our team leaves by choice, and I have no intentions of letting anyone go. This is due to several factors:

* Pershing Square’s large amount of assets under management per investment principal and per overall employee are important ratios to consider when evaluating the sustainability of Pershing Square or any hedge fund for that matter. The economics of a high Asset per Employee ratio attract and allow for the retention of top talent. Our team can be compensated appropriately even in times of short-term underperformance. Hedge funds which barely (or don’t even) cover their costs with management fees are inherently unstable enterprises because in an unprofitable year they cannot pay their people and are likely to lose their most talented professionals to other firms.
* Pershing Square is a nice place to work. While this sounds like an obvious approach to retaining talent, many and perhaps most hedge funds don’t fit this description. We are big believers in taking care of our team not just financially and with attractive benefits, and we have those in spades. We consider every employee at the firm a member of our extended family, and we treat and care for them appropriately. We do this not for business reasons, but it has important long-term business benefits.
* Pershing Square is an extremely exciting place to work. We believe our work creates value beyond the profits we historically have generated for our investors. Our approach to value creation at businesses has created enormous value for investors who happened to own companies to which we contributed to the creation of value. Similarly, investors and counterparties who listened to our views on the bond insurers, Fannie Mae and Freddie Mac, etc. saved themselves from large losses or perhaps profited by short sales. The fact that our work creates value for the markets as a whole provides additional motivation to the team.

Bottom line, we are built to last, and we will continue to work hard to deserve your continued support.

Reputational and Regulatory Risk

Reputational risk is one of the key risk factors for a business that is subject to a high degree of regulatory scrutiny in an industry that seems to generate considerable public scorn. Our approach to assessing reputational risk is to apply the New York Times test. We ask ourselves whether we would be comfortable having our family and friends read a front page New York Times story about actions taken by Pershing Square written by a knowledgeable and intelligent reporter who has access to all of the facts. If we are comfortable with such an article being read by our close friends, our families, and the public at large, our action passes the test. If not, we reconsider our potential action.

More recently, I have decided to participate in the public dialogue about hedge funds, agreeing to occasional appearances on television or otherwise talking to the press, speaking at industry events, meeting with Congressman, Senators, and other officials. I do so not for any desire for public recognition, but rather because I believe that it is important for the hedge fund industry to come out of the shadows and defend the importance of our work. If we and others (that includes hedge fund investors in addition to the managers) don’t do so, the industry, in my view, is at even greater risk of further regulatory, tax, and other legal changes that will materially harm our business models and industry.

One does not need to look further than the recent short selling ban which was an extremely ill-advised regulatory change that contributed to market turmoil and the recent market decline. By imposing a ban on an investment approach that has been legal for generations with no warning or opportunity for public debate, the SEC caused a short squeeze and subsequent market disarray that wiped out large amounts of hedge fund capital, caused forced selling as long/short, market neutral, quantitative, and other managers had to sell long positions to rebalance their books. More significantly, it cost the U.S. capital markets its highly respected position as an exemplar free marketplace where the rule of law prevailed. It also contributed to hedge fund underperformance, thereby leading to investor redemptions, further reducing industry capital.

I believe the short selling ban also contributed to continued market declines since the ban was put into place. In that hedge funds are among the most opportunistic investors in the world, destroying large amounts of hedge fund capital likely contributed to market declines because of a dearth of opportunistic hedge fund buyers who would normally step in and purchase the compelling values created by falling markets.

Even though the restriction on short selling has been eliminated, the longer-term consequences of populist regulatory actions will continue to be felt by the markets and its participants until such time as our securities regulator makes clear that the U.S. will never again change the rules of the game mid play.

Specifically, the short selling ban was harmful to Pershing Square because we lost the opportunity to lock in even greater gains on our Wachovia investment by not initially being able to hedge our Wells Fargo exposure. I estimate this loss at approximately 3% to 4% of fund performance. This loss was somewhat offset by our ability to sell certain investments into the short squeeze at higher than anticipated prices. We were otherwise not materially affected because short selling equities has not been a material part of our investment program, although we did cover one large equity short at a loss which is now trading at a more than 40% lower price, another 4% to 5% potential loss of profit assuming we had not covered at higher prices.

Hedge fund investors - the pension funds, state plans, charitable, healthcare and other institutions and the individuals who invest in hedge funds - are a much more appealing constituency to defend the industry than the managers themselves. I encourage you to consider becoming part of the public debate on the industry. We collectively need one another’s support.

Investor Risk

The stability of a hedge fund’s capital base is critical to its long-term success. We have endeavored to attract high quality investors who have a deep understanding of our investment approach. We do our best to continually inform you of the progress of our holdings and business, and remind you of the inherently volatile nature of our concentrated strategy. Our investment strategy is also transparent. The nature of our approach requires most of our holdings to eventually be disclosed publicly. As such, it is easier for you to understand how we have made and lost money over the years, and to assess our ability to replicate our historic strategy and performance.

Over the last nearly five years, we have delivered very little of the volatility that investors are concerned about, that is, downward volatility. As such and with strong historical performance, we have not “tested” our investor base. We hope never to “test” our investor base.

While we have considered a longer-term lock-up structure, we chose not to modify our existing liquidity terms because we did not want our terms to be overly burdensome to investors and to present a hurdle to the reinvestment of capital, particularly during a period of temporary underperformance. Year to date, we have had minimal redemptions. New commitments have exceeded our redemption requests by approximately 3 to 1. We have a pipeline of new prospects that are in the process of completing their due diligence. That said, the continuity of our investor base is a long-term success factor for the funds and for this we are relying on you.

Is Now a Good Time to Invest in Pershing Square?

I have never before suggested that one time or another would be a better time to invest in Pershing Square. I am going to take the risk of doing so now. At the risk of sounding promotional, I believe that now is perhaps the best time in our history to increase your investment in Pershing Square. A few thoughts to consider:

When one invests in Pershing Square today, with respect to our current portfolio and potential opportunities in the market, the spread between price and value is the widest it has been since the inception of Pershing Square and likely over the last 30 or more years in our opinion. Investments like Target Corporation which we purchased initially in the mid to high $50s per share now sell at approximately $40 per share and there has been no meaningful diminution in the per-share value of Target since our initial purchase 18 months ago. In fact, the probability of Target and other Pershing Square holdings implementing a value-creating transaction are higher today than before because of management and shareholder frustration with current share price levels. Consider that Target management options are nearly all out of the money, and a meaningful number of vested options will soon likely expire worthless if there is no change in the status quo.

An additional investment in Pershing Square today also purchases a pro rata interest in our cash and near-cash investments. While purchasing cash indirectly is not an inherently attractive proposition, we are currently analyzing a number of long and short investments that appear extremely interesting, and subject to completion of our due diligence, may become large new commitments. While for the first nearly five years of our business, we found only a limited number of interesting opportunities, albeit a sufficient number to generate attractive returns, we are now presented with tens of intriguing situations that are worthy of careful review. One could reasonably conclude that the greater spread between price and value and a wider selection of attractively priced opportunities will lead to higher rates of return on these commitments than during previous periods of greater market efficiency which characterized the first four years of the funds’ existence.

While many have portrayed the current environment as a highly risky time to invest, these individuals are likely confusing risk with volatility. We believe risk should be determined based on the probability that an investor will incur a permanent loss of capital. As market values have declined substantially, this risk has actually diminished rather than increased. Risk is high now for the leveraged short-term investor, but actually much lower for the unleveraged, long-term investor in high quality, mid and large capitalization, modestly leveraged businesses.

Unlike levered hedge funds whose risk increases as NAV declines, Pershing Square’s risk has declined with the recent decline in the value of our portfolio. Why? This is due to the fact that a leveraged manager’s probability of being sold out by its prime broker increases as its portfolio’s equity declines. Many hedge fund strategies are confidence and credit sensitive because they require continued access to low-cost financing. Recent declines may also require leveraged hedge funds to post additional collateral on trades which did not require an initial down payment. Because our investment strategy does not require leverage to operate, recent increases in financing costs and reductions in leverage afforded to hedge funds have no impact on our current or future prospects. In our case, the margin of safety of our investments actually increases, the greater the decline in our holdings’ share prices. We, of course, also have no margin leverage creating the risk of a forced sale. So yes, I believe now is a good time.

Pershing Square Advisory Board Addition

Matt Paull joined the Pershing Square Advisory Board on September 1st. For some of you, Matt’s name may be familiar for he was formerly the CFO of McDonald’s Corporation before his retirement earlier this year. I have known Matt for about 10 years, and interacted with him intensively in mid to late 2005 and in early 2006 when Pershing was advocating for change at McDonald’s.

As CFO of McDonald’s, Matt was one of the most highly regarded public company CFOs in the country. Shareholders were the beneficiaries of superb capital allocation and strong share price appreciation during his tenure as CFO. I consider it one of Pershing Square’s greatest accomplishments that we were able to garner Matt’s respect and friendship even though there were occasionally contentious moments during our engagement with McDonald’s.

Matt has already proved enormously helpful in our interactions with Target Corporation. As a former CFO, particularly one that has been on the other side of one of Pershing Square’s most significant engagements, Matt brings a uniquely valuable perspective to the firm and to the management teams of our portfolio companies.

In addition to his Pershing Square advisory role, Matt is currently serving on the business school faculty of University of San Diego.

Organizational Update

We completed our move to the 42nd floor of 888 Seventh Avenue in August. The second time round, we really got it right. The space is beautiful, promotes communication, and is extraordinarily well organized and efficient.

After the move, we made several additions to the team. Courtney Leonardo and David Robinson joined the IR team in administrative roles, roles which had previously been filled by temporary employees. Alex Song joined us from Goldman Sachs as the newest junior member of the investment team. Amy Stern joined the Finance and Accounting team from Tiger Global, and will focus her efforts on management company accounting. Amy is also attending the NYU Stern School of Business where she is working on a business school degree. Jill Skousen replaced Whitney Stodtmeister as the administrative assistant for the investment team after Whitney moved to Santa Barbara. Helena Tunner joined us to work with Dianna Baitinger at front desk reception.

On other news, Alex Kaufmann of our IR team will be attending Columbia University’s Executive MBA program on Fridays and weekends. We are big believers in continuing education for our personnel.

As always, we are extremely appreciative of your support, particularly during uncertain times. If there are any questions I have failed to answer above, please call Doreen, Alex, Ashley or myself.

Sincerely,
William A. Ackman



People who read this post also read these:

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,
Posted in Markets | No Comments »

McCulley: The Paradox of Deleveraging will be Broken

Monday, November 24th, 2008


Paul McCulley, Managing Director and Portfolio Manager, PIMCO, earlier this year wrote a landmark discussion piece titled, “The Paradox of Deleveraging,” in which he postulated that the deleveraging of the credit market would have a profoundly negative impact that only a government sponsored plan could subdue, as no other party could be big enough to slay the affliction of credit abuse in the housing, investment and banking industries. Here is the follow up:

I’ve only written this essay once since the Kansas City Fed’s annual symposium in late August.1 But it hasn’t been because I’ve been lazy. Rather, I’ve been working virtually around the clock ever since, in my day job as head of PIMCO’s Money Market and Funding Desk. On Wall Street, this desk is frequently viewed as a backwater, a temporary home for new MBAs getting their feet wet before moving on to higher-value-added desks, or a retirement home for those with more senior moments than fresh ideas.

That’s never the case here at PIMCO, even though a number of now PIMCO partners spent their first days trafficking in the money markets and I, of ever-graying hair, still make my home here in the early hours of the day. Money markets frequently are a backwater, except when they are not, in which case they are cascading rapids. Liquidity pressures inevitably are the precursor of solvency and/or going-concern problems. Just ask Wall Street’s independent investment banks.

We here at PIMCO have always known this. Accordingly, we’ve always been conservative beyond conservative in our money market operations, on both sides of the balance sheet - no asset-backed commercial paper (ABCP) for us, and no tri-party repo without regard to collateral types or haircuts either. Meat and potatoes only, no fancy garnishes necessary. But the meat and potatoes must be cooked properly.

Hence, the work load of PIMCO’s money market and funding desk. My new deputy, Jerome Schneider, hit the ground running in early August, a most propitious time, just before the global money markets became not just cascading rapids, but roaring waterfalls. The financial world will never be the same after the U.S. Treasury and Federal Reserve’s fateful decision of the weekend of September 13-14 to stand aside as Lehman Brothers plummeted to death on the rocks below.

Whether that decision was the right one or not, we will never know. Yes, I know that many are quick to take the Treasury and the Federal Reserve to task, maintaining that the on-going global financial crisis - and, thus, growth crisis - would not be nearly so severe if Lehman had been tossed a life line. I simply don’t know. What I do know is that the global financial system was fundamentally broken long before Lehman’s watery death.

Thus, I believe the powerful, systemic policy responses that have unfolded in the post-Lehman world were destined to come about. Lehman was but the unfortunate tipping point. My heart still aches for the pain suffered by my many friends there. Fate is not always fair and at times, is arbitrary and capricious.

But what ailed Lehman was but a manifestation of what ailed, and ails the global financial intermediary system: the presumption that grossly levered positions in illiquid assets can always be funded, because those doing the funding will always assume the borrower is a going concern.

To understand the nature of this systemic malady, we need to return to first principles. Bear with me, please; this is going to be a bit academic. But, I submit, it was the loss of understanding of first principles that lies at the heart of the on-going paradox of deleveraging, which is the proximate cause of the on-going downward spiral of asset and debt deflation.

The Nature of Banking
When I studied the origins of banking in college, we started with the Medici Family of 15th century Italy. I’m quite sure banking existed long before then, just that I haven’t studied it. But regardless of the origins of banking, its founding premise has always been the same: In normal times, the public’s collective, ex ante demand for access to at-par, immediately-available bank money is always greater than the sum of the public’s individual, ex post demand for access to such liquidity.

Thus, the genius of banking, if you want to call it that, is simple: a bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is notionally of finite maturity, as short as one day in the case of demand deposits.

It’s the same alchemy that permits mutual funds to commit to next-day redemption at tonight’s NAV, even though all reasonable people know that a mutual fund - with the possible exception of a money market fund - could not possibly liquidate all assets on the wire tomorrow at tonight’s NAV marks. Systemically, it’s the illusion of liquidity, as so elegantly described by John Maynard Keynes:

“The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment.

For the fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma.

So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organizing markets wherein these assets can be easily realized for money.”2

Yes, liquidity for all at last night’s marks is an illusion. But for banks, unlike mutual funds, it’s not so much an illusion after all, for two simple reasons: banks have access to deposit insurance underwritten by fiscal authorities and to a discount window underwritten by the monetary authority (and one step removed, the fiscal authority). Thus, banks are unique institutions, providing a “public good:”

*
Liquidity on demand at par for their depositors, because of the safety net underwritten by the sovereign, yet
*
The ability to invest in longer-dated, more risky, not-always-at-par loans and securities, because the existence and credibility of the public safety net systemically renders the public’s ex post demand for liquidity at par below the public’s ex ante demand.

Yes, banking with a sovereign safety net against deposit runs is a really cool business. Indeed, the difference between the public’s ex post and ex ante demand for at-par liquidity could be called the banking system’s “float,” similar to that of a Buffet-style insurance company.

But since it’s a really cool business and since the sovereign providing the liquidity safety net is a de facto equity partner in the business, the sovereign quite rationally wants a say in how the business is run - the degree of leverage, corporate governance, risk management controls, etc. Kinda like I do when I pay the insurance premium on my 19-year old son’s car. Jonnie doesn’t like it, and neither do bankers. Or would-be bankers.

Thus, both bankers and would-be bankers have, from time immemorial, sought to get the benefits of the sovereign’s liquidity safety net without shouldering the associated regulator nuisance. And I’m sure that 19-year old sons and daughters, too, have been doing the same for just as long.

Over the last three decades or so, the growth of “banking” outside formal, sovereign-regulated banking, has exploded, in something that I dubbed the Shadow Banking System.3 Loosely defined, a Shadow Bank is a levered-up financial intermediary whose liabilities are broadly perceived as of similar money-goodness and liquidity as conventional bank deposits. These liabilities could be shares of money market mutual funds; or the commercial paper of Finance Companies, Conduits and Structured Investment Vehicles; or the repo borrowings of stand-alone Investment Banks and Hedge Funds; or the senior tranches of Collateralized Debt Obligations; or a host of other similar funding instruments.

The bottom line is simple: Shadow Banks use funding instruments that are not just as good as old-fashioned sovereign-protected deposits. But it was a great gig so long as the public bought the notion that such funding instruments were “just as good” as bank deposits - more leverage, less regulation and more asset freedom were a path to (much) higher returns on equity in Shadow Banks than conventional banks.

And why did the public buy such instruments as though they were “just as good” as bank deposits? There are a host of reasons, not the least of which was lust for yield. But most fundamentally, Keynes again gives us the systemic answer (his italics, not mine):

“In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention - though it does not, of course, work out quite so simply - lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely.

The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities.

We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuations which are in no way relevant to the prospective yield. Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention.

For if there exist organized investment markets and if we can rely on the maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be very large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence.

Thus investment becomes reasonably “safe” for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are “fixed” for the community are thus made “liquid” for the individual.

It has been, I am sure, on the basis of some such procedure as this that our leading investment markets have been developed. But it is not surprising that a convention, in an absolute view of things so arbitrary, should have its weak points. It is its precariousness which creates no small part of our contemporary problem of securing sufficient investment.”4

And so, Keynes provides the essential - and existential - answer as to why the Shadow Banking System became so large, the unraveling of which lies at the root of the current global financial system crisis. It was a belief in a convention, undergirded by the length of time it held: Shadow Bank liabilities were viewed as “just as good” as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by both the sovereign and the sovereign-blessed rating agencies.

Until, of course, convention was turned on its head, starting with a run on the ABCP market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization of Fannie and Freddie in July, and the actual death of Lehman Brothers in September 2008. Maybe, just maybe, there was and is something special about a real bank, as opposed to a Shadow Bank!

And indeed that is unambiguously the case, as evidenced by the on-going partial re-intermediation of the Shadow Banking System back into the sovereign-supported conventional banking system, as well as the mad scramble by remaining Shadow Banks to convert themselves into conventional banks, so as to eat at the same sovereign-subsidized capital and liquidity cafeteria as their former stodgy brethren.

The new conventional wisdom: levered capitalism is good, and made even better with a bit of socialism to protect the downside.

Well Maybe
I’m quite sure that last sentence is not going to sit well with some of you. It’s not supposed to sit well. It doesn’t sit well with me, I must acknowledge, nay confess. Like most of us, I’ve always had a separation in my mind between strictly capitalist activities and strictly public activities. Not that the demarcation is always clean. But it’s a useful way of thinking.

As far as I know, the place where I buy my fishing tackle is a capitalist outfit. If we customers don’t buy enough rods and reels, the owner will go broke; his operation is simply not systemically important enough to be bailed out by the taxpayers, including my neighbors who don’t fish. In contrast, the local Department of Motor Vehicles, sometimes called the DMV, is unambiguously not a capitalist outfit, but a public outfit. It cannot go broke, as evidenced by our tolerance of its fluctuating service level, because it provides a public service that the private sector can’t provide. To be sure, AAA can get you new plates for your car, but you can’t renew your driver’s license at the AAA; for that, you have got to go to the monopoly called the DMV.

Well actually, that’s not entirely true, either. The DMV is actually an oligopoly, with offices in many surrounding neighborhoods. And rumor has it here that the service is a lot quicker at the San Clemente office than the Costa Mesa office, which serves Newport Beach. So the consumer does have the choice of driving to San Clemente, a form of time arbitrage versus going to the Costa Mesa office. However, rumor also has it that this rumored better service in San Clemente is so widespread that, as Yogi Berra might say, the San Clemente office has become so popular nobody goes there anymore.

But you get the point: there is private enterprise and there is public enterprise. And then there is banking, a hybrid of the two. There is no way ‘round this, for good or bad, because fractional reserve banking depends upon the sovereign’s safety net against liability runs, a safety net that the private sector definitionally can’t universally supply. In this sense, the safety net is like national defense: we all need it, but since nobody individually has the incentive to pay for it, we collectively tax ourselves to pay for it.

Yes, sometimes we collectively end up paying $800 for military toilet seats, as was the case about 25 years ago. But that doesn’t change the proposition that public goods do exist, and a stable system of intermediation of private savings into private investment is indeed a public good. The maturity transformation power of a fractional reserve banking system provides an unambiguous benefit to society and as such, must be underwritten by society.

Bottom Line
I could regale you yet again about the power of the analytical thinking of Hyman Minsky, complete with his Forward Journey turning into his Moment, followed by his Reverse Journey.5 But I don’t need to do that any more: we’ve collectively lived it and are now caught in the debt-deflationary pathologies of “the paradox of deleveraging.”6 Not everybody in the private sector can delever at the same time without creating a depression. Accordingly, the sovereign must go the other way, levering up the public balance sheet. And Washington has finally started to do so with appropriate vigor and enthusiasm.

It’s not a pretty picture. In fact, it’s repugnant, giving proof to the proposition that breaking the paradox of deleveraging does involve socializing the downside of previously profitable private sector activities. In a recent speech, I called it “creeping socialism” and was interrupted by an irate, older man in the back of the room bellowing, “It ain’t creeping socialism, it’s galloping socialism!” I really didn’t have a soothing come back, noting that many things are what they are only in the eye of the beholder. But his point wasn’t lost on me or anybody else in the room.

And it is not lost on Washington, DC either, I can assure you. If the sovereign must backstop a private sector activity that produces a public good, then the sovereign will, at least in a democracy, rightfully demand both bottom-up and macro-prudential rules to harness the greed that lubricates the invisible hand of capitalism. Yes, the visible fist of government and the invisible hand are presently engaged in a massive arm wrestling contest in the provision of financial services. And the fist is winning.

At least for now. Capitalism, and especially financial market capitalism, brought this outcome upon itself through greed and hubris. Capitalism is now re-grouping and learning how to play by new rules, which are still being written. And ultimately, I’m sure, capitalistic bankers will once again bend those rules in the pursuit of higher profitability. And that’s okay, I think. In the end, we really don’t want to turn our banking system into the DMV. At the same time, we also don’t want our banking system to be nothing more than a betting parlor.

Or, in the famous words of Keynes again:

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

Paul A. McCulley
Managing Director
November 13, 2008

You can download a complete PDF here.


More on this topic (What's this?)
"Deflation has become inevitable" (naked capitalism, 12/12/08)
The Great Fractional Reserve Banking Scam (Contrarian Profits, 11/28/08)
Problem Institutions: Breaking Out (Financial Armageddon, 11/25/08)
Read more on Banking at Wikinvest

People who read this post also read these:

Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,
Posted in Markets | No Comments »

Cramer: Dow 8300, Oil $50, Obama

Wednesday, October 8th, 2008


From Jim Cramer in New York magazine:

What will New York look like a year from now? The answer: bad and probably worse, and perhaps downright catastrophic. Three degrees of awful. The first step was passing the bank-bailout legislation. Now that it’s done—and if it didn’t get done we would have been looking at a guaranteed economic collapse—the critical issue will be presidential leadership. And while any president will be an improvement over the current one, there is a growing belief on Wall Street that Barack Obama has the capacity to lead us out of this wilderness while John McCain does not. I’ll go a step further: Obama is a recession. McCain is a depression…

At this time next year, I could see the Dow as low as 8,300. That’s more than 40 percent off its October 2007 high of 14,164. On Main Street, that means a further slowdown in consumer spending, as buyers feel poorer, and another hit for 401(k) and college savings accounts. For Wall Street, it means more bank closures and mergers and still more layoffs. The two remaining independent commercial banks–née–investment banks, Goldman Sachs (GS) and Morgan Stanley (MS), will have to fight mightily to remain independent. The bet here is that Goldman makes it but Morgan Stanley succumbs to one of the four emerging megabanks — Citigroup (C), JPMorgan (