FOMO is a hell of a drug

The most dangerous feeling in finance  is “fear of missing out”(FOMO). FOMO causes people to make hasty emotional decisions, generally near to the top of a speculative mania.  FOMO is the force behind ponzi schemes, stock promotions, and simple legit bubbles.  The Stanford Business School has even looked into this 

Fear of Missing Out

The danger of FOMO impacts people regardless of  socieoeconomic status or education. It even impacted Isaac Newton:

FOMO is a hell of a drug

Source: the Vantage, (which has some excellent personal finance tips on avoiding the dangers of FOMO)

Last week things got a bit volatile. Markets corrected all the way to… (wait for it) the price level of a couple months ago. This was the result of a sudden sharp reversal of record retail inflows. Although it wasn’t really an abnormal reversal, the media made it sounded like the beginning of another financial crisis.

 

Day trading in the volatility complex is popular.  Some people were getting rich, at least temporarily, by making highly levered bets on continued calm in financial markets. But for people who got in late, it ended badly.   I doubt most investors  in volatility products understand the risks  Historically what happened this past week isn’t really abnormal.  Volatility is normal in financial markets.  (for an excellent explanation of the XIV debacle, see this article ).

Where are we in the cycle? I don’t know and I don’t care that much. I’m responsible for building wealth over the next few decades regardless of the vicissitudes of the broader market. I guess building up a retirement stash would  be easier if I could dollar cost average into great businesses at absurdly cheap prices for several years.  The founder at my employer loves to tell stories of the 70s bear market, which was preceded by the “go-go growth bull market in the 1960s.  Once the bull market ended, stocks reversed sharply, kept going down often to absurd levels. He came into a small boost in investable cash right as the bear market started.  He gradually took significant stakes in microcaps during several years of pain.  Then he ended up getting rich in the 80s.  I wouldn’t mind the opportunity to do the same, although it would be difficult from an emotional and career perspective for a few years.

Anyways, markets tend to top after a flood of people enter due to FOMO, rather than true understanding of what they’re buying. Prices collapse once there isn’t a greater fool to sell to.

Jeremy Grantham’s recent letter   discussed valluation metrics and other characteristics of asset price bubbles:

In looking for signs of late bubble behavior, we have to reconcile to the fact that no two bubbles, even the classics, are the same. They share the fact that there are many signs of investor euphoria, sometimes indeed approaching the madness of crowds, but the package of psychological and technical indicators has been different each time.

Grantham noted that although valuation metrics are high, euphoria isn’t quite as extreme as he has seen in the past.

Anyone around in 1999 and early 2000 has had a classic primer in these signs. We know we’re not there yet, but we can perhaps see some early movement: increasing vindictiveness to the bears for costing investors money; the crazy Bitcoins of the world (this is a true, crazy mini-bubble of its own I expect – it has certainly passed my “nephew test” of his obsessing about buying or not); and Amazon and the other handful of current heroes – here and globally – taking over more of the press coverage and a growing percentage of total market gains (Amazon +13%, the day before I started to write this, and Tencent doubling this year to a $500 billion market cap). The increasingly optimistic tone of press and TV coverage is also important. A mere six months ago, new market highs were hardly mentioned and learned bears were featured everywhere. Now, the newspaper and TV coverage is considerably more interested in market events. (This last comment reminds me of some advice for contrarians: There is usually a phase or two in each cycle where most investors expect a market gain or loss and it actually happens. The mass of investors usually ends up wrong in the end, but not all the time, for Heaven’s sake!)

 

I can’t  help but notice several  euphoria indicators have been accelerating.  Here are a collection of eerie warning signs indicating that we probably aren’t at a market bottom.

Things you don’t see at Market Bottoms

Extreme Investor bullishness

Investor’s entered 2018 with near record optimism:

Investor optimism in this market has reached new heights following a year of serious growth,” commented Mike Loewengart, VP of Investment Strategy at E*TRADE Financial. “While there are more than a few uncertainties to keep investors awake at night, they are clearly reacting to the roundly positive economic data that has been coming in at a steady stream, not to mention the boost that tax reform may bring. And as we approach our first earnings season of the year, investors are eyeing a variety of opportunities across the market.

 

Investor sentiment

That E-Trade Advertisement Indicator

E-Trade is blatantly trying to capitalize on FOMO. For example, “the dumbest kid in high school just got a boat…” “Don’t get mad, get E-Trade”

 

Here are a couple ads from the dot com bubble:

 

 

Joseph Kennedy reputedly sold out of stocks and went short right before the great depression based on the fact that his shoeshine boy started giving out stock advice.  I’m hesitant to use the “shoeshine boy indicator” because I truly believe basically anyone should be able to build a decent retirement through decades of careful saving and prudent investing.   The problem is the get rich quick mentality that leads to the extreme bubbles.  You don’t see people with no interest in business suddenly pursuing riches in the stock market at market bottoms.

That Cramer article indicator

February 2000 (one months before the .com bubble top) : Winners of the New World

January 2018: ‘This time it’s different’ is no longer risky

These articles aren’t completely wrong- industries often do experience secular change- but they demonstrate a level of arrogance and  not typically seen at market bottoms.

Confirmation bias and the XFL

The XFL is coming back. It was first founded in 1999, and played only one inaugural season(2001). Its founding effectively coincided with the top of the tech bubble. This has nothing to do with market valuation, and the fact that I noticed it is probably just confirmation bias.

 

 

Warren Buffett, Aesop's Fables, Dot-Com Bubble

Warren Buffett, Aesop’s Fables, and the Dot-Com Bubble

I recently went back and re-read the Berkshire Hathaway letters from during the dot-com bubble. Buffett and Charlie Munger mostly sat out the mania, then used Aesop’s Fables to explain it all when it was done. Investors can learn  from their ability to maintain equanimity amidst the madness of crowds.  However its also important to note that they made errors of omission as technology altered industries.  Investors do themselves a disservice if they automatically reject tech investments, just because those are not areas that Berkshire Hathaway invested.   Buffett’s letters to investors are a pretty good vantage point from which to understand repeating historical patterns.

 

 

1997: Maintain discipline in the mania

As the dotcom bubble started gathering momentum, Warren Buffett reaffirmed commitment to discipline:

Though we are delighted with what we own, we are not pleased with our prospects for committing incoming funds. Prices are high for both businesses and stocks. That does not mean that the prices of either will fall — we have absolutely no view on that matter — but it does mean that we get relatively little in prospective earnings when we commit fresh money.

Under these circumstances, we try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his “best” cell, he knew, would allow him to bat .400; reaching for balls in his “worst” spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.

If they are in the strike zone at all, the business “pitches” we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today’s balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can’t be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun.

Although way too early, he started lamenting high prices:

In the summer of 1979, when equities looked cheap to me, I wrote a Forbes article entitled “You pay a very high price in the stock market for a cheery consensus.” At that time skepticism and disappointment prevailed, and my point was that investors should be glad of the fact, since pessimism drives down prices to truly attractive levels. Now, however, we have a very cheery consensus. That does not necessarily mean this is the wrong time to buy stocks: Corporate America is now earning far more money than it was just a few years ago, and in the presence of lower interest rates, every dollar of earnings becomes more valuable. Today’s price levels, though, have materially eroded the “margin of safety” that Ben Graham identified as the cornerstone of intelligent investing.

Notable Actions in 1997:

Net sales of 5% of the stock portfolio

increasing emphasis on “unconventional commitments”, including oil derivatives, and direct investments in silver.

1998: Trimming positions too early

During the year, we slightly increased our holdings in American Express, one of our three largest commitments, and left the other two unchanged. However, we trimmed or substantially cut many of our smaller positions. Here, I need to make a confession (ugh): The portfolio actions I took in 1998 actually decreased our gain for the year. In particular, my decision to sell McDonald’s was a very big mistake. Overall, you would have been better off last year if I had regularly snuck off to the movies during market hours.

1999:Circle of competence +staying invested although concerned

As an increasing portion of the public is investing in things they don’t understand, Buffett and Munger emphasize staying in their circle of competence:

If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries — and seem to have their claims validated by the behavior of the stock market — we neither envy nor emulate them. Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it’s almost certain there will be opportunities from time to time for Berkshire to do well within the circle we’ve staked out.

It should be noted that Buffett and Munger later acknowledge that missing certain changes in the dot-com error, notably the rise of Amazon, was a mistake. Investors should stay within their circle of competence, but also aggressively work to expand that circle of confidence. The reality is speed of change is very fast in most industries, so investor’s can’t avoid technology. They can, however, avoid investing thoughtlessly in “next new things” they don’t understand.

Prices continued to rise in 1999. Buffett didn’t try to market time by running to cash. He just stayed in the good businesses he understood.

Right now, the prices of the fine businesses we already own are just not that attractive. In other words, we feel much better about the businesses than their stocks. That’s why we haven’t added to our present holdings. Nevertheless, we haven’t yet scaled back our portfolio in a major way: If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price.

Our reservations about the prices of securities we own apply also to the general level of equity prices. We have never attempted to forecast what the stock market is going to do in the next month or the next year, and we are not trying to do that now… equity investors currently seem wildly optimistic in their expectations about future returns

Berkshire will someday have opportunities to deploy major amounts of cash in equity markets — we are confident of that. But, as the song goes, “Who knows where or when?” Meanwhile, if anyone starts explaining to you what is going on in the truly-manic portions of this “enchanted” market, you might remember still another line of song: “Fools give you reasons, wise men never try.”

2000: Beware of bird-less bushes

NASDAQ peaked in early 2000, and declined throughout the entire year(but it still had a long way to fall. Berkshire Hathaway was in a good position.  Buffett used Aesop’s fable to explain it all:

 

Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oilroyalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota — nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component usually a plus, sometimes a minus in the value equation.
Alas, though Aesop’s proposition and the third variable that is, interest rates are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.
Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well founded positive conclusion. But the investor does not need brilliance nor blinding insights.
At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

Now, speculation — in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it — is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
Last year, we commented on the exuberance and, yes, it was irrational that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was an irrational expectation: For American business as a whole, there couldn’t possibly be enough birds in the 2009 bush to deliver such a return.
Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.
This surreal scene was accompanied by much loose talk about “value creation.” We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get.
What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street a community in which quality control is not prized will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.
At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five in the phonebook.”). Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.
Lately, the most promising “bushes” have been negotiated transactions for entire businesses, and that pleases us. You should clearly understand, however, that these acquisitions will at best provide us only reasonable returns. Really juicy results from negotiated deals can be anticipated only when capital markets are severely constrained and the whole business world is pessimistic. We are 180 degrees from that point.
Warren Buffett, Aesop's Fables, Dot-Com Bubble

Is credit really the smart money?

Conventional wisdom holds that credit markets are “smart institutional money” that sees problems faster than  equity markets that  are full of less sophisticated retail investors.  I question whether that is still empirically true.  Retail investors now own large portions of the credit market, including high yield. Credit markets appear to be distorted by a combination of indexation and a reach for yield.   Its possible that bonds trading at par can be a false comfort signal for an equity investor looking at a highly leveraged company, because in many recent cases equity markets have been faster to react to bad news.

Retail ownership of credit markets.

However you slice and dice the data, there is clearly a lot more retail money in credit than there was a decade ago.  The media  mostly reports on noisy weekly or monthly flows, even though there has been a clear long term change.

Bond funds in general have experienced dramatic inflows over the past decade:

bond mutual funds.png

Source: ICI Fact Book 2017

 

The issues becomes more serious when you look just at the high yield part of the market. Boaz Weinstein of Saba Capital estimated that between ½ or ⅓ of junk bonds are owned by retail investors in the current market. The WSJ cited Lipper data that says mutual fund ownership of high yield bonds/loans is $97 billion today vs $18 billion a decade ago. ICI slices the data differently, and comes up with a much nosier data set for just floating rate unds, indicating large outflows in 2014 and 2015.  However it shows net assets in high yield bond funds up 3x compared to 2007, and the total number of funds up over 2x during that time.

High Yield inflows.png

Source: ICI Fact Book 2017

Its not just mutual funds either- there are now more closed end type fund structures that market towards retail investors.  BDCs experienced a fundraising renaissance through 2014, and are now active in all parts of the high yield credit markets- from large syndicated loans to lower middle market.  Closely related, before the last financial crisis, ago there was minimal retail ownership of CLO equity tranches, but now there are a few specialist funds, and a lot of BDCs have big chunks of it as well.     Oxford Lane and Eagle Point were sort of pioneers in marketing CLO investments to retail investors but many others have followed.   Interval funds are a tiny niche, but over half the funds in registration are focused on credit.  It seems just about every asset manager is cooking up a direct lending strategy.  The illiquid parts of the credit market are harder to quantify, but there has been a clear uptick in retail investor exposure since before the financial crisis.  The marginal buyer impacting pricing is increasingly likely to be a retail investor rather than an institution.  

Retail investors to exhibit more extreme herding behavior.  According to Ellington Management Group:

This feedback loop between asset returns and asset flows has magnified the growth of the high yield bubble.

Capital Distortions

Its pretty easy to make a loan, its much harder to get paid back.

-Jeffrey Aronson, Centerbridge Capital

 

Credit is cyclical, and we are clearly getting into a more dangerous part of the cycle. In frothy markets lending standards deteriorate, and yields are lower than justified by the risk.

Back in 2014, the Office of Comptroller of the Currency started warning that :

Investor demand for high-yield products continued to surge, with more relaxed structures incorporating fewer covenants and lender protections“

Reuters recently reported that Middle Market covenant lite  lending reached an all time high in 2017, even higher than it was in 2007. This cyclicality happens whether the investors are retail or instituttional, but the high retail ownership means the overshooting may be severe.  Indeed, retail vehicles are among those most likely to be impacted in a downturn, according to the report:

As for types of lenders expected to face the greatest challenges in their loan portfolios this year, 26% of respondents said mezzanine lenders are at the top of the list. Business Development Companies (BDCs) were next in line with 23%, 18% said distressed investors and 14% selected traditional banks. Specialty finance companies and direct lenders were tied at 6.84% each, while bank asset-based lenders and equipment finance companies are ranked least likely to face trouble, at less than 5% each.

“Many BDCs make investments in much smaller companies, which can be more vulnerable to economic contraction. BDCs also have a higher cost of capital relative to regulated banks, which dictates looking to invest in places that justify their cost of capital, which can also translate into added risk,” said Flynn.

There are mutiple othe rexamples of very risky credit trading at prices that don’t reflect risk. HYG, a high yield corporate bond etf tha tinvests in some speculative credit, yields only 5% for example.  

From Almost Daily Grant’s yesterday:

 This morning, Bloomberg reports that a breakneck rally in triple-C-rated debt (characterized by S&P as: “currently vulnerable to nonpayment and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitments on the obligation”) has compressed spreads to an average of 579 basis points over Treasurys, tightest in more than three years. In the first week of 2018, triple-C spreads have compressed by 36 basis points.  More broadly, the spread between the Bank of America Merrill Lynch High Yield Index and Treasurys has narrowed to 336 basis points, within one basis point of its tightest reading since July of 2007

Horizon Kinetics has pointed outsome of the distortions,  as part of its broader analysis of distortions caused by indexation.  Essentially bonds that are picked up by index funds tend to have absurdly low yields regardless of credit risk.  This problem is further exacerbated by the fact that high yield bond indices are market cap weighted, meaning they buy more of entities as they pile on debt.  

According to Horizon Kinetics:

How is it possible that Russian Federation 15‐year bonds trade at the yield of 10‐year IBM bonds?  How does a company in the midst of a massive fraud investigation, its senior executives in prison, trade at a yield not much above a diversified index of U.S. high yield bonds? (referring to Petrobras) And, really, how does a nation the size of Vermont, on the brink of collapse, situated where Lebanon is, borrow more cheaply than Wendy’s?   

If these yields to maturity are really inadequate compensation for the risk assumed by owning these bonds, do the prices result from some other factor, such as artificial supply‐and‐demand pressures? In EMHY, new money is allocated based on float. In other words, the more debt a nation has issued, the greater the allocation to the bonds of that nation because it has a greater capitalization. That is the mathematical model, and that is entirely logical – to a point. 

Somewhere in this country, a robo advisor has just instructed an individual, and an asset allocation committee for a public pension fund has just made an adjustment to their exposures, and both have decided to establish, or add to, their emerging markets high yield segment. EMHY has $228 million in Assets Under Management (“AUM”). If this one pension fund is $10 billion (which wouldn’t even make the list of the largest 300 global pension funds) and wished to allocate merely one‐half of 1% of its portfolio to EMHY, that would be $50 million, or 20% of the ETF. That’s a lot. If the ETF could exercise subjective judgment, perhaps some decisions would be made about how to allocate that $50 million other than according to the existing float‐based weightings and other than immediately.  But in this instance, the mathematical model becomes the reality – which is not a good idea. The computer cannot calculate the subjective judgment, however realistic that subjective judgment might be, of the probability of default, nor is there a “valuation” factor, extreme or otherwise, in its program – they simply don’t exist. Accordingly, not only does the computer purchase additional Lebanese bonds in the precisely correct ratio, but if Lebanon issues more bonds in order to stay afloat, the total capitalization of Lebanese bonds increases, and the ETF will assign yet a higher weight to Lebanon and purchase proportionately more…..

False Signals to the Equity Markets

  There have been a few recent high profile examples of the global equity market seeming to “get it” faster than the credit markets.  Noble Group, a Singapore based trading company had bonds trading around par until the eve of debt restructuring in summer 2017 even as its equity plummeted over a year in advance.  A similar phenomenon occurred with Banco Popular in 2017, and I think the junior debt got zero along with the shareholders in the end.  Noble Group, a Singapore based trading company had bonds trading above par until the eve of debt restructuring in summer 2017 even as its equity plummeted over 90% from its 2014 level.  Is similar phenomenon occurred with Banco Popular in 2017, and I think the junior debt got zero along with the shareholders in the end. In  some cases junk bonds fall as much as equity does, so a bond investors gets no added safety from being in a debt instrument rather than equity.   Boaz Weinstein of Saba Capital pointed out the example of Chesapeake Energy, where the bonds and stock each dropped closed to 90% around the same time.   

In the past it used to be possible to look to the bond market for comfort when analyzing a levered equity, but that no longer seems logical.  Apparently some hedge funds have set up interesting counterintuitive pair trades shorting overpriced credit, and buying under priced highly levered equities. Of course in other cases, if both debt and equity are trading at premiums, then the equity may be the first to break.

Lenders be careful out there.

See Also: Minsky and the Junk Bond Era

Trump’s foreign policy: Pulling a Homer

It is almost universally accepted that Donald Trump’s foreign policy is going to be a disaster. But what if his bizarre antics actually work? What if Trump pulls a Homer on foreign policy?

Trump Foreign Policy: Pulling a HomerTrump Foreign Policy: Pulling a Homer

Pulling a Homer

Here’s a scenario under which Trump ends up being known as a foreign policy success. It probably won’t happen, but if it does, you heard it here first.

  • The Iran protestors succeed in replacing or drastically reforming the government in Iran. The new regime remembers Trump was the first world leader to directly support them. US-Iran relations open up. Trump takes credit whether he deserves it or not.
  •  China and South Korea get so concerned with Trump’s impulsiveness that they finally decide to take action on North Korea. Trump takes credit whether he deserves it or not.
  • Israel and Palestine come  together in sort of a reverse Camp David summit as a result of Trump’s recognition of Jerusalem as the capital of Israel. Both parties are concerned with Trump’s bizarre behaviour, and finally start negotiating from realistic basis. Trump takes credit whether he deserves it or not.
  • As a result ⅔ of the “Axis of Evil”  is fixed through diplomatic means, and Middle East peace achieved during the Trump administration. History books go on to credit him as a highly persuasive foreign policy president. Scott Adams’ “4d Chess” analogy for Trump’s actions, however preposterous it seems now, ends up becoming the accepted narrative.

Trump Foreign Policy Compared to Nixon

Its worth remembering that Nixon’s foreign policy team managed to open up China, and negotiate the Strategic Arms Limitation Treaty with the Soviet Union all while the Watergate scandal engulfed the administration domestically. Nixon brooded in the White House about real and imagined domestic enemies, but his team still goes in history as actually pretty decent from a foreign policy perspective. Nixon had Kissinger, who is now synonymous with high level diplomatic maneuvering, but came as a Washington outsider. Trump has Rex Tillerson, an experienced global businessman, but certainly no Kissinger when it comes to knowledge of history and international relations. Yet, like Kissinger he is willing to in pursuit of his ideas and schemes, and are willing to take risk what more experienced diplomats would consider insane.

Its true that the general “status” of the US around the world is likely to decline partially as a result of the fact that Trump made the US seem like a more unreliable partner. But that’s a fuzzy concept hard to trace to any individual. Being overstretched and self serving around the globe has been the US Modus Operandi since the end of world war II. Concrete accomplishments would outweigh everything else in people’s minds.

 

Minsky and the Junk Bond Era

King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone discusses the early days of the leveraged buyouts(LBOs) and junk bonds from the vantage point of Blackstone’s founders.

In 1978, KKR did an LBO of an industrial pumps make (Houdaille Industries). There had been many small LBOS of private businesses, but no one had gone that big,  done a public company. A young investment banker named Steve Schwartzman heard about the deal and realized he had to get his hands on that prospectus. “He sensed something new was afoot — a way to make fantastic profits and a new outlet for his talents, a new calling.

“I read that prospectus, looked at the capital structure, and realized the returns that could be achieved.” he recalled years later. “I said to myself, ‘This is a gold mine.’ It was like a Rosetta stone for how to do leveraged buyouts. “

Speculative Bridge Financing

It quickly became apparent how lucrative leveraged buyouts could be.

LBOs were financed with Junk Bonds. The process of issuing junk bonds was messy and cumbersome. It took most banks an extremely long time to issue bonds. Drexel was so adept at hawking junks, that companies and other banks in a deal would go forward on an LBO based solely on Drexel’s assurance that it was “highly confident” it could issue bonds. Other banks that couldn’t do that would offer short term financing, aka bridge loans, so a buyer could close a deal quickly, and then issue bonds later to repay bridge loans This alowed DLK, Merril Lynch, and First Boston to compete with Drexel in the LBO financing space.

But what if the bonds couldn’t issued? How would the bridge loan be paid for?

… bridge lending was risky for banks because they could end up stuck with inventories of large and wobbly loans if the market changed direction or the company stumbled between the time the deal was signed up and the marketing of the bonds. The peril was magnified because bridge loans bre high, junk bond-like interest rates, which ratcheted up to punishing levels if borrowers failed to retire the loans on schedule. The ratchets were meant to prod bridge borrowers to refinance quickly with junk, and up until the fall of 1989, every bridge loan issued by a major investment bank had been paid. But the ratchets began to work against the banks when the credit markets turned that fall. The rates shot so high that the borrowers couldn’t afford them, an the banks found themselves stuck with loans that were headed towards default.

In the late 80s/early 90s. several junk bond deals fell through with disastrous consequences. The $6.8 billion United airlines buyout turned out poorly. Several stores ended up going bankrupt due to a failed junk bond deal: Federated Department stores , the parent of Bloomingdale’s, Abraham & Strauss, Filene’s and Lazarus, etc. etc. First Boston nearly failed due to its exposure to junk bond deals. Blackstone mostly sidestepped the worst problems of the era, but fought hard to get refinancing in some cases, and had a couple deals jeopardized.

The Minsky view of junk bonds and LBOs

The collapse of the bridge financing market in the junk bond era illustrates a key idea in Hyman Minsky’s Financial Instability Hypothesis: the idea of three types of leverage.

Three distinct income-debt relations for economic units, which are labeled as hedge, speculative, and Ponzi finance, can be identified

Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit.

Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities: (e.g. issue new debt to meet commitments on maturing debt). Governments with floating debts, corporations with floating issues of commercial paper, and banks are typically hedge units.

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.

According to Minsky the shift from hedge to Ponzi financing makes a economic system unstable, ultimately leading to a crash.

In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.

Speculative and Ponzi financing can lead to assets becoming overvalued. A frothy LBO market depends on the availability of cheap junk bond financing.  Seth Klarman noted how this influenced this influenced stock market valutions leading to the 2009 financial crisis:

Pre-2008, nearly all stocks had come to be valued, in a sense, on an invisible template of an LBO model. LBOs were so easy to do. Stocks were never allowed to get really cheap, because people would bid them up, thinking they could always sell them for 20 percent higher. It was, of course, not realistic that every business would find itself in an LBO situation, but nobody really thought much about that. Certainly, many of the companies had some element of value to them, such as consumer brands or stable businesses, attributes that value investors might be attracted to. But when the model blew up and LBOs couldn’t be effected, the invisible template no longer made sense and stocks fell to their own level.

Will this repeat? The high yield credit market does look a bit frothy, with low junk bond yields, overlevered buyouts, and weak debt covenants.

As other areas of finance have shown, history does have funny way of repeating.  

 

Optimizing An Organized Mind

How can one maximize mental performance? The Organized Mind- Thinking Straight in an Age of Information Overload by Daniel Levitin is a book that works towards an answer to this question. The book’s ideas on offloading things to external systems and organizational techniques are very similar to David Allen’s , Getting Things Done . However, The Organized Mind, provides much more historical and scientific background an context. Further, An Organized Mind avoids being overly prescriptive, and instead gives the reader ideas on how to best optimize for their own situation.

Some of my highlights on the key themes of the book:

Getting the mind into the right mode

One useful framework that the books develops is hte idea of the mind as functioning in different modes. An important component of high performance is the ability to use the right mode at the right time.

There are four components in the human attention system: the mind-wandering mode, the central executive mode, the attention filter, and the attention switch, which directs neural and metabolic resources among the mind-wandering, stay-on-task, or vigilance modes.

Remember that the mind-wandering mode and the central executive work in opposition and are mutually exclusive states; they’re like the little devil and angel standing on opposite shoulders, each trying to tempt you. While you’re working on one project, the mind-wandering devil starts thinking of all the other things going on in your life and tries to distract you. Such is the power of this task-negative network that those thoughts will churn around in your brain until you deal with them somehow. Writing them down gets them out of your head, clearing your brain of the clutter that is interfering with being able to focus on what you want to focus on. As Allen notes, “Your mind will remind you of all kinds of things when you can do.

The task-negative or mind-wandering mode is responsible for generating much useful information, but so much of it comes at the wrong time.

Creativity involves the skillful integration of this time-stopping daydreaming mode and the time-monitoring central executive mode.

Insights into how human memory works

The book delineates the nuances of human memory by comparing it to systems in the physical world.

Being able to access any memory regardless of where it is stored is what computer scientists call random access. DVDs and hard drives work this way; videotapes do not. You can jump to any spot in a movie on a DVD or hard drive by “pointing” at it. But to get to a particular point in a videotape, you need to go through every previous point first (sequential access). Our ability to randomly access our memory from multiple cues is especially powerful. Computer scientists call it relational memory. You may have heard of relational databases— that’s effectively what human memory is.

Having relational memory means that if I want to get you to think of a fire truck, I can induce the memory in many different ways. I might make the sound of a siren, or give you a verbal description (“ a large red truck with ladders on the side that typically responds to a certain kind of emergency”).

This feature can lead to either valuable insights or being overwhelmed, depending on how it is controlled:

If you are trying to retrieve a particular memory, the flood of activations can cause competition among different nodes, leaving you with a traffic jam of neural nodes trying to get through to consciousness, and you end up with nothing.

Categorization is key to mental functioning.

This ability to recognize diversity and organize it into categories is a biological reality that is absolutely essential to the organized human mind.”

Shift burdens to external systems

You might say categorizing and externalizing our memory enables us to balance the yin of our wandering thoughts with the yang of our focused execution.

Write things down to avoid getting caught in an unnecessary “rehearsal loop. “

Make a big list of everything on you mind, notice you feel better.

When we have something on our minds that is important– especially a To Do item, we’re afraid we’ll forget it, so our brain rehearses it, tossing it around and around in circles in something that cognitive psychologists actually refer to as a rehearsal loop, a network of brain regions that ties together the frontal cortex just behind your eyeballs and the hippocampus in the center of your brain. This rehearsal loop evolved in a world that had no pens and paper, no smartphones or other physical extensions of the human brain; it was all we had for tens of thousands of years and during that time, it became quite effective at remembering things. The problem is that it works too well, keeping items in rehearsal until we attend to them. Writing them down gives both implicit and explicit permission to the rehearsal loop to let them go, to relax its neural circuits so that we can focus on something else.


If you want to look at this from a Zen point of view the Masters would say that constant nagging in your mind of undonne things pulls you out of the present– tehers you to a mindset of the future and enjoying whats now.

Developing an organizational system

The book describes a notecard system, but makes it clear that people need to find a system that works for them. There is no one size fits all solution.

The index card system is merely one of what must be an infinite number of brain extension devices, and it isn’t for everyone. Paul Simon carries a notebook with him everywhere to jot down lines or phrases that he might use later in a song, and John R. Pierce, the inventor of satellite communication, carried around a lab book that he used as a journal for everything he had to do as well as for research ideas and names of people he met. A number of innovators carried pocket notebooks to record observations, reminders, and all manner of what-not; the list includes George S. Patton (for exploring ideas on leadership and war strategy, as well as to record daily affirmations), Mark Twain, Thomas Jefferson, and George Lucas. These are serial forms of information storage, not random access; everything in them is chronological. It involves a lot of thumbing through pages, but it suits their owners.

Not finding something thrusts the mind into a fog of confusion, a toxic vigilance mode that is neither focused nor relaxed. The more carefully constructed your categories, the more organized is your environment and, in turn, your mind.

 

The next level of shareholder activism

…shareholder activism can be put to good use and bad. It challenges inefficient corporations that waste valuable assets, but it can also foster destructive and destabilizing short-term strategic decisions. The key issue in an activist campaign often boils down to who will do a better job running the company—a professional management team and board with little accountability, or a financial investor looking out for his or her own interests.

Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism

Elliott Management is a prominent hedge hedge fund with a succesful 4 decade track record, perhaps most infamous for seizing a  ship from Argentina’s Navy during a debt dispute back in 2012. Elliott has become a most widely known as an activist investor in recent years.  Its impact has also been important because it has shaken up large companies previously thought immune to activists. Furthermore, Elliott has been a successful activist in Europe and Asia, where conventional wisdom once held  that activism didn’t really work.

Elliott’s tactics are extreme, and controversial, but they work. Although sometimes there are unintended consequences- Elliott has indirectly affected regime change in two different sovereign nations.  Fortune’s latest issue has an in depth profile of Elliott Management that is well worth reading.

For more on the history of corporate activism, and its impact on  the history of capitalism,  Dear Chairman is a definitive guide.

Business history teaches us that the pursuit of profit brings out an extreme and obsessive side of people. When we harness it well, we get Wal-Mart, Les Schwab Tires, Southwest Airlines, and Apple. When we don’t, we get salad oil swindles, junk bond manipulations, and Steak ’n Shake funneling its cash to its CEO’s hedge fund. The publicly owned corporation has been a remarkable engine engine for progress and economic gowth because it can place large amounts of capital in the hands of the right people with the right ideas. Without proper oversight, however, public companies can squander unimaginable amounts o money and inflict great harm on everything around them. The emergence of the shareholder as the dominant force in corporate governance has bestowed a tremendous amount of power and responsibility on investors….

Dear Chairman

Is it really necessary to have a meeting?

A lot of time and money is wasted on unnecessary corporate meetings. Since the early days of Amazon , Jeff Bezos has taken a unique approach to meetings.


At a management offsite in the late 1990s, a team of well-intentioned junior executives stood up before top brass and gave a presentation on a problem indigenous to all large organizations: the difficulty of coordinating far-flung divisions. The junior executives recommended a variety of different techniques to foster cross group dialogue and afterward seemed proud of their own ingenuity. Then Jeff Bezos, his face red, and the blood vessel in his forehead pulsating, spoke up.

“I understand what you are saying, but you are completely wrong,” he said.

“Communication is a sign of dysfunction. It means people aren’t working together in a close, organic way. We should be trying to figure out a way for teams to communicate less with each other, not more.”

…At that meeting and in public speeches afterward, vowed to run Amazon with an emphasis on decentralization and independent decision-making. “A hierarchy isn’t responsive enough to change,” he said. “I’m still trying to get people to do occasionally what I ask. And if I was successful, maybe we wouldn’t have the right kind of company.

Bezos’s counter intuitive point was that coordination among employees wasted time, and that the people closest to problems were usually in the best position to solve them. That would come to represent something akin to the conventional wisdom in the high-tech industry over the next decade. The companies that embraced this philosophy, like Google, Amazon, and, later, Facebook, were in part drawing lessons from theories about lean and agile software development. In the seminal high-tech book The Mythical Man-Month, IBM veteran and computer science professor Frederick Brooks argued that adding manpower to complex software projects actually delayed progress. One reason was that the time and money spent on communication increased in proportion to the number of people on a project.

When you do have a meeting, make it useful

Of course, some meetings are necessary. There is value to cross-pollination of thoughts among intelligent people. Some processes do require explicit coordination and discussion. However, in practice, many hours are wasted on routine updates, grandstanding, and “thinking out loud”. To ensure meetings were productive Bezos required the person who leads a meeting to write detailed prose explaining their thoughts. The first half hour or so of every meeting would be silent reading time. This ensured everyone thought deeply and expressed complete thoughts cogently.

Meetings no longer started with someone standing up and commanding the floor as they had previously at Amazon and everywhere else throughout the corporate land. Instead, the narratives were passed out and everyone sat quietly reading the document for fifteen minutes—or longer. At the beginning, there was no page limit, an omission that Diego Piacentini recalled as “painful” and that led to several weeks of employees churning out papers as long as sixty pages. Quickly there was a supplemental decree: a six-page limit on narratives, with additional room for footnotes.

Riches Among the Ruins

No Economy is too small, no political crisis is too dire, and no country is too bankrupt for a solo operator like me to find riches among the ruins.

-Robert Smith

Riches Among the Ruins: Adventures in the Dark Corners of the Global Economy is an incredibly entertaining bottom up look at frontier market crises over the last 3 decades from the perspective of a travelling distressed debt trader.  Each chapter is dedicated to Robert Smith’s experience in a particular country: El Salvador, Turkey, Russia, Nigeria, Iraq, etc, etc. Each country is unique, but Smith’s weaves several key lessons throughout his memoir.

Anyone who seeks  profits in inefficient markets could benefit from Smith’s experience.

Information vacuums are key for middleman and arbitrageurs

In the mid 1980s no one had any idea what an El Salvador bond was worth- which is to say, they had no idea what value others might attach to it. The ignorance, this information vacuum, was my bliss. The seller’s price was simply a measure of how desperately he wanted to dispose of a paper promise of the government of El Salvador, and the buyer’s measure of how eager he was to convert his local currency into a glimmer of hope and seeing dollars down the road. The spread, my profit, was the difference between the two. In a fledgling market, with no reporting mechanisms and precious little information floating around, the spread can be enormous, and there was no regulatory or legal restrictions on how much you could make on a transaction.

Though my sellers and buyers, usually the representative of foreign companies doing business in El Salvador, often knew each other , played golf together, or broke bread together at American Chamber of Commerce breakfasts, I knew it would take some time before they eventually started to compare notes. At the beginning I doubt any of them even mentioned they were trying to sell or buy El Salvador bonds because the market didn’t exist yet. But until the market matured it was a gold rush, and I developed a monopoly on that most precious of all commodities in any market: information. I found out who wanted to sell, who wanted to buy and their price, and I held that information very tight to the vest.

In some cases buyers and sellers were on different floors in the same office building, or different divisions of the same global corporation.  The biggest challenges for foreign companies doing business in the developing world was converting local currency revenues back into dollars.  One way to get money out was to buy dollar bonds at fixed exchange rate and over time collect principal and interest in dollars.

Creativity and information edge: Struggles over bondholder lists

In almost every country, Smith, goes through difficulty to get the list of people holding the bonds in which he was seeking to make a market. Arbitrageurs and brokers who had access to the list guarded it aggressively, because it gave them an edge in acquiring positions at a discount, or profiting as a middleman. This was a key bit of information, available from connections at the Central Bank or other places.

His experience of trading nonperforming notes(NPNs) in Nigeria exemplifies the struggle over bondholder lists.

At one point Smith worked with a counterparty who was himself tasked with acquiring as many of the NPNs as possible. Smith was hired as a broker on this mission. The counterparty gave him a list that literally had physical holes. His counterparty had cut out names of big holders, limiting Smith to chasing down small holders(keeping larger investors to himself). Of course, in those small illiquid assets portfolio aggregation had value, so smaller the note better the price from buyer perspective. However, building up the portfolio was an arduous process. Smith was interested in maximizing profit, but his counterparty was tasked with acquiring as many NPNs as possible.

The Nigerian situation was interesting because the NPNs were spread out to investors around the world. The Nigerian bank held a meeting in the UK with countries trade creditors ostensibly to announce terms of payment. Prior to getting the list, a key bit of information Smith tried to get was simply who was in attendance at the meeting(unfortunately his lawyer failed to get it).

He ultimately tracked down the full list- it was actually quite easy once he learned where to ask. He called up a friend at the bank serving as the paying agent on the notes. It turned out that by law that only the Law Debenture Corporation, the official registrar could provide the list with one call to London. Ironically, Smith ultimately learned that each holder of an NPN was legally entitled to the whole list.

In the case of Iraq, it turned out information on holders of the debt instrument he was looking to acquire could be pieced together from information on the UN website. This highlights another a subtle change from Smith’s earlier glory years. Now information is theoretically less precious than it used to be. However, often few people know how to use it/find it/analyze it. Sometimes “publicly available” information is known by so few people, that it can lead to a significant edge.

Few who fancy themselves international mavens of finance want to do the grunt work.

Smith’s struggles parallel the adventures of investors in nanocap equities, real estate private partnerships, and other thinly traded securities, especially investors interested in activism or tender offers. Rules on getting the lists of asset holders vary between companies, and jurisdictions. Sometimes you buy one token share and demand it, but the company might make it difficult. In some jurisdictions , you can find shareholder lists online or from other public sources. A little creativity and extra knowledge of the rules can be a huge edge.

The role of misperception

At one point El Salvador had bonds that were objectively as low risk as Treasuries, but trading at 75-85 cents on the dollar because of political instability in the country. Smith was one of the few brokers making a market in these bonds, and he also cherry picked a few of the best bonds for his own account.

How was this possible? The answer was widely held misperception. Few people looked at a key detail:

I noticed something very interesting something other savvy buyers also noticed, no doubt. The principal and interest being paid to the bondholders was coming not from the central Bank of El Salvador but, but in the form of checks from the United States Treasury Department. To bolster the government of El Salvador, its client, and to protect its interest in the country, the US was going to ensure that El Salvador did not default. The real risk in these bonds was practically nil. The US was virtually guaranteeing they would be paid – and paid on time. On top of that, the bonds with the earliest maturities were often being called and paid in full before the due date. With the big boys at Citibank, Morgan Stanley, and the other major investment banks out of the game — too dangerous– stakes too small— I had the playing field to myself and what a field of dreams it proved to be.

Nigeria was another key example of how misperceptions influence markets:

Nigeria also taught me the value of circumspection. Even today when there is so much more financial information readily available in real time on computer screens throughout our world, circumspection is essential in a business such as ours. The Nigerian buyback succeeded in part, because everyone involved kept their own counsel about what was unfolding. There was nothing fraudulent or even unethical about, at least not by the commonly accepted standards of institutional finance. In our business, everyone is secretive because information is truly power in the zero-sum game of making money. Therefore those who know don’t say, and those who know don’t say.

…the larger point however, is that I was able to thrive precisely because there was not yet any real market in these instruments back then. Everyone was stumbling around in the dark with no information. Everyone, that is, but me. I had just enough to make a go of this business.

Origins of distressed debt exchanges

A distressed company or country can reduce its leverage by purchasing or otherwise acquiring its existing debt instruments at a discount to face value. The company may (discreetly) buy back its debt on an open market, or make a cash tender offer. Alternatively it may negotiate with lenders to exchange debt for equity. (See Distressed Debt Analysis: Strategies for Speculative Investors for more detail on the mechanics of distressed debt exchanges and other techniques distressed companies can use to reduce leverage)

These techniques are widespread in developed world distressed debt markets today, but according to Smith, the original development of these techniques came in response to blocked currency problems of companies doing business in countries where it was difficult to convert local profits into a hard currency such as dollars. Turkey was one of the first countries to use this technique to address foreign debt problem and attract new foreign investment. Many emerging market companies did this as a way of realizing value from non-performing loans.

The idea was to retire dollar debt by exchanging it with the Central Bank of the country for local currency that would then be invested in a company, factory ,or real estate in the country. Indeed some countries , to bolster certain segments of its economy, might, by the terms of the deal, restrict the equity investment to specific types of investments.

These methods can be applied to trade creditors as well as bank loans. For example, if Ford  sells  car parts to Turkey, and the buyer defaults on the dollar invoice due to currency restrictions, the trade claim can be swapped for equity ownership in real estate or an operating company. That ownership can be sold to other party for higher price than it would get for trade claim.

For more detail on the early use of debt for equity swaps by emerging markets, see The Global Bankers by Roy Smith.

Dynamics of negotiations impacted how the value got distributed, but in most cases, all parties ended up at least slightly better than they would have been otherwise. Seller of debt gets higher price than secondary market, and local currency investment might be more profitable in long run, but would still have difficult problem of converting currency out. The country would get debt swapped at a discount, and get new capital investment in. From a macroeconomic perspective in a small frontier economy, there is, however, risk of adding to inflation.

Nigeria was Smith’s exposure to the debt equity buyback as a technique for reducing indebtedness and improving a balance sheet. Now the technique was widely used. Sometimes the operations are initially kept secret so the debtor can buyback as much as possible at a low price.

More on the nuances of middleman

Smith operated as a middleman and is justifiably proud/cynical about the middleman’s ability to extract value from markets. When he spoke with buyers he would be optimistic about the country, when he spoke with sellers he would be pessimistic. He never introduced his buyer and seller. However, a middlemen often proved to be essential in the areas in which Smith operated.

Here are three scenarios in financial markets where middleman are genuinely very useful or essential:

  • Market doesn’t exist yet. Smith created markets where none had existed. Many times his sellers were stuck with seemingly useless paper without him. Sometimes the buyers and sellers knew each other, but without Smith had no idea it was possible to trade. Smith did millions USD in transactions from simply placing advertisements in newspapers such as WSJ and FT saying he wanted to buy assets, and  placing advertisements in local frontier market papers saying he was selling.
  • Buyer wants to be discrete.  In illiquid markets, its critical for a buyer to be discrete. This is where a middleman can be of significant value, because even after collecting their fee, the buyer still gets a better average cost. When Nigeria was buying back NPNs, it was essential to keep actions secret by spreading purchases around middleman, and spreading purchases out over time. Middleman asking to buy does not arouse suspicion.  However, an entity affiliated with Nigerian central bank buying would drive up prices.  Plus being able to chase down buyers/sellers was valuable since Smith was more willing and able to do grunt work than people affiliated with large financial institutions.

Once people understand what you’re doing, the price goes up. Why? DuPont might be happy with $300,000 for a million dollar claim, but if they realize it would still be a great deal for [the buyer] at twice that price, they might not part with their claim so readily. Having a middleman is essential. With a middleman, DuPont and the buyer would never meet.

  • Legal restrictions on foreigners. Some countries have restrictions on foreigners buying trade claims, so foreign need to find a foreign partner. Smith experienced this in Turkey.

What makes a market ripe for a lone operator

Smith operated mostly alone out of dilapidated hotel rooms in various countries around the globe. Even as he built up his business he still stayed independent from all of the major investment banks. Indeed he targeted markets that were ignored by the larger players.

Two factors make a market ideal for a small, lone operator:

  • Sums to be made relatively modest.

    “When the big boys saw me running around San Salvador trying to make a deal, they thought it was a joke. At first I thought they might be right. But I was happy to pick up the crumbs they wouldn’t touch. “

    The six figure/ low seven figure transactions he made were far too small for major financial institutions to bother with, but they were relatively large from the perspective of his one man operation.

  •  Extremely dangerous. Smith took the “go where others are afraid to go” to the extreme. At the time he visited Nigeria, it was in such disarray that many westerners had taxi cabs get hijacked in broad daylight. He traveled to El Salvador in the middle of a civil war and a deadly leftist insurgency brought violence close to his operations. It wouldn’t be the last time he traveled into a war zone to make investments.

 Lessons from struggles/failures.

  • Smith tried to launch a remittance and check cashing business, but it didn’t work. He shares several things he learned from the experience:
    • The business didn’t have didn’t have enough locations on sending side. Most of the locations on the sending side were located in a main city, but customers were scattered throughout the countryside. The only way they could use the services was to make the long journey into town.
    • The failed remittance business also taught Smith not to be overly impressed by people with wealth and power. His partner was wealthy and powerful, but he was still unreliable, so the business didn’t work.
    • He wasn’t comfortable profiting from the poor. He was fine profiting from the blind large institutions as a trader in obscure debt instruments.
    • One thing he did right was cut his losses early. He passed on an opportunity to throw more money into the business because he saw it wasn’t going to work.
  • No permanent allies, only permanent interests He had falling out with people and did business with them again later when interests realigned.
  • Like many frontier and emerging market investors He made the mistake of investing in Russia right before it defaulted. His holdings dropped to almost zero on a mark to market basis. Although he ended up making his money back, its not clear that his IRR was anywhere close to what he would normally seek. His fateful decision to invest in Russia occurred after taking a bank sponsored trip to Russia, where in retrospect there were many red flags. Two quotes stand out as lessons from the problems he experienced in Russia:

If you’ve been in the market a long time and you see that nothing is clear that corporate governance isn’t transparent, that there isn’t a legitimate tax systems and no rules or regulations to protect investors you are not made to feel better by drinking lots of wine, eating good food, and flying in a private jet.

If Wall Street is saying this is the best thing since sliced bread, the juice is all runout.

History Repeats: The Serpent on the Rock

“History Repeats.  The first time as a tragedy, the second time as a farce.”

– Karl Marx(1)

There are amusing parallels between the rise and fall of the real estate private partnership market in the 1980s, the pre financial crisis tenant in common(TIC) syndication market, and  the post financial crisis non-traded REIT market driven by Nick Schorsch and his AR Global empire.

Each episode involved high fee investment products designed to fulfill investor desires for yield, tax efficiency and perceived stability, while creating disproportionate benefits for intermediaries.  Each episode ended badly.  And the cycle repeats, again and again.

First of all, the charts tell parallel stories:

Real Estate Limited Partnerships 1970-1991

Real Estate Limited Partnerships

Source: Obstacles and opportunities in the establishment of a secondary market for real estate limited partnerships  

 

TIC Equity raised 2001-2012:

Tenant In Common Equity

Source: Securities Litigation and Consulting Group

Non-traded REIT Equity Raise 2000-2016:

Source: Stanger Report, author’s calculations based on SEC filings.

Note that the 2015-2016 dropoff would be much sharper if you excluded Blackstone’s REIT, which entered the wirehouse channel in late 2016, and accounted for 50% of total annual NT REIT sales within a few months.  Sales to the independent broker dealer(IBD) channel, which Blackstone largely bypasses, were completely decimated, and the dropoff has accelerated in 2017. (2)

May Day

High fee products are sold, not bought. The commissions on illiquid real estate products have always been higher than other investments available to retail investors.

In Serpent on the Rock Eichenwald traces the original real estate partnership craze back to the May 1, 1975 abandonment of fixed commissions on sale of stocks and bonds. Yes it is viciously ironic that commissions were fixed before 1975. The financial services industry was apparently afraid of capitalist competition and all the wonderful creative destruction it brings. Once they lost large commissions on simple security trades, they went looking through more complex higher fee product.

After May Day:

No longer could brokerage firms subsidize their bloated through fat commissions on securities trades. Firms unable to adjust collapsed by the dozens. The industry had to either dramatically cut back expenses or find new products with higher commissions that could be pumped through the sales force. Suddenly tax shelters, which sold for higher commissions than stocks and bonds didn’t look so unappealing.

The impact of May Day has continued to drive down commissions decades later. This makes sense. After all, transactional costs should approach zero over the long run, because with computers the marginal cost of doing a trade in all but the most illiquid complex markets is effectively zero. Significant scale and technological investment is necessary to run a brokerage business focused on liquid markets.

Consequently, the current IBD ecosystem is highly dependent on non-traded REITs and other high fee direct private placement programs. This is complicated by the fact that IBDs payout a high proportion of commissions to the financial advisers(like 90% in many cases). Many financial advisers built their business on 1031 exchanges, non-traded REITs or other private placements. TICs typically charged 20-30% commissions. Commissions eat up a large portion of offering proceeds for non-traded REITs.  Additionally, non-traded REIT sponsors pay out a due diligence kickback to broker dealer home offices. Many smaller IBDs depend on these kickbacks for survival.

Of course, the commissions were much more egregious the first time around. Old timers fondly remember 20%+ loads on product. up front sales loads have now declined to high single digits and low double digits. Inland has driven down commissions on 1031 exchange product. Plus state securities regulators put out NASAA guidelines to limit loads on registered products. Nonetheless in an age where interactive Brokers charges $1 per side on a trade regardless of size, and few modern brokerages charge more than $7 per trade, even high single digit sales loads on non-traded retail product are absurd.

In Backstage Wall Street Josh Brown outlines his “Iron law of product compensation”:

The higher the commission or selling concession a broker is paid to sell a product, the worse that product will be for his or her clients.

This was the thread that connects the 1980s private partnership craze, with the pre financial crisis TIC explosion and the post financial crisis non-traded REIT market.

Yield Pig Exploitation and the Illusion of Safety

Just like private partnerships in the 1970s and 1980s, brokers sold TICs and Non-traded REITs to unsophisticated yield hungry retirees as safe, stable investments.
Here is one description of the private partnership market:

Many of the public offerings were promoted as a way for the small investor to participate in real estate, widely believed to be an inflation hedge, offering greater return and moderate risk as compared to stocks. The ability for an individual of modest net worth or income to invest in securitized real estate was viewed as a real benefit of public syndications.
The limited partners were sold their investments on the assumption that real estate was a safe, growing investment. Often these investors were unsophisticated in investment matters, and were more often swayed by aggressive brokerage salesmanship. The importance of liquidity became apparent to the investors only after substantial investment had already occurred. Liquidity was never promised for limited partnership securities and the partnership structure itself was designed to constrain liquidity.

Source: Obstacles and opportunities in the establishment of a secondary market for real estate limited partnerships  

In Serpent on the Rock Eichenwald meticulously tracked the juxtaposition between sales materials promising safety and the ultimate collapse in values.Non-traded REITs and TICs are also sold as safe investments that do not have the volatility of the stock market. Of course the stability is an illusion, and investors are still highly dependent on the real estate performance.

 

Due diligence

Eichenwald describes due diligence at Prudentialduring the peak of the private partnership craze:

The due diligence team was not just overwhelmed from the number new deals they had to approve- they also had to keep tabs on the old deals that had already been sold. Darr had negotiated for Bache to be paid a monitoring fee from some tax shelters it sold in exchange for reviewing their financial performance. Supposedly, this was designed to make sure that the general partners managing the deals did things right and took care of their investors. It was a key selling point for Bache brokers: In sales pitches, they painted a picture of top Bache financiers in green eyeshades peering over the shoulders of the General partners, watching everything that was done, The image of financial professionals crunching numbers late into the night to make sure investors were protected was a persuasive marketing tool.

But asset monitoring paid only a small fraction of the fees that Bache received from selling new deals. So the job of keeping an eye on the performance of old shelters quickly became viewed as simply a headache. It was an obligation that slowed down the whole process of churning out deals., without enough juice from fees to make up for the effort. The monitoring assignment became a hot potato, passed from executive to subordinates, and from then on down the line.

Many similar scenes in the book are shockingly familiar to anyone who has worked in the alternative investments space.

In subsequent years, third party due diligence firms serving broker dealers helped drive improvements in deal quality, but there are still many serious gaps. Since IBDs depend on the revenue from commissions and due diligence kickbacks, they are under pressure to find product to approve. This bias leads to cognitive dissonance. As non fiduciary middlemen, they often sell things that they wouldn’t invest in themselves, especially with a full sales load.

In the wake of the bankruptcy of TIC Sponsor DBSI, and the collapse of several tax driven energy deals, Reuters investigated due diligence in the independent broker dealer space. It highlighted a too cozy relationship between sponsors and third party due diligence firms.

Perhaps of even greater concern is the  disconnect between due diligence process and the needs of end investors.

Potentially alarming findings are often obscured in multiple pages of recondite language, with no definitive conclusions. “They’re these long-winded things that bury things that might be important inside boilerplate disclosures,” said Jennifer Johnson, a professor at Lewis & Clark Law School in Portland, Oregon, who has written extensively about the private-placement business.

Due diligence firms say their reports aren’t designed to be read or understood by investors. Rather, they are meant to help brokers decide whether to recommend private placements to their customers.

Source:Reuters

Same Same, But Different

Although the distorted incentives,exploitation of unsophisticated yield pigs,were almost identical in each of the three historical examples in this post, there are several key differences. Broker dealers primarily sold private partnerships in the 1980s as a way of reducing taxes. An investor can use a TIC structure as part of a 1031 exchange to  delay taxes when selling a property. REITS are a unique IRS creation but the reason for investing in a REIT is mainly income(Excluding situations where someone exchanges via an UPREIT transaction)
The private partnership market collapsed because the tax reform act of 1986 destroyed their entire structure, and basically collapsed the national real estate market. (see: this FDIC report )

The TIC market collapsed when the financial crisis hit the entire real estate market, exposing the problematic underwriting of the TIC Sponsors. However, regulatory issues weren’t the main driver of the collapse. Like the private partnership craze in the 1980s, the modern Non-traded REIT market also collapsed due to regulatory change although the . Finra 15-02, which increased the transparency on client statements, made it harder for advisors to get away with charging the massive sales loads. The fiduciary standard required broker-dealers to act in the best interest of clients, also led many broker-dealers to suspend or slow down the sales of high commission products.

 

The farce of AR Global’s collapse

Although private partnerships and TIC sponsors generally overpaid for properties they purchased, the collapse of their structures happened during a time of across the board real estate declines in the US

In contrast, investors in post financial crisis vintage non-traded REITs have suffered, in spite of a buoyant real estate market.    ARC Hospitality(Now Hospitality Investors Trust) offered shares at $25.00 a share from 2013-2015, and a client statement never would have shown a value below $22.00 until this summer. It  revalued at $13.20.  A PE fund recently offered  $5.53 for the shares.  Likewise ARC Healthcare Trust III sold shares $25.00, and recently marked its value down to $17.64, and is now subject to an affiliated transaction with no liquidity event in site.

Private partnerships and TICs were tragedies, AR Global was a farce.

 

To be continued….


 

(1) This is from The Eighteenth Brumaire of Louis Napolean.
The full translated quote is :Hegel remarks somewhere that all great world-historic facts and personages appear, so to speak, twice. He forgot to add: the first time as tragedy, the second time as farce.

(2) Wirehouses generally did not sell non-traded REITs until Blackstone entered the market in 2016 Anyone who carefully read The Serpent on the Rock will note how incredibly ironic it is that wirehouses have started to sell non-traded real estate securities again.  More on his in a future post.