Wednesday, February 3, 2010

Live By The Sword And Die By The Sword

Here is something I wrote to a friend the other day about TOO BIG TO FAIL.

Well, I have been reading this book and while I think Andrew Sorkin knows his stuff, or, should I say, I hope he does. The simple, the very simple, at times, goes unexplained. Leverage is another word for borrowing money. A corporation that is highly leveraged makes big money, or more precisely their return on equity is a bigger number, than a corporation that isn't so highly leveraged. You see, once you pay the "rent" on the money known as interest you borrow to make more money, the rest is pure profit after the corporation's expenses. So, if you borrow a lot and have a 30:1 ratio of borrowed cash to cash you own, you can make lots of money. But, what happens if you borrow a lot of money and you buy ice cream and your refrig goes bad and your ice cream melts? Now you have borrowed a lot of money and no ice cream to sell to pay the borrowed money back. Now substitute mortgage-backed bonds or real estate holdings for ice cream and instead of the ice cream melting, the bond market has a meltdown because no one knows what the bonds are worth because they ain't worth the triple-A credit rating they were given by the credit rating agency that rated them, or the real estate is not worth what the investment bankers paid for it. This shit is not complicated, but if you don't work in the field, it seems very complex. This complex bullshit is what the people on Wall Street want everyone to think.

The other big problem for investment bankers and their publicly traded corporations is short sellers. Those that live by the sword die by the sword. The firms make nice money when other corporations are being shorted by their hedge fund manager clients that trade with them, but when the shorts are directed at them, they cry foul. Well, you can't have it both ways. Either stand up for reform of the shorting of equities with the up tick rule, or, remain silent and await your turn to be stabbed in the back.

The other big problem for a publicly traded investment bank is the practice of mark to market. In the Super Bowl this Sunday, when a team commits a foul the yardage is walked off. Yes, you screw up and the ref walks off 5, 10 or 15 yards and now you have further to go for a first down and a touchdown. Simple. On Wall Street, mark to market of real estate or bonds that have no buyers is a ticklish thing. No one wants the yardage walked off against them. They want to commit capital to a "bad play" and not have to receive any penalty. Here is where the short sellers come in. They, the short sellers like a hedge fund, don't believe the books that the investment bank puts forward to reflect the financial condition of the corporation. And, before you know it, everyone is joining the party and selling that corporation's stock down to oblivion. At this point, the lights on the pinball machine go crazy and the hedge funds make lots of money. Game over.

Just for one second can you imagine, what a Super Bowl would look like if only say one ref took the field to call the game? What do you think the game would look like? I was watching an NFL game this past season one evening and I saw former Fed Chairman Alan Greenspan sitting in a box eating and watching the Washington Redskins. I wonder if he ever gave a thought to what football would look like if we took the refs off the field and let the teams "self-regulate" the game? I have already written my feelings about Mr. Greenspan's intellectual abilities more than a few times. Yes, I hope he enjoys soaking in his tub.

Stay tuned.


LceeL said...

Okay - simple left unexplained? What is the 'up tick' rule? And what IS 'Mark to Market'?

moneythoughts said...

Oh Lou, you would have to put my feet to the fire. : )

The "up Tick Rule" simply stated is that short sellers could not continue to sell a stock short until there was a trade to buy the stock, which would cause an "up tick" in its price. The way they let the things go was that hedge fund managers could just pile on and drive the stock price down to nothing without there being some buyers to cause an up tick in the price. Naturally, they have to buy it back at some price to repay the stock to the broker they borrowed it from. The difference in the price of the stock they sold it at and the price they buy it back is their profit in the stock. Sell at $100 and buy it back at $25 and you make $75 less your commission to do the trade. Pretty good work if you guess right.

Mark to Market simply means that any asset, such as a bond or real estate is valued at the price that it can be sold in the market at a particular point in time, usually the end of a quarter, such as in a quarterly report or an annual report. If the corporation does not mark their "mistakes" down at realistic levels, then the hedge fund managers will see this and make a determination that that corporation's stock may be over priced in the market. Holding a lot of over priced real estate or bonds on the balance sheet as an asset when the real estate or bonds are only worth half the value the corporation paid for them is simply over stating the financial strength of the corporation.

This is where corporations get themselves into trouble. Write down your mistakes and take the penalty now. Don't wait for some hedge fund manager to feel your corporation isn't being truthful with the public. Once they smell blood, it is like a shark attack. The market value of the corporation gets butchered by the short sellers.

winslow said...

There definitely should be rules about the amount of leverage a company can take. How would this affect a private company?

Along with all the ridiculous activities companies have gotten away is another problem....
a co-worker just told me his wife has over $30,000 in credit card debt........again! They are going to re-finace their house...for the 3rd or 4th time...and incorporate the credit card debt in their payments. After 1 year, they will just walk away from the house.

I find this immoral and unethical. I'm struggling to keep up with my payments and others are allowed to make a mockery of the system. This is not right.

moneythoughts said...

Winslow, I agree, something needs to be done to make everyone more responsible for their debts. The bailout was just that a BAILOUT. A better system of keeping everyone on the straight and narrow would be ideal. I know there are times due to illness (that's why we need reform in health care) that a family winds up with huge debts from no fault of their own. But, these type of events don't happen to everyone, thank God. Children in school should be taught how to survive in a complex financial world. That would be a good first step.