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How our financial world has changed since 1999
The Roll-Up is gone, Roach Motels are bigger, and the Sheeple still feed the wolves
by Eric Janszen
The Devil's Derivatives Dictionaryof financial market terms got its last update in July 2000, seven yearsago this month. The work of derivatives industry professional and bookauthor William Margrabe, the site went quiet November 2001, leaving theDictionary as a time capsule of the period, a treasure chest of acerbicwisdom modeled on Ambrose Bierce's Devil's Dictionary.
While most of Margrabe's definitions are timeless, those that no longerapply reveal a changing world. We review a few favorites.
Today this term applies as well to larger operations, such as hedgefunds that invested heavily in illiquid credit instruments likeasset-backed securities. Easy enough to buy into those funds when themarket for ASB CDOs was $30 billion a month as it was in April 2007.But in May when the market suddenly shrank to $2 billion some investorstried to run to redeem their shares. They found their feet firmly glued to the floor. The hedge fund game was already on, in accordance with the iTulip Law of Replacement. Even as the stock market bubblegame was winding down, the hedge fund game was already in play, asMargrabe points out in his definition of an Accredited Investor.
Like a Ponzi scheme, the influx of new money into the sector drives upprices in the early stages of the cycle, and the investor can bragabout how much money they've "made" on paper. They can make actualmoney if they are smart and quick enough to get out before the otherguy, the way Sam Zell did recently when he dumped all of hissoon-to-be-distressed commercial real estate holdings on a privateequity firm. We've been wondering who's going to occupy all of thoseempty office buildings with the "For Lease" signs we've seen alongsuburban highways for the past seven years, as the outsourcing andwork-at-home trends grow.
When a bubble pops Joe Sixpack, on the other hand, usually doesn't knowwhat hit him. The high tech industry went into deep recession after2001, with unemployment in the metro San Francisco area exceeding 25%in 2002. Many friends lost both their money and their jobs. We suspectthat the industries that private equity corporation flippershave focused on for the past few years will suffer a similar fate. Butnot for long, thanks to the Air Bag Economy, as defined by Margrabe.
Sifting through the contents of the Margrabe time capsule we findschemes that were popular at the time but which have since the collapseof the stock market bubble either been regulated away or faded away asmany bad investment ideas do, by running out of new suckers. Forexample, the Technology Stock IPO.
Continuing down memory lane, we come across other defunct investor schemes. Remember the Roll-Up?
How many? According to our recent interview with John Challengerpossibly enough to put the US economy into recession at some point overthe next year or two. In fact, that is the only potential source ofrecession on his radar. The way we see it, the housing bubble inducedrecession occurs first, in Q4 2007, leading to a drop in demand anddeclining revenues. The recession is then amplified by corporaterestructuring. Evidence that this process has already begun is showingup in sales tax receipt numbers.
While we read about the big disasters like the Bear Sterns hedge fundsthat made heavy ABS CDO bets, you don't hear as much noise as you mightexpect, considering the market for hundreds of billions of dollars ofsecurities disappeared virtually overnight. According to our sources,dealers are sitting on their hands waiting for the market to improve,while the banks that lent the money that the CDO firms leveraged putthe loans in the balance sheet "cache" rather than write them off. (Weheard this from three of the CDO fund managers we interviewed, alongwith what really happened at Bear Sterns. Stay tuned here for thatstory.)
This next entry reveals just how much the global finance economy has changed over the past seven years.
Such lending practices as "packing" and "flipping" were wellestablished back when Margrabe last updated his dictionary in 1999.Around the same time the widely ignored by lawmakers and the press housing appraiser's petitionwas launched. We concede that Margrabe was way ahead of us noting thewhole mortgage lending racket back. While emerging markets rose fromthe market corruption muck, the USA standardized third world lendingpractices.
There are many gems in Margrabe's dictionary and we will return another time to review them. We leave you with two more.
The first cautions that a government's ability to bail out certain sinking financial ships has limits.
The Roll-Up is gone, Roach Motels are bigger, and the Sheeple still feed the wolves
by Eric Janszen
The Devil's Derivatives Dictionaryof financial market terms got its last update in July 2000, seven yearsago this month. The work of derivatives industry professional and bookauthor William Margrabe, the site went quiet November 2001, leaving theDictionary as a time capsule of the period, a treasure chest of acerbicwisdom modeled on Ambrose Bierce's Devil's Dictionary.
While most of Margrabe's definitions are timeless, those that no longerapply reveal a changing world. We review a few favorites.
Roach MotelJudging by the contents of our full-to-the-brim dailyemail spam folder, penny stock promoters continue to do a thrivingbusiness, albeit out of the Ukraine today more often than New Jersey asin the late 1990s.
An investment that you can get into, but can’t get out of.
The prime example is a thinly traded penny stock whose price promotersare manipulating. Its price keeps rising on small volume. You get in atthree and watch the price go up to seventeen. You try to get out andfind that the only bid is two.
Today this term applies as well to larger operations, such as hedgefunds that invested heavily in illiquid credit instruments likeasset-backed securities. Easy enough to buy into those funds when themarket for ASB CDOs was $30 billion a month as it was in April 2007.But in May when the market suddenly shrank to $2 billion some investorstried to run to redeem their shares. They found their feet firmly glued to the floor. The hedge fund game was already on, in accordance with the iTulip Law of Replacement. Even as the stock market bubblegame was winding down, the hedge fund game was already in play, asMargrabe points out in his definition of an Accredited Investor.
Accredited InvestorAccredited investors rarely complain when they get rippedoff because making money is only one of the reasons they invest in highrisk funds. The other and perhaps more important motivation to some isto earn cocktail party bragging rights as sophisticated investors.Confessing to gullibility by crying foul defeats the purpose. The fundsales people know this, of course, and will always drop the names ofprominent investors in a fund in order to give the prospective investorthe sense of joining an exclusive club.
In the eyes of the SEC, an outlaw not deserving of the usual standardsof financial disclosure, because of his past frugality or past andanticipated near-term productivity. The SEC can rely on a variety ofbounty hunters–including bucket shop operators, promoters of limitedpartnerships and penny stocks, hedge fund managers, and commodity pooloperators–to cut this vile character down to size.
SEC Rule 505, which offers one way of issuing securities without registering them, defines accredited investor to include
1. a natural person with a net worth of at least $1 million;
2. a natural person with income exceeding $200,000 in each of the twomost recent years or joint income with a spouse exceeding $300,000 forthose years and a reasonable expectation of the same income level inthe current year.
According to SEC regulations, an accredited investor is fair game forthe sellers of a variety of securities, including interests in hedgefunds. This is analogous to the statutory rape laws that define aperson over the age of consent (12 years old, in Delaware) as fair gamefor any smoothie with a good pickup line or a new pickup truck. Toquote the SEC, "It is up to you to decide what information you give toaccredited investors, so long as it does not violate the antifraudprohibitions."
Like a Ponzi scheme, the influx of new money into the sector drives upprices in the early stages of the cycle, and the investor can bragabout how much money they've "made" on paper. They can make actualmoney if they are smart and quick enough to get out before the otherguy, the way Sam Zell did recently when he dumped all of hissoon-to-be-distressed commercial real estate holdings on a privateequity firm. We've been wondering who's going to occupy all of thoseempty office buildings with the "For Lease" signs we've seen alongsuburban highways for the past seven years, as the outsourcing andwork-at-home trends grow.
When a bubble pops Joe Sixpack, on the other hand, usually doesn't knowwhat hit him. The high tech industry went into deep recession after2001, with unemployment in the metro San Francisco area exceeding 25%in 2002. Many friends lost both their money and their jobs. We suspectthat the industries that private equity corporation flippershave focused on for the past few years will suffer a similar fate. Butnot for long, thanks to the Air Bag Economy, as defined by Margrabe.
Air Bag EconomyNeither Margrabe nor iTulip guessed back in 2000 that someof the principles of the Japanese Air Bag Economy were soon to beapplied to the US economy, but USA-style and to far greater affect. Asthe stock market crashed 2000 - 2001, a housing bubble rapidly inflatedvia tax policy and super-low interest rates to cushion the impact. Sixyears later, as the housing bubble deflates, energy and infrastructurebubbles are inflating to keep the US economy and markets going. Werefer to this as The Bubble Cycle (2004), which has for all practical purposes replaced the business cycle in the US.
The Japanese economy, where the government intervenes to protectbusinesses and banks from crashes in prices of goods, services, stocks,and real estate. As a result, " ‘Everybody has jobs, everybody hashealth care, and nobody’s out on the street,’ Professor Morse said."Also, nobody has the proper incentive to take strong action and fixwhat’s broken. The result – economic stagnation from 1990 to 1999 – andstill counting. (Nicholas D. Krisfof, "The Japanese and Inertia," NYT,6/19/98.)
Sifting through the contents of the Margrabe time capsule we findschemes that were popular at the time but which have since the collapseof the stock market bubble either been regulated away or faded away asmany bad investment ideas do, by running out of new suckers. Forexample, the Technology Stock IPO.
Technology Stock IPOStock lock-up regulations put in place in 2001 prevent IPOshare flipping, putting an end to the IPO boom, although we areexperiencing a minor echo bubble today in tech IPOs, encouraged by theongoing echo bubble in the stock market.
You had to beg your registered rep to let you in on the deal. Now,you tell him you want to "flip" your shares (sell them after holdingthem only briefly) and you meet resistance: "Do you really want tosell, now? You'll be leaving a lot of upside on the table." Turns out,if you sell, his boss makes him pay a severe penalty for not handlingyou properly. Of course, "the customer's interest is primary," but theunderwriters dumped their stock as soon as possible.
Continuing down memory lane, we come across other defunct investor schemes. Remember the Roll-Up?
Roll-UpRoll-Up schemes ended, as the NYTimes article predicted,when the debt and stock markets tanked. In its place have the LBObubble run by private equity, in turn fueled by the market forcollateralized loan obligations (CLOs). Now that game is going the wayof the stock bubble era roll-ups. The difference is that companies thathave been left with impaired balance sheets due to debt leverage willin the future when revenues fall in the next slow-down have to choosebetween laying off employees or not meeting the payment terms if newdebt can't be raised. That means bankruptcies and layoffs.
Definition:
1. A firm that tries to make a huge, silk purse out of a large number of tiny sows ears.
2. A firm that creates “growth through a constant acquisition binge” of small firms within a single industry.
Examples: U.S. Office Products Co. and Waste Management Inc., circa 1998.
Applications: Wayne Huizenga consolidated garbage companies into WasteManagement and video stores into Blockbuster. Others have consolidatedsmaller firms in the funeral home, internet service provider, andplumbing sectors.
Theories behind the “roll-up business”:
1. “[R]oll-ups … bring economies of scale, management discipline andaccess to capital into industries dominated by inefficient,undercapitalized mom-and-pop shops.”
2. The acquisitions provide a way to create spurious earnings growth.
3. They borrow and buy, borrow and buy. So when the stock market andbond market are up, roll-ups prosper. When either the stock market orbond market tanks, roll-ups suffer. When both markets tank, roll-upsdie.
Source: Paul M. Sherer, “Roll-Ups: Ironing out the Bumps,” NYT, 9/3/1999.
How many? According to our recent interview with John Challengerpossibly enough to put the US economy into recession at some point overthe next year or two. In fact, that is the only potential source ofrecession on his radar. The way we see it, the housing bubble inducedrecession occurs first, in Q4 2007, leading to a drop in demand anddeclining revenues. The recession is then amplified by corporaterestructuring. Evidence that this process has already begun is showingup in sales tax receipt numbers.
While we read about the big disasters like the Bear Sterns hedge fundsthat made heavy ABS CDO bets, you don't hear as much noise as you mightexpect, considering the market for hundreds of billions of dollars ofsecurities disappeared virtually overnight. According to our sources,dealers are sitting on their hands waiting for the market to improve,while the banks that lent the money that the CDO firms leveraged putthe loans in the balance sheet "cache" rather than write them off. (Weheard this from three of the CDO fund managers we interviewed, alongwith what really happened at Bear Sterns. Stay tuned here for thatstory.)
CacheApparently the dealers think that waiting versus trying tosell into a dead market will allow these securities to ripen to a morepalatable Fair Value.
"A portion of RAM set aside as a temporary storage area, or buffer, tospeed up communications between the microprocessor and the hard driveor other components." ("Jargon Watch," Fortune Technology Buyer'sGuide, Winter 1998, p. 10.)
A portion of the balance sheet set aside as a temporary storage area,or buffer, to slow up the communication between the trading area andthe controllers, financial accountants, top management, and/or theshareholders. In commercial banks, it has in the past consisted of aninvestment portfolio that the bank need not mark to market and cancarry on the books at cost. In investment banks, it has recentlyconsisted of a reserve account and non liquid investments that thetrader can mark at will.
Fair ValueRose soup. Yum. Another Margrabe dictionary entry remindsus that every major crash in US markets over the past 30 years wasprecipitated by Asian investors pulling money out of some market tobring it home to meet some urgent domestic need.
Futures pricing for those idealists who believe that rose soupshould be better than onion soup, in theory, because a rose smellsbetter than an onion.
Russian fluWatch what happens when China some day yanks money out of US markets to reflate a crashing banking system at home.
Lackluster performance in the Russian financial markets in late 1997,largely because foreigners (largely, Asians, particularly Koreans, whowere feeling the effects of "Asian flu" withdrew some $7 billion ofinvestment during that period. (Laure Edwards, "Russian Flu Symptoms,"Financial Trader, 2/98.)
This next entry reveals just how much the global finance economy has changed over the past seven years.
Emerging MarketParadoxically, since Margrabe penned this definition in1999 not only have most of these "backward" economies repaid theirloans to the World Bank and IMF, but by investing their "excesssavings," as the Fed and Congress prefer to call it, in US debt marketskeep the US economy from submerging into tight credit and highinflation quicksand. Did this relationship between the borrower andlender reverse because the institutions in emerging market countriesover the course of a few years suddenly become transparent andscrupulous, or has a kind of third world market standards role reversalhappened to level the playing field?
A backward economy, temporarily growing faster than its indigenousthieves can deplete it, as brokers and dealers, those imaginativeauthors of modern financial fairy tales, describe it to theirstarry-eyed victims. A future submerging market (q.v.).
Such lending practices as "packing" and "flipping" were wellestablished back when Margrabe last updated his dictionary in 1999.Around the same time the widely ignored by lawmakers and the press housing appraiser's petitionwas launched. We concede that Margrabe was way ahead of us noting thewhole mortgage lending racket back. While emerging markets rose fromthe market corruption muck, the USA standardized third world lendingpractices.
PackingOnce frowned upon, these practices have become suchstandard practice in the US that the terms "packing" and "flipping," bythese definitions, now seem quaint. Today one can simply substitute theterms "lending" and "refinancing." We note that while Americanconsumers have been infantilized by government agencies charged withkeeping dioxin out of the drinking water and anti-freeze out of thetoothpaste, and putting air bags in autos to save lives in crashes,perhaps some day when the banking industry gets its claws out ofCongress we'll see a few consumer protections from toxic creditproducts. We expect to see this after the last eight years of masspoisoning of household balance sheets with credit card and mortgagedebt produces the kind of disaster that got Congress off its ass toface down chemical, food, and automobile companies lobbies.
The lending practice of piling credit fees and insurance productsonto a loan, until the drowning borrower can no longer stay afloat. Cf."flipping" and "packing." To the great credit of Sen. Charles Grassley(R. Iowa), chairman of the Senate Special Committee on Aging, he doesnot plan legislation to infantilize American borrowers by regulatingthis process, but is only pointing out the abuses by "a few bad apples"who are "con artists" and "immoral and unethical". (Matt Murray, "Ford's Loan Unit Draws Criticism at a Hearing," WSJ, 3/17/98.)
Flipping
Giving a borrower more and more rope, until he hangs himself. Namely,"extend[ing] to borrowers a succession of loans, with each new loanrefinancing the terms of its predecessor." Cf. "packing" and"stripping."
There are many gems in Margrabe's dictionary and we will return another time to review them. We leave you with two more.
The first cautions that a government's ability to bail out certain sinking financial ships has limits.
BailoutThe last is our own. While we are honored to be includedin Margrabe's dictionary, we're not sure that we in fact invented theterm "Sheeple" in 1999. We will accept credit for coming up with aclever definition in our April 1999 warning to mutual fund investors, The Sheeple Shall be Shorn. It applies as much today as then, for while the bubbles and players may change, the game never does.
What the federal government didn't do for Long-Term Capital–instead, it "persuaded" LTC's lenders to bail it out.
A bailout is an effort to remove the water from a sinking vessel.Sometimes it works – Chrysler Corp.– and sometimes it doesn't – theU.S. thrift industry and the Titanic.
Sheeple (1999)iTulip Select: The Investment Thesis for the Next Cycle
n: a mass of investors comprised of individuals each of whom makesinvestment decisions based on the observed actions of the other membersof the herd : sheep-like as a : one unable to make rational investmentdecisions based on personal observations that lead to actions thatcontradict the actions of the herd b : uncritical of information inputsfrom those who seek to profit from them, such as financial servicescompanies c : in for a big surprise
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