Archive for May, 2008

Not to alarm you…

Thursday, May 29th, 2008

Here’s an interesting cluster of headlines.

Nov 2007: Wells Fargo Bank: worst housing crisis since Great Depression.
Feb 2008: US govt: Ohio job losses worst since Great Depression.
Apr 2008: Soros: worst financial crisis since Great Depression.
Apr 2008: Stiglitz: worst recession since Great Depression.
Apr 2008: IMF: worst financial crisis since Great Depression.
Apr 2008: IMF: US in worst economic crisis since Great Depression.
May 2008: Moody’s worst housing crisis since Great Depression.

The bad part of the above is the high credibility of the sources.

The silver lining, if any, is a reasoning error that occurs when reading headlines like these. One infers “as bad as the Great Depression,” when in fact they merely say “worse than everything except the Great Depression.”

Those statements are very different. If today’s situation is only slightly worse than the 1970s, then we can cheerfully look forward to a decade of falling real asset prices and standard of living. Why cheerfully? Because it does not automatically imply the starvation, revolution and global warfare that are conjured up by invoking “Great Depression.”

That said, notice also that the 1970s and 1930s were nothing alike, and this one will likely be yet again something else.

My thinking cannot help being influenced by Nassim Nicholas Taleb, whose excellent book I’m currently reading.

Time Warner and the Spinoff Surge

Friday, May 23rd, 2008

The financial press observes correctly that Time Warner’s recently announced cable spinoff reflects a more general surge in corporate spinoffs in 2008. Why would this be happening now?  Like everything else these days, it results from the credit crunch.

The first reason is the collapse of private equity.  Before August 2007, if a public company even hinted about splitting off an attractive division, the division was immediately swallowed up by Blackstone, Cerberus or their peers.  This is now impossible, because private equity firms cannot obtain cheap debt financing for acquisitions.

The second reason is slightly more complicated.  Most stocks are priced as a multiple of their earnings per share.  Many such stocks have been going down in recent months, for three reasons:

  1. Corporate earnings have stalled as consumers and businesses feel the pinch of reduced borrowing power.
  2. Pessimistic investors will no longer pay so large a multiple of earnings as before.
  3. Stocks compete with bonds.  The credit crunch has increased the amount you can earn from a bond investment, making stock yields less attractive by comparison.

How does this result in spinoffs?  Because corporate management and investors constantly seek ways to increase share value.  If the normal solution — increased profits — doesn’t work, they look for other ways.

Spinoffs fill the bill nicely, because they address two of the three issues above:

  1. Corporate earnings have been shown to grow faster post-spinoff.  This is believed to result from better management incentives:  if you increase profits as a division head within a company, you get a pat on the back, but if you do it as CEO of an independent firm, you get millions of dollars in incentive pay.
  2. Investors have been shown to pay higher earnings multiples for more easily understandable businesses.  Spinoffs increase understandability.  For example, Time Warner is a complicated conglomerate, but Time Warner Cable is simply a cable company.

Activist investors are increasingly aware of the spinoff effect, and have been pushing for breakups at well-known companies.  For example, Nelson Peltz appears to have been instrumental in spinoffs Cadbury Schweppes in 2008 and Wendy’s in 2006;  Carl Icahn pushed for the spinoffs at Time Warner and Motorola in 2008.

There are two barriers that prevent a real flood of spinoffs.  

  • Some conglomerates tend to receive higher debt ratings than would their component businesses. As a result, and again because of the credit crunch, some spinoffs may be prevented by the inability to issue bonds as an independent company.  For example, there was some question whether the Dr. Pepper Snapple spinoff from Cadbury several weeks ago would be delayed by debt issuance problems.
  • The compliance costs of the Sarbanes-Oxley Act of 2002 make it prohibitively expensive for companies under about $100m market capitalization to go public.  This would not affect larger companies like Time Warner Cable.

Both these barriers may be removed, as corporate debt issuance settles down and the SEC provides an exemption (proposed) for smaller firms from the most onerous parts of Sarbox compliance.

    How to destroy Google

    Wednesday, May 21st, 2008

    I like Google.  They are brilliant, non-evil, I use their various services daily, my best friend from college works there, etc.  No complaints.  The following is merely an academic exercise in business strategy.  

    If you were a loser in pay-per-click search advertising (e.g. Microsoft), how would you fight back?  Taking Google’s customers is too hard, because there’s no real reason to switch.  Instead, why not just destroy the entire PPC ad market by open-sourcing the web search industry?

    Imagine that MSFT and other also-rans funded a truly independent, nonprofit, open-source-based search site, which ran no ads. Computer makers could easily be convinced to use it as their default search engine, because it would reduce their dependence upon Google, without increasing their dependence on Microsoft.

    This strategy would steal page views from Google.  It is not necessary to kill Google to end its dominance:  a 30-point loss in market share could drive Google into the red, throwing its virtuous cycle (earnings, stock options, recruiting) into reverse:  share collapse, layoffs, reduced retention, etc.

    There are no anti-trust concerns — this would be a truly independent entity, jointly funded by a consortium, rather like Mozilla.

    The technical hurdles are low.  Search engines long ago reached the “good enough” stage.  The insights of Page and Brin in the mid-1990s were so great that little has changed in the past several years.  There already exist reasonably good open-source modules for web search.  

    The main hurdle is the capital expense of a big server farm.  Assuming a consortium pays for this, all that’s needed is to plug some GPL modules together, scale them up, and set this as the default search engine on all new HP and Dell computers.

    Such a service would not work as well as Google.  But it would be good enough, and would be the default on every new computer.  By thus sucking revenue out of pay-per-click, MSFT could sustain the Empire for a few more years.

    Why would I write this, if I love Google?  First, because it’s the truth, and second, because there is no risk that paralyzed, rudderless Microsoft would actually do it.



    Ending the credit crisis

    Tuesday, May 13th, 2008

    Solutions suggest themselves when you state a problem precisely.

    The phrase “credit crisis” is unusably general.  The precise problem is that no one trusts their own estimates of default risk, so they’re afraid to lend.  It’s that simple.

    Here are some key tools used to estimate default rate, and why they are no longer trusted.

    1. Credit rating.  In 2007, it emerged that thousands of AAA ratings granted by the three rating agencies (Moody’s, Standard & Poor’s, and Fitch) were completely wrong.  
    2. Extrapolation.  The economic environment has changed so abruptly, and so many unregulated financial instruments have been introduced in such a short time, that extrapolation of past default rates is increasingly recognized as a fallacy.  As an easy example, exotic mortgages mostly didn’t exist 10 years ago, so there is no historical basis to estimate default rates.
    3. Financial statement transparency.  Previously, you could estimate the default risk of a company by looking at its books.  Today, increasing use of complex derivatives and off-balance-sheet liabilities make this more difficult.  For example, since many derivatives are illiquid, their market value cannot be estimated from current prices;  derivatives face their own counterparty risk (aka clearing risk) that is hard to estimate;  etc.  Worst, everyone knows the big financial institutions are holding out on us — whatever their books say, everyone knows they still have yet to write off all the junk.  As long as everyone believes that, they will be afraid to lend.

    Note we have not mentioned monetary policy at all.  That’s because it doesn’t help.  As written here in January, short-term rates could go to zero, and lenders would still be afraid to lend, because they cannot estimate default risk from credit rating, nor balance sheets, nor extrapolation from the past.

    The solution — the only solution — is to restore confidence through transparency.  At minimum, this would require:

    • Major central banks to agree on disclosure standards, and force all banks to air the dirty laundry.  
    • A very noisy, very public government oversight campaign to restore confidence in bond rating agencies.
    • FASB standards to require public disclosure of the maximum exposure of a company’s derivative instruments, rather than just the market value of those instruments.

    These and other steps would begin to restore a rational basis for estimating default risk, which in turn would permit rational pricing of bonds, which in turn would restore the bond market, which would cause bond yields to fall, which would restore the stock market.

    The financial press and powers that be are weirdly silent on all these issues, exactly those required to mitigate the damage.  How strange that some civilian in southern California would even find it necessary to write a post like this one.