PE model threatened

Ivy League Universities and educational institutions have long been dominant investors in private equity firms. For some big ticket buyout firms like Blackstone and KKR, University endowments have been major source of funding. But now it appears that too is drying up fast.

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While Yale froze salaries to employees drawing more than $75 k, Harvard froze it across the board on its Arts and Science school. Harvard with an endowment of $39.6 billion freezing wages, huh? Yes, you heard it right. The 2007 figures and allocations for the entire $43 billion portfolio are disclosed in the endowment’s 2007-2008 year-end report.

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With such mainstay funding sources for PE firms fast drying up and leverage already a bad word, how long will the asset class sustain...?

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Scourge of the bailouts

The scourge of the bailouts is that it helps an addict get deeper into the malaise. First it was the Wall Street Banks, then it’s the Big three and even Biotech companies in Britain that line up with hat in hand. John Grapper in his FT column hollers “it’s time we stop improvising our way out of trouble”.

Steven Horwitz, an economics professor at St. Lawrence University, got it right when he wrote, “There will be short-term pain if we don’t bail out these firms, but that is the hangover price we pay for 15 years or more of binge lending. The proposed bailout cannot prevent the pain of the hangover; it can only conceal it by shifting and dispersing it among the taxpayers and an economy weakened by the borrowing, taxing and/or inflation needed to pay for that $700 billion.”

I look at a basic aspect. Somebody makes a mistake, a very big mistake and everyone is made to suffer. How long can this amnesty go on? Call it moral hazard, but it’s perpetuation of the ineptitude. It’s like serving more booze to an alcoholic.

Take the big three case for bailout. Isn’t it better to float three new car companies with the money that they say they need? Doesn’t that make better sense? Buyout the assets of the existing companies in their bankruptcy proceedings (liquidation) and then rejuvenate them under a new name, minus the union commitments. The only commitment to the organized labor should be just jobs. No huge healthcare excess baggage or other perks for the wily top managements.

The only condition should be make profits and share the loot. I think that sounds more like it. Hank Paulson should be pleased.

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"Don't disgrace potato buyers"

Nitin Desai in Business Standard talks about the market for credit.

“The market for credit is not like the market for potatoes. When I buy potatoes, I choose a vendor, select the spuds, pay the cash and that is the end of it. I do not need to know much about the vendor; nor does he need to know much about me. Once I have paid for and collected the potatoes, the relationship between us is at an end.”

I would say the metaphor is just not up. When my wife buys potatoes, she checks each spud out, rolls it in her hand and looks for any sign of decay or staleness. No she didn’t call that “due diligence”. I guess this must be the practice of every potato buyer since we don’t want to risk our health and that of the family.

But MBA’s do it differently. If there is a market for risk, then it’s not risk for them. Name of the game is slice and dice. So are the credit rating agencies. They just sniff around for a (seemingly) credible issuer (just a name) and that’s it. That’s why capital adequacy and other supervisory arrangements have failed to prevent an elaborate tower of debt, built on shaky foundations that came crashing down when the first high flyer crashed into it.

"Nitin, for God's sake, don’t bunch ordinary potato buyers with those gilt edged MBAs. They are far more caring.

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Hang in there and you'll know

Hank Paulson is not having it easy at all.

When the Congress passed his $700 billion bailout package, the world heaved a sigh of relief. The whole world expected it to contain in its point of origin – that is the US – itself. But it was not to be. What had begun as a mortgage crisis, loomed into a financial crisis and is now threatening to be a global economic crisis.

So what does Paulson do? He goes back to the drawing board, buries his original plan and is redrawing it. Now he doesn’t intend to buy the toxic assets but prefers to recapitalize banks and non-bank financial institutions such as financing arms of America's big car companies(though not, for now, the carmakers themselves). He also disclosed that the Treasury and the Federal Reserve are exploring the creation of a “liquidity facility” to buy top-rated securities backed by credit-card, car and student loans, and perhaps mortgages. Banks used to bundle many such loans into asset-backed securities which they then sell in the capital markets. But that market has all but disappeared. Looks like he hopes private investors to come back and recreate that market.

In the end, it is clear nobody has a clue. Financial anarchy always favor the influential and connected. What I can say for sure is that average Joe is not going to get any better. Just that if you hang in till the end, you’ll know who is going to get off with the loot!

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When nations go belly up

Iceland, a tiny economy with a population of just 320,000 and GDP of £14 billion ($ 23.85 billion) has liabilities in excess of $100 billion against annual GDP of just $14 billion. Clearly, a case of a nation going bankrupt. It is starting to adopt extreme measures by forcing Icelandic institutions such as pension funds to repatriate funds to bolster its reserves in defense of the collapsing currency.

As the Economist puts it –

"Iceland’s rapid rise and even faster fall has been viewed from afar as a parable of greed and hubris, in which a nation of farmers and fishermen borrowed too much and are paying the price. But that is to draw false comfort. Although Iceland represents an extreme case of a huge financial system towering over a small economy, other states suffer from similar imbalances. They differ only in scale, but not substance. Kreppa (“in a pinch”) may be an Icelandic term, but it translates."

The only avenue open to Iceland to function economically on a day to day basis i.e. so as to enable Iceland to import resources such as food and fuel is by long-term loans and guarantees from the IMF and other countries such as Russia which has loaned Iceland euros 4 billion. The net effect is that Iceland is likely to experience a severe and prolonged economic recession and will be forced to develop cash generating commercial industries such as fishing to finance the increased debt burden. The expectation is that over time governments will cancel the Icelandic bad debts in exchange for geopolitical influence.

The fact is, in the flat world in which we live in, Kreppa will more likely translate. Not all may have the EU umbrella above their heads...

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Some questions just stay asked

The Economist on Bank failures –

"…The money markets are a bit like the sewers of the financial system: in normal times, nobody notices them but when they get blocked up, the stench is abominable. And they are severely congested at the moment. The good news is that, unlike last week, it is possible for banks to borrow overnight at a reasonable rate. The bad news is that borrowing at longer rates is either impossible or prohibitively expensive.

…It is, indeed, unfair that banks tend to be rescued when they go wrong whereas coal mines and shoe retailers do not. But banks play a key role in oiling the system; they provide the credit that lets the rest of us do business. They also have innate risk; because they lend more money than they have cash in hand. To put it another way, they borrow short and lend long. This has made them the subject of panics throughout history, and those panics have always led to economic turbulence. The authorities can let them go bust, but the risk is depression. Or they can hold their noses and bail them out.

…And there will be more crises in future. Now that investment banks are part of commercial banks, we have returned to the risks that characterized the system before the Glass-Steagall Act of 1933—specifically, that reckless investment banks can fritter away retail depositors’ money. And what will we have to do if that happens? Bail them out again."

In short, the article says banks should be bailed out because if you don’t it leads to depression. Not because they deserve it, Ha! The banks fail because of mismatch of maturities; they borrowed short to lend long. But how do tax payers care? These banks didn’t fetch them a penny when the going was good. Now when they go belly up, why should they care?

No answers. Some questions just stay asked.
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Hank Paulson kneels; Condy Rice ducks

News. Condy Rice rushing to douse the fire in the old ally’s barn even as she has her own forest fire to deal with. Makes sense. Barn fires in the neighborhood can be put off with a good sprinkling of water. Forest fires die a slow death. Henry Paulson has already knelt down before Ms.Pelosi – No go?

Condy Rice is wise. She fled the scene of the flames to help the fraternity!

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Where will they find the $700 billion?

I don’t really know who else read my previous post. But seems folks at NY Times certainly have. Hardly a day had passed, here they throw up an elaborate Q&A…

Read and figure !

Why just the FM twins, why not Lehman?

So the US government okays a $700 billion bailout package for its distressed financial institutions.

I began to think about the nature of the lifeline. What exactly does a bailout mean? Will the US treasury buyout bad assets and refinance the failed lenders so that they can resume business? Will it float a freshly funded SPV to absorb the bad assets, clean up the muck from the rogue lenders’ books and then eventually sell them? Or will the Fed just go and print fresh notes equal to $700 billion and honor the bonds as they come back to collect?

I look up federal bailout history. The handling of the great depression of 1930’s, the savings & loan scandal of 1989 and a few other. Nothing has been this big. Even more were allowed to go under. They were just not qualified for a bailout, bit like Lehman Brothers.

So where did Lehman goof up? Why only the FM twins (Fannie Mae & Freddie Mac), Bear Stearns and Merrill Lynch? What gives?

To be eligible for a bailout, firms must also demonstrate a particular genius for screwing up. Before it went bust, Bear Stearns had a monstrous $33 of debt for every dollar of capital, and hedge funds it owned destroyed hundreds of millions of dollars of clients' cash. It got a bailout.

Financial intermediaries like Bear Stearns and the FM twins function like the heart of the global financial system. If they go into cardiac arrest, the whole body is in danger. Since Bear Stearns was a counterparty to (and guarantor of) trades and financial arrangements with the world's major financial players, its failure would have triggered a cascade of losses. In the same vein, huge quantities of the $5.4 trillion in debt issued and insured by FM twins sit on the balance sheets of central banks and financial institutions around the globe. For the U.S. government simply to let this debt — which it had been implicitly backing for decades — go bad would have meant inflicting severe damage on America's most significant diplomatic and trading partners. Fannie Mae wasn't too big to fail, it was too Chinese to fail.

So now I get it. To be eligible for a bailout it’s not enough to be just too big. Screw it up real bad that it should threaten the global financial system. So much so that the ensuing stress on financial markets should mean massive job losses, devastated retirement accounts, further erosion of asset values and absent loans – not just in your country, across the world.... New world order, period.

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What's left in Wall Street?

Bear Stearns, Merril Lynch, Citicorp, UBS, Washington Mutual, Fannie May, Freddie Mac and now Lehman Bros. What’s left in Wall Street?

Waves of selling wiped out nearly half of Lehman’s value in the stock market on Tuesday, leaving the firm, one of the nation’s oldest and largest investment banks, in an all-out fight for survival.

“He [Richard S Fuld, Jr., CEO of Lehman Bros] is dealing as if he has a whole deck of cards, when as he has none” – NYT reporters quoting a banker who has had recent dealings with Lehman, representing a potential foreign buyer.

How long can they live in denial?

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After bailout, comes the default

If it was the massive bailout last Sunday, it seems all that prayers in the Church may not have worked. Now here is what it triggered – a massive CDS default…
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Why does it linger?

The Economist brings out a brilliant analysis of why the liquidity crunch refuses to die down.

It’s a long article. Here is my synopsis –

The double shock of decline in house prices and the sudden slump in prices of ABS have come at a time when the global economy is also witnessing a surge in commodity prices. This limits the power of the central banks to cut interest rates as it could stoke inflation further up.

The double shock entails uncertain direction of monetary and regulatory policy. When inflation targets are revised upwards, central banks will crack down so hard on inflation pushing the economies into recession. Further the effect of investment bank rescues will let in a harsh new regulatory regime that will stifle credit and hence future growth.

Then it is the nature of the previous boom fueled by indiscriminate borrowing by people to buy houses that they couldn’t clearly afford hoping to cash in on capital gains and investors buying complex high yield debt products they hardly understood. Both the lenders and investors were beholden to banks and that former wellhead of finance has now run fairly dry. In turn, that explains the absence of bargain hunters, particularly in the debt markets.

Investment-grade debt might look attractive on a five-year view, if all you have to worry about is the risk of default. But most investors in that market have a three- or six-month view; they cannot afford for things to get worse before they get better, in case they are forced into a fire-sale of their assets.

"So the markets (and the developed economies) are waiting for a catalyst for recovery. Lower commodity prices helped for a while, and may help further if they encourage central banks to cut rates. Evidence of a bottom in the American housing market may also do the trick. But the crisis seems certain to linger into 2009, and could even make it into the following year. Successful horror movies tend, after all, to have several sequels."

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"When a big tree falls....

…the earth shakes." So if you are quake-o-phobic, prop it up. Never let it fall. That’s what regulators did with MBIA, the big bond insurance company, reneged on a promise to shore up a crucial unit with $900 million in capital.

MBIA has written $137 billion in swaps, which are privately traded insurance contracts that let people bet on companies’ financial health. Most of these contracts stipulate that if MBIA’s bond insurance unit becomes insolvent or is taken over by state regulators, buyers can demand payment immediately.

"But if that were to happen, MBIA would have far less money to pay policyholders and owners of municipal bonds backed by the company. So the swaps give MBIA significant leverage over Eric R. Dinallo, the commissioner of the New York State insurance department, who wanted the company to bolster its insurance unit with the $900 million in cash.

In the case of Bear Stearns, the Federal Reserve feared that credit default swaps might unleash a chain reaction of losses if the bank were allowed to collapse. Given the threat that similar swaps may pose to MBIA, Mr. Dinallo is unlikely to push for a regulatory takeover of the subsidiary even if Joseph W. Brown, MBIA’s chief executive, refuses to recapitalize the unit." [Hat tip : NYT]

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