Feb 27, 2009

Working in Media is Its Own Reward...

In December, the Tribune Co,, publisher of the Chicago Tribune, Los Angeles Times and Baltimore Sun, filed for bankruptcy protection.

In January, the Star-Tribune, publisher of Minneapolis' largest newspaper also filed for Chapter 11 protection.

This week, the Rocky Mountain News announced it was shutting down a few weeks shy of its 150th birthday, the Philadelphia Inquirer filed for Chapter 11 in its 180th year and the Journal-Register, publisher of 20 daily newspapers, also filed for bankruptcy.

Hearst Corp. has threatened to shut down the Chronicle in San Francisco if it cannot get concessions from its employees and has said it will shut down the print edition of the Seattle Post-Intelligencer if it cannot find a buyer within 60 days.

Meanwhile, the New York Times Company, publisher of the New York Times and the Boston Globe, is trying to sell off assets and has suspended its dividend to conserve cash.

So, in the last three months, the publishers of leading newspapers in eight of the biggest 23 markets have entered bankruptcy proceedings or threatened to shut down. I sense a trend.

To be fair, a number of the bankruptcy filings are related to bad capital structures (too much debt) rather than loss-making businesses. (See related article at Ad Age) But the businesses are surely weakening as websites cut into classified advertising and the slow economy reduces ad spending generally. And newspapers have historically relied on local ad spending from the automotive, real estate and retail sectors, all of which struggle with their well-documented challenges.

Today, Ad Age reports that local ad spending may continue to decline through 2013, according to BIA Advisory Services. Could ad spending be declining on a long-term trend beyond the current recession?

It could.

I remember - during the Web 1.0 era as it's now called -- listening politely as budding internet entrepreneurs quoted the line attributed to John Wanamaker, the Philadelphia-based merchandiser who founded the eponymous department store chain. Wanamaker is reputed to have said, "Half the money I spend on advertising is wasted; the trouble is I don't know which half."

The marketing pitch from the internet entrepreneurs was that the targetability and interactivity of internet advertising would make advertising so much more efficient by allowing advertisers to reach their target audience with a high degree of precision.

The question I always posed was, "If interactive capabilities can make advertising twice as effective, won't advertisers be able to cut their budgets in half to eliminate the "wasted" half? The usual answer was... silence.

Nobody's predicting a 50% reduction in local advertising spend just yet, and BIA's forecast does predict continued double-digit annual growth in online spending. But this just makes the picture worse for "traditional" media like newspapers and cable TV as they are expected to bear more than 100% of the overall decline in local ad spending.

The current recession, especially if it is prolonged, may be the catalyst for the profound change in media economics that those internet entrepreneurs predicted a decade ago.

Greenspan-o-Meter - February Update

On December 5, 1996 Fed Chairman Alan Greenspan famously wondered whether stock prices reflected an "irrational exuberance" on the part of investors. This afternoon, the S&P 500 closed below its level on that day more than twelve years ago. For an earlier post on the same subject, click here.

While We're On the Subject...

"Representative Barney Frank of Massachusetts, chairman of the House Financial Services Committee, along with 17 Democrats on the committee, demanded Tuesday that Northern Trust repay what it spent on entertainment during the [Northern Trust Open held in Los Angeles] which ended on Sunday."

"And Senator John Kerry of Massachusetts vowed to introduce legislation to end “the extravagant spending practices” of banks that received taxpayer dollars in the federal bailout."

Link to NYT story

Congressman Frank and Senator Kerry:

By my reckoning, the US federal deficit has soared from around $1 trillion when Congressman Frank first entered Congress in 1981 to $10 trillion today and we're on our way to $12 trillion according to the President's recent budget proposal.

Until the federal government pays back this money, there are a few expenditures I'd like to discuss with you.

In the meantime, I trust that you and your honorable colleagues in the House and Senate -- mindful of taxpayer concern over profligate spending -- are currently using the Metro for your daily commute. If not, you should know the Federal Center station is mere 6-minute walk to and from the Capitol. I know the fare-card system can be confusing at first, but my nephew's third-grade class has been studying the Metro and would be happy to organize a field trip to help you and your colleagues learn the ropes.

We look forward to your continuing vigilance on behalf of the tax-payers.

Dumb and Dumber

I don't know which is sillier.

1) The outrage professed by certain politicians that banks receiving government assistance engage in marketing activities, which might include entertaining clients and fulfilling obligations made months ago to sponsor a golf tournament, or

2) The ridiculous statements made by the PR departments of banks that "... the money for these activities comes from operating profits, not TARP funds."

One expects the grandstanding from politicians, but the bankers really ought to know better. What percent of the population do they think buys the notion that TARP funds are "balance sheet" cash distinct from cash used in operating activities? Please just stop it.

It suffices to say, as Northern Trust recently did, "We came to the conclusion that no public purpose would be served by canceling the Northern Trust Open and related events.” But then they blew it by trotting out the "No TARP funds were used..." defense.

Marketing your business, raising money for charitable purposes and supporting your local community are valid reasons for sponsoring a golf tournament and remain so today. Here's my suggestion. Take away the single malts in the courtesy tent: your customers will gladly drink blended scotch in these parlous times. Make your employees double up in hotel rooms; none of them will WANT to go without a compelling business reason for doing so. Keep it low key, and maybe get the local hospitality and restaurant businesses to highlight the dollars and jobs that are supported by a major golf event.

Then, shut up.

Taxpayers are not stupid. Eventually someone will observe that government assistance is not exactly a novel idea. Farmers receive agricultural subsidies, households receive tax credits, not-for-profits enjoy their tax-free status. If the receipt of a financial benefit from the federal government is sufficient reason for Barney Frank to weigh in on every recipient's every expenditure, then maybe he should personally do the grocery shopping for every family on food stamps.

Finally, I have to reprint comment 8. to the NYT article linked above. I can attribute it only to "Joe", but it bears quoting in its entirety.

"Money is fungible, idiots! Either give them money, or don’t and take them over. This false outrage is really getting tiresome. I say let them golf. But force them to tee off from the blue tees and make Barney Frank go along with them, in bright Madras shorts and cap, to provide oversight and prevent them from taking mulligans. That ought to freak them out a little bit. Then post their scores publicly. Bankers need all the humiliation they can get these days."

Feb 25, 2009

Golf Primer
How to Make Birdies

"On the next hole, Woods hit his second shot to within four feet of the hole, using a 5-iron from 235 yards."

Quants vs. Suits - Who's to Blame for the Financial Meltdown?

Eric Falkenstein has posted an exceedingly well-written response to Felix Salmon's recent Wired article, "Recipe for Disaster: The Formula that Killed Wall Street" over on SeekingAlpha. Falkenstein nicely captures the interaction between the "quants" and senior management in financial institutions when he writes,

"The decision makers are rich, powerful, kind of smart, do not feel embarrassed by their lack of knowledge in obscure technical trivia, and surely are not intimidated by it."

In my experience, the best quants are generally quite keen to identify and debate the risks and assumptions in their models, but too rarely encounter non-quant managers who show the patience to comprehend the implications. If you're rich, powerful and kind of smart, it's more comforting to say: "I don't pretend to understand all this greek, but I've hired the smartest guys to do the math" than to say "I've tried to understand it, and frankly it's over my head."

Felix Salmon's Wired article is indeed worth reading, although the headline is a tad melodramatic. In Salmon's view, the adoption of Gaussian copula techniques to model the risk characteristics of mortgage-backed securities mortally wounded Wall Street.

Over at the New York Times, Joe Nocera seems to think it was a Value-at-Risk spreadsheet that killed Wall Street in last month's "Risk Mismanagement" article.

Perhaps Wired magazine will sponsor a debate between Mr. Salmon and Mr. Nocera about whether it was a VaR model or a Gaussian copula model that buried Wall Street. Nassim Taleb might be willing to moderate.

To Mr. Salmon's credit, his article does discuss what is -- in my opinion -- the single biggest source of failure in these risk management models. Namely, the use of CDS price data as a proxy for otherwise hard-to-track correlations among many discrete and illiquid securities. It was the availability of a real-time price series that apparently made the Gaussian copula function "tractable", but the use of CDS price data appears to have led to models that vastly and tragically oversimplified the real world relationships they were meant to simulate. Moreover, as Salmon points out, the limited history of CDS prices meant that the historical data was largely drawn from a period of benign economic data. Finally, the CDS market ultimately became a speculator's market with the notional value of default insurance dwarfing the underling credits supposedly being insured, which undoubtedly raised the noise-to-signal ratio on CDS price movements and correlations.

Salmon's and Nocera's articles are the most prominent examples of a growing "The model made me do it" set of explanations for Wall Street's current predicament. Unfortunately, the journalistic imperative for a catchy headline and strongly themed story tends to gloss over the more complex human, institutional and managerial failings that are more appropriately to blame.

If you've read this far, and you're truly interested in the subject, I highly recommend reading UBS's confessional Shareholder Report on UBS Writedowns (pdf). This remarkable report from April 2008 describes the causes of UBS's losses related to US residential mortgages, which at that time were a mere $18.7 billion.

What you will find in this report is a board-approved "hurry up" strategy to rectify lagging league table performance in global fixed-income markets, which led to an aggressive market entry into the RMBS market as it was peaking. You will find that internal capital charges were not routinely adjusted for the true risks of proprietary positions, leading to "carry trades" and correspondingly high inventories of ultimately risky securities. You will find that "warehoused" securities held-for-sale were not hedged at all. You will find that dubious AAA-rated mortgage backed securities were hedged based on the five-year default histories of the small handful of remaining AAA-rated corporates during period of strong economic growth. And you will find that compensation policies rewarded traders for current year profits, even if the positions they held proved toxic down the road. What you don't find in this document is "Oops, the models broke" types of excuses.

For anyone interested in the subject, I also recommend Suna Reyent's article on SeekingAlpha as well.

Feb 23, 2009

The Equity Risk Premium Puzzle-
Who are the Long-term Holders?

One of the unsolved mysteries of modern finance theory is the "Equity Risk Premium" puzzle. In a sentence, the puzzle is why equities have historically outperformed bonds (in real, dividend-adjusted terms) by such a large margin? For an elegant illustration of the concept, see Brad DeLong's 2006 blog post here.

Of course, stocks should deliver a larger return since they are riskier claims than bonds; and the variance of stock returns -- the measure of risk in modern finance theory -- is manifestly greater than the variance of bond returns. But the magnitude of stocks' outperformance is the puzzle, especially in light of the well-known fact that the variance of stock returns can be mitigated by long holding periods. (note 1)

This latter notion is most famously articulated in Jeremy Siegel's "Stocks for the Long Run" and more infamously in Glassman & Hassett's "Dow 36,000".

Barring a quick rebound in the US stock markets, the Equity Risk Premium puzzle is likely to be a hot topic in finance departments over the next few years. And if the US experiences another decade of meandering stock price performance to match the current Japanese experience, it may be decided that there's no puzzle at all. The major Japanese market indices are hovering at the same levels they first reached twenty years ago and are roughly 80% below their all-time highs. The current generation of Japanese investors are probably not scratching their heads over the inexplicably high historical returns of common stocks.

Recent news events may shed some light on the issue as well. Like many universities, Harvard has recently reported that it's endowment shrunk 22%, or $8 billion, in the last half of 2008 and that it may shrink by as much as 30% when illiquid assets such as private equity and venture capital positions are marked to market. Geraldine Fabrikant has covered this story for the New York Times here

"Harvard Endowment Loses 22%"

and here.

"Endowment Director is on Harvard Hot Seat"

What I find interesting in this news is the fact that "Harvard depends on its endowment for about 35 percent of its operating budget..." representing $1.4 billion of endowment income contributed to annual operating expenses according to this letter from Drew Gilpin Faust, the university's president.

"Letter to the Community - February 18, 2009"

Now, $1.4 billion per year equals 3.8% of Harvard's endowment of $36.9 billion as it stood on June 30, 2008. But $1.4 billion per year comes to 5.4% of the $25.8 billion that Harvard's endowment will shrink to if realized losses are in fact 30%. At current prices, I suppose it's possible to construct a diversified portfolio of this size that would generate a pre-tax return of 5.4% without touching the endowment principal; but it wouldn't be easy and, more importantly, the income stream likely would not grow as fast as the operating expenses it funds.

Hence, Harvard is selling off a number of its endowment positions in public and private equity and borrowing in the debt markets to provide short-term cash. On the operating front the university is tightening its belt, suspending some ambitious construction plans and instituting certain pay freezes. The university will undoubtedly be reaching out to the alumni base for increased giving as it celebrates its 373rd anniversary this year.

But if Harvard, whose endowment is managed with a multi-century time horizon, finds its liquidity affected by the current crash in financial asset prices, who exactly are the long-term holders who can ignore the current volatility in stock prices and sit tight for the long term? Insurance companies like, for example, AIG?

There may simply be an insufficient amount of investment capital with a multi-generational investment horizon that is indifferent to market volatility like we're experiencing today. This alone could explain a good bit of the Equity Premium Puzzle. Moreover, the NYT "Hot Seat" article on Jane Mendillo, Harvard's new endowment manager, suggests a related agency issue. Even if Harvard University can take a truly long-term view, ultimately the investment decisions are made by individuals (or committees) whose career horizons are quite a bit shorter than Harvard's. Even if one truly, truly believes that in the long-run stocks will deliver premium risk-adjusted returns, it's no fun to report a 30% decline on your watch.

So for all those young investment bankers who intend to wait out the current recession in business school for the next two years, start reading up on the Equity Risk Premium Puzzle and the Liquidity Preference Function. They should be hot topics for the next couple of years.


Some more comments by RHH on this topic over at Seeking Alpha

Annals of Rank Hubris, Larry Summers Edition

Larry Summers's Billion Dollar Harvard Gamble

(note 1)
Much, though not all, of the data used to analyze the Equity Premium Puzzle comes from US stock returns from the mid-1920's, or in some cases stretching back to the Civil War. This is largely due to data availability and reliability. Some commentators on the Equity Risk Premium Puzzle have noted that returns for US equities over this period may be related to country-specific factors, specifically the evolution of the US from an agrarian, emerging economy into a political and economic super-power. As such, US returns may reflect a "success bias" making them unrepresentative of global equity returns over the same periods. For a good discussion of global equity returns, see "Global Evidence on the Equity Risk Premium" (pdf).

It should also be noted that even 160 years of stock price data represents only eight non-overlapping 20-year observation periods, a relatively small data sample. Likewise, the commonly used U.S. data back to 1925 represents less than five non-overlapping 20-year periods. This means that new, extreme data points can dramatically change our view on the odds of their occurring. This time last year, one could say that a 50% peak-to-trough decline in the S&P 500 had occurred only once in 88 years, and that was associated with the Great Depression. As of today, it's occurred twice.

Feb 12, 2009

Working in Media is its Own Reward...

Spotted on the WSJ Tech page (click image to enlarge)

Feb 9, 2009

Alan Greenspan, Market Timer?

Floyd Norris's piece in the New York Times "A 10-Year Stretch That's Worse Than It Looks" is well worth reading.

Click to read article

According to Norris, the 10-year stretch ended January 31, 2009 represents the worst 10-year return (in real terms, including dividends) since the S&P 500 index was created. The compound annual loss in purchasing power was 5.1%.

Further says Norris, "Taking inflation and dividends into account, an investor who put money into the market any time after the end of 1996, and held on, now has less value than when he or she started."

Here Norris misses the opportunity to trot out Alan Greenspan's infamous "irrational exuberance" quote. Over the years, I have asked many sophisticated investors and financial professionals if they remember when Greenspan made the comment. Most give answers between 1998 and 2000, corresponding to the Nasdaq bubble.

In actuality, Greenspan made the comment on December 5, 1996. Closing prices of the major US indices that day (and on Jan 30) are shown here.

It's worth remembering Greenspan's quote more fully. The Fed chairman was addressing the American Enterprise Institute for Public Policy Research on the topic "The Challenge of Central Banking in a Democratic Society." In a wide-ranging speech that briefly covers the history of the central bank, Greenspan raises the issue whether the Fed's goal of price stability should include not just the prices of those goods and services that make up the inflation indices, but of financial assets as well.

"But where do we draw the line on what prices matter? Certainly prices of goods and services now being produced--our basic measure of inflation--matter. But what about futures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy?"

"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"

How do we know when? When the Fed chairman starts talking -- however obliquely -- about overheated equity markets, that's when.

Ironically, Greenspan finishes up with the following thoughts:

"Along with our other central bank colleagues, we are always looking for ways to reduce the risks that the failure of a single institution will ricochet around the world, shutting down much of the world payments system, and significantly undermining the world's economies. Accordingly, we are endeavoring to get as close to a real time transaction, clearing, and settlement system as possible. This would sharply reduce financial float and the risk of breakdown."


For the full text of Greenspan's speech, click here.

Feb 5, 2009

Well, duh...

"Hands criticises 'pass the parcel' inflation effect" -

"Guy Hands, one of Europe's top private equity bosses, has criticised "pass the parcel" deals, in which buy-out groups sold companies to each other for ever increasing prices, for inflating the bubble that left investors facing big losses."

"'We saw an increasing number of pass-the-parcel transactions between general partners [in private equity firms], where limited partners [investors] essentially retained the same asset while paying fees and carry each time it changed hands,' he said."

What is most puzzling is why the largest, and presumably most influential, limited partners in private equity funds permitted this to happen. As noted by the esteemed Mr. Hands, many LPs -- who had investments in both the selling and the buying PE firms -- were essentially paying 20% carry for the privilege of moving their investment from their left pocket to their right. Surely there must be some cases where an LP investor actually increased his net investment in a particular company and paid a carry on the step-up in value.

If anyone has an example, please let me know.