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 Dictionary of financial market terms got its last update in July 2000, seven years ago this month. The work of derivatives industry professional and book author William Margrabe, the site went quiet November 2001, leaving the Dictionary as a time capsule of the period, a treasure chest of acerbic wisdom modeled on Ambrose Bierce's Devil's Dictionary.
While most of Margrabe's definitions are timeless, those that no longer apply reveal a changing world. We review a few favorites.
Roach MotelJudging by the contents of our full-to-the-brim daily email spam folder, penny stock promoters continue to do a thriving business, albeit out of the Ukraine today more often than New Jersey as in 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 promoters are manipulating. Its price keeps rising on small volume. You get in at three and watch the price go up to seventeen. You try to get out and find that the only bid is two.
Today this term applies as well to larger operations, such as hedge funds that invested heavily in illiquid credit instruments like asset-backed securities. Easy enough to buy into those funds when the market 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 investors tried to run to redeem their shares. They found their feet firmly glued to the floor.
In 2000, the hedge fund game was already on, in accordance with the iTulip Law of Replacement. Even as the stock market bubble game was winding down, hedge funds were positioned to take over where venture capital left off, as Margrabe points out in his definition of an Accredited Investor.
Accredited InvestorAccredited investors rarely complain when they get ripped off because making money is only one of the reasons they invest in high risk funds. The other and perhaps more important motivation to some is to earn cocktail party bragging rights as sophisticated investors. Confessing to gullibility by crying foul defeats the purpose. The fund sales people know this, of course, and will always drop the names of prominent investors in a fund in order to give the prospective investor the sense of joining an exclusive club.
In the eyes of the SEC, an outlaw not deserving of the usual standards of financial disclosure, because of his past frugality or past and anticipated near-term productivity. The SEC can rely on a variety of bounty hunters–including bucket shop operators, promoters of limited partnerships and penny stocks, hedge fund managers, and commodity pool operators–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 two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
According to SEC regulations, an accredited investor is fair game for the sellers of a variety of securities, including interests in hedge funds. This is analogous to the statutory rape laws that define a person over the age of consent (12 years old, in Delaware) as fair game for any smoothie with a good pickup line or a new pickup truck. To quote the SEC, "It is up to you to decide what information you give to accredited investors, so long as it does not violate the antifraud prohibitions."
Like a Ponzi scheme, the influx of new money into the sector drives up prices in the early stages of the cycle, and the investor can brag about how much money they've "made" on paper. They can make actual money if they are smart and quick enough to get out before the other guy, the way Sam Zell did recently when he dumped all of his soon-to-be-distressed commercial real estate holdings on a private equity firm. We've been wondering who's going to occupy all of those empty office buildings with the "For Lease" signs we've seen along suburban highways for the past seven years, as the outsourcing and work-at-home trends grow.
When a bubble pops Joe Sixpack, on the other hand, usually doesn't know what hit him. The high tech industry went into deep recession after 2001, with unemployment in the metro San Francisco area exceeding 25% in 2002. Many friends lost both their money and their jobs. We suspect that the industries that private equity corporation flippers have focused on for the past few years will suffer a similar fate. But not for long, thanks to the Air Bag Economy, as defined by Margrabe.
Air Bag EconomyNeither Margrabe nor iTulip guessed back in 2000 that some of the principles of the Japanese Air Bag Economy were soon to be applied to the US economy, but USA-style and to far greater affect. As the stock market crashed 2000 - 2001, a housing bubble rapidly inflated via tax policy and super-low interest rates to cushion the impact. Six years later, as the housing bubble deflates, energy and infrastructure bubbles are inflating to keep the US economy and markets going. We refer 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 protect businesses and banks from crashes in prices of goods, services, stocks, and real estate. As a result, " ‘Everybody has jobs, everybody has health care, and nobody’s out on the street,’ Professor Morse said." Also, nobody has the proper incentive to take strong action and fix what’s broken. The result – economic stagnation from 1990 to 1999 – and still counting. (Nicholas D. Krisfof, "The Japanese and Inertia," NYT, 6/19/98.)
Sifting through the contents of the Margrabe time capsule we find schemes that were popular at the time but which have since the collapse of the stock market bubble either been regulated away or faded away as many bad investment ideas do, by running out of new suckers. For example, the Technology Stock IPO.
Technology Stock IPOStock lock-up regulations put in place in 2001 prevent IPO share flipping, putting an end to the IPO boom, although we are experiencing a minor echo bubble today in tech IPOs, encouraged by the ongoing 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 holding them only briefly) and you meet resistance: "Do you really want to sell, 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 handling you properly. Of course, "the customer's interest is primary," but the underwriters 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 LBO bubble run by private equity, in turn fueled by the market for collateralized loan obligations (CLOs). Now that game is going the way of the stock bubble era roll-ups. The difference is that companies that have been left with impaired balance sheets due to debt leverage will in the future when revenues fall in the next slow-down have to choose between laying off employees or not meeting the payment terms if new debt can't be raised. That means bankruptcies and layoffs.
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 Waste Management and video stores into Blockbuster. Others have consolidated smaller firms in the funeral home, internet service provider, and plumbing sectors.
Theories behind the “roll-up business”:
1. “[R]oll-ups … bring economies of scale, management discipline and access 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 and bond market are up, roll-ups prosper. When either the stock market or bond market tanks, roll-ups suffer. When both markets tank, roll-ups die.
Source: Paul M. Sherer, “Roll-Ups: Ironing out the Bumps,” NYT, 9/3/1999.
How many? According to our recent interview with John Challenger possibly enough to put the US economy into recession at some point over the next year or two. In fact, that is the only potential source of recession on his radar. The way we see it, the housing bubble induced recession occurs first, in Q4 2007, leading to a drop in demand and declining revenues. The recession is then amplified by corporate restructuring. Evidence that this process has already begun is showing up in sales tax receipt numbers.
While we read about the big disasters like the Bear Sterns hedge funds that made heavy ABS CDO bets, you don't hear as much noise as you might expect, considering the market for hundreds of billions of dollars of securities 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 put the loans in the balance sheet "cache" rather than write them off. (We heard this from three of the CDO fund managers we interviewed, along with what really happened at Bear Sterns. Stay tuned here for that story.)
CacheApparently the dealers think that waiting versus trying to sell into a dead market will allow these securities to ripen to a more palatable Fair Value.
"A portion of RAM set aside as a temporary storage area, or buffer, to speed up communications between the microprocessor and the hard drive or other components." ("Jargon Watch," Fortune Technology Buyer's Guide, 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 and the controllers, financial accountants, top management, and/or the shareholders. In commercial banks, it has in the past consisted of an investment portfolio that the bank need not mark to market and can carry on the books at cost. In investment banks, it has recently consisted of a reserve account and non liquid investments that the trader can mark at will.
Fair ValueRose soup. Yum. Another Margrabe dictionary entry reminds us that every major crash in US markets over the past 30 years was precipitated by Asian investors pulling money out of some market to bring it home to meet some urgent domestic need.
Futures pricing for those idealists who believe that rose soup should be better than onion soup, in theory, because a rose smells better than an onion.
Russian fluWatch what happens when China some day yanks money out of US markets to reflate a troubled banking system at home.
Lackluster performance in the Russian financial markets in late 1997, largely because foreigners (largely, Asians, particularly Koreans, who were feeling the effects of "Asian flu" withdrew some $7 billion of investment 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 in 1999 not only have most of these "backward" economies repaid their loans to the U.S.-backed World Bank and U.S.-backed IMF, but by investing their "excess savings," as the Fed and Congress prefer to call it, in US debt markets keep the US economy from submerging into tight credit and high inflation quicksand. Did this relationship between borrower and lender reverse because the institutions in emerging market countries over the course of a few years suddenly become transparent and scrupulous, or has a kind of third world market standards role reversal happened to level the playing field? A bit of both. Certain "emerging" markets, such as Korea and India, have indeed become more transparent, while U.S. markets, through the growing influence of private equity and hedge funds, have become less so, and lending practices that were once confined to loan sharks became a hot new growth area for U.S. lending institutions under state and federal government agency regulation.
A backward economy, temporarily growing faster than its indigenous thieves can deplete it, as brokers and dealers, those imaginative authors of modern financial fairy tales, describe it to their starry-eyed victims. A future submerging market (q.v.).
Such lending practices as "packing" and "flipping" were well established back when Margrabe last updated his dictionary. Around the same time the widely ignored by lawmakers and the press housing appraiser's petition was launched, to which more than 9,000 house appraisers have signed their names, complaining of systematic abusing and illegal practices in the lending industry. We concede that Margrabe was way ahead of us noting the whole mortgage lending racket so many years ago. While emerging markets rose from the market corruption muck, the USA standardized third world lending practices.
PackingOnce frowned upon, these practices have become such standard practice in the US that the terms "packing" and "flipping," by these definitions, now seem quaint. Today one can simply substitute the terms "lending" and "refinancing."
The lending practice of piling credit fees and insurance products onto 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 does not plan legislation to infantilize American borrowers by regulating this 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.)
Giving a borrower more and more rope, until he hangs himself. Namely, "extend[ing] to borrowers a succession of loans, with each new loan refinancing the terms of its predecessor." Cf. "packing" and "stripping."
We also note that while American consumers have been infantilized by government agencies charged with keeping dioxin out of our drinking water and anti-freeze out of our toothpaste, and putting air bags in autos to save lives in crashes, similar quality control has not been extended to credit products. Perhaps some day when the banking industry gets its claws out of Congress, consumers may enjoy a few protections from toxic credit products. We expect to see this after the last eight years of mass poisoning of household balance sheets with credit card and mortgage debt produces disaster–a kind of a kind of credit Love Canal–that finally got Congress off its ass to face down chemical, food, and automobile company lobbies.
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 included in Margrabe's dictionary, we're not sure that we in fact invented the term "Sheeple" in 1999. We will accept credit for coming up with a clever 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 – the U.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 makes investment decisions based on the observed actions of the other members of the herd : sheep-like as a : one unable to make rational investment decisions based on personal observations that lead to actions that contradict the actions of the herd b : uncritical of information inputs from those who seek to profit from them, such as financial services companies c : in for a big surprise
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