Foreclosure Of A Hedge Fund Dream

Media personalities who took a career detour into managing hedge funds are the latest casualty of the subprime fallout, reports New York Times journalist Andrew Ross Sorkin.

Sorkin profiles Ron Insana the former CNBC news anchor who founded Insana Capital Partners at the height of easy credit in 2006 and closed ICP in August 2008.  Insana raised $US116 million from major investor Deutsche Bank and media contacts.  Rather than invest directly in complex financial instruments Insana chose an intermediary position: a fund of funds investor in a diversified portfolio of hedge funds.

Insana made several errors that led to ICP’s blow-up.  Sorkin notes the US$116 million was a smaller capital raising than its blue chip competitors.  The fund of funds positioning meant a rational herds strategy on the hedge funds that ICP invested in.  Subprime-caused market volatility set off a cascade: the hedge funds didn’t make alpha returns above the market and ICP didn’t have the diversified portfolio to weather the volatility.  Consequently, ICP still had to pay out investors in full for their original investments (the ‘high water mark’ rule) before it could earn its ‘1.5 of 20’ fee (1.5% management fee on funds and 20% of fund profits).

Sorkin is insightful about the cost structures of hedge funds:

That would have been enough if it was just Mr. Insana, a secretary and
a dog. But Mr. Insana was hoping to attract more than $1 billion from
investors. And most big institutions won’t even consider investing in a
fund that doesn’t have a proper infrastructure: a compliance officer,
an accountant, analysts and so on. Mr. Insana had seven employees, and
was paying for office space in the former CNBC studios in Fort Lee,
N.J., and Bloomberg terminals — at more than $1,500 a pop a month —
while traveling the globe in search of investors. Under the
circumstances, $870,000 just wasn’t going to last very long.

This ‘contrarian’ observation highlights the leverage of institutional investors, and, in contrast to the usual media portrayal, the regulatory burdens of institutional compliance on funds.

Sorkin’s profile raises some interesting questions beyond his comparison of Insana and the media-savvy millionaires who blew-up after the April 2000 dotcom crash.  Did ICP adopt the trend following strategy from CNBC’s media coverage and Insana’s popular books?  If so, could Insana distinguish between market noise and critical events?  How did Insana grapple with the career change from CNBC news anchor to hedge fund head?  What risk mitigation steps did ICP’s investors demand, and did Insana exercise prudential caution? When he had to close ICP was Insana able to be self-critical about his past decisions and errrors?  Are there firm-specific, operational and positioning risks for fund of funds?  That would be a really interesting post-implementation review for aspiring hedge fund mavens.

Don’t expect to see it in CNBC European Business or Bloomberg Markets anytime soon.

Predicting The Unthinkable In Financial Markets

The nuclear strategist Herman Kahn coined the phrase ‘thinking about the unthinkable’ in a series of black comic Air Force briefings that became On Thermonuclear War (Princeton University Press, 1960).  Faced with a year-long crisis in US credit markets analysts have embraced similar imagery in their forecasts of catastrophic risk.

Several different players in the financial ecosystem rely on the forecasts for multiple payoffs, one for their target audience and the other for themselves:

  • Research Analysts: (1) Provide clients with guidance and metrics to the market turbulence; (2) stand out in the pecking order of research firms and competing industry/sectoral analysts to remain relevant.
  • Investment Media: (1) Catastrophes as the source of drama and headlines to keep consumers engaged; (2) Financial and operational synergies of convergent media production.
  • Fund Managers: (1) An external input to valuation models for visiting potential firms to invest in; (2) A parameter for deciding on the asset classes, diversification and hedging for investment portfolios.

Some questions to ask in evaluating any catastrophic forecasts that predict the unthinkable:

  • What is the source, type and timeframe of the evidence presented?  The source may be company interviews, earnings calls, investment calls and trade seminars.  The type may be firsthand observation, market rumour, financial model, computer simulation or analyst conjecture.  The timeframe may be historical simulation of past data, quarterly forecasts or a longer time horizon for capital financing, global market entry, innovation pipelines or sustainability projects.  The source enables you to filter any possible agendas, the type refers to the information structure, whilst the timeframe often has embedded assumptions about cause-effect relationships, impacts, and the actions of others.
  • Why is the analyst making this forecast and could there be other agendas? Analysts have biases and personal theories that an attention economy might amplify.  At a group level this becomes self-reinforcing collective wisdom that may turn out to be flawed.  In embracing a current meme in a true believer stance analysts create a cognitive frame prevents them from considering alternative outcomes, options and possibilities.  At its most cynical this question is a reminder that forecasts are not objective or value-neutral, especially if the analyst is under pressure to generate earnings revenue or has a different private opinion to their public view.
  • What is the analyst’s track record in accurate forecasting?  This focuses on the analyst’s patterns of thinking and rhetoric in forecasts; how their performance compares to an industry, market or sectoral baseline; and the margin of error in their past forecasts.  This can be used to construct a brains syndicate, to filter out media reports and noise, to surface hidden assumptions and how they affect performance, and as a quality assurance check.
  • How might the catastrophic forecast be hedged? This shifts the focus from optimistic versus pessimistic views to the risk management focus on mitigative strategies and action planning.  To be effective, this requires an understanding of your risk profile and risk-return needs (risk averse, neutral or seeking), your time horizon, and the nature of the financial instruments, investment portfolio and markets to be used.

Ebook Textbooks & The Market for Lemons

The software consultant Ed Yourdon once warned US programmers in his book Decline and Fall of the American Programmer (1992) that they faced global hypercompetition.  This was a fashionable message in the turbulent early 1990s of industry deregulation, export tariffs, mega-mergers, downsizing and reengineering.  Spenglerian pessimism made Decline and Fall an IT bestseller as Eastern European and Russian computer programmers emerged as low cost competition with their US counterparts.  Now in Thomas Friedman‘s vision of a flatter world the Eastern European and Russian computer programmers have help from an unlikely source: electronic copies of IT textbooks.

Several barriers mean that US textbook publishers are cautious about embracing ebook versions.  Publishers fear the Napsterisation of ebooks on peer-to-peer networks.  There’s no standard ebook device although Amazon’s Kindle is the latest candidate.  There’s no standard ebook format: most use Adobe PDF, however when Acrobat 8 was released Adobe shifted its ebook functionality to a new Digital Reader that did not necessarily read a user’s existing ebook collection.  Potential customers do not have a utility function to necessarily favour ebooks over printed copies: publishers charge high prices for ebook versions that may contribute a higher contribution margin to profits but that give the customer little price differential compared with print counterparts.

The implementation of digital rights management (DRM) also leaves much to be desired: McGraw-Hill’s Primis uses a digital fingerprint on a hard-drive that voids an ebook even if reinstalled on a reformatted drive due to a virus, whilst Thomson’s Cengage Learning uses a time-sensitive model which gives the user access for one semester to an ebook with the full price of its exact print version.  Publishers are also slow to adjust cross-currency rates: Australian textbooks still cost $A120-$200 despite near parity between the Australian and US dollars.

Thus, it’s no surprise that ebook divisions remain small in multinational publishing conglomerates.  One exception is Harvard Business School Press which appears to have ditched Sealed Media’s DRM plugin for Adobe Acrobat after Oracle acquired SM in August 2006 and then had integration problems with information rights management.

These barriers suggest a failure in market design with analogies to George Akerlof‘s study of the used car market in his influential paper The Market for Lemons (1970).  Publishers counter that although there is a lack of ebook standards similar to Akerlof’s paper the economics of publishing provide a disincentive to lower prices.  They claim high fixed costs in printing, photography rights and licensing fees for the case studies taken from Businessweek, Fortune and The Wall Street Journal.  Author fees and promotional budgets to professional associations add variable costs –  however, Australian academics have a disincentive to publish textbooks compared with their US colleagues, as Australia’s Department of Education, Employment & Workplace Relations does not provide recognition points.

To survive US textbook publishers have turned to global market models with regional editions of popular texts (such as Asia-Pacific editions with local coauthors), and adopted the music industry’s business model of electronic and online content (similar to how record labels have released Dualdisc, DVD and collectors editions of albums).  However as Yourdon warned US programmers this may not be a business model with longterm sustainability.  MIT’s OpenCourseWare, Apple’s iTunesU and Scribd all provide free content that mirrors the generic content in most textbooks, although some differentiate via a problem-based approach.

Yourdon’s ‘challenger’ computer programmers now also have illegal BitTorrent sites such as The Pirate Bay, filehosting networks such as Rapidshare, and ebook sites including Avaxsphere.com and PDFCHM to choose from.  The last two provide solutions to Akerlof’s challenge in market design: they have an easier user interface, a broader (illegal) catalogue of ebook titles, and DRM-free files compared to Cengage Learning or McGraw-Hill.  Even business strategists are getting in on the act, as Clayton Christensen, Curtis Johnson & Michael Horn explore in Disrupting Class: How Disruptive Innovation Will Change the Way the World Learns (McGraw-Hill, New York, 2008).

There’s one textbook coauthor who came up with a unique solution to Akerlof’s dilemma in market design.  His Macroeconomics book coauthors Andrew Abel and Dean Croushore opted for the mod-cons from publisher Addison-Wesley: an online site and a one-semester ebook version as a bundle deal.  The textbook coauthor?

Federal Reserve Chairman Ben Bernanke.

Investors’ Regret: Société Générale v Jérôme Kerviel

On 4th July 2008, The Banking Commission of France (BCF) fined Société Générale €403 million euros for the bank’s lack of internal controls in a €4.9 billion trading loss in January 2008.  SocGen blames ‘rogue trader’ Jérôme Kerviel for the loss after it discovered his trading positions on 18th January.  SocGen’s chairman Daniel Bouton also blamed Kerviel for the stockmarket’s 6% fall on 21st January 2008.

Kerviel counter-blames SocGen for its loss, fired his lawyers, and adopted an aggressive stance with a new legal team during a court hearing in France on 23rd July. SocGen had already suffered fallout from the revelations about Kerviel’s losses: Bouton made changes to senior management, and the French bank had to raise €5.5 billion euros to recapitalise, and prevent SocGen from becoming an M&A takeover target.SocGen’s ‘rogue trader’ claim against Kerviel recalls the fate of trader Nick Leeson whose speculation on derivatives and options markets led to the collapse of Baring’s Bank in 1995.  Leeson attempted to trade himself out of bad decisions through his knowledge of exotic options, his control of the settlements role, and his tactical deception using spreadsheet models and accounts with whited-out text that was invisible to others.  SocGen claims Kerviel used complex program trades with exchange traded funds and swaps for a similar tactical deception.  Leeson’s losses made Baring’s illiquid and in 1995 the English merchant bank was sold to ING for £1.

On the surface Leeson and Kerviel share enough similarities as a pair to warrant the ‘rogue trader’ label.  Both had knowledge of sophisticated financial instruments and markets.  Both used this knowledge to make substantial profits for their respective firms.  Both were in teams which faced rapid revenue growth but also with a lack of internal controls: Singapore for Leeson and Delta One for Kerviel.  Both used tactical deception in attempts to escape from adverse trade situations, caused by the misuse of financial instruments, dynamic disequilibriua in the markets, and cascade events.  In Leeson’s case, Japan’s Kobe earthquake on 17th January 1992 was also a Black Swan event.  Both Leeson and Kerviel have made counter-accusations that the banks’ senior management were scapegoating them for larger institutional losses.

One central difference between Leeson and Kerviel is that all game-players are now more aware of ‘rogue trader’ as a media narrative and symbol of financial villains.  Bloggers posted Kerviel’s resume online and registered his name as a website address.  Bouton quickly singled Kerviel out for blame before French authorities also charged Kerviel’s manager. Kerviel countered this with claims that SocGen’s senior management was happy with his trading and that the bank had broader problems with its risk management system.  Independent sites such as ReTheAuditors.com also discussed Kerviel’s case.

SocGen appointed a Special Committee to investigate Kerviel’s trades and to evaluate its corporate governance and risk management systems.  The Special Committee and General Inspection reports found problems with Kerviel which echo post-mortems on Leeson: no supervisor, an inexperienced new manager, problems with intraday positions and high-correlative markets, ignored red flags, and a lack of transparency between middle office and back office functions.  The bank also derisked its internal review by hiring PricewaterhouseCoopers to evaluate SocGen’s risk management systems.  The audit firm then derisked itself by de-scoping its report which PwC claims was based on SocGen’s internal documents and industry best practices.

Was this an exercise in ‘plausible deniability’?  Perhaps.  Did it interest book publishers? Yes, the entrepreneurial small press turned Kerviel’s case into several ‘quick books’ for micro audiences.  Did Kerviel create a new market?  Definately: at a university career fair in May 2008 a Gen Y consultant pitched to me that her Big 4 accounting firm could prevent future Leesons and Kerviels through the automatic control of access rights to critical IT systems.  I countered that whilst this solution would provide audit trails, it might not deal with the ‘human factors’ that allow failures such as Leeson and Kerviel to (re)occur.

CF’s fine signals some deeper problems in SocGen’s corporate governance and risk management systems.  Traders can use knowledge of complex derivatives, options and trading systems for tactical deception.  They may also perceive risk management as a separate function rather than an integral process, although this is changing after the 2007 subprime crisis.  Senior managers who keep changing their stories in a crisis may be stonewalling.  The pressure to make profits can mean that outcomes-based systems are manipulatable according to the outcomes demanded.  In Kerviel’s case managers ignored ‘red flags’ from the Eurex derivatives exchange.  Could Eurex have the independent power to bar traders who reach a high level of ‘red alerts’ in a given period?  What if Eurex took a solution from nuclear detente and have a ‘red phone’ line direct to SocGen’s internal auditors and external regulatory agencies?

Leeson and Kerviel are proof that traders always face the possibility of large losses from consistent market trades.  Fans of Oliver Stone’s film Wall Street (1987) and Michael Lewis’s memoir Liar’s Poker (W.W. Norton & Co., New York, 1989), which is mandatory reading in many MBA corporate finance classes, can overlook this market reality.

But equally overlooked is a more troubling problem: the differences in promotion pathways and work culture between compliance/legal/risk staff and traders who must live by their next deal regardless if the client blows up.  Gordon Gekko (Michael Douglas) recruits Bud Fox (Charlie Sheen) in Wall Street because Fox is ambitious, risk aware, and his working class roots give him a gritty edge.  Lewis suggests in Liar’s Poker that Salomon Brothers traders share a similar outlook.  SocGen’s managers promoted Kerviel to junior trader from a compliance role and SocGen’s lawyers now believes this risk management knowledge aided Kerviel’s tactical deception.  Described by friends as ‘honest, working class’ Kerviel might be Bud Fox without the ‘remorse of conscience’.

Are Financialistas Over Hedge Fund Chic?

You can blame George Soros for making hedge funds the dark horse of the irrationally exuberant 1990s.

As the public face of the Quantum Group of Funds, Soros gained notoriety for short selling the English pound in September 1992 and allegedly making $1 billion in profits.  Adam Curtis observes in his riveting documentary The Mayfair Set (BBC, 1999) that Soros’ victory signalled the first time that market speculators had beaten a country’s central bank.  In the aftermath Soros cultivated a master trader persona based on his personal ‘theory of reflexivity’ or how ‘participant’s bias’ can shape our actions in and perceptions of market events.  Hedge fund chic arose in Wall Street as investment banks rushed to found hedge funds, which use leverage and pooled capital to manage assets, derivatives and securities for an investor group.

Financialistas however are showing signs of buyers’ remorse as subprime turbulence brings an end to Soros-inspired hedge fund chic.  The high-profile collapse of Bear Stearns‘ two hedge funds in mid 2007 was only a precursor, Hedge Fund Research notes, of 170 liquidated in early 2008.  The survivors have adopted Soros’ global macro strategy which relies on computational finance and dynamical models of currencies, interest rates and other macroeconomic factors to achieve returns.

Global macro is a risky strategy for several reasons: it requires forecasting models of complex interactions, computing power and fund mangers with impeccable judgment for asset allocation.  In fact global macro deals with a specific risk class known as systemic risk that results from business cycles and macroeconomic movements, thus it cannot be diversified away.  Add funds’ massive leverage of pooled securities, industry secrecy, little government regulation and hypercompetition between different funds and managers, and an accurate calculation of risk-return is difficult.  These challenges overshadow the potential of applied research solutions, such as Fritz Zwicky‘s morphological analysis, a problem-solving method which deals with ‘multi-dimensional, non-quantifiable problems’ – relevant to the macroeconomic factors and systemic risk in global macro strategies.

Hedge fund chic faces several other problems.  As an investment category hedge funds have matured and their combination of high leverage and high management fees are unsuitable for many non-institutional investors.  Subprime fallout is triggering change in US financial and regulatory institutions which will inevitably lead to more rules and regulatory oversight of edge funds and managers.  Internally, hedge funds also need to separate managerial processes (principal management, portfolio execution) from financial reporting (mark to market book) and governance (board, corporate and policies & procedures).

Which means despite Soros’ alchemical touch hedge fund chic may now be a fad.

Henry Blodget’s ClusterStock

Former securities analyst Henry Blodget recently launched ClusterStock which provides daily news, commentary, and research analysis on the economy, energy, financial services, retailing and technology sectors.  ClusterStock’s parent company Silicon Alley Media appears to follow the Web 2.0 nanopublishing business model of Gawker Media‘s Nick Denton and Mahalo founder and entrepreneur Jason Calacanis.

In a 2008 last-minute submission to Australia’s Review of the National Innovation System I contended that market-based approaches may resolve some challenges in the organisational design and concept to cash/concept to market processes of R&D consortia and institutions.  ClusterStock provides an example for strategic implementation: coverage of market events by sector specialists, near real-time commentary on conference calls, and assumptions testing via reader/user feedback.  The public face provides an information filter and feedback loop in the incubation and idea generation phases of creative innovation.  R&D consortia could implement this web publishing model as a peristyle public face with separate internal processes for ‘commercial in confidence’ information and corporate/government partners.

For his side of the infamous dotcom era blow-up plus an insider’s critique of the investor ecosystem see Blodget’s informative consumer guide The Wall Street Self-Defense Manual (Atlas Books, New York, 2007) and Slate Magazine’s accompanying articles.

Subprime Winners: Rational Herds & Decision Researchers

US capital and derivatives markets in mid-2008 provide a real-time laboratory for behavioural finance analysts who want to understand the madness and wisdom of crowds.  The past week’s case studies include the implosion of the US bank IndyMac and the market volatility triggered by fears that Fannie Mae & Freddie Mac are highly exposed to liquidity risk.

As financial reporter Michael S. Rosenwald notes in The New York Times, these recent events appear to fit the behavioural finance hypothesis that individual investors who make fear-driven and risk-averse decisions can trigger pricing shifts as an aggregate rational herd.  Guillermo A. Calvo and Enrique Mendoza found in a 1997 paper that globalisation counteracts the emergence of rumour markets based on imperfect information and country-specific knowledge, although not in emerging markets due to uncertainties.

However the recent events have different conditions that set delimits on Calvo and Mendoza’s model: the United States is the epicentre of the bear market triggered by the 2007 subprime crisis, Fannie Mae and Freddie Mac have psychological primacy as major financial institutions with US Federal Government backing, and investment media firms such as Bloomberg and CNBC use globalisation to create de facto rumour markets amongst day-traders and others.

Readers interested in rational herds should also check out Christopher P. Chamley’s book Rational Herds: Economic Models of Social Learning (Cambridge University Press, Cambridge UK, 2004), excerpt here.

Decision researchers are the other early winners of the 2007 subprime crisis, due to the failure of many quantitative models to predict the Black Swan event.  Rosenwald mentions Harvard University’s new Bio-Behavioral Laboratory for Decision Science which conducts ‘conducts research on the mechanisms through which emotional and social factors influence judgment and decision making.’  He also refers to the Oregon-based nonprofit group Decision Research.  An Australian-based counterpart might be the Capital Markets CRC, an R&D consortia that focuses on ‘new technologies and improvements in market design’.

Investment analysts still have divergent opinions on recent events.  However the research agenda above prompts several new questions:  What happens to rational herds and rumour markets when bio-behavioural methods of decision-making are no longer ‘imperfect information’ but are widely understood and integrated into investment choices?  How will markets be redesigned to cope with this eventuality, and who will take on this responsibility?  What new financial instruments, markets and products will emerge generativity?

Leximancer’s Customer Insights & Social Media

Leximancer is data mining software that enables you to find statistically significant text patterns in unstructured data.  The software uses a collections/processing approach to gather a cohort of documents, specify filters and rules, run a batch process, and then displays a graphical concept map with causal and statistically significant relationships.  M&A, competitive intelligence, legal and market research teams may find this approach useful for document support.

University of Queensland researchers developed Leximancer, the UniQuest incubator commercialised it, and London’s Imprimatur Capital provided seed capital investment.  The team also recently launched a Customer Insight blog and portal which will explore Leximancer applications in customer experience, surveys and social media.  Its data analytics and statistics capabilities may make Leximancer the evidence-based management solution for those Technorati forecasters who suffer from optimism bias about keywords and the creation rate of new blogs.

Frank Lowy Named In US Investigation on Offshore Tax Havens

The New York Times reports that the US Senate Permament Subcommittee on Investigations named Australian property maven and philanthropist Frank Lowy in a 114-page Staff Report on how the investment bank UBS created offshore tax havens in Liechtenstein.  The report is part of a Permanent Subcommittee investigation on Tax Haven Banks and US Tax Compliance which held a hearing on 17th July 2008.

The Permanent Subcommittee’s press release claims that Lowy used Liechtenstein’s LGT Bank to ‘transfer companies and a foundation with a Delaware corporation to
help the Lowys hide their beneficial interest in a foundation with $68
million in assets.’  NYT reveals the foundation was Laperla based in Liechtenstein and used to funnel up to $US100 million.

The Sydney Morning Herald reports Lowy is cooperating with an Australian Taxation Office audit.  Lowy’s son Peter is rescheduled to appear at a Permanent Subcommittee hearing on 25th July.

The Australian Financial Review‘s forensic journalist Neil Chenoweth investigated Australian entrepreneurs with Swiss offshore tax havens in Packer’s Lunch (Allen & Unwin, Sydney, 2007).  For a broad international context also see my 2006 essay on anti-money laundering initiatives.

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