Corporate Finance: August 2008 Archives

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.

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.
  

Financial contagion is a powerful media narrative for business journalists.  The fallout makes sellable news copy: the melodrama of market volatility, trainwrecks and corporate collapses, and the spectre of nation-state breakdown and global disorder.  Chroniclers from Charles Mackay to Charles P. Kindleberger have recognised this madness in markets.  So why hasn't this been applied to business journalists apart from critiques like Thomas Frank's sobering One Market Under God (Anchor Books, New York, 2000)

For example is the Australian economy facing a deep financial crisis compared with the US subprime fallout?  The Telegraph's Ambrose Evans-Pritchard contends yes.  Evans-Pritchard uses inductive reasoning to build many examples that illustrate his conclusion that 'that the Antipodes are tipping into a serious downturn'.  These include share write-downs at the National Australia Bank (NAB) and New Zealand's Guardian Trust; rising household debt and current account deficits in Australia; cross-currency volatility on the forex market; and turbelence in the regional economies of Japan and New Zealand.  Evans-Pritchard's examples collectively add up to a disturbing and pessimistic view of the near future.

On closer examination many of Evans-Pritchard's examples fall apart, partly because he over-relies on comments from analysts at BNP Paribas and Lombard Street Reearch instead of doing his own evaluation.  NAB's write-down was very likely due to high exposure to Merrill Lynch derivatives and ML's write-down announcement 12 hours earlier in US markets.  The $A still remains strong against the $US and the shifts are due to forex market volatility.  Evans-Pritchard fails to explain which productivity growth gaps are meant or the possibility that this is due to adjustment lags after 1990s reforms.  He glosses over the different dynamics and histories of Australian, Japanese and New Zealand markets to reach a false consensus of Pacific Rim economies.

Some comments are nonsensical in the context of free market ideals: the Reserve Bank of Australia's monetary policy is not Keynesian and thus is open to 'vast inflows of Asian capital' -- into investments and property developments -- just as the US economy is open to investment from sovereign wealth funds.  Perhaps Evans-Pritchard's fears of Japanese money are about Bondi Beach's gaudy tourism?  If your ideal is free market flows of global capital then you have to accept the entrepreneurial sources who will take on the risk-return (if that's not your ideal, or the ideal turns out to have some adverse consequences in practice . . .).

Evans-Pritchard is closer to the mark in his comments on the current account deficit (macroeconomics) and household debt (microeconomics).  Australia's mining and resources boom won't cancel out its current account deficit alone, and given the economy's structure, its reliance on cheap imports and its debt servicing costs it's ridiculous for Evans-Pritchard to think so.  Household debt and mortgage stress levels are worrying - but Evans-Pritchard leaves out the role of inflated house prices, interest rate risk, and consumer expenditure.  Despite the high rents and shortage of new houses Australia is nowhere near as exposed to collateralised debt obligations and subprime mortgages as the US is.

Business journalists can be guilty of creating noise in the face of financial contagion.  As Henry Blodget observes in his contrarian book The Wall-Street Self Defense Manual (Atlas Books, New York, 2007) the financial media wants to hold your gaze: 'You will know the arguments and action of the day, recognize the major players, and feel the market excitement.  You will develop strong opinions about the future.' (p. 203).  Who cares if the strong opinions are formed on the basis of noise rather than signals?  Instead, Blodget argues that we should see Bloomberg and CNBC as players in a financial services ecosystem who thrive on melodrama and noise, especially during a contagion, crash or panic.

The philosopher and post-trader Nassim Nicholas Taleb is even more scathing in his contrarian book Fooled by Randomness (Texere, New York, 2004): 'To be competent, a journalist should view matters like a historian, and play down the value of the information he is providing, such as by saying: "Today the market went up, but this information is not too relevant as it emanates mostly from noise."  He would certainly lose his job by trivializing the value of the information in his hands.' (p. 58).  As Evans-Pritchard's overreaction to the NAB write-down and cross-currency fluctuations in the forex market show, he and many other business journalists would fail Taleb's test because their reportage is a reaction to financial market events that are noise, and don't factor in the dynamics of chance, randomness and volatility.