Rare display of introspection in structured finance

Securitisation

Fear and loathing, and a hint of hope

Feb 14th 2008 LAS VEGAS
From The Economist print edition

Not all is lost for the structured-finance business. But it faces further discomfort before it can start to recover some of its past sheen

AS GAGS go, it was cheap. But irresistible. As a banker from Citigroup placed his chips on the roulette table, a watching wise-guy sniggered: “There goes another $15 billion.”

Even though it was held (as usual) in Las Vegas, this year's conference of the American Securitisation Forum (ASF), between February 3rd and 6th, was a subdued affair. First staged only in 2004, the event has become a mecca for those whose job it is to spin mortgages, credit-card debt and other bread-and-butter financial assets into tradable securities. But this time attendance was down—and tension up, as the neck-masseuses in the exhibit hall could attest. Black humour and self-deprecation replaced the self-congratulation of past years. John Devaney, a hedge-fund manager who had to sell his 142-foot yacht, Positive Carry, and his Gulfstream IV after making bad bets on mortgage bonds, told an audience: “I'd like to thank the market for dealing me a direct hit. As a trader if you don't get sucker-punched every once in a while, you don't understand what risk is.”

You might suppose that meeting in America's gambling capital would provide symbolism enough. But the conference Super Bowl party had plenty more. It was hosted by Countrywide, a big, troubled mortgage lender that has had to fall on the charity of Bank of America. And, as the guests digested the dramatic ending of the New England Patriots' long winning streak by the New York Giants, they may have sensed an uncomfortable parallel. After a quarter-century of growth that turned structured finance from a capital-market cog into an engine of growth, their business has been buckled by the crash in subprime mortgages and the successive blows throughout credit markets. Worse, some blame securitisation for causing the pile-up in the first place.

The limits of gonzo finance

Securitisation has greatly enhanced the secondary market for loans, giving originators, mainly banks, more balance-sheet flexibility and investors of all sorts greater access to credit risk. Both have embraced it. By 2006 the volume of outstanding securitised loans had reached $28 trillion (see chart 1). Last year three-fifths of America's mortgages and one-quarter of consumer debt were bundled up and sold on.

Along the way, banks cooked up a simmering alphabet soup. The ingredients included collateralised-debt obligations (CDOs), which repackage asset-backed securities, and collateralised-loan obligations (CLOs), which do the same for corporate loans, as well as structured investment vehicles (SIVs) and conduits, which banks used to keep some of their exposure off their balance sheets.

The breakneck growth of this business went into reverse last summer, when it became clear that defaults would undermine the structures built around America's mortgage markets. So tarnished has the subprime-mortgage market become, because of shoddy loan underwriting and fraud, that investors are likely to shun securities linked to it for months if not years. Securitisation of better-quality “jumbo” mortgages—too big to be bought by government agencies—is also at a near-halt. “Mortgages were traditionally seen as very safe assets. Now all but the very best are stamped with a skull and crossbones,” says Guy Cecala, of Inside Mortgage Finance, a newsletter.

CDOs are unlikely to regain a following in a hurry (see chart 2). Still less popular are CDO-squareds (resliced and repackaged CDOs) and higher powers. CLOs have also been battered as the leveraged loans they are linked to have tumbled in value. However, their collateral is sounder than that backing subprime CDOs, being based on company financials rather than the blandishments of mortgage brokers.

The prospects for SIVs are bleaker still. SIVs borrow short-term to invest in long-dated assets; and investors will no longer tolerate such mismatches in vehicles shielded from standard banking regulation. With the disappearance of the SIVs' funding sources, notably asset-backed commercial paper, banks had to bring over $136 billion-worth onto their books. That comes on top of over $160 billion, so far, of subprime-related write-downs, over a third of which has come at three banks: Citigroup, Merrill Lynch and UBS.

Though few bankers worked in structured finance, it was a huge earner, accounting for 20-30% of big investment banks' profits before the crisis, according to CreditSights, a financial-research firm. Banks such as Bear Stearns, Lehman Brothers and Morgan Stanley, which bought or built mortgage-origination businesses to fuel the securitisation machine, have rushed to close or pare them. Merrill, whose fees from CDOs alone peaked at $700m in 2006, said recently that it would stop packaging mortgages altogether.

Alongside the banks, the “gatekeepers” who were supposed to lend stability and credibility to the new originate-and-distribute model of finance have also been found wanting. Rating agencies' models underplayed the risk that loans from different lenders and regions could turn sour at the same time. Bond insurers, too, misjudged the risks lurking in CDOs. That failing has undermined the worth of their guarantees and strained their own credit ratings—and hence financial markets.

George Miller, the ASF's executive director, accepts that this crisis of confidence will lead to a degree of “re-intermediation” for a time, as some banks go back to balance-sheet lending. But he insists that it highlights the dangers of lax lending standards in a particular market rather than fundamental faults in securitisation itself.

A study by NERA, an economic consultancy, commissioned by the ASF before the crunch, offers some support for this view. Preliminary results, based on data from 1990 to 2006, suggest that increased securitisation leads to lower spreads in consumer credit and softens interest-rate shocks for banks, especially smaller ones. On the other hand, in a recent paper two economists at the University of Chicago's business school conclude that securitisation encouraged mortgage originators to lend to dodgy borrowers.

Stresses and strains

What is not in doubt is that the subprime crisis has exposed four deep flaws in the practice of securitisation. The first is that by severing the link between those who scrutinise borrowers and those who take the hit when they default, securitisation has fostered a lack of accountability.

A debate has been rumbling over how to ensure that lenders have more “skin in the game”. Some think they should set aside a sliver of capital even for loans they sell on. Andrew Davidson, a structured-finance consultant, suggests an “origination certificate”, guaranteeing the quality of the underwriting, issued by the lender and broker, which stays with the loan. Alex Pollock of the American Enterprise Institute thinks that securitisers should be required to guarantee the quality of their loan pools, as are America's government-sponsored mortgage giants, Fannie Mae and Freddie Mac. Others counter that most such exposures can be neutralised these days through derivatives markets.

The second flaw is the sheer lack of understanding of some instruments. Not long ago investors took too much on trust. They are now clamouring for more “transparency”. Some want a central trade-quoting facility for lumpy asset-backed products: regulators have approached the New York Stock Exchange. CME Group, which runs the world's largest futures exchange, is also looking to expand its clearing of over-the-counter securities.

Yet reams of information already accompany mortgage-backed securities sold in public markets. Even SIVs provide a steadier stream of data to investors than most of the banks backing them. So some interpret calls for greater disclosure as whimpering by investors who did not do their homework.

However, more information about the performance of loans after origination would help, particularly those in leveraged structures such as CDOs. This opens up opportunities: fewer banks were at the ASF conference this year, but more data-analytics firms turned up. Clayton, the largest mortgage-surveillance company, unveiled a partnership with Experian, an information-services firm, that will help mortgage-servicers to package subprime loans for modification under a plan backed by the ASF and America's Treasury. Later, it hopes to offer a swathe of data to buyers of structured products.

Understanding the underlying assets is, or should be, at the core of securitisation. Securitisation is really an arbitrage: with surplus collateral, assets can be bundled into an entity with a supercharged credit rating. But if investors fail to spot the jiggery-pokery with credit scores and the outright fraud that permeated the subprime market, that cushion of safety quickly disappears. Witness the speed with which losses have spread into supposedly safe, “super senior” tranches of CDOs.

This points to the third flaw: that some securities were poorly structured, often because their risks were not fully understood. The upper layers of a well-designed securitisation vehicle should be all but impervious to loss. But poorly structured deals, like those stuffed with subprime and marginally less iffy “Alt-A” loans in 2006 and early 2007, have crumbled as the weakness of the collateral becomes clear.

The fourth flaw was the market's over-reliance on ratings as a short cut to assessing risk. In the go-go years, people wrongly assumed that an AAA-rated mortgage bond—even one with a high yield—would never lose value. But the rating agencies, paid for their appraisals by the seller not the buyer, were compromised from the start. Moreover, their quantitative models appear to have ignored “fat-tail” risks—the possibility that large losses are likelier than standard statistical models predict.

Though the agencies do not have to suffer giant write-downs, they have paid a high price. Before the market imploded, almost half the revenue of Moody's, a leading agency, came from structured finance. Now the agencies are revising their rating criteria in a bid to head off tougher regulation. “Either deals get less complex or we have to find a better shorthand for measuring risk,” says Ron Borod of Brown Rudnick, a law firm. The rating agencies say they were never supposed to substitute for investors' own due diligence. That is disingenuous, given their past self-assuredness. Still, wise investors will take future ratings with a pinch of salt, as most hedge funds have long done.

As the market grapples with change, some is likely to be imposed from above. Separately, international regulators and the President's Working Group (comprising America's Treasury, the Federal Reserve and others) are looking into securitisation's part in the crisis. By co-operating over loan modifications, the ASF may have gained favour with the working group.

The industry is more worried about two bills in America's Congress. Securitisers can live with much of the one that has been passed by the House of Representatives. What alarms them is an “assignee liability” provision that would hold them partly responsible for lax lending by originators. This, they say, would send a chill through secondary markets, cutting credit to thousands of worthy borrowers. Precedent is on their side. Georgia introduced assignee liability, only to back-pedal after the state's subprime market started to seize up. Not all bankers are against it: in Las Vegas, Bianca Russo of JPMorgan Chase argued that some form of it was needed to counter the perception, if not the reality, that securitisation was harmful.

The other bill would allow bankruptcy judges to alter the terms of struggling borrowers' mortgages. The industry argues that this would be an intolerable violation of the sanctity of loan-pooling contracts. In addition, securitisers face probes by several state attorneys-general, the Internal Revenue Service, the Federal Bureau of Investigation, the Securities and Exchange Commission and the Justice Department, as well as lawsuits from investors and a rising number of stricken municipalities.

Bankers will tell you that the subprime meltdown was just that: the product of irresponsible lending to, and borrowing by, flaky consumers, not a broader crisis of securitisation. Maybe, but the severity of the credit crunch points to broader pain ahead. More will come from housing: much of the 30-40% of American home-equity loans that have been securitised looks wobbly, as does a growing chunk of the $800 billion of Alt-A paper outstanding. Loans for offices are an even bigger worry. The spread on the AAA tranche of an index tracking bonds backed by commercial mortgages has tripled since the turn of the year. New issuance is frozen.

Trouble is also brewing for securities tied to non-mortgage consumer assets, such as credit-card debt, car loans and student loans, which make up a good slice of the asset-backed market (see chart 3). Credit-card delinquencies are creeping up as the economy turns down. The sharp slowdown in card borrowing, reported recently by the Fed, will mean less raw material for securitisation. Standards for car loans dropped in 2006-07, though not as dramatically as they did for mortgages.

One ominous sign is that structured instruments tied to student loans are coming unstuck, although the loans typically carry a federal guarantee. Recent auctions of such securities by Citigroup, Goldman Sachs and others have failed. Normally the banks would have bought in whatever did not sell. But they have declined, because they dare not cram even more assets onto their already strained balance sheets.

Yet securities of these types should be more resilient than those tied to subprime loans. Their structures are tried and tested, having evolved, along with performance data in their markets, over many years. In contrast, subprime mortgages with only a short record were shoved into many-layered structures that depended on house prices holding up. “They started from the other end entirely, asking how can we create CDOs, backed by mortgage-backed securities, themselves backed by collateral with barely any history, and their stress tests assumed house prices would be stable and the loans in the pools uncorrelated,” says Mr Borod.

Encouragingly, credit-card receivables are still being bundled and sold. There are even shoots of hope in the mortgage market, thanks to a refinancing mini-boom in the wake of interest-rate cuts—though most new deals are backed by the giant agencies, Fannie Mae and Freddie Mac, not Wall Street (see chart 4).

Saunter down the strip

It is also worth remembering that securitisation has not been confined to consumer and corporate loans. In the past decade financial engineers have found ways to package and sell tobacco-settlement and mutual-fund fees, sports and fast-food franchise rights, life-insurance premiums, intellectual property, music royalties and much more. Hollywood studios use securitisation to help finance film-making. With intangible assets accounting for an ever-growing share of corporate value, this trend looks likely to continue.

That may be scant consolation to the banks whose bets have gone so spectacularly wrong. Their fingers are still being singed by mortgage-backed securities and CDOs that continue to burn. Those hoping for a recovery face a long wait, maybe 18 months or more for out-of-favour collateral such as non-agency mortgages. Some once-enthusiastic cheerleaders are turning gloomy: Bear Stearns said recently that its net short position on subprime loans and bonds had risen to $1 billion. Others are redeploying staff and capital to fee businesses that don't put a strain on the balance sheet, such as merger advice.

But it would be a mistake to write the obituary of structured finance. Even its sternest critics accept that securitisation has brought real economic benefits, and that it would be wrong to throw away the whole barrel because of a few subprime apples. Some students of financial innovation think the market will come back even more inventive after scorching its less attractive pastures. “As with past forest fires in the markets, we're likely to see incredible flora and fauna springing up in its wake,” says Andrew Lo, director of the Massachusetts Institute of Technology's Laboratory for Financial Engineering.

So it may just be a matter of hanging on. As any punter in Las Vegas will tell you, every losing streak ends eventually, if you can only stay solvent for long enough.

Should we worry about heavy borrowing from TAF?

How Non-Borrowed Reserves Became a Sexy Subject: Caroline Baum

Commentary by Caroline Baum

Feb. 8 (Bloomberg) -- Technically insolvent! This has never happened before! Without the Temporary Auction Facility, where would banks be?

When I got the fifth hysterical e-mail on the subject of -- sit down -- the decline in banks' non-borrowed reserves, I thought I was back in the Volcker era.

That would be Paul Volcker, chairman of the Federal Reserve from 1979 to 1987. Volcker knew interest rates had to rise significantly to slay the inflation dragon; he didn't know by how much. So he changed the Fed's operating procedure from targeting a price (the overnight interbank lending rate) to a quantity (the monetary aggregates -- specifically non-borrowed reserves).

``There is no relationship between non-borrowed reserves and anything the Fed cares about, be it inflation, employment or real GDP,'' said Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

He said that 20 years ago, when I was just starting out, but I still remember his exact words. They came back to me when I learned of the latest obsession with this irrelevant statistic.

A few basics are in order. I promise not to make this too geeky.

Banks are required to keep a certain amount of funds in reserve -- as vault cash or on deposit at the Fed -- to meet unexpected deposit outflows. These are called required reserves (catchy, isn't it?). Sometimes depository institutions elect to hold more than is required. These are called excess reserves.

Sources and Uses

Congratulations. You have just completed the introductory course in the uses of reserves. What about the sources?

Reserves can be borrowed (from the Fed's discount window) or non-borrowed (supplied via the Fed's daily open market operations). It matters not one whit to the Fed where the banks acquire the reserves they require. If they borrow directly from the Fed, they don't need to tap the interbank, or fed funds, market.

What's caused the hullabaloo recently is the dive in non- borrowed reserves from $44 billion in early December to minus $8.8 billion at the end of January.

It isn't a mystery what happened. The Fed announced the creation of a Term Auction Facility on Dec. 12, enabling banks to borrow for 28 days versus a wide range of collateral. The minimum bid the Fed accepts is the expected funds rate one month out, which in the current environment means cheaper funding costs than the fed funds market.

So what would you do if you were a bank?

Lower Cost

Loans made through the TAF are categorized as borrowed reserves. The Fed had $50 billion of loans in place at the end of January, which ``caused the borrowed reserves figure to balloon and the non-borrowed figure to decline by a corresponding amount,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, in a Feb. 6 commentary. (He's on the same e-mail lists I am.)

All of a sudden, people who never glanced at the Fed's H.3 statistical release are now experts on ``Aggregate Reserves of Depository Institutions and the Monetary Base.'' Their e-mails have the same sense of foreboding as the missives put out by the Black Helicopter/Tin-Foil Hat crowd.

``What if the Fed's rate cuts aren't motivated by the desire to stave off recession, rather to prevent a major banking crisis?'' one e-mail read. ``The Fed's not telling anyone what it's up to because it doesn't want to cause panic, but the evidence is there in its own data.'' (Gosh, you'd think it would do a better job of hiding it. Maybe send H.3 to join M3!)

Monopolist Provider

The writer of the e-mail directs his readers to the most recent H.3 report, which shows total reserves ($41.6 billion) less TAF credit ($50 billion) less discount window borrowings ($390 million) equals non-borrowed reserves (minus $8.8 billion). The negative number is really an accounting quirk: If banks borrow more than they need, non-borrowed reserves are a negative number.

This gentleman is overlooking the fact that the Fed is ``a monopoly provider of reserves,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. ``This is a non-starter. There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply.''

There may be times, such as late last year, when banks are reluctant to lend to one another for a period longer than overnight. ``And any one bank can have a problem'' funding itself, Glassman said. But in a world where ``the Fed can print money, there is no shortage,'' he said. ``The banks get the reserves they want.''

Low Priority Worry

Those hyperventilating over TAF borrowing may want to consider an alternate scenario.

``Suppose the Fed cut the discount rate so that it stood below the funds rate,'' Kasriel said. (He said this yesterday, not two decades ago.) ``Would these folks be upset if banks went to the discount window for funds? What's the difference? It's a difference without a distinction.''

In a commentary this week, Goldman Sachs Group Inc. senior economist Andrew Tilton dismissed the case of the disappearing non-borrowed reserves as ``evidence of the markets' obsession with the health of the financial system.''

Some of the concern is justified, he said, given banks' massive losses and writedowns on subprime loans.

Of all the things to worry about right now, this isn't one of them.

Asset inflation and its place in US economic policy

The debt delusion

The US economy relies upon asset price inflation and rising indebtedness to fuel growth - and this contradiction has global implications

By Thomas Palley

(Guardian) A second big American interest-rate cut in a fortnight, alongside an economic stimulus plan that united Republicans and Democrats, demonstrates that US policymakers are keen to head off a recession that looks like the consequence of rising mortgage defaults and falling home prices. But there is a deeper problem that has been overlooked: the US economy relies upon asset price inflation and rising indebtedness to fuel growth.

Therein lies a profound contradiction. On one hand, policy must fuel asset bubbles to keep the economy growing. On the other hand, such bubbles inevitably create financial crises when they eventually implode.

This is a contradiction with global implications. Many countries have relied for growth on US consumer spending and investments in outsourcing to supply those consumers. If America's bubble economy is now tapped out, global growth will slow sharply. It is not clear that other countries have the will or capacity to develop alternative engines of growth.

America's economic contradictions are part of a new business cycle that has emerged since 1980. The business cycles of presidents Ronald Reagan, George Bush Sr, Bill Clinton, and George Bush share strong similarities and are different from pre-1980 cycles. The similarities are large trade deficits, manufacturing job loss, asset price inflation, rising debt-to-income ratios, and detachment of wages from productivity growth.

The new cycle rests on financial booms and cheap imports. Financial booms provide collateral that supports debt-financed spending. Borrowing is also supported by an easing of credit standards and new financial products that increase leverage and widen the range of assets that can be borrowed against. Cheap imports ameliorate the effects of wage stagnation.

This structure contrasts with the pre-1980 business cycle, which rested on wage growth tied to productivity growth and full employment. Wage growth, rather than borrowing and financial booms, fuelled demand growth. That encouraged investment spending, which in turn drove productivity gains and output growth.

The differences between the new and old cycle are starkly revealed in attitudes toward the trade deficit. Previously, trade deficits were viewed as a serious problem, being a leakage of demand that undermined employment and output. Since 1980, trade deficits have been dismissed as the outcome of free-market choices. Moreover, the Federal Reserve has viewed trade deficits as a helpful brake on inflation, while politicians now view them as a way to buy off consumers afflicted by wage stagnation.

The new business cycle also embeds a monetary policy that replaces concern with real wages with a focus on asset prices. Whereas pre-1980 monetary policy tacitly aimed at putting a floor under labour markets to preserve employment and wages, it now tacitly puts a floor under asset prices. This is not a matter of the Fed bailing out investors. Rather, the economy has become so vulnerable to declines in asset prices that the Fed is obliged to intervene to prevent them from inflicting broad damage.

All these features have been present in the current economic expansion. Wages have stagnated despite strong productivity growth, while the trade deficit has set new records. Manufacturing has lost 1.8m jobs. Prior to 1980, manufacturing employment increased during every expansion and always exceeded the previous peak level. Between 1980 and 2000, manufacturing employment continued to grow in expansions, but each time it failed to recover the previous peak. This time, manufacturing employment has actually fallen during the expansion, something unprecedented in American history.

The essential role of asset inflation has been especially visible as a result of the housing bubble, which also highlights the role of monetary policy. Despite the massive tax cuts of 2001 and the increase in military and security spending, the US experienced a prolonged jobless recovery. That compelled the Fed to keep interest rates at historic lows for an extended period, and rates were raised only gradually because of fears about the recovery's fragility.

Low interest rates eventually jump-started the expansion through a house price bubble that supported a debt-financed consumer-spending binge and triggered a construction boom. Meanwhile, prolonged low interest rates contributed to a "chase for yield" in the financial sector that resulted in disregard of credit risk.

In this way, the Fed contributed to creating the sub-prime crisis. However, in the Fed's defence, low interest rates were needed to maintain the expansion. In effect, the new cycle locks the Fed into an unstable stance whereby it must prevent asset price declines to avert recession, yet must also promote asset bubbles to sustain expansions.

So, even if the Fed and US treasury now manage to stave off recession, what will fuel future growth? With debt burdens elevated and housing prices significantly above levels warranted by their historical relation to income, the business cycle of the last two decades appears exhausted.

It is not enough to deal only with the crisis of the day. Policy must also chart a stable long-term course, which implies the need to reconsider the paradigm of the past 25 years. That means ending trade deficits that drain spending and jobs, and restoring the link between wages and productivity. That way, wage income, not debt and asset price inflation, can again provide the engine of demand growth.

Exxon returns favour to Hugo Chavez - Sovereign debt swings towards distress

Exxon Venezuela asset freeze new blow to Chavez
Fri Feb 8, 2008 12:12am GMT

By Brian Ellsworth
CARACAS (Reuters) - Exxon Mobil's move to freeze billions of dollars of Venezuelan oil assets around the globe adds new complications to President Hugo Chavez's crusade toward socialism, which is already facing growing obstacles.

Fresh off a 2007 nationalization drive that led to a takeover of a large Exxon oil project in Venezuela, the leftist leader is struggling with the fallout over a December poll defeat, growing economic problems and discontent among supporters.

Chavez faces a potentially huge legal battle with one of the world's largest companies after Exxon's gambit, which freezes some of Venezuela's cash and blocks it from selling billions of dollars worth of assets.

But paying a settlement to the Texas energy giant could mean sacrificing millions of dollars needed for the social programs and suffering a humiliating defeat to a transnational company the anti-U.S. leader has described as "imperialist."

News of the court ruling prompted a sell-off of Venezuelan debt.

"It makes the actions you took a year ago fairly pricey," said Dino Barajas, an expert in energy law at Paul, Hastings, Janofsky & Walker LLP.

Exxon (XOM.N: Quote, Profile, Research) court filings revealed on Thursday show the company won rulings preventing Venezuelan state oil company PDVSA from selling assets such as refineries while also preventing Venezuela from withdrawing more than $300 million in cash from a U.S. bank account.

It was unclear exactly what the impact would be on the day-to-day operations of PDVSA, which critics say is weakened by government's demands it work on social projects, road repairs and food imports.

"Nobody really knows what is the real reach of these decisions, but it doesn't look good for PDVSA, or for the country, which depends on the company for everything, even importing food," said one Venezuelan investor, who asked not to be named.

Chavez launched a broad energy sector nationalization campaign in 2007 as part of a drive to create a socialist society.

Exxon is suing Venezuela for its takeover of the multibillion-dollar Cerro Negro heavy oil project, arguing the OPEC nation violated its contract and illegally snatched complete control.

Venezuela's Information Ministry said it could not comment on the information.

The news comes only months after Chavez lost a referendum that would have let him run indefinitely for re-election. He is now facing growing criticism over nagging shortages of basic groceries like milk and chicken.

The leftist government is also seeing a growing cash flow crunch at PDVSA, which finances the social programs that keep Chavez popular among the nation's majority poor.

A new obligation to pay billions of dollars in compensation to Exxon would put further strain on the finances of the company, which saw its debt rise by $13 billion in 2007 to reach $16 billion -- largely driven by the nationalization crusade.

Court papers suggest the move came as a surprise to PDVSA.

In the court documents, PDVSA's law firm complained that Exxon's lawyers had been "feigning continued cooperation in good faith while another law firm was working behind the scenes preparing this attachment."

(Additional reporting by Ana Isabel Martinez and Frank Jack Daniel; Editing by Christian Wiessner)

SPAC's rise with fall of LBO financing

Wall Street Peddles Blank-Check IPOs as Returns Trail S&P 500

By Elizabeth Hester

Jan. 7 (Bloomberg) -- Special-purpose acquisition vehicles, companies with no product, earnings or sales that make takeovers, are Wall Street's growing source of fees now that the market for subprime-mortgage securities has dried up.

The trouble is that investors who have spent $18 billion since 2003 on U.S. initial public offerings by such shell companies would have been better off holding a mutual fund that tracks the Standard & Poor's 500 Index.

While some special-purpose acquisition companies do rise, such as the 98 percent gain last year by the units of Nicolas Berggruen's GLG Partners Inc., the average annual return of the past five years has been 5.8 percent, according to SPAC Analytics, a Turks & Caicos-based independent research service. The S&P 500 advanced 13 percent annually in the same period.

``It seems as if everybody is raising a SPAC,'' David Rubenstein, co-founder of the Washington-based private-equity firm Carlyle Group, said last month at an industry conference in Dubai. ``The jury is still out as to whether these are good things other than for the investment bankers who raise them.''

The securities industry raised $11.7 billion last year for the special-purpose acquisition companies, an almost fourfold increase from 2006, data compiled by Bloomberg show. Billionaire dealmakers Ronald Perelman and Nelson Peltz plan to bring in a combined $1.25 billion before the end of March with SPACs.

Hicks Sale

The surge in SPACs coincides with a decline in leveraged buyouts. LBOs all but disappeared in the second half of 2007 as borrowing costs almost doubled from June to December, Merrill Lynch & Co. data show. U.S. buyouts fell to $103.2 billion in the second half from $322.4 billion in the first six months of the year as the subprime-mortgage market collapsed.

SPACs sell units, usually one share of common stock and one warrant, and use the money to buy a closely held company. They were dubbed blank-check companies because they don't disclose their targets before the IPO. Any takeover must be approved by at least 70 percent of the SPAC's shareholders. If a purchase isn't completed within a set time, usually two years, the money is returned to investors, minus incurred operating costs.

Thomas Hicks, the leveraged buyout pioneer and owner of the Texas Rangers of Major League Baseball, raised $552 million for Hicks Acquisition Co. I in September.

``I plan to use the vehicle to try to build three or four or five significant companies over the next five to 10 years because it's permanent capital,'' Hicks, 61, said in an interview from his office at Hicks Holdings LLC in Dallas. ``Once you make an acquisition, that entity has the ability to continue growing both internally and by acquisitions because it will be very lightly leveraged compared to leveraged buyouts.''

Sluggish Performance

Hicks Acquisition has declined 1 percent in American Stock Exchange composite trading since the IPO. Hicks Acquisition has yet to announce a takeover.

SPAC shares often languish until a deal is disclosed. Returns for blank-check companies that have announced but not completed a purchase have averaged 14.6 percent a year, while those still looking have gained 4.6 percent, according to SPAC Analytics.

After a purchase, the shares trade on the fundamentals of the operating company such as earnings and sales growth. SPACs that have completed their initial transaction rose by an average of 3.7 percent a year.

Services Acquisition Corp. International, sponsored by former Blockbuster Inc. Chief Executive Officer Steven Berrard, raised $138 million in June 2005 in an IPO underwritten by Broadband Capital Management LLC. In March 2006, the SPAC said it would buy juice-smoothie retailer Jamba Juice Co.

Bankers' Fees

Services Acquisition climbed 56 percent from the announcement until the closing date the following November. Since the deal was completed, San Francisco-based Jamba's shares have dropped 77 percent amid rising costs and sales that fell short of forecasts.

Wall Street earned more than $770 million by selling shares of 64 SPACs last year, up from 36 offerings in 2006. The fees helped securities firms offset a 1.2 percent decline in revenue from conventional IPOs, data compiled by Bloomberg show. Underwriting also puts banks in line for advisory business when SPAC clients are ready to pursue takeovers.

Citigroup Inc., the largest U.S. bank by assets, managed its first SPAC IPO in 2005 and ranked No. 1 last year among blank-check underwriters, Bloomberg data show. The New York- based firm earned $302.8 million in fees, ahead of second-ranked Deutsche Bank AG's $92 million. Deutsche Bank is based in Frankfurt.

`Cash Vehicle'

Citigroup probably will report a fourth-quarter loss of $4.2 billion, or 83 cents a share, after writedowns of subprime- related securities, according to a survey of 17 analysts by Bloomberg.

Morgan Stanley, the second-biggest securities firm by market value after Goldman Sachs Group Inc., and No. 5 Bear Stearns Cos. also reported losses during the worst U.S. housing slump since the 1991 recession. All the companies are based in New York.

Citigroup's SPAC clients include Hicks; Jonathan Ledecky, the former CEO of Washington-based U.S. Office Products Co.; and former hedge-fund manager Berggruen.

Berggruen, 46, raised more than $1 billion in the IPO of Liberty Acquisition, the largest SPAC to date. His previous SPAC, the $528 million Freedom Acquisition Holdings Inc., took New York-based hedge-fund manager GLG Partners public on Nov. 2. GLG units rose 31 percent since the deal was announced in June.

``We felt in this environment that having a cash vehicle would really give us a competitive advantage,'' said Jared Bluestein, chief financial officer of New York-based Berggruen Holdings Ltd. ``The ability to do deals without a high degree of leverage will always be an attractive opportunity for both buyers and sellers.''

Blank Checks

Fees for underwriting SPACs are 6.6 percent of assets raised, compared with the 6 percent average for all IPOs in the U.S., Bloomberg data show. SPAC share sales accounted for 21 percent of dollars raised last year in the U.S. IPO market.

Since the start of 2003, 144 blank-check companies have sold shares, raising $18.1 billion with 13 of the deals coming before 2005, according to SPAC Analytics.

As the largest Wall Street firms began underwriting SPACs, it attracted bigger names and prompted investors to pile more money into the vehicles. The average capital raised in 2007 IPOs was $183 million, up from $76.4 million in 2005, SPAC Analytics data show.

Perelman and Peltz

Perelman, the 65-year-old chairman of skin-care company Revlon Inc., has filed to raise $500 million for MAFS Acquisition Corp. The New York-based investor also brokers deals through his closely held holding company, MacAndrews & Forbes Holdings Inc., and M&F Worldwide Corp., which trades publicly.

Peltz, who's known for putting pressure on the managements of companies including ketchup-maker H.J. Heinz Co. to improve shareholder value, is seeking $750 million for New York-based Trian Acquisition I Corp. The IPO is scheduled for Jan. 21. Peltz, 65, separately won clearance from regulators last week to buy a stake of New York-based insurance broker Marsh & McLennan Cos.

Peltz and Perelman declined to comment.

Other newcomers to the SPAC club include Barry Sternlicht, the 47-year-old founder of White Plains, New York-based Starwood Hotels & Resorts Worldwide Inc.; mergers advisory firm Lazard Ltd., run by Bruce Wasserstein, 60; and rival bank Greenhill & Co. Lazard and Greenhill are based in New York.

Different Than LBOs

``We're looking to back proven people,'' said Whitney Tilson, who manages about $160 million at T2 Partners LLC in New York. ``It's a much better deal than investing in your typical LBO fund. In your typical LBO fund you're locked up for 10 years and you can't give thumbs up or thumbs down on a deal by deal basis.''

Buyout firms raise money privately, returning profits from their deals to investors over seven to 10 years. LBO funds range from several hundred million dollars to the record $21.7 billion gathered by New York-based Blackstone Group LP last year.

Since SPACs sell shares with the goal of buying an existing company they haven't yet identified, IPO investors are betting on the ability of the executives to find a suitable target.

Context Capital Management LLC, a hedge-fund firm with about $700 million of assets, is creating a new pool to buy SPACs. The company, which has offices in San Diego and Stamford, Connecticut, aims to raise $300 million, said William Fertig, Context's co-founder and co-chairman.

Credit Risk

``The market opportunity is enormous because the asset class has grown so dramatically,'' he said. ``It could be a billion- dollar opportunity.''

Even if a SPAC can't find a business to buy, investors will most likely break even since almost all the money raised is held in a trust account, Fertig said.

``There is very little credit risk associated with a SPAC because most of the proceeds are held in trust,'' he said.

SPAC founders have much to like about the deals since they'll own part of a publicly traded company once a purchase is completed.

``It's a great deal for the sponsor because they get 20 percent of the company,'' said Steven Kaplan, a finance professor at the University of Chicago Graduate School of Business. ``If a deal doesn't go through, everyone gets their money back. That's pretty good: heads I win, tails I'm even.''

Shortest path vs path of least resistance

Forget how the crow flies

By John Kay, FT.com site
Published: Jan 16, 2004

If you want to go in one direction, the best route may involve going in the other. Paradoxical as it sounds, goals are more likely to be achieved when pursued indirectly. So the most profitable companies are not the most profit-oriented, and the happiest people are not those who make happiness their main aim. The name of this idea? Obliquity

The American continent separates the Atlantic Ocean in the east from the Pacific Ocean in the west. But the shortest crossing of America follows the route of the Panama Canal, and you arrive at Balboa Port on the Pacific Coast some 30 miles to the east of the Atlantic entrance at Colon.

A map of the isthmus shows how the best route west follows a south-easterly direction. The builders of the Panama Canal had comprehensive maps, and understood the paradoxical character of the best route. But only rarely in life do we have such detailed knowledge. We are lucky even to have a rough outline of the terrain.

Before the canal, anyone looking for the shortest traverse from the Atlantic to the Pacific would naturally have gazed westward. The south-east route was found by Vasco Nunez de Balboa, a Spanish conquistador who was looking for gold, not oceans.

George W. Bush speaks mangled English rather than mangled French because James Wolfe captured Quebec in 1759 and made the British crown the dominant influence in Northern America. Eschewing obvious lines of attack, Wolfe's men scaled the precipitous Heights of Abraham and took the city from the unprepared defenders. There are many such episodes in military history. The Germans defeated the Maginot Line by going round it, while Japanese invaders bicycled through the Malayan jungle to capture Singapore, whose guns faced out to sea. Oblique approaches are most effective in difficult terrain, or where outcomes depend on interactions with other people. Obliquity is the idea that goals are often best achieved when pursued indirectly.

Obliquity is characteristic of systems that are complex, imperfectly understood, and change their nature as we engage with them. Forests have all these features. Fire is the greatest enemy of the forest. From the late 19th century, the policy of the US National Parks Service was of zero tolerance towards fire. Every outbreak, however small, would be extinguished. But the incidence of fire did not fall: it increased.

Computer simulation of fire control policies suggests the explanation. Most forest fires are small, and burn themselves out. In doing so, they remove combustible undergrowth, and create firebreaks that limit the spread of future fires. In 1972, the National Park Service determined a new policy: it would put out man-made fires, but allow natural ones to burn.

Sixteen years later, the largest fire known swept through Yellowstone National Park. In extremely dry conditions, several fires - some sparked by lightning, some by arsonists - joined together. The blaze was fought by 25,000 firefighters at a cost of $120m; more than a third of the park's vegetation was destroyed.

Today's guidelines allow forest rangers to use their judgment in deciding which fires should be tackled and which left to burn. Experience has shown that too much effort devoted to fire extinction is counterproductive. Time demonstrates, but only slowly, whether policy has gone too far in one direction, or the other. Forest management illustrates obliquity: the preservation of the forest is not best pursued directly, but managed through a holistic approach that considers and balances multiple objectives.

Forests are not the only systems structured in this way. Obliquity is equally relevant to our businesses and our bodies, to the management of our lives and our national economies. We do not maximise shareholder value or the length of our lives, our happiness or the gross national product, for the simple but fundamental reason that we do not know how to and never will. No one will ever be buried with the epitaph "He maximised shareholder value". Not just because it is a less than inspiring objective, but because even with hindsight there is no way of recognising whether the objective has been achieved.

For most of the 20th century, ICI was Britain's largest and most successful manufacturing company. In 1987, ICI described its business purpose thus: "ICI aims to be the world's leading chemical company, serving customers internationally through the innovative and responsible application of chemistry and related science.

"Through achievement of our aim, we will enhance the wealth and well-being of our shareholders, our employees, our customers and the communities which we serve and in which we operate."

ICI's corporate portfolio had evolved over the decades - the company's traditional strengths had been dyes and explosives, but its chemical expertise had taken it into other industrial feedstocks and agricultural fertilisers. After the second world war, the management of ICI concluded that in future "the responsible application of chemistry" was most likely to be found in pharmaceuticals. ICI recruited a team of able, young, academic scientists but the team was slow to bring returns.

The pharmaceutical division was a drain of ICI resources until, in the 1960s, the discovery of beta-blockers gave the company the first effective drug for controlling hypertension. More discoveries followed and, by the 1980s, pharmaceuticals had become the growth engine of the company.

In 1991, Hanson, the predatory UK conglomerate that had successfully acquired and reorganised sluggish British manufacturing businesses such as Ever Ready and Imperial Tobacco, bought a modest stake in ICI. While the threat to the company's independence did not last long, the effects were galvanising. ICI restructured its operations and floated the pharmaceutical division as a separate business, Zeneca. The rump business of ICI declared a new mission statement: "Our objective is to maximise value for our shareholders by focusing on businesses where we have market leadership, a technological edge and a world competitive cost base."

While the National Parks Service had moved from a narrow, focused objective to a broader holistic view of forest management. ICI made the opposite shift - from a grand vision of the responsible application of chemistry to a narrow concentration on established, successful activities. The aim of bringing benefit to a wide range of stakeholders was replaced by the specific objective of creating shareholder value from narrowly focused operations. The company translated this into an operational strategy by disposing of the company's interests in bulk chemicals to acquire a niche group of speciality businesses: ICI, once the main supplier of chemical products to one third of the world, was reinvented as a smells company.

The outcome was not successful in any terms, including those of creating shareholder value. The share price peaked in 1998, soon after the new strategy was announced. The decline since then has been relentless. After two successive dividend cuts the company was ejected in early 2003 from the FTSE 100 index, the transition from industrial giant to mid-cap corporation had taken only 12 years.

ICI is not the only company for whom greater emphasis on corporate financial goals led to less success in achieving them. I once said that Boeing's grip on the world civil aviation market made it the most powerful market leader in world business. Bill Allen was chief executive from 1945 to 1968, as the company created its dominant position. He said that his spirit and that of his colleagues was to eat, breathe, and sleep the world of aeronautics. "The greatest pleasure life has to offer is the satisfaction that flows from participating in a difficult and constructive undertaking," he explained.

Boeing's 737, with almost 4,000 aircraft in the air, is the most successful commercial airliner in history. But the company's largest and riskiest project was the development of the 747 jumbo jet. When a non-executive director asked about the expected return on investment, he was brushed off: there had been some studies, he was told, but the manager concerned couldn't remember the results.

It took only 10 years for Boeing to prove me wrong in asserting that its market position in civil aviation was impregnable. The decisive shift in corporate culture followed the acquisition of its principal US rival, McDonnell Douglas, in 1997. The transformation was exemplified by the CEO, Phil Condit. The company's previous preoccupation with meeting "technological challenges of supreme magnitude" would, he told Business Week, now have to change. "We are going into a value-based environment where unit cost, return on investment and shareholder return are the measures by which you'll be judged. That's a big shift."

The company's senior executives agreed to move from Seattle, where the main production facilities were located, to Chicago. More importantly, the more focused business reviewed risky investments in new civil projects with much greater scepticism. The strategic decision was to redirect resources towards projects for the US military that involved low financial risk. Chicago had the advantage of being nearer to Washington, where government funds were dispensed.

So Boeing's civil orderbook today lags that of Airbus, the European consortium whose aims were not initially commercial but which has, almost by chance, become a profitable business. And the strategy of getting close to the Pentagon proved counter- productive: the company got too close to the Pentagon, and faced allegations of corruption. And what was the market's verdict on the company's performance in terms of unit cost, return on investment and shareholder return? Boeing stock, $48 when Condit took over, rose to $70 as he affirmed the commitment to shareholder value; by the time of his enforced resignation in December 2003 it had fallen to $38.

In Yellowstone National Park, at ICI and at Boeing, the attempt to focus on simple, well defined objectives proved less successful than management with a broader, more comprehensive conception of objectives.

The 20th century saw the rise and fall of modernist rationalism in many activities. Nowhere was the change more visible, or the results more disastrous, than in architecture and town planning. In the modernist vision, technology emancipated builders from tradition and accumulated knowledge. Twentieth- century planners could redesign our environment from first principles.

Charles Jencks, the architectural commentator, announced that modernism ended at 3.32pm on July 15 1972, when demolition contractors detonated the fuses to blow up the Pruitt-Igoe housing project in St Louis, Missouri. Less than two decades earlier, the scheme had won awards for its pioneering, visionary architecture. Tower blocks were the supreme expression of Le Corbusier's view that "a house is a machine for living in". Corbusier himself designed the first such buildings, the Unite d'Habitation on the edge of Marseilles.

But a house is not simply a machine for living in. There is a difference between a house and a home. The functions of a home are complex and the utility of a building depends not only on its design but on the reactions of those who live in it. The occupants of the Pruitt-Igoe scheme, like those of similar buildings, were alienated by the isolation of a living environment that saw no need for accidental, unplanned social interactions. They showed no respect for its public spaces. The functionality of the blocks proved, in the end, not to be functional.

Communities are complex organisms, imperfectly understood, and their functioning depends on their social relations. Great architects implicitly understand obliquity, but obliquity is so important to the design of towns that the most successful towns have no designer at all. The planned city was conceived in the late 19th century. Baron Hausmann swept away the jumble of Paris streets that had developed over the centuries to create grand boulevards. From the 1920s to 1968, the powerful, autocratic Robert Moses controlled the physical environment of New York, driving expressways through apartments, offices and factories.

The zenith of these ideas was reached in planned cities such as the designed capitals of Brasilia, Canberra and Chandigarh. But all these cities are dull. They lack the vitality of real communities. As with tower blocks, their very functionality is dysfunctional.

The National Park officials who thought they could eliminate fire; the managers who thought they could reinvent ICI and Boeing; the architects who believed they could discard thousands of years of experience and redesign buildings on purely functional lines; the planners who attempted to rationalise the patchwork evolution of historic cities: all made the same mistake of underestimating the complexity of the system with which they dealt and the value of the traditional knowledge they inherited. And the answer to their problem is not better analysis and more sophisticated modelling, but more humility.

Such humility is not commonly found in the business world. Re-engineering the Corporation by Michael Hammer and James Champy became a New York Times bestseller in 1993. Hammer and Champy are as radical in aspiration as Le Corbusier: "Re-engineering means asking the question `If I were re-creating this company today, given what I know and given current technology, what would it look like?' Re-engineering a company means tossing aside old systems and starting over. It involves going back to the beginning and inventing a better way of doing work."

Obliquity gives rise to the profit-seeking paradox: the most profitable companies are not the most profit-oriented. ICI and Boeing illustrate how a greater focus on shareholder returns was self-defeating in its own narrow terms. Comparisons of the same companies over time are mirrored in contrasts between different companies in the same industries. In their 2002 book, Built to Last: Successful Habits of Visionary Companies, Jim Collins and Jerry Porras compared outstanding companies with adequate but less remarkable companies with similar operations.

Merck and Pfizer was one such comparison. Collins and Porras compared the philosophy of George Merck ("We try never to forget that medicine is for the people. It is not for the profits. The profits follow, and if we have remembered that, they have never failed to appear. The better we have remembered it, the larger they have been") with that of John McKeen of Pfizer ("So far as humanly possible, we aim to get profit out of everything we do").

Collins and Porras also paired Hewlett Packard with Texas Instruments, Procter & Gamble with Colgate, Marriott with Howard Johnson, and found the same result in each case: the company that put more emphasis on profit in its declaration of objectives was the less profitable in its financial statements.

Similarly the richest men are not the most materialistic. Sam Walton, founder and principal shareholder of Wal-Mart, the world's largest retailer, drove himself around in a pick-up truck. "I have concentrated all along on building the finest retailing company that we possibly could. Period. Creating a huge personal fortune was never particularly a goal of mine," Walton said. Still, five of the top 10 places in the Forbes rich list are occupied by members of the Walton family.

Henry Ford was sued by stockholders who resented his determination to expand his automotive business rather than distribute the profits. When they won their case, most of the dividend that the court required the Ford Motor Company to pay went to Henry himself. He used the money to buy back stock and regain freedom of operations. The dissatisfied stockholders would have done better to keep quiet.

Warren Buffett, the most successful investor in history, still lives in the Omaha bungalow he bought almost 50 years ago and continues to take pleasure in a Nebraskan steak washed down with cherry Coke. For Buffett: "It's not that I want money. It's the fun of making money and watching it grow."

The individuals who are most successful at making money are not those who are most interested in making money. This is not surprising. The principal route to great wealth is the creation of a successful business, and building a successful business demands exceptional talents and hard work. There is no reason to think these characteristics are associated with greed and materialism: rather the opposite. People who are obsessively interested in money are drawn to get-rich-quick schemes rather than to business opportunities, and when these schemes come off, as occasionally they do, they retire to their villas in the sun.

And so, the greatest happiness is rarely achieved by those who set out to be happy. The development of psychology and neurophysiology gives us more insight into the real determinants of happiness. Author and psychologist Mihaly Csikszentmihalyi explores the nature of happiness by listening to what people say about their activities through what he calls experience sampling. He pages people frequently to write down structured reports of exactly how they feel about what they are doing at that moment.

Although we crave time for passive leisure, people engaged in watching television reported low levels of contentment. Csikszentmihalyi's systematic finding is that the activities that yield the highest for satisfaction with life require the successful performance of challenging tasks. These moments are encountered as frequently in work as outside it, and they constitute the state of mind which Csikszentmihalyi describes as flow. "Flow tends to occur when a person's skills are fully involved in overcoming a challenge that is just about manageable."

Csikszentmihalyi's formulation exactly parallels that of Boeing's Bill Allen - "the greatest pleasure that life has to offer is the satisfaction that flows from participating in a difficult and challenging undertaking." Flow is as characteristic of the successful business as of the contented individual.

Yet there are fundamental differences. While the quest for happiness is complementary - by achieving it we make it easier, not harder, for others to achieve the same goal - the development of business is competitive. Tolstoy claimed in Anna Karenina that "All happy families resemble one another, but each unhappy family is unhappy in its own way."

However, the opposite is true in commercial life. Unhappy businesses resemble one another: each successful company is successful in its own way. Business achievement depends on doing things that others cannot do - and still find difficult to do even after others have seen the benefits they bring to the imitators. So the most profitable companies are those that are successful with major challenges - like Boeing's creation of the jumbo jet or ICI's development of a pharmaceutical division. For Csikszentmihalyi, flow is the accomplishment of a difficult task, involving the successful match of capabilities to environment. In the less elegant language of business gurus, Collins and Porras describe the same phenomenon in business as the achievement of "big hairy audacious goals".

Companies that succeed in such challenges are disproportionately represented in the case studies of business schools. We don't hear much about business innovators who adopted big hairy audacious goals and failed, although failure, not success is the norm. For every Bill Gates, Sam Walton and Warren Buffett, there are a hundred people with similar ambitions, and not necessarily much less talent, whose pictures will never be seen on the front cover of Fortune magazine.

Success through obliquity is a product of natural selection in an uncertain, but competitive, environment. It is almost certainly true that, on average, profit-oriented companies are more profitable than less profit-oriented companies. It is very likely that on average people who are interested in money are richer than people who are not. But at the same time that the most profitable companies are not the most profit-oriented, the richest people are not those most interested in money. Outstanding success is the product of obliquity.

This oblique relationship between intention and outcome is the subtle, but frequently misunderstood, message contained in Richard Dawkins' metaphor of the selfish gene. The gene is not actually selfish: the gene has no motive at all, in the sense in which we normally talk about motive. Genes that survive the processes of selection are those well adapted to their environment, and such adaptation was not the product of any conscious design. And this is also true of the forests we travel thousands of miles to see, the great capital cities of history, the traditions of classical architecture, and the development of great businesses. All of them are the product of evolution in a universe too complex and unpredictable for any of us fully to understand. All of them survive and prosper because they are well adapted to their environment.

The University of Sheffield Sports Engineering Research Group, after analysing David Beckham's performance on the football field, announced in 2002 that they had discovered a physics genius. The scientists had identified the complex differential equations that need to be solved to bend it like Beckham. No doubt their computers are already crunching numbers to tell Jonny Wilkinson how to drop a goal.

But little research is needed to confirm that Beckham is not a physics genius. Solving equations of motion is a means of understanding what happens, but is not a means of making it happen. Similarly, the financial returns of a business record what it achieves but are not the means by which it is achieved. Successful companies do maximise long-term shareholder value, or at least create large quantities of it. But that does not imply they were any more capable of formally calculating the results of their activities than Beckham can. Still less can we infer that such calculations were the basis of their achievement.

Would Boeing really have benefited from careful analyses in the mid-1960s of the prospective return on investment from development of the 747? An analyst would have had to anticipate the oil shock, the globalisation of world markets and the development of the aviation industry through to the end of the century. Anyone who has built models of these kinds, or scrutinised them carefully, knows that the range of possible assumptions is always wide enough to allow the analyst to come up with whatever answer the person commissioning the assessment wants to hear.

ICI might have made calculations in the 1950s that estimated the market capitalisation Zeneca would have achieved in the year 2000. Their strategists could then have put that number into a discounted cash flow calculation to estimate a return on the company's early investment in its pharmaceutical business. But no one would or should have taken such a calculation seriously.

The distinction between intent and outcome is central to obliquity. Wealth, family relationships, employment all contribute to happiness but these activities are not best conducted with happiness as their goal. The pursuit of happiness is a strange phrase in the US constitution because happiness is not best achieved when pursued. A satisfying life depends above all on building good personal relationships with other people - but we entirely miss the point if we seek to develop these relationships with our personal happiness as a primary goal.

Humans have well developed capacities to detect purely instrumental behaviour. The actions of the man who buys us a drink in the hope that we will buy his mutual funds are formally the same as those of the friend who buys us a drink because he likes our company, but it is usually not too difficult to spot the difference. And the difference matters to us. "Honesty is the best policy, but he who is governed by that maxim is not an honest man," wrote Archbishop Whately three centuries ago. If we deal with someone for whom honesty is the best policy, we can never be sure that this is not the occasion on which he will conclude that honesty is no longer the best policy. Such experiences have been frequent in financial markets in the last decade. We do better to rely on people who are honest by character rather than honest by choice.

In a similar way, the statement "we look after employees because we care" is not the same as the statement "we have introduced new compensation arrangements because, having calculated the relative costs of benefits enhancements and staff turnover, and commissioned a consultant's report on the policies of competitors, we believe it will produce a net enhancement of earnings per share". Even if the pensions and healthcare benefits are the same, the response from those affected is different. That is why companies that put the second statement in their board papers and investor presentations typically put the first statement in their press releases and communications to employees. But people who work in a business generally know its nature well enough to see the instrumentality at work.

Marks and Spencer was famous for decades for the breadth of its staff welfare programme. In particular, the company pioneered the provision of high-quality meals at nominal prices. The policy did not originate in any nice calculation of costs and benefits. It was adopted when a shop assistant fainted as Simon Marks was making one of his legendary store visits. Marks discovered that her husband was unemployed and the family did not have enough to eat. Marks was not engaged in philanthropy - he did not offer to feed his employee's family. Nor was his purpose the creation of shareholder value. Marks was making a sincerely felt statement about the kind of business he wanted his company to be. Such statements about the nature of the business defined the iconic company Marks and Spencer became. As at ICI and Boeing, Marks and Spencer was to sacrifice that status in the rationalist 1990s in the ultimately unsuccessful pursuit of growth in earnings per share.

You don't prolong life much by adopting long life as your goal. Nor do you learn much about the sources of longevity by asking very old people how they did it. Medical interventions don't have a large overall impact on life expectancy - medicine is to health what fire control is to forest management. The most important influences on life expectancy are environment and general health. We extend our lives most effectively, not through hypochondria, but by caring for our bodies and ourselves in a comprehensive, holistic manner.

Happiness is achieved in the same way. As John Stuart Mill said: "Those only are happy who have their minds fixed on some object other than their own happiness... aiming thus at something else, they find happiness by the way."

The great cities of the world lift our spirits, not because some great designer set out to achieve that effect, but because of their lack of planning, their diversity and vitality, their unexpected encounters and conjunctions. And they evolve, not through conservative preservation or planned change, but by a process in which undistinguished buildings are torn down and only the best examples of each era are preserved.

Forest management is unexpectedly complex. The regimented plantation proved as unsuccessful as the planned city, and ecologists today are tearing such plantations down. Monocultural forests are not only dull to look at, but vulnerable to disease and fire. Managed woodlands are economically and environmentally superior. But no one knows the best way to manage a forest, or even what "best" means in this context. Our objective in a complex system is not to find the optimum, because no one can know before or after whether such an optimum has been achieved. We can and should be satisfied with an outcome that is good enough.

What is true of forests is equally true of businesses. The great corporations of the modern world were not built by people whose overriding interest was wealth, profit, or shareholder value. To paraphrase Mill: their focus was on business followed not as a means, but as itself an ideal end. Aiming thus at something else, they found profit by the way.

This is how Hewlett Packard described it: "Profit is a cornerstone of what we do... but it has never been the point in and of itself. The point, in fact, is to win, and winning is judged in the eyes of the customer and by doing something you can be proud of."

Obliquity is relevant whenever complex systems evolve in an uncertain environment, and whenever the effect of our actions depends on the ways in which others respond to them. There is a role for carrots and sticks, but to rely on carrots and sticks alone is effective only when we employ donkeys and when goals are simple. Directness is appropriate. When the environment is stable, objectives are one dimensional and transparent, and it is possible to determine when and whether goals have been achieved. Obliquity is inevitable when the environment is complex and changing, purposes are multiple and conflicting, and when we cannot tell, even with hindsight, whether they have been fulfilled.

Balboa made the first transit of the American continent. The last great crossing was the completion of the Canadian Pacific Railroad, which runs almost 3,000 miles from Toronto to Vancouver. The most impenetrable stretch of the Rockies was the Selkirk Mountains. The builders of the railroad, faced with a costly detour, offered $5,000 and naming rights to anyone who discovered a pass. These incentives worked. On the Trans-Canada Highway today you cross the Selkirks through the pass named for the ambitious and intrepid Major A.B. Rogers. But even here, obliquity kicks in. The Rogers Pass is more or less parallel to the Panama Canal, and your westward journey across Canada is best accomplished by veering south-east to traverse it. But sometimes directness is the best solution. In the 1910s, after struggling to keep the Rogers Pass open in an area that often gets 100 metres of snow per year, Canadian Pacific bored a tunnel that runs straight as an arrow through Mount Macdonald.

John Kay is an FT columnist and the author of `The Truth About Markets' (Allen Lane)

Mezzanine funds gain an edge in credit market turmoils

LBOs Find Cash as Goldman, TCW Raise Mezzanine Funds (Update1)

By Sree Vidya Bhaktavatsalam and Jason Kelly

Dec. 13 (Bloomberg) -- Goldman Sachs Group Inc., TCW Group Inc. and New York Life Capital Partners are raising more than $30 billion to increase their investments in leveraged buyouts.

At least 32 firms are starting mezzanine debt funds as investors shun bonds and loans used to finance LBOs out of concern that the collapse of prices for subprime-mortgage securities will spread. Mezzanine funds make loans to companies at higher rates than banks and buy their preferred stock. They earn returns from interest payments and the eventual sale of the equity interest.

``Today, virtually no one is willing to finance LBOs and it's created an opportunity for mezzanine providers,'' said John Morris, managing director at Boston-based HarbourVest Partners LLC, which oversees $24 billion of private-equity investments for institutions.

Goldman, the world's most profitable securities firm, is gathering $20 billion for the biggest mezzanine fund, said two people with knowledge of the matter. TCW, which manages more than $150 billion, is raising $4.5 billion to split between two funds, said the people, who declined to be identified because the companies haven't disclosed their plans.

Officials at New York-based Goldman and TCW in Los Angeles declined to comment.

New York Life Capital, the investment unit of New York Life Insurance Co., raised $800 million last month for its second mezzanine fund, $200 million more than originally sought. The fund will provide financing for acquisitions as large as $4 billion, said Thomas Haubenstricker, a senior managing principal at the firm.

Funding Backlog

``We have the opportunity in this market to work on deals that are larger than what would typically come to our market,'' Haubenstricker said.

With financing readily available, LBO firms announced a record $582.6 billion of deals in the first half of 2007, data compiled by Bloomberg show. That fell to $171 billion in the past five months as lenders were left with $370 billion of debt that they couldn't sell to investors, according to a Sept. 24 note by analysts at Bank of America Corp. in New York.

``When the big commercial banks move, they go far in both directions,'' said Rick Rickertsen, managing partner of Washington-based private-equity firm Pine Creek Partners.

While the banks have reduced some of the backlog, they are still sitting on $230 billion of debt, according to a Dec. 4 report by JPMorgan Chase & Co. analysts in New York.

Taking More Risk

Private-equity firms use funds raised from investors to finance as much as 30 percent of their acquisitions. They borrow the rest against the assets of the companies they buy, using the business's cash flow to pay down the debt.

As much as 50 percent of the funding comes from senior debt, which banks package and sell to investors. The remainder is financed using high-yield loans and mezzanine debt, which is unsecured, high-yield borrowing that ranks last for repayment in the event of default.

``The ability to access the high-yield markets, which is a very important component of all buyouts, has if not disappeared, become very tough,'' said Scott Sperling, co-president of buyout firm Thomas H. Lee Partners LP in Boston, said today in a Bloomberg TV interview. ``That makes mezzanine financing a more attractive alternative and sometimes the only alternative to help finance buyouts.''

Mezzanine funds also acquire equity in some buyouts to generate higher returns for investors. They take the added risk to earn annual returns of as much as 20 percent before fees, said Patrick Campbell, a principal at New York-based Benedetto Gartland & Co., which raises money for mezzanine-fund managers.

By contrast, junk bonds, often sold as part of LBOs, returned an average 6.97 percent from 1997 to 2006, according to indexes compiled by Merrill Lynch & Co.

``Investors have a much greater appetite for mezzanine funds because the risk-return rewards are so much better,'' Campbell said.

The following is a list of the 10 largest mezzanine funds being
raised:

Fund                            Target     Manager
GS Mezzanine Partners V         $20B       Goldman Sachs
TCW/Crescent Mezzanine Fund V   $2.5B      Trust Co. of the
West
TCW Energy Fund XIV             $2B        Trust Co. of the
West
N.Y. Life Mezz. Partners II     $800M*     N.Y. Life Capital
Capzanine II                    $368M**    Capzanine
CapitalSouth Partners Fund II   $300M      CapitalSouth
Partners
Darby Asia Mezzanine Fund II    $300M      Darby Overseas Ltd.
Darby Latin Am. Mezz. Fund II   $300M      Darby Overseas Ltd.
MidWest Mezzanine Fund IV       $200M      Midwest Mezzanine
BNY Mezzanine Partners          $200M      Bank of N.Y./Mellon

*Closed
**250 million euros

Some asset backed loans are better than others

Despite Credit Woes, Asset-backed Loan Funds Enjoy Steady Returns

By David Price
November 21, 2007

With Wall Street’s giants taking billion-dollar write-downs from subprime-linked losses following this summer’s spate of hedge fund closures, mortgage lending has become the black sheep of the investment family. But a small number of hedge funds have carved out a niche for themselves in this market, and the results are eye-opening.

Even at the height of the credit meltdown this summer, the Ambit Bridge Loan Fund was clicking along, turning out roughly the same 1% return it has produced each month since its March 2005 launch. Contrast that with the shellacking many other funds took at the same time and Ambit's strategy of asset-backed lending looks positively stellar.

Ambit originates and services short-term real-estate loans, writing checks for up to $25 million to developers seeking to get commercial projects off the ground. The loans are secured at a maximum of 70% of the property's value. Interest, which is typically 12% to 15% per year, is pre-paid and held in escrow, creating a sure-fire revenue stream to support fund returns. Through the end of October, the domestic Ambit fund and an affiliated offshore fund, Ambit Bridge Loan International, are up 9.84% net this year. Over the past 12 months, both funds were ahead 12.72%.

"During the past few months, our strategies have held up very well," Ambit Managing Director Ben Shoval says, adding that the recent upheaval in the credit markets may actually be working to Ambit's advantage by expanding the pool of potential borrowers.

Meanwhile, Jonathan Kanterman, managing director at hedge fund firm Stillwater Capital Partners, estimates that dealflow for his New York-based firm has tripled in recent months, with traditional bank lenders pulling back as the sub-prime credit crisis spreads. Like Ambit, Stillwater is enjoying significant improvement in the collateral offered by would-be borrowers as well as a favorable swing in the loan terms it can command.

But perhaps most noticeably, Kanterman says, there has been a big jump in investor interest. He explains that in the past, the lack of volatility in ABL fund returns was often a fund’s own worst enemy, because many institutional investors were willing to take on more risk in return for the potential for much bigger returns. Then, the credit and equity markets began to sink, "and all of a sudden, the steady-eddy hedges like us were getting a lot more attention," he says.

Both Ambit and Stillwater are currently open to new investors, and Stillwater also recently partnered with U.K.-based Matrix Group to market a new fund of ABL funds. The firms have weathered the recent financial turmoil relatively unscathed, although Ambit did have a $5 million redemption earlier this year when a pair of limited partners with their own cash needs¬ pulled out of its fund.

Shoval, who managed three funds of hedge funds for several years before locking in on an ABL strategy in 2005, says his investors now include at least one "major" investment bank, a few insurance companies and a family office. Assets under management across both the domestic and offshore funds by the Wilkes-Barre, Pa.-based firm total about $210 million.

According to Gregg Winter, president and founder of Winter & Co. Commercial Real Estate Finance, a commercial mortgage brokerage and advisory firm in New York, hedge funds are a more efficient vehicle to source, originate and service short-term loans, compared with pulling together investors for each deal. He launched the W Financial Mortgage Fund in June 2003 and now manages nearly $30 million, all from accredited individuals. The fund makes close to $80 million in loans, and net returns for investors have been just under 11% per year since inception.

"This is a progression of hard-money lending," Winter says, adding that investors benefit by gaining greater diversification and a more reliable income stream under the hedge fund model. "It's the same philosophy behind investing in a mutual fund—there's a lot less risk in spreading out investments across a portfolio of stocks rather in than a single company." Looking to capitalize on the booming interest in asset-based lending, Winter plans to open up the fund to institutional investors in early 2008.

As with any asset-backed vehicle, the biggest downside risk for ABL funds would be a precipitous decline in the value of the underlying asset. But while residential property values have fallen in many parts of the country, commercial real estate prices have so far held strong. The short time frame, along with the low loan-to-value ratio typical for bridge loans, also provides a substantial financial cushion for fund managers if a borrower falls behind or defaults on a loan. A sudden glut of similar properties on the market could whittle away some of those gains, Kanterman says, although "it's pretty unlikely that the commercial real estate market is going to drop 25% or 30% in only a year or two.”

Because of their stringent due diligence, however, most ABL fund managers say that foreclosures are extremely rare in their business. At Ambit, Shoval said he has only had one loan get into trouble, while Winter says W Financial has yet to experience a single default or foreclosure.

As a rule, ABL funds are also relatively conservative in their own use of leverage. Many, like Ambit, don't borrow at all, although some of its limited partners have levered positions to boost their earnings potential. Winter, on the other hand, said he occasionally will take on debt—either to keep the fund fully deployed or to swing slightly larger deals.

And despite the growing interest by institutions and the resulting tide of new money, Winter said he doesn't anticipate the eventual rise of huge ABL mega-funds. Real estate is a very local business, he explains, making it tough for a firm to expand much beyond the markets it already knows intimately.

"This is a niche strategy, and to do it well, you really have to understand the territory. That's probably going to keep most firms from getting too big or going national," he says. "I'd think it would be difficult to ramp up to $1 billion or more in size.

Old feature article on CDO recovery rates

May 2004 | Feature

CDO guide: recovery rates

Severity of default is key

(Credit Magazine) For investors to feel comfortable with investing in CDOs they must feel confident about the circumstances under which they will win and lose. Here the recovery rate of the underlying assets is the key to performance

For investors in the CDO market, it is important to distinguish between default and recovery rates. A default is defined as occurring at the moment that a promised payment on a bond is missed by the issuer, or the time at which an announcement of a missed payment is made regardless of the allowable grace period. For example, the way that Moody’s rates bonds means: “If issuer ABC misses an interest payment on the due date but makes the payment during the grace period, Moody’s treats ABC as a defaulted issuer at the time of the missed payment.”

For CDO investors, therefore, the severity of loss rather than the severity of default is the key. Clearly, recovery rates in the event of liquidation of assets will vary widely across various claims in the capital structure. S&P’s recovery assumptions, for example, range from highs of 50% to 60% in the case of senior secured bank loans through to lows of 15% to 28% for subordinated debt and just 15% for emerging market corporates. For individual distressed credits, therefore, recovery rates can also vary dramatically. For example, according to figures published by S&P, recovery rates have varied from as low as 9–12% for WorldCom and 11–24% for Enron through to as high as 78–90% in the case of Railtrack in the UK.

Aside from the specific circumstances of default, a number of other factors can and do influence recovery rates. For example, on average, the longer collateral managers hold on to defaulted securities, the greater their recovery values become. That does not necessarily mean that collateral managers will usually aim to retain ownership of defaulted securities, because in most cases the terms of their contracts will make them forced sellers in a default scenario.

The important differences between default and recovery rates mean that calculating historical recovery levels and therefore extrapolating likely future trends is far from straightforward. A complication in the European market is that information on recovery rates has historically been kept private by banks in the loan market, forcing rating agencies and other analysts to apply a so-called ‘haircut’ to recovery rate data from the US, where much broader information on recovery rates for bonds and loans is available.

An added complication, especially for CDO investors tutored in the bankruptcy laws that apply in the US, is that insolvency regimes continue to differ throughout Europe. France, for example, is notorious for being highly protective of borrowers while Germany is regarded as being much more pro-secured creditors. Furthermore, as the Credit Guide to CDOs published in 2002 observed: “In many European jurisdictions, bond investors have no control over any work-out process: this is in stark contrast to the situation in the US, where both loan and bond investors get a seat at the table. As a result of these structural features, European high-yield bonds are proving to have abysmal recovery rates.”

Those poor European recovery rates, however, are not confined to the high-yield market. According to Moody’s, while the default rate in the European corporate bond market plunged from 20.1% in 2002 to 6.9% in 2003, the average recovery rate was almost unchanged at 19.9% in 2003 compared with 20% the previous year. Recovery rates in Europe, Moody’s advises, continue to be roughly half the North American average.

Structuring and constructing a CDO

The financial press will often make its first mention of a ‘new’ CDO on or around the time of its closing – with the closing date generally the day on which the CDO issues tranches of debt and equity to investors. Prior to that day, however, there will have been a so-called pre-closing or ‘warehousing’ period, typically lasting between three and six months. During that period the asset manager will have acquired (or ‘warehoused’) assets to act as collateral for the securities to be issued by the CDO via a special-purpose vehicle (SPV – see box) on the closing day. Closing of a fund usually occurs when a CDO has acquired between 40% and 60% of its targeted assets.

Clearly, however, given that the proceeds of the CDO notes will only become available following their sale on closing day, CDO managers will often need a bridging loan facility (or ‘warehouse facility’) during the warehousing period.

Following the issuance of notes on closing day, the CDO will have a period usually lasting between 60 and 360 days – although the period can also be much longer – in which to complete the process of buying the assets backing the CDO. This important phase is commonly known as the ramp-up period, and the year in which the ramping-up takes place is referred to as the CDO’s vintage. The final investment amount amassed following the ramp-up is sometimes known as the target par amount, which is the total size of the fund less its start-up costs. A portfolio that has been ramped-up with a relatively large number of small exposures is described as being granular, whereas a more concentrated portfolio with a small number of exposures is known as a lumpy fund.

After completion of the ramp-up, there is usually a reinvestment (or revolving) phase lasting up to five years, during which any cashflows arising from amortisation, maturity, prepayment or the sale of assets can be reinvested, as long as a number of basic performance objectives have been maintained.

Finally, during the amortisation phase, which can last for between five and 30 years depending on the underlying assets of the CDO, cashflows earned by the fund are used to pay down its liabilities.

CDO repackaging (repacks) The repackaging of CDOs (known as CDO repacks) is a relatively recent phenomenon arising from the poor performance of a number of CDOs in 2002 and 2003, and another good example of the flexibility and adaptability of the market to respond to fluctuations in credit quality and economic volatility. Repacks are considered to be ‘first derivatives’ of CDOs and, as Moody’s explains: “In a typical repack, the terms of the existing CDO are restructured, with changes in seniority, notional amount, coupon, maturity and waterfall priority. The cashflows of the existing debt are used to support restructured debt securities to achieve the desired ratings.” Moody’s adds that repackaged structures, 45 of which were rated by the agency in 2003 compared with just 11 in 2002, will be able to achieve a higher rating due to an increased subordination and the support of extra interest. “After the restructuring of the existing CDO structure, the new bond will be more appealing to the investors who are seeking higher credit quality,” Moody’s notes.

The role of the SPV ABS (including CDOs) are generally issued by SPVs or special-purpose entities set up to allow for the transfer of risk from the originator to an entity that is generally thinly capitalised, bankruptcy-remote and isolated from any credit risk associated with the originator. According to a JP Morgan handbook: “To limit the universe of an SPV’s potential creditors, it is usually a newly established entity, with no operating history that could give rise to prior liabilities. The SPV’s business purpose and activities are limited to only those necessary to effect the particular transaction for which the SPV has been established (for example, issuing its securities and purchasing and holding its assets), thereby reducing the likelihood of the SPV incurring post-closing liabilities that are in addition or unrelated to those anticipated by rating agencies and investors.”