Business Law Prof Blog

The Index Fund Internecine Fight

The New York Times has discovered the index fight.  Why?  Because academics have come to calling each other names over the dispute.  The fight itself is definitional.  The traditional "index" fund is a fund that matches a well known market index (the S&P 500 or 100, the Wiltshire 5000).  These indexes are "capital weighted", that is, the stock prices of component stocks are weighted by the total capital of the issuing company.  The funds are based on reams of financial data that shows "managed funds" rarely beat the indexes over significantly long periods of time.  Now come the new "index" funds trumpeted by academics that create funds "weighted" and chosen by different measures -- earnings or dividends or a combination of the two.  The new funds are also "index funds" because they are based on formulas (indexed to the market).  The traditionalists say, with good reason, that these are not index funds but old-fashioned ?managed" funds (they choose "value" stocks over "growth" stocks); they are not based on traditional indexes in widespread use.  Using the new fund managers logic, all quant hedge funds are index funds.  These are fighting words to the new fund purveyors because "managed funds" have such a bad name.  The traditionalists are correct, of course, until an index based on earnings or dividends is created and widely used.  But the entire debate is silly -- the proof will be in the pudding.  Which funds out perform over time?? The new index purveyors look backward and claim the data is on their side.  Many of the new index funds themselves, so far, have not outperformed traditional index funds however.  It is an old-fashioned marketing argument for investors money.  I welcome the competition and chuckle at the marketing. 

It's the Liquidity, Stupid!

Many in the market claim that we are in a "credit crunch."  In other words, folks are not loaning each other each money.  They are partially right.  There is much money on the sidelines waiting to get in; it is scared. Why?  Because of the real problem -- the liquidity crunch.  Many in the market invested in illiquid investment instruments -- these are investment instruments in thin markets that rely on good times to stay open. We are not in good times.  Once the thin markets shut down, folks holding the instruments take huge losses -- they cannot unload them and cannot even value them.  People with cash to lend stay on the sidelines until the mess clears up.  Credit swaps, asset based securities, and auction-rate securities are the current examples of illiquid investment instruments.  Holders assumed (or were misled to assume) that the thin markets in these securities would survive.  The took for granted liquidity, which occurs in boom markets but disappears when times get tough.  We are in a liquidity crisis which has spawned a credit crisis.

GE's Problems Continue

Ex-CEO John Welch has publicly criticized the current CEO Jeffry R. Immelt for not being correct in Immelt's projections of earnings.  It is a very rare public moment.  The problem is, of course, deeper.  GE's stock has slumbered since Immelt's appointment.  GE is simply too large; it's returns cannot beat the market, it is the market.  Yet the company, through management missteps, can have returns that fall behind the market.  GE needs to bust itself up.  A bust-up, once announced, would immediately drive up the stock price and reflect a board and a CEO that care about investors, not the management perquisites of size.   

Sorkin's Interview with Stephen A. Feinberg

Sorkin, noted business columnist for the New York Times, has ripped Stephen A. Feinberg, founder of Cerberus Capital Management, for being "cold and ruthless."  So, Feinberg, following the dictates of modern public relations specialists, did penance and invited Sorkin in for a rare media interview.  Feinberg's offense?  He noted that returns for investors did not necessarily mean Chrysler would survive in its present form -- that he his task was not to be a "hero."  Well how cruel and heartless.  In any event, Feinberg called in Sorkin and fell on his sword.  He noted his "national responsibility" for "American manufacturing" and that he was uncomfortable as a student at Princeton ("I should have gone to a public school").  Sorking loved it of course.  If I was an investor in Cerberus, which I am not, I would have hated it --- either he does not mean what he says or he does -- both are a problem. 

Israel, Founder of Bayou Group, a Hedge Fund, Goes to Jail

Samuel Israel, III, the co-founder of a hedge fund, Bayou Group, was sentenced to 20 years in prison two days ago.  His Connecticut based hedge fund took $400 from investors and lied to them about profits and losses.  They fabricated financial statements and siphoned money off in a phone brokerage operation.  Co-founder James G. Marquez was sentenced to four years and three months in prison.  The failure of Bayou in 2005 was one of the events fueling an outcry among commentators and academics for more regulation of hedge fund operations.  Seems like a 20 year prison sentence ought to be sobering enough.

Turn-Around Funds: Apollo and Appalossa's Woes

Turnaround private equity funds that purchased struggling companies in good times, with leverage, have found that their turnaround plans and suffering the with economy.  Plans that may have worked in good times have no chance in bad.  Apollo Management is an example.  Apollo's turnaround plans for Linen 'n Things may be unreveling and Apollo may be "throwing good money after bad" in continuing to prop up the company's debt.  Another turnaround hedge fund, Appalossa Management, has lost 17 percent last quarter.  Hopeful that Appalossa can turn it around it Carnegie Mellon that has put Appalossa's manager's name, Tepper, on its business school in exchange for $55 million.

Top Ten Hedge Funds

The Trader Monthly has data out on the top pay for hedge fund managers for last year.  The top manager, John Paulson in New York, made $3 billion, more than the GDP of Rwanda. If he made $3 billion, his funds showed a gross return of around $14 billion.  Not a bad year. Four of the top ten earners were in London.  Chris Hohn, of the London based "Children's Investment Fund" make $900 million and donated much of it to an affiliated charity.

Tough Times Mean More Pressure for Government Preferences and Setasides

Two items of interest are in the news.  First women are upset that the Small Business Administration announced rules that require at least 5 percent of all federal government contracts to go to female "controlled" companies.  Controlled companies include those managed by women or owned 51% by women.  The women wanted more, 8% perhaps.  Small business owners are upset that the agency did not increase the present 23 % set aside for small business; they want 30%.  Second, state pension funds are participating in the bailouts of banks that employ people in their states.  New Jersey's pension fund is investing in both Citigroup and Merrill Lynch (along with governments of China, Korea, Singapore, Kuwait and others) to shore both up the banks' capital.  Many states put pressure on state investment funds to invest in "local businesses." 

This is all bad.  First, the subsidies pile up and hard to eliminate when the reasons for them wane.  Why not Latino set asides?  to geographic setasides (is the suffering Midwest getting its due in contracts?)?  Second, investment returns or quality of contracts is given a back seat to social engineering.  Give grants or loans to favored businesses -- they are more transparent and do not affect the healthy competition that maximizes the quality of the product sought (investment returns or product quality).  Third, China's investment fund has done this for years.  Is this the example we want to follow?   

Quant Funds: The Tower of Babel

Those running quant funds are using very sophisticated models to predict markets and programed trades to take advantage of those predictions.  The experts use mathematics, engineering and physical science; some are experts in chaos theory.  Ordinary day traders now have access to web cites that allow them to develop their own trading programs that resemble the best the quant folks could put together as little as ten years ago.  The goal?  To keep the human decision making to a minimum.  Well the past few months have taught the quants a thing or two about hubris.  First, the quants themselves mimic each other.  The community of quants is very small and inbred.  The effect is that the movement of the program trades together frustrates the programs assumptions.  Second, the quants met some trade conditions that fell outside of their assumptions.  The effect was a liquidity crunch.  And third, and most important, the quants found out that a human must, in the end decide when stop the automatic program trading in light of market conditions.  A quant could not, as hoped, just sit and watch the trades unfold.  This meant that human discretion was back in the picture and, horrors, it was often untrained and unexperienced.  A quantum physicist is no stock trader.  The quants remain optimistic:  They are buys changing the formulas to account for this year's events so they new formulas will be "perfect."  Yet another story of the overreaching of humans.

Goldman Sachs Plays Both Sides

The activities of Goldman Sachs in collecting fees by creating and funding SIVS the purchase subprime loans (as an underwriter of the SIV securities) and in profiting as an investor by shorting the subprime loan market are raising eyebrows from Wall Street to Washington.  The size of the short position does not support an argument for a pure hedging position.  At issue is whether Goldman, and other banks that may have done the same thing, mislead investors as an underwriter by pushing secuirties that another part of the bank thought were going to decline in value.  Many are carefully re-reading those underwriting prospectuses.  For private litigants, this is a 33 Act Section 11 liability claim -- easier to prove than Rule 10b-5 liability (which also may be alleged).  The SEC may have an even easier time with Section 17. 

Goldman Sachs: Playing Both Sides?

There is scuttlebutt in the markets that Goldman Sachs, while creating the SIV vehicles based by mortgage loans that issued the CDOs that had caused such massive write downs, was, at the same time shorting the sub prime market.  It took fees for creating the SIVs and investment gains on the short positions.  If true, this should attract the attention of the class action plaintiff lawyers.

The SubPrime Pain: The Big Lie

Much of the roiling in the markets has been caused by a very simple lie:  Many investors hold positions that were advertised as bankruptcy proof (very low risk) and found out, much to their anger and surprise, that the low risk promise may have been untrue.  Their response is to flee the questionable positions and no wait for assuring claims of insurance or guarantees.  There are several examples.  First and foremost are those holding money market accounts who have found out that some of the commercial paper in the accounts was from SIVs issuing asset back securities.  Surprise! They thought that commercial paper came from blue chip operating companies and that the default risk was negligible (only Penn Central has defaulted on its commercial paper).  The response?  Withdraw from money market funds and refuse to buy, even through, intermediaries, any asset back commercial paper.  It is a rational response to having been misled.  Similarly, E*Trade now has people moving deposits and investment accounts to other banks and to other brokers respectively because they have discovered that E*Trade has lost a boat load of money in CDO investments.  Surprise! You might have to rely on SDIC insurance or on SIV insurance against losses.  They do not want to claim insurance proceeds, they want their money in secure accounts as they were told they would be.  So they flee.  Those who offer the utmost security and then disappoint get severely burned, as they should. 

Another Valuable Role for Short Sellers

With true investigative journalists suffering from job cutbacks and claims of political bias, we have another source of truth telling, the short seller.  A short seller tested the clothing make by Lululemon Athletica and found that, contrary to its claim, it was not made our of "seaweed."  He toke a short position in the stock and released his study.  The New York Times picked up the study, did one of its own, and wrote a confirming story.  So now the NYT reports are watching clever short sellers for good information.

E* Trade's Troubles

E*Trade is facing the potential of a good ol' fashioned run on the bank.  Depositor in E*Trade's retail banking business and investors who hold stock through E*Trade brokerage accounts are nervous because E*Trade has substantial exposure to loses in the subprime credit markets.  The depositors and investors do not want to take the time to figure out, based on complex legal analysis of business structure and guarantees, whether their own funds are at risk; they want out now.  E*Trade is livid about the suggestion that investors and depositors are at risk, offering all sorts of assurances.  Folks, they're done.  Yet another bank is finding out that you cannot hold depositors and investors accounts under the same name as the name attached to a risky investment business.

Real Estate Flipping

I am still perplexed at how easily real estate flippers got away with false appraisals on overvalued land.  The banks loaned too much based on the true value of the underlying collateral and the seller's walked with the excess cash (often repeating the process as buyer then seller in the next cycle).  In the simple case the lending bank has a strong interest in checking the accuracy of the appraisal (or hiring its own reliable appraiser) before loaning money on a land purchase and taking back a mortgage.  Some argue that structured finance dilutes everyones incentive to check for fraud. The argument notes that the bank sells the paper to a special purpose vehicle (SPV) and the SPV sell securities to investors.  The risk of fraud is borne by the investors who do not or cannot check on the validity of any appraisals.  The investors rely on rating agencies to rate the default risk and the rating agencies are operating under conflicts because they are paid by the SPV and get consulting fees from the SPV.   The bank (and the originating broker) and the SPV no longer care because they take fees and pass on the risk.  The investors end up holding the bag.  The argument seems overly simplistic.  Most SPVs sell tranches and the lowest tranche, the so-called equity tranche, is not rated and very risky.  Those who buy the equity, usually hedge funds, have an increased risk of loan defaults and should therefore have an increased incentive to monitor the quality of the loans.  Indeed, one could argue that the equity buyers and a stronger incentive than a bank that does not sell the paper to check on the default risk in the loans because the hedge funds took more risk with each default. There were long time rumors in the market of real estate flipping. Why did the hedge funds not check out the rumors, or at least price the equity to account for the rumors?  Moreover, many of the same banks that passed on the risk to the SPV then bought SPV securities in their own hedge funds (and those funds are now in distress).  Why did the banks not have the proper incentive, when purchasing back the paper, to make sure the paper that went to the SPVs they invested in was sound?  In short, I continue to be baffled by stories of easy money (made even by gangs of thugs) on real estate flipping that overvalued land in the appraisals. 

Liquidating Hedge Funds

Now that some hedge funds are insolvent and forced to liquidate, investors are no longer gleeful over enjoying the tax benefits of a hedge fund organized abroad in tax havens such as the popular Cayman Islands.  How does one go through bankruptcy proceedings with a fund organized in the Caymans?   Our courts will have to apply the complexities of Chapter 15 of the federal bankruptcy law, which applies to oversees liquidations.  Again investors are reminded that the legal paper matters (what are the termination and redemption rights or the insolvency rights???) when the markets turn south. 

The Journalist as Sucker

At the turn of the century, financial journalists at some of our finest papers were paid by our financial titans to post news that helped out the titans stock positions.  It took some time for financial journalist to establish a reputation for trustworthiness.  The new problems seems to be financial journalists played as suckers.  The front page of the New York Times has an article by Eric Dash and Vikas Bajaj entitled "Small Investors Feel Less Pain as Stock Slide: Bigger Players Are Hit Hardest by Turmoil."  Whenever the big time financial speculators get in trouble we get calls to "little guys" from everyone with a tie to rising markets -- politicians, bankers, brokers, and large investment funds -- that the little guys "not panic."  This is an implicit recognition that although the big speculators play in the markets everyday, the smaller investors (who hold stocks and positions in mutual funds, ETFs, and private investment funds) are the backbone of the market.  Once the little guys start to move their investments out of equity and risky debt into traditionally "safe" investments, the markets, already in a roil, will take some time to rebalanced and will rebalanced at lower levels.  In short, many speculators will go broke and claims of a "healthy economy" are a bit more shallow.  Journalist's dutifully report these calming claims, complete with data ("after 2001 those who held through the crisis have recouped their losses", etc.).  I do not mind the reporting of the claims; I do mind the reporter's lack of acknowledgement that those making the pleas to the "little guy" not to panic (when the hedge funds are in a panic) are self-interested, at this time.    Unfortunately, when the little guy hears such pleas for calm it is usually too late to sell.

"Freezing Hedge Funds"

The action by the French bank to "freeze" several of its hedge funds has confused many.  What the bank did was to block  "terminations." withdrawals, by fund investors.  Hedge funds allow for liberal withdrawal rights to encourage investors to invest.  Once a fund becomes insolvent it can no longer respect terminations, they are illegal preferences.  So a "freeze" is a declaration that a fund is insolvent, must wind up and will pay investors whatever they can. 

Amaranth : Lessons on Hedge Fund Failures

The difficulty of Amaranth has three notable features.  First, there was no market panic. It caused barely a ripple.  Those who believe a hedge fund failure could take down our financial system are... well... silly.  Second, investors are learning and getting education on the effects of lock ins.  Those investors who are trying to leave Amaranth with what is left are finding their redemptions penalized in the fine print of their investment contracts.  With many funds, it costs .24 to 2% to get out before a two year lock up period expires.  If too many ask to redeem the fund can stagger repayments and so.  Moreover, investors are discovering that some negotiated for better redemption terms than others (called "side agreements").  The problems with Amaranth redemptions will not be lost on a very intelligent group of investors; risk assessments will factor in  redemption terms.  Third, investors are a bit surprised by Amaranth's COO's appearance at two "beauty shows" hawking his funds, claiming a 25% return, during the two days when the fund was starting to lose big.  Investors have hired lawyers and are looking into lawsuits based on misrepresentation.  Hedge Funds, who often use the law to attack management, are going to find that their investors know how to do this too.

Amaranth's Troubles

A big hedge fund, Amaranth Advisors, is reported to have lost over $3 billion in the natural gas market.  The healthy part of the story is how quickly Amaranth investors discovered the loss.  Several investors investigated personally Amaranth's books to determine the extent of their exposure.  The quick action of investors is very healthy and a signal that the hedge fund market is working, not that it is failing.