I’ve got to give credit where credit is due. Up until recently, we’ve been highly critical of this management team for exploiting the easy money era without the proper risk management strategy. They’ve dug a pretty massive hole of debt, covenants, capex, and a lack of liquidity. However, it’s time for redemption and MGM is off to a good start.

As best as we can figure out, here is the three pronged strategy:

1. Sell off assets – TI should close in Q2 but there may be others (The Mirage?). This is not, in and of itself deleveraging, particularly with the huge tax bite, unless the proceeds are used to buy discounted sub debt. See #2 below.
2. Buy back heavily discounted subordinated bonds – As we discussed in our 12/17/08 post, “MGM: UPON FURTHER REVIEW”, buying back its own discounted bonds is a deleveraging transaction by the amount of the discount. Buy at 65 and retire at par. Thankfully, MGM’s credit facility allows it to buy back sub debt with the proceeds of asset sales.
3. Cut Capex – For the second time in the last few months, MGM downsized CityCenter Capex, this time by $200 million to go along with the $400 million cut announced during the Q3 earnings release. You can bet MGM isn’t buying many slot machines either.

We calculate this strategy will carry MGM through 2009, but just barely, as the chart shows. Our projection assumes $1 billion in cash spent for bonds at 65 cents on the dollar. The company will come dangerously close to breaching the leverage covenant in Q3. However, if they can close another sale, such as The Mirage by the end of Q3, and use some of the proceeds the buyback more bonds, they should clear the covenant fairly easily.

This strategy can only take MGM so far. The company will run out of availability on its credit facility to buy enough bonds to avoid a 2010 covenant breach. However, buying time is critical. Much can happen in a year including a more favorable refinancing environment, improved operating conditions, etc.

Q3 is tight unless they can sell The Mirage or another asset

Eye On Re-Regulation: Where There's Smoke...

Someone To Watch Over Me

Monday’s Wall Street Journal highlights the role of the compliance officer (“Keeping the Watchdogs Busy”, January 5, page R9). From management’s perspective, compliance is pure overhead, and its contribution is hard to evaluate. How much is it worth to not be put out of business? Compliance officers are generally paid a base salary, plus a discretionary bonus, but very few senior managements have an actual performance metric. A standardized compliance metric would fit with the concept of Principles-Based regulation which has been getting some lip service lately, though we believe the reality post-Madoff will be rules, rules, and more rules.

Our championing of capitalism at home – manipulated by government meddling though it may be – is being challenged by those who remember the conversation between Alan Greenspan and the Bank of England’s Monetary Policy Committee on the occasion of his knighthood. The Committee were full of praise for Chairman Greenspan, who piloted the US markets through the Scylla of collapsing share prices and the Charybdis of massive bond defaults brought on by the internet bubble, all with nary a bank failure. Surely, they asked the Maestro, someone must have lost all that money? Thanks to the global market in complex derivatives, the Chairman announced with a serene smile of satisfaction, the losses were suffered by “European insurance companies.”

This conversation, and the Chairman’s Schadenfreude, have been widely reported. We are now witnessing the delayed reaction. On top of the domestic US malaise, the Europeans have warned President-Elect Obama that they, not the US, will set the agenda for new global regulation of the banking and financial sectors. French President Sarkozy, addressing a conference on Capitalism and Ethics, said, (Financial Times, January 9, page 3, “French and Germans Put Foot Down on Tightening Financial Regulations”) “In the 21st century there is no longer only one country that says what we should do and think. We will not accept any return to a single way of thought.” The same article reports that German Chancellor Merkel is pulling for a traditional German approach, which translates into slow or zero growth, broad economic stability, and generational job security.

Translation: The US is no longer Top Dog.

Translation: Rules, rules, and more rules.

The WSJ article says “The market shake-up also has resulted in thousands of financial advisers switching firms as their current employers get acquired or as consolidation or other factors lead them to move from one firm to another.” Former SEC Chairman Harvey Pitt says this will increase the burden on compliance departments to make sure incoming employees are trained in firm practices and policies.

We are not concerned about training employees on policies and procedures – what was illegal at Merrill Lynch is also illegal at Bank of America. We are more interested in transfers of smaller groups of brokers between off-the-radar firms.

As we have seen from the Madoff scandal, investors do not check out the people to whom they entrust their cash. This is actually the regulatory obligation of the employer. Just to be clear, the “financial advisers” in the Journal article are salespeople. What we used to call “stockbrokers”. If you are a financial firm, they will be working for you one day. If you are anyone else, they will be calling you.

The Financial Times (January 7, page 13, “Future of Merrill’s Advisers Called Into Question”) raised the sudden realization – sudden to some – that Bank of America’s acquisition of Merrill Lynch may not go down smoothly. Indeed, it may collapse. Sixteen thousand sales people are unhappy with their new home – none more than their chief, Robert McCann, who just walked out the door, followed immediately by Greg Fleming, Merrill’s head of investment banking and the man who engineered the Bank of America buyout deal. Is Merrill melting down? Where will all the salesmen go? Potentially lots of different places, which concerns us.

Decisions to acquire firms are based on a “make-or-buy” calculation. Any management would love to scoop up a few billion dollars in productive customer assets. Coincidentally, it is a top priority for financial regulators to smooth the way for failing firms to be acquired because, while a regulator can not guarantee that investors will not lose money on their investments, they are committed to ensuring that investors have uninterrupted access to those investments. The orderly winding-down of a brokerage firm is predicated on a seamless transfer of the customer assets to a new firm. We have participated in a number of these hand-off operations, and the process tends to err on the side of maintaining the liquidity of the customer accounts and immediately assigning brokers to each relationship. To paraphrase the old song, “I’ve looked at SIPC from both sides now…”

Managements acquire accounts; compliance departments acquire brokers’ regulatory histories. Therein lies the rub. By the time the compliance department discovers the string of abuses their new employees have perpetrated at their former firms, the customer accounts are already transferred over, and the brokers are already rocking and rolling and generating commissions, and possibly complaints as well.

Back in the heyday of the Cold Calling Cowboys, large numbers of stockbrokers floated from firm to firm, sowing destruction in their wake. Many brokers who generated long strings of customer complaints continued to wander Wall Street with clean track records, because the firms that employed them did not want to be identified as employing criminals. There was a stratum of small and mid-sized brokerage firms that managed to flout law, regulation, ethics and good taste with impunity, while the NASD was tied up for years by a combination of its own foot-dragging regulatory process and phalanxes of high-priced lawyers representing the firms.

Countless infractions went undocumented as firms calculated ways to game the regulatory reporting system. Customer complaints were dealt with in phone conversations or face to face meetings, thus avoiding a paper trail. Compliance departments became masters of creative oversight as their principals instructed them to avoid reporting events that might lead to an allegation against the firm for Failure to Supervise. Outside counsels were brought in to tell compliance officers what to do.

The process typically ended with management asking the broker for a letter of resignation. Cash settlements with complaining customers were structured to be below the level requiring reporting to the regulatory agencies. This way, the broker could leave with a clean license, and the firm did not have to record a failure to supervise. The termination was reported as “voluntary” and no questions were asked. Not by the regulator and not by the next firm that hired the broker.

The fact is that Merrill’s brokers were no worse than any, and a damned sight better than most. The firm generally had high standards and thorough training. But these standards were enforceable within a corporate culture. What happens now when the Thundering Herd thunders off? As the bull market of the 1980’s demonstrated, large quantities of available cash constitute a magnet for criminals. Furthermore, people conform to their environments. Former Merrill Lynch brokers who land in a small firm with a sketchy business model will feel pressure to change their style.

Selling investments to the public is a capital-intensive business. Bankers take fees, underwriters take concessions, traders take spreads, trading desks take mark-ups, brokers take commissions. Then, before the firm can get its hands on what is left, they have to pay rent, phone bills, clerical staff and the compliance department’s salaries, benefits and unemployment insurance. Is it any wonder there’s nothing left for the customer?

We see a coming trifurcation of the financial markets. The Old Model businesses believe they can ride out this hiccup in the marketplace. Morgan Stanley wants to return to their old model of making money, tuned up to run in the new age. They are merely waiting for the markets to turn. Time will tell whether they stage a Come-Back or a Go-Away.

Meanwhile, our CEO, Keith McCullough, has gone on record as seeing the current crisis as a time of Creative Destruction, from which will emerge a diversity of dynamic, creative investment partnerships, in a return to the roots of Wall Street.

We also see a third stream emerging, that of a new generation of Bad Guys. The same mechanism that will spur creative geniuses to structure new firms and new business models will also permit the growth of the worst sort of noxious bacteria. And they will have two significant elements in common: they will be driven by brilliant people who see an unexploited niche and dive into it; and they will operate at maximum efficiency, without hiring people who do not contribute meaningfully to the firm’s goals. Read: competent compliance staff.

The globalization of regulation will not be able to focus on the lower end of the marketplace. While Obama and Bernanke haggle with Merkel and Sarkozy over The Big Picture, we foresee a new Golden Age of small-time fraud by off-the-radar operators in the US retail markets.

There may not be another Bernie Madoff for a generation or two, but there will be five hundred or more frauds to the tune of $100 million or more. Do the math.

From Bernard to Bernard, There Was None Like Bernard
The main purpose of the stock market is to make fools of as many men as possible.
- Bernard Baruch

Do you sincerely want to be rich?
- Bernard Cornfeld

It’s a proprietary strategy. I can’t go into it in great detail.
- Bernard Madoff

Here are two scenarios.

Bernard Madoff, creator of the third market, head of a major Wall Street house, respected CEO of the Nasdaq Stock Market and longtime adviser to regulators, ran a large and profitable brokerage firm. When audit time came, both the NASD and the SEC used the firm as a training ground for rookie examiners. What better way to train new auditors than by sending them into a large, complex firm run by one of the certified masters of Wall Street? The best way to groom new examiners is by showing them a squeaky-clean firm that operates exactly the way it is supposed to.

As rumors and allegations arose regarding Madoff, the regulators’ understandable first response was to shrug it off. Think: allegations of the Pope stealing from the collection plate. Think: allegations of the Commissioner of Baseball scalping playoff tickets. Just plain think about it. In this manner, even the Markopolos letter – a brilliant and thorough analysis, and an uncanny prediction of the fallout – apparently was sent through the channels, sort of like the Ark of the Covenant at the end of “Raiders of the Lost Ark”.

The letter came to Meaghan Cheung, Branch Chief of the New York office of the SEC. Cheung signed off on a 2006 SEC report giving Madoff the All Clear (New York Post on line, January 7, “The SEC Watchdog Who Missed Madoff”). The SEC receives countless unsolicited communications from financial firms “exposing” their competitors as being frauds, and the Markopolos letter was presumably sent, perhaps with a “PRIORITY” stamp, to a senior examiner. By 2005, the rookie examiners who audited Madoff in the early 1990’s had become senior staffers. Perhaps the very same rookies who went into Madoff in 1992 were now heads of audit at the Office of Compliance Inspections and Examinations, and it was they who would have been charged with following up on these allegations. “Bernie? A crook? I cut my teeth on that firm. That firm is clean as a whistle. You’re going to do a helluva lot of convincing to get me to even look at it.” Cheung, the New York Branch Chief, may not have had any reason to insist on digging relentlessly, and the inquiry likely died of skepticism at the senior examiner level.

If you prefer, here is a more cynical scenario: Regulatory audits of large, complex firms are done in teams. The over-the-counter market making desk might be audited by one team, the listed executions desk by another, customer accounts by a third, investment banking and syndicate by another, and a separate team would audit the firm’s regulatory net capital filings. Certainly in the early stages, no audit team would go into Madoff’s offices anticipating finding anything improper.

But let’s say they did. Let’s say that the examiners on the OTC desk found a pattern of principal transactions crossing in front of market maker trades. We believe this was how Madoff made his money in the early days, when he was rebating trading desks for their order flow. The Markopolos letter gives a detailed breakdown of how much information a penny can buy, showing that a penny could be worth as much as fifteen cents per share, on a consistent basis, if Madoff used the order flow information to front run executions.

The examiners would bring their suspicions and documentation to the senior examiner running the audit. That examiner would take the information to his or her supervisor, and it is at that level that a decision might be made to refer the matter to Enforcement for investigation.

Bernie, his roots sunk deep in the consciousness of the regulatory agencies, would make tremendous headway merely by laughing it off.

But let’s say he could not. Let’s say that some senior examiner saw what was going on, and suspected the worst. A cynic might say there was no way Madoff could do this kind of business without paying off someone at the highest levels of the regulatory agencies.

It is perhaps incredible – and certainly impressive – to contemplate the level of uprightness in the world of securities regulation. To be sure, there was a spate of nasty dealings in the earlier days of the NASD. And there was the case of the collection of Tiffany lamps that accumulated in the office of a NYSE regulator who was selling registration data to firms. But, given their level of access and control, we are impressed at how the dedicated men and women of the regulatory agencies steer clear of impropriety.

And so, sadly, we like our first scenario and would bet on it before we would bet on someone being on the take. We recognize that it is both aesthetically and morally preferable that there be a vast conspiracy. If the Madoff scandal were the handiwork of a cabal of wicked traders, regulators and politicians, we could all come away secure in the knowledge that our system works. Are all things possible? To be sure. But in the category of Truth Stranger Than Fiction, it is completely credible to us that this whole thing just blew by the regulators. We hate to disappoint you, but we think this is more likely the result of a string of regulatory lapses than of criminal collusion.

This is the result of a system that takes people out of college or law school, puts them through institutional training, then sends them out to oversee an industry in which they have never been active. Until regulators are willing to pay up to attract Wall Street veterans, it remains wholly credible to us that SEC and NASD examiners would permit Bernie Madoff to explain to them why their own calculations were wrong. Most of them could not do the difficult analysis themselves. They would not know where to begin. To quote Jackie Mason, “All right, it’s not their field!”

Not for nothing did FDR put Joe Kennedy in charge of the SEC. We urge the Obama Administration to staff up the SEC with seasoned Wall Street executives at private sector salaries, and to give them free rein. Coming from Wall Street, these new hires will be gone in a New York Minute if they have to deal with the Commission’s bureaucracy. Mary Schapiro should be urged to create a Financial Markets Delta Force and turn them loose on the industry. They could be paid a bounty for each Bad Guy they nail. It could work. Trust us.

It is credible that rookie examiners were taught to approach the business using Madoff as a paradigm. That senior regulators, who rubbed elbows with Bernie and his family at industry roundtables and SEC advisory panels, rejected outright any hint that Bernie might not be legit. That the SEC and NASD bigs who hobnobbed with the Madoff clan at the wedding of his niece Shana to Eric Swanson, former Assistant Director of the SEC Washington Office of Compliance Inspections and Examinations, did not for a moment believe that their Bernie might not be on the up and up. To us, it is completely believable that all these regulators found the allegations absurd.

Two other significant points: one is Bernie’s activities as a major political contributor, including to Senator Chuck Schumer, who sits on the Senate Banking and Finance Committee. The other is the general environment of reduced regulation, in which digging too deeply into Bernie’s private client business was, perhaps, just Not Something We Do.

The allegations that might trouble the regulators would have come from senior Wall Street professionals. Like the Markopolos letter, these were based on a sophisticated understanding of the inner mechanics of the markets, and Bernie was able to cajole or bamboozle the examiners into disbelief. Think, if you are a professional securities trader, how difficult it is to explain to a lay person the concepts of short selling, spreading options, or double counting in trade reporting. Multiply that by several orders of magnitude and you have a credible conversation between Bernie Madoff and an examiner.

To quote Groucho Marx, “What are your going to believe, me or your own eyes?”

Moshe Silver
Director of Compliance

Quote Of The Week: Barack Obama

Obama's response to reporter's question this week and criticism from Paul Krugman:

"Democrats or Republicans, we welcome good ideas...I want this to work. This is not an intellectual exercise, and there's no pride of authorship. If members of Congress have good ideas, if they can identify a project for me that will create jobs in an efficient way, that does not hamper our ability to over the long term get control of our deficit, that is good for the economy, then I'm going to accept it. If Paul Krugman has a good idea, in terms of how to spend money efficiently and effectively to jumpstart the economy, then we're going to do it. If somebody has an idea for a tax cut, that is better than a tax cut we've proposed, we will embrace it. One of the things I'm trying to communicate in this process is for everybody to get past the habit that sometimes occurs in Washington of whose idea is it? What ideological quarter does it come from? Just show me. If you can show me that something is going to work, I will welcome it. If it works better than something I've proposed, I'll welcome it. “

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Chart Of The Week: Unemployment's Peak Pessimism?

While the propensity for emotional over reactions in markets never cease to amaze me, this one was rather predictable – that’s why we sold down a lot of our invested exposure early in the week as the market was making its new 3 month-cycle highs at SP500 941.

Plenty of money managers and the manic media alike basically aren’t allowed to be bullish anymore – with the SP500 already down -1.4% for 2009 to date, the trigger fingers associated with chasing short term performance are already shaking.

I don’t think it’s the actual level of unemployment that’s freaking revisionist historians out in this country as much as it is the steepness of its acceleration. As always, in order to frame up yesterday’s news we must look back and consider where The New Reality fits within the context of economic history.

This 7.2% unemployment rate, of course, is last year’s number. Markets move on expectations of tomorrow, and this week’s -4.5% drop in the SP500 implies that the masses genuinely expect US unemployment to worsen – and I agree that it will – but NOT at an accelerating 6 month rate…

That’s why I am getting bullish for another “Trade” higher in both commodities and stocks. Everything that matters in my macro model occurs on the margin. If the unemployment rate starts to go up at a decelerating rate, the US stock market is going to continue to make higher lows.

Look at the chart below – is it steep? You bet your Madoff it is! This is the steepest 6 month sequential acceleration that the USA has seen in unemployment in 33 years. You have to go back to 1 to see this kind of 6 month delta and, on a 6-month basis, I don’t think it will re-accelerate from here.

On the contrary, I think there is a much higher probability than current expectations bake in that, come one month from now, we will not be looking back on peak pessimism for what it was – at the peak of a sequential acceleration. Yes, I think the unemployment rate will test 8%, but I do not think that we’ll be testing 9% or higher 6 months from now (7.2% +180 basis points of continued acceleration = 9%, which I believe is Goldman’s estimate).

1. US jobless claims have improved, materially, in the last 2 weeks
2. Obama’s “shovel ready” plan of 3M jobs has basic math implied that provides a cushion to my estimate
3. Unless either points 1 and 2 change, I won’t need to change my view.

I realize this is not consensus, but when I was calling for a 6-7% unemployment report by 2008 end at this time last year, at least as many people disagreed with my bear case. This is what makes a market. Lets strap the accountability pants on - put me in print at less than 9% unemployment 6 months from now.

Keith R. McCullough
CEO / Chief Investment Officer

US Market Performance: Week Ended 1/9/09...

Index Performance:

Week Ended 1/9/09:
DJ (4.8%), SP500 (4.5%), Nasdaq (3.7%), Russell2000 (4.9%)

2009 Year To Date:
DJ (2.0%), SP500 (1.4%), Nasdaq (0.3%), Russell2000 (3.6%)

Keith R. McCullough
CEO / Chief Investment Officer


I’ve thought the two most compelling acquisitions for PENN were buying PNK or an MGM Strip asset. The pendulum appears to be swinging west all the way to Vegas.

The deal absolutely makes sense strategically. PENN would gain a high quality, well maintained, upper mid property in the premier gaming destination in the country. The Mirage brand is powerful and would bring a destination property into PENN’s portfolio. The cross marketing benefits are potentially huge. PENN’s current properties are widely dispersed with millions of customers in its database. Many of these players are already going to Las Vegas anyway and now they can be incentivized to stay at The Mirage. Harrah’s Entertainment has been very successful with this strategy and is the only company with the geographic diversity to pursue it, until now (maybe).

While we don’t know the price, an acquisition of The Mirage probably works economically. How many gaming companies can borrow over a billion dollars at 1.25% above LIBOR right now? None. We believe PENN would pay between 7.5x and 9x forward EBITDA for The Mirage. Of course, forward EBITDA is a very depressed number so the timing is probably right. We calculate The Mirage will generate $155 million in 2009. At those multiples the deal could be accretive to EPS by 20-25% to a run rate EPS number of $1.50. More importantly, the acquisition would add over 10% to free cash flow.

The previous assumptions assume PENN borrows the full purchase price from its credit facility. There is another, potentially more value added approach PENN could take. As we wrote about in our 7/25/08 post, “PENN: ‘BASSET’ SWAPS AND VALUE CREATION”, PENN may have bought/buying MGM bonds at a steep discount in order to trade them back to MGM in exchange for The Mirage. The transaction would be a “win-win” because PENN takes ownership of the property for less than 7.5x-9x discussed above while MGM retires debt at par. In effect, PENN pays a lower price than MGM is receiving. Thanks to a very lenient credit facility that allows MGM to use proceeds from asset sales to retire subordinated debt, this transaction is feasible.

Either way, the purchase of The Mirage for 9x EBITDA or below looks attractive for PENN shareholders.

Economics likely attractive

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