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EYE ON RE-REGULATION: What’s In A Name?

What’s In A Name?

That which we call a rose, by any other name would smell as sweet.
- Shakespeare, “Romeo and Juliet”

An on-line dating service guarantees to find you a compatible match, using a sophisticated scientific screening method. If your subscription to the service runs out and you still have not found your soul mate, they will give you an additional six months for free. To anyone who has ever participated in the Singles Scene, this sounds like the old joke: First prize is one week in Philadelphia. Second prize is two weeks in Philadelphia… (Sorry, Philly – Go Eagles!, next year)

GoldenTree Asset Management, a credit hedge fund, has been hit with a wave of redemption requests, after posting losses in its portfolio. Management has invoked a clause in its offering documents that permits it to pay investor redemptions not in cash, but “in kind” – meaning that, if you are upset about how badly your portfolio has been trashed and want out, they will give you more of it, thereby tying you up in the same garbage for a longer time. When is a dollar not a dollar? When it’s a Pay-In-Kind. In the brokerage business this is called “averaging down”, and is a great way to generate commissions, if not customer profits.

Word to the wise hedge fund compliance officer: managing OPM is not dating. In Shakespeare, thwarted lovers kill themselves. In real life, angry investors will bury you. Oh yes they will – them, and their hungry, hungry lawyers.

Hedge funds might take this opportunity to do a thorough review of valuation models. In the last year-plus environment, shame on you if you are not already running a regular end-to-end look at valuations of anything you own that you cannot mark to market daily.

The Financial Times article about GoldenTree (January 14, page 13, “Fund To Pay Investors ‘In Kind’”) quotes a “person with direct knowledge of this” as saying that historically, “GoldenTree tried to keep 80 per cent of its investments in easily tradable securities and 20 per cent in less liquid investments. But recently, as the markets melted down, that ratio flipped.”

“Flipped”? Here’s how we read between those lines: we had no idea that markets could do this, we couldn’t figure out how to hedge properly, we totally blew our investment process and violated every parameter and representation in our offering documents. Wanna sue us? No prob. We’ll be glad to make a big settlement payment.
In kind…


Green Eggs And Ham
Your customers are your bread and butter. Churn them, but never burn them.
- from The Big Man’s Ten Commandments

See if you can spot the magic word in this quote from The Wall Street Journal (January 13, page C1, “Help Wanted: Wall Street Stockbrokers, No Joking”). “Brokers are particularly valuable because so many other businesses that churned out huge trading and investing profits remain staggered by the credit crisis and recession.”

That’s right, folks. Wall Street is going back to churning the good old fashioned way.

Stu Travis, “the Big Man”, can lay credible claim to having invented the cold calling stockbroker. As a young rep at Lehman Brothers in the early 1970’s, Travis went head to head with the other rising star rookie, Marty Shafiroff. Shafiroff, ultimately the greatest stockbroker on Wall Street, is the author of Successful Telephone Selling in the ‘80s and (predictably) Successful Telephone Selling in the ‘90s –books that have been avidly consumed by generations of stockbrokers.

Stu Travis, in a legendary scene from those halcyon times, marched down the hall one day and slapped a note on the door of Shafiroff’s office that read: “Stu Travis – first broker to ever do one million dollars in a single month.”

That million was “gross” – commissions – and it’s a big number for a whole year, even today.

Stu called himself the Big Man, and he was big. As all who knew him can attest, the expression “larger than life” was coined with Stu Travis in mind.

Well over six feet tall, by the time we came to know Stu he had lost the rail-hard body of the former US Marine and had become big in every sense of the word. In the days before smoking bans, Stu could be seen at his desk before six AM, his tie hanging loose down the front of his silk shirt, a giant Cuban cigar between his teeth, exhorting his minions to the battle of the day ahead. We learned great wisdom at his knee. Of all the rascals to come out of the world of retail brokerage, Stu was undeniably the most colorful, the most entertaining and, for all his faults, the most loveable. After Stu, rascalsim went into a decline. After Stu came the Bad Guys, then the Scumbags, followed by the Bridge and Tunnel Crowd, the Uptown Crowd, and the Wise Guys. Stu’s early passing in 1996 left a generation saddened and bereft of a beloved character who was both mentor and mascot. The generations of bad guys who came along in Stu’s wake gave Rascals a bad name.

In the early 1970’s Stu circulated a memo to the managers at Lehman Brothers which spelled out what was to become the famous Lehman System, the toolkit that brought average Americans into the fold of stock market investing and made stockbrokers and their employers wealthy in the process.

The first call is the Cold Call, and it is what gives the brokerage business its name.

“Hello, Mr. Jones! My name is Joe Broker, from the firm of Banker, Broker and Dealer. How are you today? Mr. Jones, have you ever heard of my firm? We are a well established investment bank here on Wall Street serving the investment needs of major corporations, governments, and a select group of private investors. We have selected you, based on your business profile, as someone who might possibly wish to benefit from our investment expertise. On a limited basis, perhaps four times a year, when the partners of the firm are taking a position for their own accounts, we would like to contact you and show you the investment position we are considering. On that basis – and with no obligation – would you be interested in hearing from us?”

Armed with the Lehman System, a growing army of stockbrokers took the world by storm, and the growth in the number of US households owning equities to a current level of better than 50% was largely fueled by their enthusiasm. People who had brokers could talk at cocktail parties. People who did not have a broker boiled in silent rage that somewhere, somehow, somebody else was making absolute gobs of money in the stock market. Men felt inadequate.

Greed is much in the news, but it takes more than greed to bring low mighty nations. Commentators neglect the narcissistic wound inflicted by the thought that someone else is making more money than we are. In the bull market of the 1980’s and 1990’s people panicked to buy stocks, not merely to make a profit, but to beat others to the opportunity. People were obsessed by the conviction that money was there to be made, and those who did not make it were truly Losers. Picking up on this trend – and whipping it along – stockbrokers manned the telephones like gunners in a dogfight. Brokers cold called America with story after story, and America responded by sending large amounts of money to total strangers on the basis of a phone call. If Charles Revson became rich by selling hope in a bottle, Wall Street did one better. We dispensed with the bottle and just sold the hope.

Investment bankers and traders looked down on stockbrokers, but the cold-calling stockbroker made Wall Street run. The Lehmans, the Bear Stearns, the Merrill Lynches generated billions in revenues, making millionaires out of people not even qualified to perform manual labor and creating a vast market for the ineffable crap put out by growing armies of bankers, many of whom were no more suited to structuring viable companies than they were to performing neurosurgery. We had arrived.

Selling was the thing. There was one famous brokerage firm whose training program consisted of drilling the sales force using Dr. Seuss’ Green Eggs and Ham. The objective of selling was to wear the prospect down until he gives in.

Is it refreshing that Wall Street is now getting back to basics? Is this what will make America great once again? Bank of America bought Merrill Lynch, in what will surely go down in history as one of the greatest bait-and-switch sales in the history of the brokerage industry. It is clear that this is a sale for which the customer was not suitable, that the buyer did not have the requisite sophistication, or financial wherewithal, to make this purchase. Where were the Risk Managers? Where the Compliance Officers?

Now Citi is foisting the rubble of Barney – Smith, that is – upon Morgan Stanley. Morgan, with its history as an investment bank, knows a thing or two about selling. But Morgan Stanley is now a bank. By which we mean, a “bank” bank. What is a bank doing hiring 20,000 stockbrokers?

The Financial Times (January 14, page 21, “Analysts Pick Gloomy Time to Sound Optimistic”) looks at the building tsunami of bullishness on Wall Street, focusing on “the upbeat assessment of prospects – including a double-digit recovery in S&P 500 company earnings by the end of the year.” This article is required reading for anyone within sniffing distance of a brokerage account, and spells out the combination of constraint and groupthink that drive investor dollars down drains that “nobody could have predicted.”

Call us nobody – and forgive the self-serving plug – but this is why a thinking person with a dollar wants a Research Edge investment process, and not a Wall Street process. The standard Wall Street research model referred to in the Financial Times article is designed not to bring investors money making investments, but to generate revenues for brokerage firms, in the form of commissions. “Gross”.

Morgan Stanley is offering its newly-acquired sales force one billion dollars in aggregate bonuses to ensure they remain with the firm and generate gross for their new employer. Bank of America, meanwhile, has just been given $15 billion to make up for its atrocious lack of judgment in buying Merrill. The Wall Street Journal (January 16, page C1, “BofA’s Latest Hit”) reports that this is to cover “previously undisclosed losses from its Merrill Lynch & Co. acquisition”, adding that Treasury “will also backstop as much as $120 billion of assets at the bank”.

In brokerage compliance parlance, we call this $15 billion an unauthorized trade, but every time we try to get the compliance department on the line, Washington keeps hanging up on us.

What has not been mentioned in any of the reporting on this disaster is the other side of broker compensation, which is Payout. We would guess the Barney Rubble brokers who are being paid a billion to stay at Morgan Staley are also on accelerated payouts, which will have a further effect on your portfolio – and not a good one.

Top producing brokers who move to a new firm are generally given a bigger percentage of gross commissions generated, to incentivize them to stay. Whereas a typical large firm broker may be getting thirty-five cents of every dollar of gross, we have seen firms giving payouts as high as 90% for the first year. In our scenario, a Smith Barney producer generating $3-$4 million a year might get a deal for 75% in year one.

This incentivizes the broker to stay with the firm. It also incentivizes him to churn your account. After all, a 75% payout will not be around forever. And the employing firm needs the gross to step up, because taking only 25% of the broker’s commissions, the firm is taking a loss.

Now for the sixty-four trillion dollar question: FINRA reports a total of 665,000 registered representatives in the US. Of these, 16,000 are now Merrill Lynch brokers, 20,000 Smith Barney brokers. All of them live by generating gross. What are they all going to sell?

Analyst research.

Are you worried about the recession? Are you hoping the markets will recover so that your 401(K) will give you a year or two of sipping gin and tonics in your rocker before you shuffle off this mortal coil?

Forget it.

Here’s the calculation: A bank buys a brokerage firm. Banks don’t know anything about the brokerage business, which is a coincidence because brokers don’t know anything about investing. Oh, and by the way, what’s up with all the media commentators talking about the “advisers” and the “advisory business model”? The media have unquestioningly bought Wall Street’s cynical line. These are not “advisory personnel,” they are stockbrokers. They don’t do investment expertise. They do Gross.

So the Fed gives away a trillion or so – this is money you had withheld from your paycheck. This goes to prop up firms who were so incompetent at running their businesses that they caused the global financial markets to collapse, endangering your paycheck, your savings, your retirement, and the American way of life. One firm takes a billion or so of your money and pays it to 20,000 stockbrokers in “stay bonuses”. These brokers will have to generate plenty Gross to justify their bonuses, an average of $50,000 each. And if they are on an accelerated payout, the firm will get even less revenue out of those gross commissions. What will they do? Why, they will immediately call you and pressure you until you invest your after-tax dollars in their firms’ investment research (see above).

But don’t worry, because the after-tax losses you suffer when you lose this money in the stock market can be applied to offset your earnings – assuming you have any. You can do your own break-even calculation: at your expected level of compensation (assuming the market meltdown does not affect the “real economy” – another policy triple-speak canard), how much money should you invest with a stockbroker – assuming I will lose 80% of your investment within one year – to maximize the after-tax return of matching your loss carry-forward against my earned income? That number, on a pre-tax basis, should be an indicator of how much the Government can safely pay to the banking firm where your stockbroker is now employed, and still enable you to break even on a net basis.

Look for a huge upsurge in enthusiasm and optimism from Wall Street, as research departments churn out rosy forecasts about the glorious upturn that’s right around the corner. Look for calls from armies of brokers, all saying things like “don’t give up on America”, and “don’t sell America short”, and “America will always bounce back”, as they churn your portfolio all the way to the end of the rainbow, by which time they, at any rate, will have a pot full of gold. Your gold.

Our advice? Urge your college-graduating sons and daughters to become stockbrokers. That way, as the money hemorrhages away, at least you will know where yours is going. Blood is thicker than water. But money is thickest of all.

America, you cannot say we did not have this coming. Merrill Lynch “downsized” by laying off risk managers and compliance officers, all with nary a grumble from the regulators. What should we expect?

Our regulators operate at the behest of Congress. Congress serves at the pleasure of the People and passes the laws we demand of them. The People – we have met the People, and it is us. Looks like the buck stops at our own front door. We should not count on too much protection from the regulators, now that the Government has become the Stockbroker of Last Resort.

That’s what we call Gross.
In memoriam
Stu Travis, “The Big Man” – 1

Moshe Silver
Director of Compliance
Research Edge LLC

Chart Of The Week: VIX vs. SPX

Enough of this holiday weekend stuff – it’s time to get back in sync with managing risk in the US stock market. China led Asia higher today, but European stock markets continued to wallow.

Last week, our old friends from October (Volatility and Cash) outperformed pretty much everything on our macro screens (see chart). On a week over week basis, the US Dollar was +2% and the VIX was +8%. This combo crushed the potential for either commodities or stocks to get a bid – they closed down -3% and -4.5% on the week, respectively. The only way to get the SP500 and CRB Commodities Index to “re-flate” is to bury both the US currency, and the consensus fears expressed via volatility.

The overlay of the chart below is an important one to keep front and center on your screens. The VIX’s intermediate “Trend” will remain a bullish factor for the US stock market, provided that it doesn’t close above the 55.02 line. Can the SP500 test my support line of 818? You bet your Madoff it can – but if the VIX doesn’t confirm, don’t hang out down there without covering any shorts for too long, or you’ll be faced with the same snap rally you saw from the lows last week, as the VIX backed off my line.
KM

Keith R. McCullough
CEO / Chief Investment Officer

GOT SCHALKS?

Gottschalks’ Ch 11 filing is theoretically a short-term negative and LT positive – that is, if capacity actually goes away (doubtful). ROST is the big loser, with JCP, M and TGT next in line.

Another retailer down. Gottschalks filed for bankruptcy last week after running out of gas on its $125mm debtor-in-possession financing from a group of lenders including GE Capital. The company says it will conduct business “as usual” during the process while it attempts to find a buyer. Good luck finding vendors that will ship ‘as usual.’

The common view is that when a retailer shuts its doors, there is a near-term margin hit for competitors due to irrational pricing, but that gives way to a cleaner and more sane market. My problem with this is that it simply does not usually work out that way. The stores usually end up simply switching hands or lingering in a state of mediocrity. This time around, I’d argue that creditors don’t want to own these stores, and those who are liquid long cash in retail are probably not looking and aged legacy department store assets. Let’s not forget that GOTT has meaningful overlap with Mervyn’s, which account for a combined $2.7bn in apparel/home furnishings sales.

Who are the losers? ROST takes first with roughly 3.5% of its stores overlapping a Gottschalks or Mervyn’s in a 5 mile radius. JC Penny and Macy’s have the next best exposure to the bankrupt stores.

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US Market Performance: Week Ended 1/16/09...

Index Performance:

Week Ended 1/16/09:
DJ (3.7%), SP500 (4.5%), Nasdaq (-2.7%), Russell2000 (3.1%)

2009 Year To Date:
DJ (5.6%), SP500 (5.9%), Nasdaq (3.0%), Russell2000 (6.6%)

Keith R. McCullough
CEO / Chief Investment Officer

UNEMPLOYMENT: SOME OF THE SAME AND SOME DIFFERENT

Following up on our “THINK LOCALLY” post of 12/07, it is clear that environment is not ideal for gaming operators. For these stocks, unemployment matters and what we care about is what happens on the margin.

The chart below shows which areas have seen an increase in unemployment and also whether the rate of change of the unemployment trend in November was greater or lesser than that in October. Clearly, it is not a pretty picture; most metropolitan areas are seeing an increase in unemployment at a faster rate than last month. LA, NY, Vegas, and other are still suffering from severely negative trends. However, it seems that Shreveport and New Orleans have seen an improvement in unemployment figures during November.

With PNK deriving 75% of its EBITDA in Louisiana, this could signal an important slowing of the unemployment tide (LA had experienced a sharp October increase in unemployment). Even in Houston, an important feeder market for PNK’s Lake Charles operations, the rate of change stabilized in November.

The consensus view is decidedly negative so any positive delta could mean a big move in the stocks. Unfortunately, Louisiana appears to be the only remotely positive take away from the disturbing unemployment picture. Of course, the new government plans to spend like drunken sailors which could provide a temporary boost to employment. We’ll have our eye on that trade too.

Rory Green


BYD: A NOT SO “RISKY BUSINESS”

Here is the consensus call: Short Boyd because business is terrible and they may bust a covenant or raise equity. My response to that is a) business is bad everywhere but that is “soooo consensus” and b) they have so many levers to pull that they will not bust a covenant nor raise equity.

So what are the levers?

1. Buy bonds at a discount – We’ve written on this extensively so all I will say is that BYD has bonds trading in the 60s so they can de-lever by about 20 cents (after tax) for every dollar they borrow from the credit facility to buy back bonds. If Senator Ensign delivers there will be not tax.
2. Cut costs – I think BYD has been very aggressive in this area and we should see it show up in their Q4 margins. Revenues are challenged but again that is the consensus view.
3. Cut Capex – Slots can wait. So can growth capex.

Management seems remarkably complacent about the covenant situation which leads me to believe that: a) recent results are better than expected, b) cost cutting is ahead of plan, c) capex is lower than projected, d) enough discounted bonds were bought back earlier in Q4 to appropriately de-lever. On a very positive note, an equity raise is not under consideration.

In the meantime, BYD will generate $175 million in net free cash flow over the next 12 months (after Q1). That is cash after all capex; growth and maintenance. The free cash flow yield on the stock is an astonishing 40%. Sometimes you just gotta say what the ….

With free cash flow like this, "sometimes you just gotta say what the ....:
Enough cushion but more levers

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