Best product they’ve had in years but still not as flashy as the other guys.  Flooding the market with Wheel games.  Solid long-term prospects.  Here are our notes





Canada replaces 20% of their games like clockwork every five years.


They went to one single platform from seven last year.


This year they have 100% more titles then last year.  ProSeries cabinet + Alpha 2.  Sold 140k iviews and now they have a lot of content coming on that: iview wheel, iview wizard.  Biometrics is going live this year.  Today BYI has 8% of the install base in North America of game opportunities and 13% of sold gaming devices.


They think that normalized replacement range is 80-110k /year.


Upside from new US jurisdictions: 125-150k.  Singapore: 2-3k, Italy: 40-50k, Australia 10-200k opportunity (not in Australia yet but looking for entry as if new regulations pass which would spur replacement cycle), Mexico 30-50, and Brazil 75-ish


The new Uspin touch screen game very cool.  They are going to flood the market with wheel games.  


New huge jumbo 3 wheel.  It’s a huge version of the legacy games.  They added a wheel version of “Hot Shots”.  Now all the wheels will spin.  30 titles on new V32, more Transmissives.  Cash Spin game looks great.  They have a rear projector that is the competition to MLD.  The Uspin touch screen is very cool and is rolling out March/April.  Loveseat "meet in the middle" with two screens.  There is more interaction between players.  New MLD-like product allows the casino to customize pay tables to different customers.  New game maker with progressive.  New “Hot Shot” gives you second chance to win.  


How do they balance more product variety and good product margins?  If volumes increase then they will be able to be able spread fixed costs over a larger base.  Also, they haven't sold a lot of conversions. 300-500 of labor and overhead per unit.  Higher volume allows them to get better pricing on parts.  Think that more volume adds a point and conversion kits is most of it. Doing more legal/accounting from India as well.


50% of their game operations is fixed pricing.  Uspin will be 80/20 participation - but not finalized. Integrating systems and games - touch screens/iviews.  Sold 140K iviews with little content before - now coming out with content - would drive the recurring revenue systems line.


Australia - regulatory changes? It is a mature gaming market with 200k units. If the proposed gaming legislation passes then all units would need to be replaced by 2016.  They may buy someone to get into that market.


Don't see that gaming becomes all software driven. 


Strategy in Italy?  Have done a lot - lots of operators have submitted Bally’s tech specs.  Have handshakes on sales.  In Illinois they will have a distributor.  Have to work on the 500 bet limit content. 





Cool new products: Bally’s live, cool sign, iview DM, biometric recognition.


Bally integration gateway allows for interoperability between all different products and vendors.


SDS 11: the largest slot system manager.  Same code basis globally, backward compatible, internationalized, open, scalable.


Business intelligence - captures data from the casino - reports/dashboards - allows you to track all metrics that you care about that are constantly updated.  Visualization/mapping - allows you to visualize the popularity of the floor and the market that people are coming from.


In FY09, they did 224 implementations (new installs: 46, add-ons: 88 like iview, BI, bonusing, upgrades: 90)


FY 08: did 193 installs - 49 new, 77 add-ons


Have 408,000 slots connected to their system.  600 locations.  240 locations are on high speed networks. 

28 of the largest 46 casinos world wide use Bally’s.


Competitive replacements:

  • Oneida - replaced IGT
  • Coushatta- ALL
  • South point BI - IGT mariposa
  • Greektown BI - IGT marisposa
  • SJM: ALL


ISLE came back to them from the IGT system that they replaced them with 4 years ago


BYI makes about 3k per slot device on a systems install - legacy - new are about 4k per device.  Average net competitive systems replacements - 8k slots: 32mm, new casino additions - average 17K units - new casino additions.


Canada is coming out with 100s of MMs of RFPs over the next few months.


Server based gaming:

  • Targeted marketing at point of play. 1) They will be able to customize second chance to win  2) Slot tournaments 3) customizing marketing content by gender and age 4) community events - however the operator defines them


Employee and customer self service:

1) Drinks ordering

2) Kiosk and POS


Game management:

1) Game configuration

2) Dynamic bet configuration

3) Peripheral management - for things like software upgrades/new bills/etc


Their iviews can talk to any system/any protocol/any manufacturer.  This allows customers to add new technology on old devices.


Showcased their server window.  Users can buy lottery tickets, place bets, order drinks (and save each customer's preferences). Can hide the window.


At City Center, the system isn't really stable.  BYI, ALL, Konami decided that it wasn't in their best interest at opening.  All their games will be there (22% of floor) but will have next generation and not SB. 100 WMS games will have SB windows and the rest will have Next Generation. All their games and ALL and Konami will just have Next Generation. Later on they will move to DM once the environment is stable.  Ask WMS why 450 of their games at city center won't have a SB window.  “Go check out Monte Carlo and see for yourself why".


Will have multiple properties committed to full DM view rollout before end of the year.  Also have a language option and ability to have a left hand screen pop out as well.


IGT hosted a series of presentations at G2E.  The new products looked very good.  CityCenter roll out of SBG not going well.  “Wheel of Fortune” will face a lot of competition from BYI.  Here are our notes.





The company has a tendency to be silo focused but they are working very hard to break those silos down.  They are setting “leaner, meaner" organizational goals.


The primary goal is to manage their asset base rigorously. Having more interoperability is a very important component of customer service. They are focused on protecting their market share and growing revenues.

  • Focused on improving performance of their games
  • They are preparing for a rebound
  • Higher conversion of R+D to revenue


Management is very happy with their share this quarter and hoping they will maintain that going forward.


In the long term:

  • Focusing on diversifying their revenue base (beyond Wheel of Fortune too)
  • Outsized revenue growth
  • Stimulating replacement demand (using balance sheet and producing better content)


2010 goals:

  • Clients today are focused on enhancing performance today - not 5 years out (think they are referring to failure of SB)
  • Focusing on new markets - Italy, Brazil and China.
  • Focus on their scale and the operating leverage that should come with that.


Changes that they have made so far to ensure that they maximize their ROI on R+D:

  • Created smaller studios focused on specific products.
  • No more new platforms for every theme on the game ops side.  Everything will be on the same platform which is reusable.


New titles they are excited about:


  • “Sex and the City”
  • “American Idol”
  • “Amazing Race”
  • Center stage series - entirely reconfigurable, basically a huge display over five seats.  "Movie theatre style concept". 103" and 70" displays.  Have 4-5 titles in the works.  First one is Wheel of Fortune, American Idol is another.


MLD product "dynamix brand" only manufacturer that can have an all in one box that can be a 3,4, reel game or a video poker game. These games are consistently earning above floor average.  IGT is focusing on renewing the content on those devices and introducing new feature. This is the new server based platform - most exciting thing.



Future product:

  • Improving their time to market - which lets them know if the game will be a hit earlier in the process - rationalizing their platforms - allows them to put their content across more platforms helping them save money



  • A lull like this allows you to rethink your strategy
  • On the sales side they have restructured around the customer, now they have one person per client that can talk about all of their products.  Still organized to sell and take orders at the property level but also have corporate level relationship managers.
  • Branding project around "IGT".  


Government Relations - US market opportunities:

  • 940,000 legal installed games in new America in ‘09
  • Have not exercised all the legal potential to install games "150k" games in jurisdictions like Kansas, California and Illinois
  • Think that 75k machines can be installed in the near term.
  • 26 states with new budget shortfalls now and 2010 is an election year - so he thinks that it’s easier to vote for gaming than higher taxes.
  • Approved markets with expansion opportunities: MD,  CA, KS, IL, FL
  • Potential markets: OH, TC, AL, NH


International opportunities:

  • Casinos: two openings in Singapore, Rosario in South America
  • Longer term: Philippines in 2012/2013 (Manila Bay); Taiwan was close but voted no; Japan may potentially legalize, project starting in Hungary and Spain - early stage


2010 opportunities for VLT:

  • Italy - 56,697 units (14% of existing AWP) converting to VLT as part of earthquake relief effort. Pays (upfront) 800mm euros in new tax revenues in order to get license.  IGT is in discussions with licensed operators to see how they can participate
  • Longer term: Brazil has a bill currently under consideration.  Vote in may 2010 which could legalize gaming


Internet gaming (primarily a UK opportunity):

  • Wager works: a content provider in UK and emerging European markets (Spain, France, Italy)
  • Offers internet, digital TV and mobile gaming
  • Longer term Africa/Australia and even the US is possible


For 2010 they are focused on controlling costs until the market recovers to get to 30% operating margins.  IGT is focused on reducing production costs, standardization, and content.  Took $50mm out of material and labor costs this year on game production.  Hard to see with depressed volumes.  When volume comes back there will be big margin upside.


Next few years they will focus on reducing leverage from 3.5x to under 2x (2.5x by next year). They will continue to do equipment finances for customers.



Manically focused on what they can control until times get better.



  • How is the executive team compensated? 50/50: revenue growth and operating income growth.  Lower down its more ROI focused on things like reduction of working capital, win per unit, margin expansion on for sale
  • R+D: pull money more towards mega jackpot product.  Turn the investment in server based gaming to for sale and jackpot products
  • How do they benchmark conversion of R+D to revenues?  In the past they didn't - only looked at R+D/revenues.  They are focused on how much they spend that never results in a revenue generating product.  Killing bad projects earlier.  Basically what percentage of projects is generating money?  They are doing more market research and analysis now too
  • They are using the balance sheet more to drive sales?  Their balance sheet allows them to do it on a larger scale than competitors.  Have $175mm out to casinos (for development).  Want to be more creative on just lending directly to game ops.  More creative pricing, more leasing, more partnership lending
  • There is not much M+A in the near term/any divestitures.  Expect some cautious investments in tuck in technologies for core business but also video lottery and remote gaming.  Have no sacred cows at IGT - if they have bad business they will either get rid of them or fix them. (A la walker digital)
  • Replacements for next 12 months: bottom end of guidance assumes replacements like ‘09. High end/"best case" think that it’s like last Q.  No indication yet that 2010 will better than 2009
  • Server-based gaming's ability to stimulate demand?  High degrees of interest, clear view on how they would use it.  BUT given the economy, they are now focusing on bridge products (sounds just like BYI)


R+D center in Beijing.  Interaction between on and offsite R+D.  In China there are 500k graduating engineers yearly vs 69k in the USA.  The cost of an engineer in China is 45% of the cost of a US engineer.


  • There are big opportunities to hire amazing people there.  The China center is embedded across all their platforms.  So they are fully integrated
  • So will they also be manufacturing in China?  IP protection issues?  Portion the code/responsibility so they eliminate a lot of the IP risk.  Purchase a lot of material from Asia (50-55% from low cost suppliers)
  • Subcontracting Australian product to get manufactured in China.  So, they are testing the waters.  They reduced their own manufacturing work force by 38% this year.  Generally trying to move to a more variable cost structure throughout the organization.


In Illinois IGT decided to go through a distributor given the nature of that market.  They have an exclusive agreement with the largest distributor in that market.  Now they are getting to know the route operators.  In other markets like Illinois they are usually one of 2-3 suppliers that survive.  Illinois is more of a 2011 relationship.  In addition, they are financing there - which they believe you need to finance to get the business.  That can be a $100mm market for them.


In Italy there are already existing shops betting parlors and more casinos-like facilities.  Have a lower priced solution (coming out of UK) and for casino option they have the Reno games.  The games must be centrally determined too.



PART TWO - Network systems presentation

Advantage: 200 installations and 200,000 EGMs


SbX:  8 installations - mostly trials


Maripose BI: 32 installations, 48k EGMs


Casinolink: international, multi-site accounts.  40 customers.  They acquired this in Jan ‘09, new markets for networked systems. Late ‘09 they will integrate SBG and in mid 2010 they will integrate the mariposa technologies.


SbX floor manager (downloading to avp) + SbX media manager - drives the service window.  All ready now


SbX is all about managing their existing real estate.  In order for it to work they need Ethernet, G2S compatible EGMs, game library and floor manager, service window and player services.  IGT's tier 1 solution is meant to be a solution (6-10/day) to conversion kits - allows you to swap out the game as soon as performance becomes poor.


Server window: allows them to customize content to each client.  Having the media manager eliminates 2k of product hardware cost - some of which they can pass down to clients.  Mid-2010 deployment.


Trial data?  It’s unclear because they didn't have a lot of content that was deployable on the box.  They won't really comment on the results/ROI - even though it’s been at Monte Carlo for almost 5 months.  The SB window is very cool and we really like their ability to also use the top LCD to real estate as well.  Can work side-by-side with next generation.


The 103 game is more about the puzzle and a community gaming. Expect to see on floors in March.  Not for sale till January 2010.  Top dollar - new high and mid denomination game.  “Alice in Wonderland” - new progressive game.  Doesn't reset each time.  “Quest for Lost City” - another fantasy progressive  - remembers where you left off.  Lots of very cool MLD games.  Introduced a transmissive element to it.  Also have 3D video slots (“Little House of Horrors” looks cool).  Multi-play - basically multi-video slots at the same time.  4 sets of 3 reels.  Average wager is 2/spin vs 50 cent average.


Reel edge: first skill-based spinning reel game.  The player can stop reels when he/she wants.  For Generation X/Y.  Seek to capture 21-35 years of age emerging customer base.  These are evolving traditionalists that have moved on to newer types of devices.


New Illinois product:  game king/poker Illinois didn't limit payouts in the state.  Can have different types of games.  Game kings, super star poker, hall of fame video games all on one box.

Chart of The Week: Benny's Gold Price

Ben Bernanke is turning into the most politicized Chief that the US Federal Reserve has ever had. Given the history of the US central bank, that’s saying a lot.


As I type this note, Bernanke is speaking at the Economics Club of New York. It seems to be a lovely affair of world class group-thinking. In his prepared remarks, Bernanke explained away a -16% crash in the price of the US Currency the same way that his political friends in Washington have asked him to.


Summers/Geithner political playbook: First, establish that the US Dollar was the “safe haven” of choice during last year’s stock market crash. Then, suggest that all we are seeing is a controlled unwind of that “safe haven” global asset allocation.


There are 3 glaring problems with this view:

  1. This political party line is inaccurate
  2. The Chinese and Japanese disagree  
  3. It implies that the only way to strengthen the dollar is to crash the stock market

From a trust building perspective for a currency, this lacks credibility to the core. As a result, the Buck continues to Burn. And everything priced in bucks continues to REFLATE.


In the chart below, Matt Hedrick and I show the visual representation of our view versus that of Mr. Bernanke. This chart of GLD (the gold ETF) is marked-to-market. Bernanke’s political stardom is marked by compromise and constrain.


I am selling half of the 7% position in Gold (GLD) that we have in the Asset Allocation Model today. While it may be cozy for Bernanke to buddy up with his banker friends who are in bonus season in NYC, his boss will be in not so friendly Chinese confines tonight. President Obama, be prepared to be laughed at if you dismiss the Burning Buck like Bernanke just did.


The long term fears associated with a US Dollar Credibility Crisis are very well placed. For the immediate term TRADE, they may be peaking right here, right now. The US Dollar is hitting new YTD lows.


I can’t think of a Fed Chairman more equipped to have delivered the message of a pandering politician. Thanks for the Gold price, Benny.





Keith R. McCullough
Chief Executive Officer


Chart of The Week: Benny's Gold Price - GLD


Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.43%
  • SHORT SIGNALS 78.34%

RESTAURANTS - A Demographic Eye on Generation Y

My colleague, Daryl Jones, wrote last week about the emerging and powerful Millennials and how they will shape investable trends and important decision making for years to come.  I included his comments below.  I would add that this specific demographic is extremely important to restaurant demand, particularly within QSR.  And, based on recent employment levels for this age group, discretionary income is coming down, which helps to explain recent industry weakness.


Although the economy is recovering from “the great recession” as a whole, the 18-29 year old US population is facing unprecedented levels of unemployment, declining credit availability and or extended credit, a baby boomer retirement cycle pressure that makes finding work more difficult and rising government debt that they are destined to work off over the course of their careers. 


RESTAURANTS - A Demographic Eye on Generation Y - Unemployment 16 20


"They're the hottest commodity on the job market since Rosie the Riveter. They're sociable, optimistic, talented, well-educated, collaborative, open-minded, influential, and achievement-oriented. They've always felt sought after, needed, indispensable. They are arriving in the workplace with higher expectations than any generation before them-and they're so well connected that, if an employer doesn't match those expectations, they can tell thousands of their cohorts with one click of the mouse. They're the Millennial Generation."
- Claire Raines, From her website -
Demographics are a popular topic at Research Edge.  Our Healthcare Sector Head, and all around boy genius, Tom Tobin does a lot of our demographic work.  Demographics is a topic that we will writing more and more on heading in 2010, and we will be developing core investment themes around these powerful trends.  In this note, I'm framing up one of the most important demographic groups domestically, the Millennials.  It is a demographic group characterized by an acceleration of live births, so is large, and one that will have an increasing impact on society and investable trends in the coming decades.
The Millennials are typically defined as those born between 1980 and 2000.  This demographic cohort goes by many names in addition to the Millennials, which include: the echo boom, generation y, boomlet, nexters, the Trophy Kids, the Nintendo generation, and the Internet Generation.  From a purely demographic perspective, the echo boom is actually defined as the five year span between 1989 and 1993 when, for the first time since 1964, the number of live births in the United States reached over four million.  Additionally, it took until 1985 for the live birth number to match that of 1965 at 3.76 million.
Understanding this group is important for a number of reasons.  First, many  of us are parents or aunts or uncles of this group.  Second, many of us own or are invested in business in which this a burgeoning client base, and a growing client base (retail, mobility, consumer products, etc).  Finally, as the baby boomers gradually retire and the Millennials come of age, this will be the dominant labor pool from which we will be hiring and/or working with. 
To understand Generation Y mindsets, we need to consider the time in which they were born, generally the  1980s and 1990s. Gen Y came of age during an unprecedented time of economic growth in the late 1990s.  Technology was rapidly growing driven by the dot com era (and bubble).  The environment in which they grew up expected more of them than in the environment in which Generation X-ers grew up, and thus how they interact with society is dramatically different from Gen X-ers.
Regardless of what we call them, and incidentally the Millennials is a name they themselves voted on based on an ABC Peter Jennings poll, this is a demographic group due to their size and characteristics that is going to have increasing impact on business and society.  Ironically, while the Millennials are sometimes refered to as generation Y, since they follow Generation X chronologically, they have characteristics that are much more in common with the Baby Boomers.  Specifically, this group tends to be more family oriented (studies have shown that when in college they contact their parents almost two times a day) and have more respect for conventional social norms. Specifically, this group has less teen pregnancies than Gen X, less use of heavy drugs, and more civic involvement.
From an international perspective, this echo boom, while prevalent in the United States, is actually not present in European and some Asian countries, specifically Japan.  This is obviously a much longer term investment theme that we will highlight in future posts.  That is, the differing aging trends of work forces globally will potentially create dramatic economic differences from country to country.  To quote a recent study:
"In many rich countries, the 1980s and 1990s were a period of rapidly falling birth rates. In Southern Europe and Japan, and less markedly in Northern and Eastern Europe, Generation Y is dramatically smaller than any of its predecessors, and its childhood years tended to be marked by small families, both immediate and extended, small classes at school and school closures."
A few key characteristics of Generation Y that are unique versus Generation X include:
-       Technology Savvy - A 2007 survey of over 7,000 college students indicated that they are incredibly connected and adept at technology.  According to the survey, 97% owned a computer, 94% owned a cell phone, and 56% owned a MP3 player. 
-       Always Connected - According to the same survey, 76% of students used Instant Messaging, were logged on 35 hours per week and chatted an average of 80 minutes per day.  Almost 15% of IM users were logged on 24 hours / 7 days a week.  The vast majority also reported doing something else while IMing, including games and schoolwork as examples.
-       New Information Sources - In addition, 40% of students reported that the television was their primary source of obtaining news while 34% reported that websites were their primary source (newspapers were the primary source for 11% and radio for 8%). In addition, 28% reported owning a blog and 44% reported reading blogs.  Also, 70% of students reported having a Facebook account and logging on at least twice a day
-       Scheduled Lives -The Millennials are also the busiest generation of children we've ever seen in the U.S, growing up facing time pressures traditionally reserved for adults. Parents and teachers micromanaged their schedules, planning things out for them, leaving very little unstructured free time.
-       Multicultural Experiences - Kids growing up in the 90s and 00s with more daily interaction with other ethnicities and cultures than ever before. The most recent data from UCLA's Higher Education Research Institute shows that interracial interaction among college freshmen has reached a record high.  In addition, being "amongst the first generations to be born and actively grow up in an American society desegregated by law (Brown v. Board of Education), imposing sexual equality by law (Title IX), and proactively defending the rights of various minority groups by law, in addition to the effects of '60s and '70s era influence on their generation, Millennials have been conditioned by the state, educational institutions, and by cultural influence to take a supportive outlook on multiculturalism."
-       Terrorism Exposure - During their most formative years, Millennials witnessed the bombing of the federal building in Oklahoma City. They watched as two Columbine High School students killed and wounded their classmates, and as school shootings became somewhat of a trend. The catalyzing event for their generation was of course, the terrorist attacks on September 11, 2001. 
The emerging and powerful Millennials, will shape investable trends and important decision making for years to come.  Especially as certain classes of workers continue to age.  As Claire Raines also noted on her website:

 "The average age for a nurse is 47. That means she-or he-will be moving on before long. Half of all certified school teachers plan to retire within five years. Sixty percent of all Federal workers are Baby Boomers who say they're on the edge of retirement. There's no getting around it. We're going to need those Millennials."
Daryl G. Jones
Managing Director

Slouching Towards Wall Street… Notes for the Week Ending Friday, November 13, 2009

Shopping Spree


Far be it from us to be so cynical as to attribute crass economic motivation to regulators, who are bound by the notions of transparency and market integrity.


The Wall Street Journal (14-15 November, “A Capital Plan For The Insurance Industry”) reports that the National Association of Insurance Commissioners (NAIC) is taking ratings of asset-backed securities out of the hands of the ratings agencies.  Their stated concern is that, with some 18,000 mortgage-backed issues slashed from A down to CCC, insurance companies will shop for ratings in an effort to mitigate their capital requirements. 


This scenario is, of course, nothing more than a rinse-and-repeat of the way the world got into this mess in the first place – where issuers, not investors, paid for ratings, and where ratings agencies had to award investment-grade ratings merely to stay competitive.


The American Council of Life Insurers, says the article, estimates “the low ratings have boosted capital charges for insurers by about $9 billion.”


The states and the federal government are locked in a winner-take-the-disgusting-leavings bout over who will regulate which aspects of the financial marketplace, and the NAIC’s push to set a standard for ratings hits two nails squarely on the head.  One, is that it challenges the clearly self-serving process of issuers and buyers seeking their best deal from ratings agencies; the other is that it flexes muscles at the state level, where insurance is regulated, and may block anything less than a full frontal assault by Congress.  With enough on their plates, and ample opportunities to repeat past mistakes, Washington may choose not to join this battle.


The NAIC’s action will play well on Main Street, as the Association can claim they are removing the conflict of interest from the rating process.  But their targeted outcome is also to reduce capital requirements at the insurers they regulate, which means it should play quite well on Wall Street. Since the SEC has not managed to keep the ratings business free of conflict, we would not be at all upset if the NAIC will.  Indeed, one could argue it was their job all along, and they failed miserably.  This still begs the question of who it is the regulators are protecting.  We suspect they are trying to strike a balance between regulatory overhaul, and not killing the goose that lays the golden eggs.


From the political side, we agree with the Journal that this action looks “rushed.”  We are all for the regulators regulating the marketplace, but regulators need a thriving marketplace, otherwise they will themselves be out of a job.  Penetrating study will be required to determine where the NAIC finds the balance between assuring the public of a safe market for investing, and assuring market participants that they will stay in business.  Who will regulate the regulators? 




Cuckoo For CoCos?


The latest regulatory trial balloon being floated in the financial press is the CoCo – the contingent convertible bond.  This new-fangled instrument appeared at its coming-out party on the arms of no less a beau than Lloyds Bank.  The debutante was wearing a tattered dress, but smiling nonetheless.


Lloyds Banking Group has offered to exchange some $11 billion of debt into CoCos, a form of subordinated debt that morphs into common equity – generally at the worst possible time, and without the bondholder’s consent. 


What is this odd beast, and how does it work?  As described in the Financial Times (13 November, “A Staple Diet Of CoCos Is Not A Panacea To Bank Failures”) “What differentiates them from a normal convertible bond is that the trigger is a regulatory flashpoint, not an asset price swing.”  This allows banks to “strengthen their capital base in a crisis, without tapping taxpayer funds, or going to the markets.”


Simple English:  when a bank’s capital ratio goes down to the point that it can no longer sustain the total debt it has issued, your chunk of that debt automatically converts to equity.  Voila!  No more nasty debt clogging up the bank’s balance sheet, no fresh injection of capital needed, and no risk of default.


Pardon us, but this looks like a total win for the banks and the leading edge of significant regulatory caving-in.  The CoCo is essentially a bond which, instead of a covenant, is issued together with a put to the bondholders.  In the Lloyds case, the exchange is being offered at a discount of more than 50% of face value to holders of subordinated debt.  One might argue that, in the current climate, subordinated debt holders are lucky to be offered anything at all – the bonds in question are no longer paying.  Still, in the good old days bondholders were protected by covenants, and banks had to maintain capital, or go to court to prove why they should not pay out on their obligations.  The risk of bond defaults, with reputational damage and the looming threat of bankruptcy, were all seen as protections for those pieces of paper whose very name means “obligation”.


Enter the CoCo, which permits the bank to automatically convert its “obligation” into “equity”.  “Equity,” we should point out, means “what is fair,” which can be very good.  It can also be very, very bad.  If there is an obligation of the bank that it pay its bondholders, the shareholders will get what’s left over.  That is fair.  And if there’s nothing left over, well, that’s fair too.


The Basel-centered regulatory regime is considering promoting CoCos across Europe and the US.  New York Fed president William Dudley recently said (Financial Times, 12 November, “Wall Street And Fed In Discussions Over CoCos”) that “the worst aspects of the banking crisis might have been averted” through the use of “contingent capital buffers.” 


This looks to us like a stupendously dreadful idea and all sorts of words come to mind.  Slippery Slope – the looming regulatory change permitting banks to all but dispense with capital requirements.  Moral Hazard – the notion that an obligation will no longer be “really” an obligation, but only an obligation as long as the bank feels like it.


This further feeds the bifurcation of the marketplace, as strong participants, major financial institutions, will insist on, and receive, guaranteed obligations with actual capital reserves underpinning them.  Meanwhile weaker investors will increasingly be cashed out with the corporate equivalent of a Pay In Kind transaction.


All of this means that legislation to promote the use of CoCos will probably be implemented soon, as the world’s regulators are desperate to be seen as doing something.  And it looks set to create a splendid new government loophole that will allow banks to issue bonds without additional capital requirements.


In the case of the Lloyds bonds, they are already in trouble.  Swapping subordinated debt which will not be paid off anyway, with a junior-junior obligation on its way to converting to equity looks like prolonging the agony.  But investors and issuers alike are notoriously reluctant to switch off life support, especially if it means a capital impairment for the bank.  In the world of financial services, where everything comes down to convincing someone else to buy something, it is easier to sell a loser a new piece of paper that, one day, will convert to yet another piece of paper than to say “Ooops.  Guess that didn’t work out.”


Forgive our ignorance, but to us the CoCo looks like a pre-guaranteed default.  It gets the government off the hook for at least that piece of the bank’s capital, and it puts the bondholder well on notice.  “Don’t say we didn’t warn you.”  This looks like a regulatory cop-out of staggering proportion, which guarantees it will be implemented.  If the whole world agrees to undermine bank capital requirements, does that make it OK?


If a bond covenant is like a prenuptial agreement, the CoCo is like asking the bride to waive alimony and child support before ever she walks down the aisle.


Would you buy a used bank balance sheet from this regulator?




The Gang That Couldn’t Prosecute Straight




That was the word last week at the US Attorney’s office in Brooklyn, when a jury acquitted Ralph Cioffi and Matthew Tannin on all counts relating to alleged fraud in the Bear Stearns hedge funds they managed in spectacularly unsuccessful fashion.


We wonder whether the prosecutors really believed that tossing inflammatory emails in front of a jury would sway them all the way to a guilty verdict.  A criminal fraud conviction is serious stuff, and the penalties are awful.  Twelve common citizens commonly rise to uncommon heights when given responsibility for a person’s freedom.  Here it would appear they took this responsibility quite seriously. 


We know enough of the practice of law to recognize that intent is devilishly hard to prove.  We wonder why the prosecutors did not tailor a more subtle case.  Surely the argument could be made that a hedge fund manager’s not sharing his existential concerns about the portfolio with investors can be termed a cover up.  One need look no further for motive than the desire to be allowed to continue to run the hedge fund and continue to draw a management fee.


The only explanation we can come up with is the prosecutors believed they could win on the crest of a wave of public outrage.  That this first case, combining as it did two such hated terms – “Bear Stearns” and “hedge fund” – would bring the jury’s blood to a boil.  If the government had won its case on sheer emotion, they could have established a prosecutorial benchmark that would have Wall Street running scared, and would be juicing defense lawyers’ fees.


Boy, did they get it wrong.  The jurors seem to have felt the US Attorney’s office was trying to dupe them by culling lines from emails.  Jurors who were interviewed after the verdict pointed to the isolation of phrases taken out of context from longer emails.  One juror spoke of Cioffi and Tannin as captains who were willing to go down with the ship.  Another praised their dedication and self sacrifice, pointing to email exchanges at 4:00 AM.  Fraudsters sleep at night, was the implication.  Honest guys don’t.  Perhaps the bluntest of all was the juror who praised Cioffi and Tannin for their tireless devotion to their investors.  If I had money, said this juror, I’d invest with them today.


Even assuming the US Attorney’s office truly believed in this case, it appears poor tactics to bring a case that changes the game, but is hard to win.  One might wonder whether the taxpayer, the investing public and the world’s financial markets have been ill served by prosecutors trying to win a case of such magnitude.


The SEC is in the on-deck circle, preparing to bring their civil case.  In the aftermath of the not guilty finding, we think they may have some difficulty.  And with Judge Rakoff’s lambasting of their process in the Galleon matter as a backdrop, the SEC might find courts and juries increasingly ill disposed towards the multiple-bites-of-the-apple approach.  To the lay person it walks, waddles and quacks like a double-jeopardy duck.


The SEC might do best to use this case to establish parameters for negligent behavior.  This could have some real utility and set the ground rules for what is sure to be an increasing flow of cases.  If the SEC’s case is going to rest on damages – you lost people’s money, you have to pay it back – then it becomes a business decision by Cioffi and Tannin, and by whatever remaining Bear entities might be drawn into the litigation.  This would result in a cash settlement with no admission of wrongdoing.  If Tannin and Cioffi really did bad things, then the government needs to get more.  But if Tannin and Cioffi really just messed up, then panicked, then messed up again, what will it take for the SEC to walk away from this case?  Nobody likes to look like a wuss.  There will be public clamoring for blood.  The question is starting to look like – will it be Bankers’ blood, or Regulators’?


It is a well-established principle in securities litigation that there is no law against being stupid.  Prosecutors and the SEC alike would do well to remember that.  And while it may be uncharitable to point out, there is no law against regulators or prosecutors being stupid either.


Caveat… everybody.




Your Arms Too Short To Box With Blankfein


We are as staggered as the next person at the scope of Goldman’s influence in the world.  Indeed, we have been known to take a cheap shot at them ourselves – though we draw the line way before the “giant face-sucking squid” metaphor.  Still, in the cold light of day it is a toss-up as to whether we would sleep better at night if Goldman were completely in charge of this country, or if it never existed in the first place.


Goldman is easy to hate.  They are big, they are successful, and they are everywhere because they really do most things better than most of their competitors most of the time.


In the context of bombast and outright wrong information swirling through the media, we are disappointed that Goldman CEO Lloyd Blankfein now wishes to retract his “obviously ironic, throwaway response” (Bloomberg, 12 November, “Blankfein invokes God And Man At Goldman Sachs”) when he told the Times of London that he is “doing God’s work.”


We like to think Blankfein was not kidding, and we also wish the Times had been less jovial and gone deeper in their reporting.  Given the level of access they enjoyed – including a one-on-one with Blankfein himself at the firm’s headquarters – and the almost 7,000 words the Sunday Times of London devoted to it, the readership was not well served by the time and effort it took to read the tongue-in-cheek piece.  There is nothing new in the fact that Goldman Sachs has lots of money, nor are we shocked that Mr. Blankfein does not come across as rivetingly fascinating.



Let’s face it, the venom and vitriol directed at Goldman comes from two things: they are supremely successful, and they have fostered a profound culture of graduating into the public sector – where former employees have been no less successful than they were at banking or trading.


Clearly, the authors of the piece had their fun.  We can practically feel the pangs of excitement as they typed out such words as “The biggest swinging dicks in the financial jungle.”  But that is not journalism.


The Times appears to have been granted unprecedented access to Goldman and its executives, a gift they largely squandered.  In the end, the piece is conversational, fun and ultimately lightweight.  It is nowhere near mean enough to make us hate Goldman, nor informative enough to make us see the firm in a new light.


And it perpetuates the notion that federal money somehow “saved” Goldman Sachs. 


We recognize that, in the Total Forget world of Wall Street, one year is a very long time.  Secretary Paulson proposed the TARP at the end of September of last year.  The Emergency Economic Stabilization Act was passed in October of 2008.


We do not make light of the depth or extent of the crisis.  But if the financial markets had been thrown to the wolves, there are certain firms that would have nonetheless survived.  Indeed, we suspect the deeper threat was not to the existence of Goldman Sachs, but that Secretary Paulson truly believed there was an imminent threat of social unrest and that he acted more to prevent the imposition of martial law, than to prevent a capital impairment at his alma mater.


Those who castigate Goldman these days forget that Goldman – as well as JP Morgan and Morgan Stanley – took the TARP monies under duress.  We understand the unanswered questions about why Goldman’s AIG trades got paid in full, about how Blankfein showed up in the room when the government was preparing to administer the coup de grace  to Lehman.  But it is simply not accurate to state that Goldman only survived thanks to taxpayer money.


Reports and analysis coming out of Washington at the time painted Hank Paulson as insisting on total control over the financial system.  Given the inherent conflicts in Washington, and their propensity to dither as they wonder How This Will Play Back Home, Paulson emerged as the likeliest candidate to get anything accomplished.  Indeed, he was the only one not conflicted.  He had already cashed out his Goldman holdings, and with the coming change of administration he was soon to be out of a job at all events.  Congress, the Senate, and Chairman Bernanke all were under political pressure to not make obvious mistakes – to not take actions that might impair their ability to continue in their jobs.  Paulson was the logical choice to take control.


In order to do that, he had to bring the banks to heel.  All the banks.  Jamie Dimon, one of the most capable financial Chief Executives in history, tried to turn down the TARP funds.  Goldman and Morgan too demurred.


But Secretary Paulson insisted on an airtight program.  He was taking direct control of the banking sector and insisted on complete cooperation.  In the end, they all dutifully took their checks.  What this accomplished was not to “bail out” Goldman, Morgan, and JP Morgan, but created a regulatory handcuff that tied them to the program.  It is well and good to carp that Goldman made out “like bandits” in the aftermath of TARP.  But no one should lose sight of the fact that they might not have.


Far from being “saved” by taxpayer largesse, Goldman has a long history of putting substantial sums aside, even as it pays out $20 billion in bonuses this year.  The London Times piece says Goldman has $1 trillion in assets.  Much of that is in what was long ago established as the partnership’s Rainy Day fund.


If AIG had not paid off, if TARP monies had not flowed through, and if the firm had not been permitted to switch charters and become a bank literally overnight, then Goldman would no doubt have to dip into that fund.  They would perhaps not be paying record bonuses.  They would perhaps be restructuring and staring at lean times.  But it is a stretch to claim they would be out of business.


Saving money is radical/  Fiscal conservatism and anti-profligacy in major investment banks is not sexy and gets brushed aside by the press in their hunger for a story.  On examination, the press may have the sizzle, but Goldman’s got the steak.


Here’s another thing Goldman does: they mark their positions to the market for risk purposes.  CEO Blankfein has spoken publicly in defense of mark to market accounting.  And surprise!  His firm considers it the appropriate way to manage risk position by position on a daily basis.


As to “doing God’s work,” we are reluctant to defend a statement when its author seeks to disavow it.  But you can’t deny the critical role played by Goldman in keeping the US marketplace liquid, active and dominant.  Do they pay themselves very, very well for the service they provide the rest of us?  Yes.  And, as neither the rules nor the nation’s morality has changed, they continue to be entitled to it.


We are not sure why Blankfein said that he was doing God’s work, what he thought he meant when he said it, and why he now seeks to make it go away.  Looking at Goldman’s phenomenal history of success, if we were God, we couldn’t wish for a better teammate.



Moshe Silver

Chief Compliance Officer



Dear Ben,


The President of the United States is in Asia this week and the two largest economies in that region are sending a clear message – STOP THE MADNESS.  Stop pandering and raise interest rates now!


If nothing else, this week the news flow out of Asia will provide some great GLOBAL MACRO theatre.


In very quiet trading the S&P 500 finished higher by 0.6% on Friday.  For the week the S&P 500 closed up 2.3%.  The market was supported by renewed dollar weakness, although the sectors that benefitted the most from the GLOBAL RECOVERY trade underperformed. The dollar sank by 0.5% and the VIX declined by 3.6% on the day.


The biggest area of concern seemed to be the MACRO calendar, as consumer sentiment fell for a second straight month in November. The University of Michigan’s Consumer Sentiment Index fell to 66 in the November from 70.6 in October, versus consensus expectations of 71.  Not surprisingly, expectations for personal finances and employment also deteriorated in November, as did the indexes measuring buying conditions for large household goods, houses and vehicles.


The Financials (XLF) sector was the worst performer declining 0.2% on Friday; the XLF was the only sector down on the day.  The banking finished lower for a second straight session, with the large-cap names such as Wells Fargo and JP Morgan were among the laggards.  It's notable that both the Financial and Materials (XLB) underperformed on Friday, as they are the two sectors of the market that have provided significant upside leadership since the March lows.


The three best performing sectors were Consumer Discretionary (XLY), Technology (XLK) and Utilities (XLU).  Despite the disappointing consumer sentiment data, the consumer discretionary sector was the best performer today as Retail was a bright spot.  Earnings helped lift some of the name and both DG and RUE rallied following their respective IPOs.


Today, the set up for the S&P 500 is: TRADE (1,074) and TREND is positive (1,039).   The Research Edge quantitative models have 9 of 9 sectors in the S&P 500 positive on TREND and 7 of 9 sectors are positive from the TRADE duration.  Two of the sectors that benefit the most from the lower dollar – Financials and Materials - are broken on the TRADE duration.   


The Research Edge Quant models have 2% upside and 2% downside in the S&P 500.  At the time of writing the major market futures are poised to open up small to the upside. 


The Research Edge MACRO Team





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