Spero Consulting

Archive for December 18th, 2008

We have two other posts today, Oil in the 30s: Merry Christ­mas, in which we oppor­tunis­ti­cally crow about our prowess at pre­dict­ing oil prices, and The Harvard-​Yale-​CALPERS Cycling Club, in which we lament the lack of imag­i­na­tion among fund man­agers and the enor­mous harm caused by inex­pe­ri­ence or inep­ti­tude (got to throw-​in the per­sonal and insti­tu­tional greed, too). We do that via an analogy.

Now, this post extends both of those because, here, we make a pre­dic­tion about the effects of the endow­ment losses suf­fered at many uni­ver­si­ties and col­leges. News media reports indi­cate that many schools will face endow­ment losses pro­por­tional to those suf­fered by Har­vard and Yale: 25 — 30%. 

Con­trol­ling for the reduc­tion in dona­tions due to the reces­sion and loss of wealth due to the sub­stan­tial decrease in equity and real estate val­ues, which admit­tedly isn’t easy, we fore­cast that dona­tions will fall even far­ther, par­tic­u­larly among the non-​wealthy, i.e., the middle-​class.

In some sense, dona­tions are a lux­ury good, and one would expect them to be highly sen­si­tive to income lev­els, but that’s not our argument.

Our argu­ment is much sim­pler: we imag­ine that lots of alumni, par­tic­u­larly the small donors, will say (at least to them­selves): “We gave you our hard-​earned money and you did what with it? Don’t you have some fidu­ciary respon­si­bil­ity to be rel­a­tively con­ser­v­a­tive to, at least, say, attempt to pro­tect the prin­ci­pal? And you did what? I’m not giv­ing you my money so you can dab­ble and “uri­nate” it away.”

Then again, maybe we’re just pro­ject­ing – the psy­cho­log­i­cal way – not the guess the future way.

My fickle friend, the sum­mer wind.

A few weeks ago, Har­vard announced that its endow­ment fund lost about $8,000,000,000 (since July 1).

This week, Yale announced that its endow­ment was down about 25% for the year. That’s about $5,900,000,000. (Their fis­cal year started July 1.)

Like­wise, accord­ing to yesterday’s Wall Street Jour­nal, CALPERS, the Cal­i­for­nia Pub­lic Employ­ees’ Retire­ment Sys­tem, has lost about one-​quarter of its assets since July 1. That’s almost $60,000,000,000. Poof! To put it into per­spec­tive; that is A LOT of money.

On their hous­ing investment, CALPERS has been able to lose 103% of their invest­ment due to lev­er­ing it. Before the losses, they were lev­ered about four-​to-​one; so, it is quite pos­si­ble that they could con­tinue to loss.¹

Now, we’re not writ­ing to directly crit­i­cize those fund-​managers’ invest­ment strate­gies. That’s rather mun­dane. We think indi­rect crit­i­cism via an anal­ogy will suf­fice because it doesn’t require any finan­cial train­ing or knowl­edge nor the abil­ity to cal­cu­late nor a host of other “skills” nor­mally cov­ered in MBA programs.

When we were younger and had fewer depen­dents we spent a sub­stan­tial amount of time and energy cycling the nar­row, twist­ing coun­try roads that abruptly climb the steep hills and quickly descend into the the dark val­leys and ravines that form much of South­west­ern Pennsylvania.

We rode good dis­tances in almost all con­di­tions – as long as the tem­per­a­ture was above 5º Fahren­heit. Where we rode, it was nor­mal to pedal for about 60% of the total dis­tance. We’d guess that it equated to about 90% of the time because one was either ped­al­ing uphill slowly or coast­ing down­hill – usu­ally quite rapidly.² As a point of com­par­i­son, in the flat – except around turns – one ped­als almost 100% of the time and distance.

One sum­mer, we decided to take the road bike to the beach. The thought of rid­ing on long, flat sur­faces seemed par­tic­u­larly appeal­ing given the omnipresent effects of grav­ity in our home terrain.

We recall our first ride on that vaca­tion. Ah, to be on a flat, smooth sur­face where every rota­tion pro­pelled one for­ward, rather than up. It was so lib­er­at­ing. We felt pow­er­ful and strong and rode for miles south along the Outer Banks. We were begin­ning to think that train­ing in the hills had made us a for­mi­da­ble coastal plain rider. We were thrilled, and decided to turn around and race home to tell the chair­man – though she wasn’t the chair­man at that time, only the boss, and she didn’t really care.

And that’s when it hit us. As they sing, “The sum­mer wind came blow­ing in from across the sea.” All that con­stancy, con­sis­tency, momen­tum, speed, and power. That feel­ing of invin­ci­bil­ity, youth, and vigor. It was – we can’t resist – it was gone with the wind.

What had been an unno­ticed tail­wind was now a very obvi­ous head­wind. It would have been per­fect if we were try­ing to fly a kite or a plane, and at the moment we under­stood com­pletely why the Wright Broth­ers from Day­ton, OH chose Kitty Hawk, NC to exper­i­ment with flight; wind, nice and strong, anytime you wanted it. We were reminded of it mile-​after-​lung-​bursting, air-​stiffening and resist­ing, lactic-​acid pro­duc­ing mile.³

We had left the hotel a few hours ear­lier as young, fit, ener­getic, twenty-​something, and returned wiz­ened, shriv­eled, aged: like the only liv­ing sur­vivor of the War between the States, which had ended 125 years earlier.

We learned some­thing that day. We sub­se­quently relearned the les­son repeat­edly and ad nau­seum as we rode through the windswept Mid­west in both Mis­souri and later in the same Min­nesota coun­try­side where Greg Lemond trained to be a cham­pion. (Don’t worry, we have no pre­ten­sions. In fact, we had and have no com­pre­hen­sion how men like Mr. Lemond can pedal as fast as they can for as long as they can. Our only con­clu­sion is the self-​comforting ratio­nal­iza­tion of medi­oc­rity: if we can’t do it, they must be freaks!)

Over time easy money poli­cies, for­eigner investors with “excess” cap­i­tal, low base rates, tight­en­ing credit spreads, and the asso­ci­ated low volatil­ity all pro­vide pow­er­ful momen­tum yet are almost imper­cep­ti­ble to the either (1) inex­pe­ri­enced – like we were those many years ago ped­al­ing down NC 12 – or (2) the slow-​witted. (You know, the folks that you joke about when you ask whether they have twenty years of expe­ri­ence or one year of expe­ri­ence twenty times.) Like us in our youth, both seem will­ing to extrap­o­late their per­for­mance from the slight­est bit of evi­dence to items far out­side their rel­e­vant and reli­able ranges and draw far too opti­mistic con­clu­sions about their own abilities.

Yes, every­one is a genius or a star when they’re run­ning or rid­ing with the wind. 

It seems that much of pelo­ton of traders, struc­tur­ers, and fund man­agers, which grew larger and larger on that rel­a­tively flat sur­face between 2001 and 2007, had no appre­ci­a­tion for the fact that some­times it is nec­es­sary to turn-​around and some­times even if you don’t turn, the winds can shift from your back to your front.⁴ 

Yes, folks. There may be wind, invis­i­ble and strong, that is assist­ing you, and that can change faster than you can say, “Where is Lehman trad­ing today?”

It’s not nec­es­sary ride like Greg Lemond into the wind, and it is unre­al­is­tic to expect many to pos­sess that abil­ity to thrive is such con­di­tions, but is it too much to ask fund man­agers to reach a level of knowl­edge and wis­dom pos­sessed by the likes of Bob Seger or Frank Sina­tra or us?

We don’t think so, but despite what appears to be a deep-​seated pessimism, we are eter­nally opti­mistic and hope. It’s why we are often dis­ap­pointed and expect to be in the future.

The reader may think of many other ways to make a sim­i­lar point, and their sto­ries may be more lucid, direct, and par­si­mo­nious, but that just goes to show how truly inept some folks have been with other peo­ples’ money. “Who could have imag­ined?” Well, the answer is, when they’re get­ting paid as much as they were, they should have been able to do so. We wrote about that in The Seventy-​Year-​Old Teenager.

Back on May Day, when oil was about $120 per bar­rel, we spec­u­lated in Com­mod­ity Bub­bles? Yeah, Prob­a­bly, that the price could be $40 per bar­rel by year end. (We weren’t very spe­cific about which kind of oil and when it was to be deliv­ered, but such is life.)

We don’t keep track of all of our pre­dic­tions – only the ones where we turned out to be right. For those, we con­tinue our streak of being 100% cor­rect, and we’ll con­tinue to occa­sion­ally high­light them in posts.

On Octo­ber 31, in Scary Thoughts on the Lack of Size and Humor, when oil was still a robust $65 per bar­rel, we revised our end-​of-​the-​year esti­mate of $40 down to $25. With the cur­rent price of January-​delivery oil con­tracts at $37 and with those con­tracts clos­ing on Fri­day, we may have to for­get mak­ing that pre­dic­tion, but who knows? Cra­zier things have hap­pened and can happen.

In that Hal­loween post, we also joked that through Con­gres­sional and exec­u­tive efforts, Con­gress­man and women were able to meet their cam­paign promises of lower energy costs. Through con­certed, bi-​partisan effort and quite a bit of sense­less panic (TARP, TARP), they were able to do it even before the election.

We must ask: has any gov­ern­ment in the his­tory of the world ever presided over a larger and faster destruc­tion of wealth? Note that there was not a sin­gle exoge­nous event that caused the mas­sive destruc­tion: no vol­cano, no tsunami, no earth­quake, no inva­sion of body-​snatchers, no forty days of rain and floods; no plague, no war, no comet or meteor col­li­sions, no pesti­lence, no drought: only inep­ti­tude and greed.

Yes, we do have cheaper oil and gas, but accom­pa­ny­ing those declines is the destruc­tion of tril­lions of dol­lars of equity and real estate val­ues. In ret­ro­spect, some of that “value” was clearly fic­tional and over-​stated, but it seems that the losses have gone deeper than to just wipe-​away the market’s froth.¹ In that regard, we can now fill the Suburban’s 44-​gallon tank for about $75, but we’d pre­fer to have the stock mar­ket at Decem­ber, 2007 lev­els or even the lower sum­mer of 2008 levels.

We doubt that all of the neg­a­tive effects of our endogenously-​caused prob­lems have been real­ized. In addi­tion, we note that the (finan­cial) impli­ca­tions of a global or national cat­a­stro­phe is truly hor­ri­fy­ing to con­tem­plate. But we ask: does the reader think that the remain­ing finan­cial firms are devel­op­ing such sce­nario analy­ses and con­tin­gency plans or do you think that as Christ­mas approaches their man­age­ments – and risk man­age­ments, in par­tic­u­lar – have breathed col­lec­tive sighs of relief and gone back to business-​as-​usual (with a myopic focus on day-​to-​day mar­ket movements)?

Despite our pes­simism, we do believe that this is the best time ever to be alive and the best coun­try – the USA – in which to live.² Thus, we do wish the reader a happy, prosperous, healthy, and blessed New Year.

We very much like the ancient Greek story of Cas­san­dra, and one could well imag­ine that for almost ten years, Harry Markopo­los felt like a modern-​day Cassandra.

We don’t know enough about Mr. Markopolos to know whether he wrote let­ters to the SEC about hun­dreds of other fund man­agers claim­ing that they also ran Ponzi schemes or were part of the con­spir­acy to assas­si­nate Pres­i­dent Kennedy, were adducted by UFOs, or pro­vided FDR with advanced knowl­edge of the bomb­ing of Pearl Har­bor or some com­bi­na­tion of the four. If so, then it is quite pos­si­ble that Mr. Markopo­los is a lucky crank, but we doubt it.

Instead, it seems that Mr. Markopo­los is quite knowl­edge­able and was quite spe­cific in his crit­i­cism of Bernard Mad­off. Moreover, it seems that he was quite will­ing to stake his rep­u­ta­tion and devote his time, energy, and con­sid­er­a­tion to doing the right thing – only to be ignored by an indif­fer­ent bureau­cracy. Now that is a sur­prise, isn’t it.¹

We sym­pa­thize with Mr. Markopo­los. Since late September, we’ve writ­ten to a num­ber of folks in the press and gov­ern­ment about our pro­posed solu­tion to the mort­gage cri­sis only to receive no seri­ous feed­back. We did received one demean­ing form e-​mail mes­sage from our Con­gress­man Jason Alt­mire.²

As The Wall Street Jour­nal reports in Chas­ing Bernard Mad­off, which appears on-​line as Mad­off Mis­led SEC in ’06, Got Off, it seems that Mr. Mad­off may have avoided some scrutiny due to fam­ily and polit­i­cal connections. 

Whether any­one acted overtly to stymie a seri­ous inves­ti­ga­tion into Mr. Madoff’s prac­tices in unclear. The much more com­mon and insid­i­ous prac­tice would be to dis­miss the alle­ga­tions with a know­ing chuckle and pos­si­bly a wink and per­haps a few rhetor­i­cal questions: “Bernard Mad­off? The for­mer chair­man of NASDAQ? Yeah, right.” Or pos­si­bly: “No, we inves­ti­gated that com­plaint. We didn’t find any­thing. I don’t know what that guy’s prob­lem is. What his name Markopolo­po­gos or what? He doesn’t think we take our jobs seri­ously. Who is he to crit­i­cize us? That …off. He should get a life.”

We sus­pect the bureaucracy’s iner­tia was moti­vated in ways sim­i­lar to those that we wrote about last month in Good Luck with that: Get­ting Bank Exam­in­ers to Act. We’d guess that if any SEC employ­ees had an inkling of the truth, they – like Mr. Mad­off – hoped that the prob­lem could be solved with a nice bull mar­ket. (One of the most damn­ing pieces of evi­dence against the SEC deals with the facts that to imple­ment Mr. Madoff’s stated strat­egy, the sizes of cer­tain equity options mar­kets – stated in terms of the num­ber of open posi­tions – would have to be about five times larger than they were/​are.)

Given that col­lec­tive behav­ior, we think that Ronald A. Cass states it best in his WSJ opin­ion col­umn, Mad­off Exploited the Jews: “The vio­la­tion of trust at the heart of that story … It illus­trates the lim­its of law, not the need for more of it.”