Eike Batista – Familiar Lessons on Financial Catastrophe

From $34B to zero
From $34B to zero

The Wall Street Journal’s review this morning of the rise and fall of Brazilian (ex) Billionaire Eike Batista’s business empire contains excellent, timeless points about entrepreneurship, investing, and the madness of crowds.  I really recommend reading all of it.

The bare facts – Batista dropped from a Forbes estimated $36 Billion net worth and business empire last year to somewhere between $1 Billion and zero net worth right now (I’m guessing the latter), amidst a dizzying series of fire sales, liquidations and bankruptcies.  The article has enough details to match up his failure with established patterns from earlier spectacular, unexpected, and outrageous failures.

The strategic role of incentives and greed

Batista loved using the phrase often heard on Wall Street – “Feed the ducks while they’re quacking” to urge his team to provide as many opportunities as possible for investors, journalists and PR people to engage with his empire, hyping it, investing in it, lending to it, pumping it up.  You never know when investors, journalists, and PR people will lose interest, so do everything right now to satisfy their demand, regardless of whether it makes any business sense.

Early backers and enablers made money

Credit Suisse made tens of millions.  Ontario Teachers made tens of millions.

Create the appearance of inside information

Batista founded his oil exploration company OGX and raised $500 million from Ontario Teachers by attracting top Brazilian oil exploration talent from state oil company Petrobras, and then marketing his “dream team” of oil insiders as uniquely poised to bid on the most attractive deep water oil fields being auctioned off by the Brazilian state.  OGX had no operations and the deepwater fields were a risky play, but Batista had the best talent including Petrobras’ “Dr. Oil.”  The implication of all that well-connected talent of course is that Batista’s company would find the inside track to the good fields.  What could go wrong?  ps. They never really found oil.

Bernie Madoff’s genius appears to have been to convince investors that although he was a little bit dirty – possibly front-running his options trading market making business – that his “victimless” front-running  benefited his fund investors.  The fact that Madoff was not front-running his options trading business at all, but rather just making up numbers out of whole cloth, appears to have taken his fund investors by surprise.

The Pink Fleet party boat
The Pink Fleet party boat

Batista presumably actually intended to find oil with all his hired talent, but I suspect the appearance of the insider track on the ‘good oil fields’ was a purposeful strategy as well.

Guarantee one side of your empire with another side of your empire by selling puts

A year ago in October 2012 Batista guaranteed the bailout of his oil enitity OGX by allowing investors to sell him $1 Billion in puts, forcing Batista to purchase his own company’s shares above market if things went badly in OGX.

Pro tip: This never works out.  Enron executives created perverse incentives to shore up special purpose vehicles with puts on Enron stock.  When Enron started slipping, these SPVs added to the momentum by forcing Enron to lose money buying its own shares above market.

Leverage

In a spectacular fall as fast and furious as this, it’s always, always, ALWAYS the leverage from debt.  Brazilian state development bank BNDES provided $3 Billion in loans.  BlackRock and Pimco and the Abu Dhabi sovereign wealth fund bought billions of Batista company bonds.  Debt leverage is a great synthetic hormone for miraculously growing companies, but it’s also a drug that can bring down empires quickly when the worm turns.

Enron also sold puts on their own business
Enron also sold puts on their own business

Focus on the flashy

The Brazilian sex-symbol Playboy wife.  The $1 million Mercedes-Benz SLR McLaren parked in his living room in Rio de Janeiro.  The party boat business called the “Pink Fleet.”  The constant claim to journalists that he would soon pass Gates or Buffett or Slim as the richest man in the world.  I mean, that’s all great, and more power to him, if it all makes him happy.

I mean, I don't blame him for this
I mean, I don’t blame him for this

The problem is just that the Forbes-list folks I’ve met in my own life tend to be earnest and understated, and they work too hard to have time for that kind of flash.  It takes time to woo supermodels and purchase the coolest gadgets, and that’s time away from actually building successful businesses.

Donald Trump has a similar approach to his ‘business.’  In a related story, Trump’s businesses declare bankruptcy on a regular basis.

The lack of responsibility

Of course Batista was misled by his own executives, “I gave out the information people gave me,” he claims in his defense for this sudden and catastrophic collapse.  The assets he still controls, he claims, will bounce back any day now.

He is being attacked by enemies: “No one can withstand a bank run.  And with all those people talking, how many of them wanted to take control of the assets for themselves?”

See?  It’s not his fault, it’s all the haters.

 

Post read (8585) times.

If You’d Like To Understand Financial Instruments But Need A Sports Hook

arian foster stockIf you’d like to understand financial instruments used on Wall Street better, but you need a sports or entertainment hook as a spoonful of sugar to make the medicine go down, I recommend this article by Katie Baker on Grantland about the proposed Arian Foster “IPO” deal.

[Katie Baker – who I do not know personally – is a hero to me, as she quit her analyst job at Goldman, Sachs a few years ago to become a sports writer (on the hockey beat) for the Bill Simmons/ESPN-sponsored online startup Grantland.  The site combines Simmons’ patented sports-plus-hollywood formula with other great writers such as Chuck Closterman, Charles Prince, and Malcolm Gladwell.  Grantland makes traditional newspaper sports sections groan-worthy yawn-fests by comparison.]

The Houston Texans’ Pro-Bowl running back Foster announced that a company named Fantex seeks to raise $10 million for him this year, in exchange for a 20% cut of his future football earnings.  The “IPO” seems to offer investors a chance to move their fandom relationship with individual players beyond fantasy football, and into an actual investment in the long-term financial success of those individual players.  The “IPO” offers the kind of risk profile – as well as upside – of investing in a startup company.

In the article and accompanying sidebar Baker explains some of the myriad details of this new opportunity (e.g. it’s targeted to unsophisticated investors, it’s an entrepreneurial idea that Fantex hopes to reproduce with other athletes, Foster recently tweaked his hamstring, Foster’s future earnings from his children’s book are not included!).

She also makes clear this Foster IPO has plenty of risks, but that it does resemble an innovative risky investment in the upside potential of a star athlete.

arian foster runningTest case of the JOBS Act

Interestingly, to me, the Fantex offering relies on the new “Jumpstart Our Business Startups (JOBS Act),” meant to lower barriers to unsophisticated (less wealthy) investors to participate in risky start-up financing.  Passed by Congress in early 2013, as of October 2013 the SEC still is in the process of clarifying provisions of the bill.

What we know so far about the JOBS Act, however, is the following:

1. Smaller companies can limit their obligations to report financial and other information to the SEC.

2. Investors with a net worth far below $1 million (the traditional threshold for sophisticated investors) can buy risky IPOs.

3. Speculative investors such as hedge funds can now advertise their funds.

4. Smaller companies can skip provisions of the Sarbanes-Oxley accounting rules introduced after the Enron debacle.

On the one hand democratizing investment participation allows non-sophisticated folks an equal chance to get-rich-quick by participating in risky investment schemes.  In addition, I’m all in favor of entrepreneurs accessing capital more cheaply and with fewer barriers.

On the other hand, I probably don’t need to spell out the obvious opportunities for fraud, trickery, moronic investing choices, and inappropriate speculation all opened up by the JOBS Act.

All in all, we’ve reintroduced more Wild West into the system.  The Arian Foster represents the highest profile example of this new Wild West.  This will be interesting to watch.

Arian Foster

Historical celebrity-backed investments

Baker goes back in time to explain the most famous example of combining a celebrity entertainers future earning with Wall Street magic – The famous David Bowie bonds.  Bowie needed money for his divorce as well as separation with his manager, but did not want to sell outright the rights to his song.  Instead, a financier created bonds backed by the future royalties from Bowie’s existing hits.

As an investment, Bowie bonds represented a safe, limited-downside opportunity from a well-defined revenue stream.   An insurance company – a typically risk-averse investor – bought all $55 million Bowie Bonds in the late 1990s.  Following payment of the bonds, Bowie retained future royalties and any excess beyond what the bonds required.  Presumably he still owns those songs, while Prudential got paid a modest return on its bond investment.

The Foster deal, by contrast, only works as an extremely risky start-up type investment.  We really don’t know what kind of future earnings Foster will have.  Fantex retains discretion to make payments, or to convert Arian Foster stock into general stock in Fantex.  Foster ‘stock’ will trade on a Fantex exchange, with Fantex earning 1% per transaction.  Practically anything can happen to a football player’s earning potential, many of them bad.

I’m sure there has to be some situation in which investors make money, but I’m equally sure Fantex depends on the ‘fantasy-football’ fun aspect of this to attract investors, rather than the correct pricing of investment risk.

“You own Tom Brady in your fantasy team?  Bro, that’s nothing!  I own a piece of Arian Foster’s future earnings, Bro!  I’m CRUSHING IT Bro!”

That kind of thing.

Concluding thoughts

If Fantex finds enthusiastic investors, Foster gets upfront money, and fans have a good time with the opportunity to gamble with real dollars and at least some probability of upside.  All this sounds cool to me.

To be clear, as an investment I find this an absurd idea, and even the ambiguous morality of it also deserves attention.

I appreciate, however, the opportunity to talk about securitization – of David Bowie royalties or any other cashflow – in reasonably complex yet digestible ways.

Most importantly, I’m interested to see how the JOBS Act turns out.

Unleashing capitalist potential – Pandora’s Box!

pandora's box

 

Post read (8115) times.

Government as Primary innovator?

I’ve written passionately about the stultifying, influence-peddling, and depressing results of local governments engaging in ‘Economic Development.’

But the thing I like best in the world** is a smart, contrarian argument that shows how I’ve not considered all sides of an issue. Like this TEDTalk for example.
We often easily dismiss the government’s role in innovation, myself included.

Watching this type of argument helps me think better.

 

The TEDTalk teaser for this video:

Why doesn’t the government just get out of the way and let the private sector — the “real revolutionaries” — innovate? It’s rhetoric you hear everywhere, and Mariana Mazzucato wants to dispel it. In an energetic talk, she shows how the state — which many see as a slow, hunkering behemoth — is really one of our most exciting risk-takers and market-shapers.

Which actor in the economy is most responsible for making radical innovation happen? Mariana Mazzucato comes up with a surprising answer: the state.

 

**Ok, there are a few things I like better in the world. Double Stuff Oreos come to mind. Red Sox World Series victories, as well.

 

ted talks

Post read (6316) times.

I Disagree about JP Morgan But I’m Totally Entertained

A friend and I debated the merits yesterday of Alex Pareene’s recent article on Salon, in which Pareene praises the most recent $13 Billion fine against JP Morgan as justifiable punishment for greedy bankers and a morally-positive disincentive to the banking industry generally.

I totally disagree.

I happen to think, and I’ve written before, that the journalistic narrative demonizing bankers for the 2008 Crisis misleads us about the root causes of the financial crises.  I will argue vigorously for a more complex understanding of what went wrong.

Jon-Stewart-Bank-Yankers-screenshotOn the other hand, and despite my disagreement, Jon Stewart is better at what he does than anybody else is good at what they do (with the sole exception of Nate Silver).  So I’m still totally entertained by his characterization of the massive JP Morgan fine, the Alex Pareene article, and the response of financial journalists.

The first Daily Show video clip is here, in which he features Pareene, and Maria Bartiromo and Jim Cramer:

The second Daily Show clip is here, in which he satirizes the financial media’s “shakedown, jihad, gun-to-the-head” characterization of the JP Morgan $13 Billion fine.

 

Post read (6395) times.

The Allowance Experiment Gets Better

Happy consequences of my wonderful, awful idea
Happy consequences of my wonderful, awful idea

More Happy Unintended Consequences

More exciting things (to me) keep unfolding from the ongoing financial education of my 8 year-old.

A little while back I took all of my daughter’s tooth fairy savings and invested it in Kellogg stock, a wonderful, awful, idea of mine to begin teaching her about investing.

Following that, my daughter realized she had no cash anymore, which she found a lot less fun than I did.

As a result, she asked for an allowance a few weeks ago, which reminded me of Andrew Tobias’ advice about allowances from his The Only Investment Guide You’ll Ever Need.

 

The Tobias allowance idea

In summary form, he advises paying ‘daily interest’ on a small nominal starting amount, over a period of 1 to 3 months, so that kids can viscerally feel the money-grows-money magic of compound interest.

For my daughter I paid $1 into a glass jar on Day 1.  Further, I have promised to pay her 10% in ‘daily interest’ on all money accumulated in the jar, over the course of 30 days.

For example,

Day 2 I paid 10 cents (10% of $1).

Day 3 I paid 11 cents (10% of $1.10)

Day 4 I paid 12 cents (10% of $1.21)

Day 5 I paid 13 cents (10% of $1.33)

Day 6 is today.

Your update on that project is as follows: This is even better than I expected, because of some unexpected consequences of my requirements.

Day 6 - Time to Round Up!
Day 6 – Time to Round Up!

My requirements[1]

I asked my daughter to document her 30 days of allowance in a lined journal.

One column shows the date, while the next column has the day number.  The third column shows the daily 10%, while the final column lists the accumulated total in the jar.

I required her to calculate 10% of the total each day, as well as add up the totals on her own.  If she wants to get paid, she needs to do the math.  It’s a small step, but I’m so happy I required this.

 

A digression

I sometimes walk around my neighborhood wondering whether all of the world’s ills could be solved if people knew how to quickly and accurately calculate percents of things.  Wouldn’t it all be better if we really understand discussions of percents of things?[2]

Am I the only one who thinks this?  The Federal budget, poverty in America, tax policy, retirement savings, or properly tipping the bartender – I mean we’d all be better at all of these key problems if we could only calculate 5%, 10%, 15%, 20%, and intuitively understand what they mean.

When I see my daughter moving the decimal place over one numerical place to figure out 10% of her allowance jar savings, a little part of me jumps up and jauntily jigs with joy.  Because this is a good life skill, and also SHE WILL BE THE NEXT FED CHAIRMAN TO SUCCEED JANET YELLEN.

 

The next math consequence – rounding numbers.

In addition to teaching compound interest, and teaching the calculation of percents, another math concept arose today.  On day 6, she has $1.46 in the jar.  Well, the contribution amount today isn’t 14 cents now is it?

My daughter is in third grade, and they’ve talked about rounding numbers, but this is probably the first time she’ll get to materially benefit from rounding up numbers.  That’s right, 15 cents goes in the jar today.  The numbers are starting to add up quickly.

I understand I derive an inordinate amount of pleasure from teaching my kid these math concepts.  But is there anything more important right now?

Ok, fine, empathy.

But then after that?

 

Please see related posts:

Daddy Can I have an Allowance?

Daughter’s First Stock Investment

Book Review of Andrew Tobias’ The Only Investment Guide You’ll Ever Need

 


[1] My managing editor (aka wife) had allowance requirements for my 8 year-old too, such as “pick your crap up off the stairs and put it back in your room where it belongs.”  But you can see that kind of stuff further described in the Mommys-Anonymous.com blog.

[2] We can all agree that the world’s ills could be solved teaching the calculation of percents, plus empathy.  But if I had to choose between teaching empathy and the calculation of percents, well, shoot, which do you think I should do?  I kid, I kid.  I’m an ex-banker.  OBVIOUSLY ITS CALCULATING PERCENTS.

Post read (9079) times.

The Problem of Tax Code Complexity

The Taxes is Too Damn Complicated!
The Taxes is Too Damn Complicated!

With the nightmare US debt default temporarily avoided, let’s review some basics.

The budgetary responsibility of the US Congress has two parts:

1. Set spending levels (money outflow) and

2. Set taxation levels (money inflow)

Congressional rhetoric in the recent nonsense weeks mostly focused on spending (money outflow), whereas the harder but more meaningful discussion should be about taxation (money inflow).

We know this happens because neither we the public – nor our Congressional leaders – have the capacity to take on the complexity of taxes.

I mean ‘capacity’ in a couple of senses.

The first most relevant sense of capacity is: cojones.  It takes political courage to engage in a conversation about taxes.  It takes leadership to engage in a conversation about taxes.  It’s risky to engage in a conversation about taxes.  Hence: No capacity to talk about taxes.

I also mean capacity in the sense of intellectual firepower.

Federal taxes are so darned complicated at this point that we just don’t have the required gigabytes and RAM inside our skulls.  The human brain 1 cannot adequately capture all the parts of our tax policy.  The Federal tax code defies our understanding.

Imagine a world in which we needed to precisely legislate the movement of quarks and protons, with respect to the Higgs Field. 2

Imagine a policy discussion about this
Imagine a policy discussion about this

I’m picturing Harry Reid and John Boehner in a debate about the Higgs Field:

“DERR, THE AMERICAN PEOPLE DEMAND A PARTICLE ACCELERATOR WITH THE ENERGY OF 12 FLEX CAPACITORS.”

“GNNNGHHHH, MY CONGRESSIONAL OPPONENT IS BADLY MISGUIDED.  PATRIOTIC AMERICANS ALL SUPPORT A MORE RAPID ACCELERATION TO RELEASE ELECTRON MASS VIA THE BIFURCATED INVERTABRATOR.”

One point is, obviously, that I know nothing about the Higgs Field.3

The other, more serious, point is that our tax laws have gotten so complex that we can no longer expect Congressional leaders to understand anything but the most simplified ideological tripe 4; nor can we, citizens and voters, meaningfully engage in the topic either, for the same reason.

We’re structurally inhibited when it comes to budget policy and discussion by the existing complexity of taxes.

Tax Complexity Paper

All of this was on my mind this week when I read this paper about “Tax Complexity, History and Humor.”

Investment advisor David Hultstrom 5 recently linked to it in his newsletter, and despite its intimidating name, there’s quite a bit of both fun and information, worth your while.

A few highlights from the paper:

The loopholes, the humorous quotes, the expert disagreement

 

1. Inexplicable loopholes in the tax code:

 

  •        Whaling Charitable Deduction. Code §170(n) reads: ” In the case of an individual who is recognized by the Alaska Eskimo Whaling Commission as a whaling captain charged with the responsibility of maintaining and carrying out sanctioned whaling activities and who engages in such activities during the taxable year, the amount described in paragraph (2) (to the extent such amount does not exceed $10,000 for the taxable year) shall be treated for purposes of this section as a charitable contribution.”
  •           Parsonage Deduction. Code §107 provides: “In the case of a minister of the gospel, gross income does not include: (1) the rental value of a home furnished to him as part of his compensation; or (2) the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home and to the extent such allowance does not exceed the fair rental value of the home, including furnishings and appurtenances such as a garage, plus the cost of utilities.” This income exclusion applies even if the minister receives the non-taxable parsonage allowance to cover real estate taxes and mortgage interest that the minister deducts on a personal income tax return.
  •         Parsonage Allowance after Retirement. Pursuant to Code §1402(a)(8) any parsonage allowance provided to a minister after retirement is not subject to self employment or social security taxes.
  •          Newsboys. Pursuant to Code §§3401(a)(10), 3121(b)(14) and 3306(c)(15), the earnings of certain people paid for newspaper delivery are not subject to FICA or FUTA taxes.

…you get the idea.

 

2.  Humorous Tax Quotes:

  •  “If Patrick Henry thought that taxation without representation was bad, he should see how bad it is with representation.” 

  • “A society which turns so many of its best and brightest into tax lawyers may be doing something wrong.”

  • “For every Tax Problem there is a Solution which is Straightforward, Uncomplicated and Wrong

  • Hiring a tax expert isn’t always a help. If you give the same problem to three tax experts, you are likely to get at least six different answers.”

  • A tax lawyer is a person who is good with numbers but does not have enough personality to be an accountant.” James D. Gordon, III

  • Definition of a Tax Attorney: Someone who solves a problem you didn’t know you had in a way you don’t understand. “

 

3.    And even the paid experts cannot agree:

 

  • In 2007 USA Today provided five tax preparers with a set of facts and asked each of them to prepare an income tax return. The five preparers produced five different tax results and could not agree among themselves on which result was correct.

  • From 1987 to 1998, Money magazine conducted an annual study in which it submitted facts to a group of tax return preparers. In Money’s 1998 report, forty-six tax return preparers had forty-six different tax results, with the tax liability ranging from $34,240 to $68,912. This was the 7th time that Money noted that none of the tax return preparers came to the same conclusion.

  • In an April 4, 2006 report, the Government Accountability Office noted that it submitted tax preparation information to nineteen commercial tax preparers around the US to determine how accurate their work was. Every one of the completed returns contained errors and some overlooked common deductions.

  • But it is not just the tax preparers who are confused. In 2002, the IRS reported that 28% of the answers given by its call centers were wrong, 12% were incomplete and 12% of the time taxpayers’ questions were not answered and taxpayers were told to do their own research.

  • If the tax professionals don’t know how to handle the complexity of our tax laws, what hope does the average taxpayer have?

My own attempt to illustrate tax complexity

As a thought experiment/illustration of the complexity of tax law, I created an infographic last Spring on just a tiny (but important!) portion of the tax code – the rules for making individual IRA contributions.  The visual joke of course is that this little thing is extraordinarily confusing, and we wonder why more people do not fund their individual IRAs.

At the very least, do not try to do your taxes on your own, as I wrote about on tax day this year.

No solutions at this point

I have no realistic solution to offer with respect to simplifying tax codes, except my belief that the complexity itself causes bad budgetary policy.   Including the kind of nonsense we all just endured from Congress.

As with investing, complexity is usually the enemy of the good.  If you can’t understand it, it’s more likely you’ll have suboptimal thoughts about it, and suboptimal decisions.

 

Please see related posts on taxes:

 

2012 IRA Contribution Infographic

Do NOT Do Your Own Taxes

A Tax Proposal Worth Considering

Shhh Please Don’t Talk About My Awesome Tax Loophole

Adult Conversation About Income Tax Policy

 

Post read (6279) times.

  1.  Until a sufficient number of aliens complete a sufficient number of abductions leading to brain enhancement surgeries, obviously.  But I don’t expect this kind of work to be complete until the year 2035, and SOCIAL SECURITY WILL BE BANKRUPT BY 2032!  WE DONT HAVE ENOUGH TIME FOR ALIEN BRAIN-ENHANCEMENT SURGERIES!  GAH!
  2.  Warning:  I have no idea what I’m talking about here.  What follows is merely an analogy, and a dramatic re-enactment of a theoretical discussion between our Congressional leaders.  The actual Congressional debate  about Higgs Boson is likely to be even more inane.
  3.  Except this!  On the day Higgs won the Nobel a few weeks back, The New York Times linked to an awesome graphic illustration of the Higgs field.  Ok, I confess, the entire analogy was a set-up to show off this amazing graphical illustration.
  4.  Left unaddressed here is the fact that while we lack a capacity to understand the tax code as a whole, our business and Congressional leaders are very capable of creating narrow loopholes for their narrow benefit.  That’s relatively easy.  So that’s usually what we get.
  5.  I have no relationship with, or info about, David Hultstrom except that I’m on his free newsletter mailing list, and that his monthly and quarterly letters are totally awesome.