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Inefficient market

17 September 2012 By Edward Chancellor

Roughly a century ago, the American writer Ambrose Bierce compiled ”The Devil’s Dictionary”. In his celebrated lexicon, Bierce displayed a profound understanding of finance, which he defined as “the art or science of managing revenues and resources for the best advantage of the manager.” Below are several other of his definitions touching on the subject of money:

Debt: An ingenious substitute for the chain and whip of the slave-driver.

Mammon: The god of the world’s leading religion. His chief temple is in the holy city of New York.

Riches: The savings of many in the hands of one.

Wall Street: A symbol of sin for every devil to rebuke. That Wall Street is a den of thieves is a belief that serves every unsuccessful thief in place of a hope in Heaven.

While Wall Street’s ethos has not changed since Bierce’s time, it is time to update and enlarge ”The Devil’s Dictionary” for the world of hedge funds, private equity, structured finance, subprime equity, etc.

A

AAA: A credit rating which indicates a company has very little likelihood of default and therefore carries too little debt. By a process of financial alchemy this rating now covers most of the riskiest corporate and consumer borrowers, which have too much debt. See rating agencies and CDO.

Alternative investment: The lucrative process of repackaging traditional equity investments. An ingenious marketing technique of the investment industry devised to boost earnings after the stock market collapse at the turn of the century. See Hedge Funds and Private Equity, also Illiquidity.

Asset-gathering: The method by which investment firms maximise the value of their businesses, normally at the expense of clients. Formerly associated with traditional investment firms, but now frenetically practiced by alternative investors. See Blackstone.

B

Bankers: People who lend other people’s money in exchange for a fee. Formerly concerned about the return of principal, but now only interested in the fee. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.” (John Maynard Keynes)

Bear: A stopped clock which is right not twice a day, but merely once a decade.

Bear Stearns: A Wall Street firm with a “savvy” (Wall Street Journal) understanding of the bond markets produces unique investment results. See High-Grade Structured Credit Strategies Enhanced Leverage Fund.

Bezzle: “At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s businesses and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow and suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.” (John Kenneth Galbraith, The Great Crash)

Blackstone: Private equity firm run by former investment banker Steve Schwarzman. In a recent interview with the Wall Street Journal, the billionaire Schwartzman emphatically denied he was a “marauding, low-class, low-brow inflictor of random damage.” See lucky fool.

Bridge loans: Temporary loans provided by banks to finance leveraged buyouts. A financial hot potato. But as the head of Citigroup, Chuck Prince, recently observed, ‘’As long as the music is playing you’ve got to get up and dance.’

Bull: Politely speaking, the stuff and nonsense of Wall Street’s daily conversation.

C

Carry trade: the act of borrowing cheaply and lending at a higher rate. Popular with hedge funds when short-term rates collapsed after the dotcom bust, viz. Charlie Munger of Berkshire Hathaway, ’’Never have so many people made so much money with so little talent.” See Greenspan.

China: A Communist country bent on undermining its capitalist enemies by gorging them on debt. In furtherance of this policy, the People’s Bank of China has recently taken a sizeable stake in Blackstone.

Collateralised Debt Obligation: A dumping ground for loans off-loaded by banks, which are pooled, sliced up and stamped with investment-grade ratings.

Covenant-lite: loans for leveraged buyouts which have many of the risks of equity without any of the upside.

Credit: Long ago, when she first appeared amongst us, ” Lady Credit” was said to be attracted to a person’s character, probity and trustworthiness. With age, she has become less choosy. See Liar loans.

Credit default swaps: A means for transferring risk. Lenders can now insure against the risk that a borrower goes bankrupt. Instead, they are now exposed to the risk that the seller of default protection, in an unregulated $30 trillion market, goes belly up.

Croupier’s take: the annual charge for managing institutional money, which includes fund managers’ fees and brokerage commissions. Conservatively estimated by Charlie Munger at roughly 3% of principal per annum.

D

Debt: a lingering disease left behind after Lady Credit has taken flight.

Delinquencies: The inevitable consequence of providing money to those who can’t afford to pay either the interest or principal on a loan.

Dividend deal: a debt-funded dividend paid shortly after a buyout. Serves to boost private equity returns at the expense of creditors.

Downgrade: A reduction in the quality of a credit rating. Normally occurs after the deterioration of fundamentals, but before the event of a default. This action protects the reputation of the rating agencies but not the wealth of bondholders. See subprime.

E

EBITDA: Earnings before interest, cash, depreciation and amortization. The maximum cash flow available to finance a buyout. When all EBITDA is used for debt service, nothing remains to invest in a company’s ongoing operations. See Zombies.

Equity tranche: The riskiest part of a CDO which takes the first loss in event of default. Popular with hedge funds which pick-up performance fees from investing in equity tranches right up to the moment they blow up. See incentives.

F

Fees: The raison d’etre of Wall Street. The means by which wealth is transferred from its owners to those entrusted to manage it. See investment banks, private equity, hedge funds, rating agencies, money managers, etc.

Financial engineering: Whereas conventional engineering seeks to take weak structures and make them solid, financial engineering aims at the opposite.

Financial Journalist: While most journalists are illiterate, financial hacks are also innumerate. “When you stand at the summit of financial journalism you are at sea level.” (James Grant, editor of Grant’s Interest-Rate Observer)

Fund of funds: The loading of fees upon fees. Institutions which speed up the transfer of wealth from owners to managers, as described above.

G

Greater fools: Wall Street’s ever expanding clientele.

Greenspan: The patron saint of carry traders.

H

Hedge funds: A lucrative compensation scheme for professional investors, who get to charge roughly 10 times as much as traditional money managers while generating, in aggregate, similar returns. See loser’s game.

Home: A building constructed on weak financial foundations. See delinquencies.

I

Initial public offering: An exit route for alternative investment managers who expect the jig is up.

Implied equity: A measure employed by private equity to forgo investing any real equity in a buyout.

Incentives: the incentives of most Wall Street professional involve asymmetric pay-offs. Known less formally as heads-I-win, tails-you-lose. See Where are the Customers’ Yachts?

Institutional investors: simple-natured fellows possessed of an incurable tendency to extrapolate from past performance. See alternative investment.

Interest cover: the ratio between a company’s debt servicing requirements and its cash flow. Buyout borrowers have recently driven interest coverage ratios to “barely 1.Ox” (Moody’s).

International carry trade: the practice of borrowing cheaply abroad to fund investments at home. Popular with Hungarian and Polish home-buyers and unpopular with central bankers in Switzerland and Japan.

Investment banks: Wall Street firms which find clever and original ways to bring the financial system to the brink, see LTCM, Enron, subprime mortgages and leverage buyouts.

Investment bankers: financiers who find clever and original ways to put their own interests before those of their clients.

J 

Junk: Riskier corporate bonds are known as “high yield” during the early part of the credit cycle. But as the cycle progresses both their credit quality and yield diminish, at which point they are properly designated “junk.”

K

KKR: The original buyout firm. Founder Henry Kravis says he shouldn’t be congratulated on buying a company but on selling it. Unfortunately, Kravis has been so busy taking other companies private this year that he missed the chance to sell his firm to the public when the opportunity beckoned. – see Pulling the IPO”

L

Leverage: The substitution of debt for skill in order to enhance investment performance or profitability. In theory, any gains from leverage are offset by a commensurate increase in risk. In practice, this theory is ignored.

Leveraged buyout: the debt-funded purchase of a company. Immensely profitable to private equity firms when profits and valuations rise and, owing to management and other fees, still very profitable to private equity when valuations and profits decline. See incentives.

Leveraged loans: the rocket fuel that powers the LBO industry. Originated by banks but quickly passed onto to hedge funds and stuffed into collateralized debt obligations. See hot potato.

Liar loans: mortgages provided to those who economize with the truth. See mortgage brokers.

Liquidity: A vogue term which provides an aura of financial sophistication to its user, e.g. “an excess of liquidity drove the market higher, today” or “a lack of liquidity drove the market lower, today.”

Loser’s game: The recognition that investors, in aggregate, are engaged in a zero-sum game – one person’s gains are equal to another’s losses, less the cost of transactions. Those who make fewest mistakes and have the lowest management expenses end up winning the loser’s game. The irrefutable consequence of this finding is that institutional funds should be largely invested in low-cost index funds. It is a tribute to the marketing power of the Wall Street that this isn’t the case. See over-confidence.

Lucky fool: A person who owes his success to luck rather than skill, but is unaware of the fact. As it takes several decades of performance data for statisticians to distinguish luck from skill in the investment game, the number of lucky fools on Wall Street must always remain indeterminate. See Steve Schwarzman.

M

Mark-to-model: The use of a mathematical model to value a complex securities, such as CDOs. “The combination of precise formulas with highly imprecise assumptions can be used to establish practically any value one wishes” (Ben Graham). Particularly useful to investors who wish to delay the recognition of a loss. See CDOs.

Master Limited Partnership: A clever corporate structure favoured by private equity and hedge funds on going public. Provides investors with few of the traditional governance safeguards, while allowing alternative asset managers to avoid paying corporation tax on their earnings. See taxes.

Mortgage-backed securities: A former blue chip of the Wall Street casino which on becoming tarnished is rapidly losing currency. See withdrawals.

Mortgage broker: A person who, in exchange for a fee, will exaggerate the income of a mortgage applicant.

Mark-to-model: the use of a mathematical model to value complex securities, such as CDOs. “The combination of precise formulas with highly imprecise assumptions can be used to establish practically any value one wishes” (Ben Graham). Particularly useful to investors who wish to delay the recognition of a loss. See CDOs.

Master Limited Partnership: a clever corporate structure favoured by private equity and hedge funds on going public. Provides investors with few of the traditional governance safeguards, while allowing alternative asset managers to avoid paying corporation tax on their earnings. See taxes.

Mortgage-backed securities: a former blue chip of the Wall Street casino which on becoming tarnished is rapidly losing currency. See withdrawals.

Mortgage broker: A person who, in exchange for a fee, will exaggerate the income of a mortgage applicant.

N

Negative amortization: mortgages provided to people who couldn’t afford the initial interest payments. The principal accrues for a year or so, after which interest payments rise (“reset”) and the home is repossessed. Increasingly popular for funding leveraged buyouts and commercial real estate deals, where negam loans go under fancy names, such as “non-accretive interest rate swaps.”

NINJA loans: Loans provided to people with “No Income, No Job and no Assets.” An example of mortgage broker wit.

O

Overconfidence: the universal willingness to pay large fees to investment managers in the hope of achieving better than average returns. See institutional investors.

P

Prime broker: the unit of an investment bank which services hedge funds. Prime broker loans to hedge funds are now securitized and sold on to hedge funds.

Private equity: A branch of the investment industry run by deal-makers rather than investors. This may explain why, despite a quarter of a century of generally rising asset prices, generally falling interest rates, and huge dollops of leverage, investors in buyout funds would, on average, have been better off leaving their money in the stock market. The same cannot be said of private equity’s General Partners. See Steve Schwarzman. 

Q

Quantitative finance: the misbegotten attempt to turn finance into a branch of physics.

Quants: the name given to second-tier mathematicians and physicists who surrender science and scruples in exchange for Porsches.

R

Rating agencies: the highly profitable cartel of private firms which provide investment quality ratings on bonds. Bondholders cannot complain about the quality of these ratings because a. they are paid for by the issuers of debt and b. the rating agencies say they are only expressing an opinion. The US constitution doesn’t require that opinions be either accurate or free from conflicts of interest.

Regulators: government-employed lawyers, who having failed to get employment in Wall Street, have trouble understanding what’s going on in Wall Street.

Risk: the flawed attempt to precisely measure an uncertain future.

Risk premium: a gauge of investors’ willingness to lose their clients’ money. A high risk occurs only after a lot of clients’ money has been lost and reflects the money managers’ fear of losing their jobs.

S

Structured credit: the greatest invention of quantitative finance which conceals risk in complexity while facilitating the extraction of further fees by investment banks, credit rating agencies, collateral managers, hedge funds, etc.

Structured Investment Vehicle: An off-balance sheet vehicle designed to generate fees for American banks and insolvency for German ones.

Subprime: The practice, initially profitable, of providing loans to those who can’t repay them.

T

Toggle notes: loans to leveraged buyouts which, at the behest of the borrower, switch from payment of interest in cash to what’s called payment “in kind”, or rather in further notes. As the toggle is likely to be exercised when cash has run out and the company’s notes are likely to be near worthless, kind is not a nice description of this type of payment.

U

Underwriting standards: the outcome of a conflict between a banker’s fear of losing money and his desire to earn a bonus. Over the course of the cycle, the bonus looms larger than the fear of loss, and underwriting standards decline.

V

Valuation: An argument with the market price.

W

Withdrawals: the belated action of investors on waking up to discover a hedge fund manager has been playing fast and loose with their money. The hedge fund industry is trying to remove this inconvenience by “locking-up” its investors. See Bear Stearns’ High-Grade Structured Credit Strategies Enhanced Leverage Fund, Dillon Read Capital Management, Basis Capital’s Basis Yield Alpha Fund and many more to come, no doubt.

X

X: “A needless letter.” (Ambrose Bierce, The Devil’s Dictionary)

Y

Yachts: “Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said,

‘Look, those are the bankers’ and brokers’ yachts.’

Where are the customers’ yachts?’ asked the naive visitor.’

(An ancient story, retold by Fred Schwed, Jr.)

Z

Zombies: a plague of the corporate living dead. The usual legacy of widespread financial engineering. Also, Wall Street slang for German bankers.

(This item was originally published in September 2007.) 

 

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