ECON 252: Financial Markets (2008)

Lecture 14

 - Guest Lecture by Andrew Redleaf


Andrew Redleaf, a Yale graduate and manager of Whitebox Advisors, a hedge fund, discusses his experience with financial markets. He addresses one of the fundamental questions in finance–whether or not markets are efficient–and concludes that although they don’t seem to be efficient, beating the market is very difficult. Mr. Redleaf discusses his thoughts about psychological barriers that make markets inefficient. He also comments on his beliefs regarding risk management and how people are compensated for mitigating risks, rather than for taking on risk as is often perceived. He ends by answering several questions from students.

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Financial Markets (2008)

ECON 252 (2008) - Lecture 14 - Guest Lecture by Andrew Redleaf

Chapter 1. The Markets Are Not Efficient [00:00:00]

Mr. Andrew Redleaf: I think — the, sort of, first thing that I think most people think about or the first question when you’re thinking about financial markets is whether they’re efficient or not — whether they incorporate all known information — if it’s possible to do, sort of, significantly better than the market as a whole. I’m not sure — used to be absolutely received economic wisdom that financial markets were efficient. Now it’s — I think it’s still the dominant academic view, but there’s a big debate and there are partisans on both sides. It’s actually — to me, it’s actually a fairly simple question.

The efficient — the notion that markets are efficient derives from an a priori theory, which is the same sort of theory about all markets. There are lots of incentives, people acting in their own interests — they have to do that. It’s a very appealing kind of a priori theory, but the thing about theories is they’re supposed to make predictions. If some of the things they predict don’t come true, the theory has to be disregarded and there are many, many, many counter examples to financial market efficiencies. On one level, there are things like companies that have two different classes of stock that are economically identical. Royal Shell used to have Dutch shares that traded in Holland and U.K. shares traded in London. Economically identical, but their prices would fluctuate and fairly dramatically. In ‘98, I forget which way, but one of the share classes was at a 20% discount to the other and that persisted for several years, so you have economically identical things trading at different prices.

You have closed end funds, which are vehicles that own a set of other securities — trade as a security listed on the stock exchange, but what they do is own other securities. And whether they trade to a discount — whether the security in the closed end fund trades at a discount or a premium to the stuff they own — fluctuates meaningfully in a way that’s sort of difficult to recognize with the idea that the securities should be reflecting economic value. You have what are called stubs, where one public company owns a significant stake in another public company. In instances where the one — 3Com owned Palm, and the value of its Palm stake greatly exceeded the total value of the market capitalization of 3Com; that persisted for a number of years. In general, less volatile stocks have done better over time than more volatile stocks, which is somewhat inconsistent with the notion of efficient markets.

Lastly, there is a meaningful number of individuals and institutions whose, sort of, performance look — whose performance in portfolios is really inconsistent with the markets being efficient. It can’t really be explained away by — some of them can but — by luck or by inside information or by something, while there’s sort of a big academic debate.

Then lastly, there are things like the Internet bubble, or more recently the housing bubble, or — they’re not usually called this, but — the lending bubble where — or the subprime mess. Lots and lots of loans, the securities that people bought at par that were worth about somewhere between zero and $.15 or $.20 and now trade there. I don’t believe that markets are efficient and it doesn’t really seem like it should be an open question. The people that believe it have to die and then nobody will believe it anymore. Not very many of them change their mind though they come up with more convoluted explanations — clever, convoluted explanations for the counter factual — for the things that happen in reality that the theory doesn’t predict. So, markets aren’t that efficient.

On the other hand, sort of doing better than the markets is a non-trivial exercise and it’s not as easy as it might appear or as — I mean, some people think it’s impossible; other people think it’s really easy. It’s actually not impossible, but hard, and there are a number of challenges. First, for individuals, I think the primary challenge is if an individual sticks to, sort of, areas where they might have an informational advantage or at least don’t have an informational disadvantage, they won’t own a diversified portfolio of securities because their informational advantage will be narrow. They also have sort of limited access to the gamut of products and so forth — restricted access and restricted offerings. So, that’s a challenge for individuals.

Institutions are sort of professional investors; all spend a lot of money on information, which requires infrastructure and resources and so forth. But the very, sort of, nature of being an institution constrains almost everybody whether it’s, in our case, all our investors have thirty-day liquidity. They can — in mutual funds, it’s daily liquidity, but their investors tend not to be as wide-awake. But that’s a constraint on us — that, except for the principles, maybe their families maybe not, all our money can disappear in thirty days, so we have to be cognizant of that. We have clients that have, sort of, a set of expectations, which you also have to, if not be cognizant about, sort of deal with. Then there are, kind of, universal psychological challenges — biases in people’s thinking — and a number of things that are just, sort of, difficult for human beings to process and make intelligent decisions. I think that’s kind of in the area of mine and one of the things that drew me to Professor Shiller and some of his other colleagues and that’s really universal to not just financial markets but to all decision making.

Chapter 2. Psychological Factors of Market Inefficiency [00:10:15]

I think, particularly in the kinds of the things that have a serious mix of randomness and skill — that’s sort of the hardest thing for human beings to process — something that’s kind of an unknown mix of randomness and skill. We can understand something that’s fully random and work out the statistics and be comfortable with that to some degree. Things that are sort of completely cut and dry, fully determinative, we like those too, but stuff that’s mixed is very, very hard. I mean, quantum mechanics makes sense to no human being, in my view. In those areas, people are inclined to do sort of strange things. I mean, one thing — I play a fair amount of — I play a little bit of poker and I’m very interested in the game. It’s sort of — it’s a little like the markets and other things in that there’s an element of randomness and an element of skill. One thing that I find interesting — typically, if you play poker in a card room or a casino, I would say nine times out of ten somebody sitting at the table will tell you that they’re not trying; it almost always happens. They’ll say, I usually play for more money and it’s hard to concentrate or I’m just screwing around.

Why do they do that? What’s — why do they not — they could just be screwing around, but why do they tell you? It’s kind of my pet theory that they would rather — they’re setting up in advance to lose. They would rather lose because they’re sort of screwing around than — that’s easier for them to, sort of, deal with than to — they could put out their best game and they would do better, but they might lose anyone given its, sort of, randomness. It is — that’s the thing about really good poker players versus less good poker players. Really good poker players play close to their best all the time and they’re not really bothered when they lose; I think that’s true in markets too.

In all sorts of decisions, what people are inclined to do or are very interested in doing is setting up posturing for credit and blame in advance and sort of having a pre-made excuse if things don’t go right. They’re more interested, to some degree at least, in having an excuse if things don’t go right, than in sort of maximizing the chance that things go right because even maximizing the chance that things go right, you can’t get it to be 100%; there’s an element of randomness. Bad things can happen, so it’s really, really hard to just focus on getting things right and not winning the argument. Setting yourself up before the fact so that you can win an argument after the fact, so that you didn’t — you just got unlucky. People are very inclined to see things as determinative to attribute — and not just in markets, but in the psychology literature — to believe if — you’re wired to believe if something — if A happened before B, A caused B. B has to be caused by something and A happened first, before it, so that’s what — so they assign causality.

They’re also inclined to focus on sort of recent things — things they see even if you know they’re irrelevant. For example, in the psychology literature, famous example is — famous kind of test question is: a tester will give the person taking the test the name of two cities that they’ve never heard of and the distance that they’re apart. So, two random cities, XYZ and ABC, are 4,200 miles apart. Then they’ll give them two other cities that they’ve never heard of and ask them how far apart they think they are. People anchor to the information they were given, even though there’s kind of no causality or no sort of reason why it should make any difference. If the referenced cities, the first cities, are 4,200 miles apart, the answers for the next two will center around 4,200 miles. If the referenced cities were 2,500 miles apart, they’ll center about that. I think it’s useful to, sort of, know all the hard-wiring biases that people have to try and de-bias your thinking, but it’s not easy and in lots of cases it’s not actually people’s objectives.

Any of you watch Mad Money on CNBC — Jim Cramer? Any Cramerites? Nobody? Well he starts his show, “Some people want to make friends; I just want to make money.” If you watch the show and you see Cramer, it’s pretty believable. I think it’s true. Almost everybody in financial markets is capable of saying that. “I don’t want to make friends, I just want to make money.” But for most of them it’s not true. They have all sorts of things that they want to do other than make money. They have office politics; they have any number of other motivations. That psychology is really hard and somewhat applicable to not just markets, but other things.

Markets aren’t efficient, but it’s not that easy to beat them. What do we try to do? I, kind of, would highlight what I view as three sorts of principles. The first, the investment world, I believe, divides between coupon clippers — bonds historically came with coupons, actual sort of coupons like the thing you bring to the grocery store and get twenty-five cents off a can of coffee. So, we have this security and a ten-year bond would have twenty coupons attached, each with a date on them. When the date came, you would cut the coupon off and go to the bank and get your interest payment. So, that was called coupon clipping. Basically, something that you would — coupons are things that you redeem for a stream of money and, in my view, the world divides between coupon clippers — people that are interested in cash flow and taking in cash flow — and, what I would call, security resellers — people that own things that they intend to sell to somebody in the future at a higher price.

There are successful coupon clippers and there are successful securities resellers and they tend to make their money off of the unsuccessful people in the other class. We try to be — I think investing is about clipping coupons, about getting cash flow and getting and controlling cash flow, but there are good resellers. I think reselling is an element of things like venture capital. The best venture capitalists don’t just have great ideas or whatever, but they take an idea, they advance it a little bit, and then they sex it up and promote it and have a good sense for what the public will buy and they get a nice valuation from the public. I think that’s at least as much a distinguishing feature between good venture capitalists among each other as the quality of their ideas. There are sort of–Cramer, again — Cramer was a good security reseller — had sort of a really good — spent a lot of time and effort kind of figuring out what is it that people will want to buy next week. That’s what I’ll buy today not because I’ll derive income off of it, but because it’s what people are going to want next week and I’ll be able to sell it higher. That’s some art, some science, and there are people that are very, very good at it. We try to clip coupons. As to some — that’s — it’s a Warren Buffetism — he says, all investing is about coupon clipping and the difference between equities and bonds are that bonds come with a coupon that’s known and equities have earnings in the future that you don’t know. You also don’t know that they’ll give them to the equity owners and to management and not to — they won’t squander in the future. But to Buffet it’s sort of same thing — it’s clipping coupons and he describes his job as figuring out what the coupon is in an equity and if it’s high enough he likes it.

The first sort of principle to me is clipping coupons. The second is that risk is primarily about what is the worst thing that can happen. In a typical security — Wall Street risk management — a lot of focus is on what is the range of moderately probable outcomes. So, people talk about VAR, value at risk, and lots of people try and build VAR systems. What they are trying to determine is how wide is the band of outcomes. How wide is the band of stuff that has a 95% probability or a 98% probability — usually 95% or 98%, but not 99.9%. If you know I have a 98% chance of not losing a dollar that works in the VAR screen and the — and it won’t tell you — won’t distinguish between whether the 2% chance is of losing $10 or losing $100. To me, that’s a fundamentally wrong approach and it’s actually done because it’s the sort of thing that statisticians are good at. To some degree, it’s harder to imagine the worst thing than to statistically sort of figure out the middle band. There’s a famous saying, “If you’re good with a hammer, everything looks like a nail.” That’s sort of what that’s like, but the really important thing is what’s the worst thing that can happen.

Chapter 3. Rewards Are for Risk-Mitigating, Not Risk-Taking [00:25:57]

The last sort of principle, which is actually most at odds with the academic community and even, sort of, the general perception is that you don’t get paid for taking risk, you get paid for eliminating risk. I actually believe in the history of the planet, there are very, very few instances of people getting paid for taking risk; they get paid for eliminating it. As an example, if you think about a tightrope walker in the circus, there’s a conception that he gets paid because it’s a risky job — he might fall down, kill himself. I think that conception is completely wrong. The lifetime earnings of a tightwire walker who falls down and kills himself aren’t very good. In fact, what he’s getting paid for is that he practiced a whole lot when he was a little kid on a wire that if he fell off of he wasn’t going to get hurt and that he’s really getting paid for eliminating the risk of falling off via practice as opposed to taking it.

You think about drug development — pharmaceutical companies and people will say, well discovering compounds that are effective drugs is an uncertain, risky business and so pharmaceutical companies are able to get paid for taking that risk. I don’t think so. I think they get paid for applying intelligence and not testing every — not for the compounds they test, but for the ones that they’ve eliminated testing for because they understand the chemistry or a disease process and have some idea what sort of compounds are more likely to work than others.

I don’t know if he remembers this. When I last explained this to Professor Shiller, he said, well what about insurance companies? I said, proves my point — the sort of exact case. An individual has risk of certain bad things happening. If the insurance company has risk, it’s because they’ve made a mistake. If they’re sort of doing their job right, they’re actually diversifying away all the risk and relying on the law of large numbers. A casino does not have a risk that the law of large numbers will be repealed and a roulette table will be a long-term losing proposition or a craps table will be a long-term losing proposition. They have risks that their overhead won’t cover or that they won’t have — their risk is that a steady stream of people won’t come and be making a steady stream of bets at which each of them has a slightly negative expectation.

We really want to think, whenever we look at anything, what kind of coupons can we extract? What’s the worst possible thing that can happen and how can we eliminate that? We do that — sometimes it’s by diversification — having a lot at sort of independent sort of bets. More times, it’s having an offsetting kind of position where we go long one security that’s issued by a company and short something else that we think eliminates our risk. A common kind of position will be long a high-yielding — a bond that yields sort of 15% or 16% and — I mean, hypothetically a bond trading at $.60 on the dollar with an 8% coupon, five-year bond that’s yielding about 18%. Maybe the company has a $15 equity price and will be short $.15 of the equity, which we’ll try and keep all the way down. If the stock’s $20 and we could stay short $.20 worth of stock all the way down — if the company went bankrupt — the company goes to zero — on our short position, we’ll have taken in about $60, which is what we owned the bond — what we paid for the bond. We have a superior claim in bankruptcy — we’ll recover something and, in the meantime, we get this 8% coupon that we get to clip. That’s coupon clipping and risk mitigation.

Now, there’s the other side of the stock going up and we have to think about how much that can cost us and whether our coupons are enough and whether the difference between the $.60 that we paid and the $100 that the bond matures enough — is apt to cover that. But that’s the sort of the thing we do and it’s coupon clipping and it’s risk mitigation or risk elimination — fairly short.

Chapter 4. Issues in the Current U.S. and Global Economies [00:33:14]

The last thing I thought I’d talk a little bit about is what some — what’s happening in the world today and the financial system today, which to us it’s — if you’re in trading and investing, things happen in your world and they’re just unbelievable. You go outside and you talk to people that have jobs and lives or go to school and they’re completely unaware that — they have absolutely no idea that this really amazing, unbelievable thing just happened. There’s a shortage in hard, red, winter wheat, so Minneapolis Wheat has gone from kind of $10 to $24, now to about $18 or $20, but in one day it went from $20 to $24.5 — a 22% move in Minneapolis Wheat. Most of the people in the world had no idea that that had occurred and it makes absolutely no difference to them.

One of the things that’s sort of happening in the world that’s sort of central to the people that look at this all the time, but of maybe less direct relevance to people that have everyday jobs, is that the banking-–more so than — I mean, I’ve been at this for thirty years. In those thirty years, there have been lots of mini crises and violent moves up or down — dramatic squeezes or liquidations — but more so than any time in the past thirty years, the banking system is really closed. The big American banks are not functioning. Their doors are open and people come and go everyday, but they’re not really open for business. They’re neither making loans nor selling the loans they have and it’s starting — it’s affecting the fringes of Corporate America now — not yet all of it. And it’s what happened in Japan from ‘90 to — is it over in Japan? Maybe or maybe not. They usually talk about it as the “lost decade,” where Japanese banks were not liquidated but they were not really in business. That’s happened now primarily as the result of losses in, now all mortgages, but mortgages and levered loans.

In my view — the Fed has dramatically cut interest rates. We started from 5% to 3%, but three-quarters of it — a quarter at a time every Fed meeting, which are — Fed meetings are generally about six weeks apart. But then, 1 ¼ of it within a two-week period — from 4 ¼ to 3 — and they’re talking about — looks like they’ll go from 3 to 2 ½ whenever the next — when’s the next Fed meeting? Within a couple of weeks. The markets are saying they’re going to go all the way back to one, which was the low for short-term rates. To some degree they say their objective is two-fold: to spur economic growth as the credit crunch slows economic activity. Also, I mean, kind of independently or complimentarily as a corollary to that — to free up the financial system and to help financial institutions. It’s kind of my contention that it’s actually hurting financial institutions. It’s actually having the effect of not letting the markets clear. It’s nature — financial — I mean that — when I was explaining it to Professor Shiller, he said he didn’t quite follow it, so I probably shouldn’t try it, and he knows more than I do.

It’s a very interesting time in that we’re having a — we have consumers under pressure because of their overextension of credit and they’re having overpaid for houses over the last handful of years. We have kind of a slowing economy either because of that or because the economy kind of slows every once in a while. We have financial institutions under stress or duress and, unlike the previous time, we have headline inflation of 4.3%. I think it’s higher — I think lots of economists think it’s lower, but it’s — headline inflation is higher than nominal interest rates. We have a very weak currency. The dollar has gone from buying a little over 1 Euro to buying 2/3 of a Euro in a couple of years and 130 Yen to 100 Yen, 1.5 Australian Dollars to a little over 1 and the — and in that scenario, there are more problems than policy tools, so any policy action has a downside, which makes it an interesting time. About half the time. Questions?

Chapter 5. Questions: Cash and Bonds as Default Investments [00:43:41]

Student: You mentioned that things are [inaudible], do you think that [inaudible]? For example, do you think that mortgage [inaudible] will have a negative impression?

Mr. Andrew Redleaf: I think that the question is whether markets are more apt to overprice versus underprice. Whether they’re more inefficient when things are going up or when things are going down. I don’t think I have a systemic sort of view. I mean, lately they’ve been more inefficient, in my view, because the Fed’s creating too much money. In recent years, there have been more examples of things that are priced too high than things that are priced too low, but there are both and the market makes mistakes in both directions.

Student: I actually have two questions. One, do you think an individual investor should listen to Cramer? Two, what do you think are the best ways an individual investor can make the best return in the market these days?

Mr. Andrew Redleaf: Again, this is something that I think Ben Stein agrees with, but just about nobody else. I think for individuals, instead of thinking of, I want to have a portfolio — I used to have a portfolio and I should be invested all the time and I should divide it up — cash, stocks, and bonds — depending upon how old I am. I think people’s default position should be cash — individual’s default position should be cash — and they should only make investments if there’s really a — if they can see a really compelling case. Over the course of time, fairly compelling cases do come up and they’re not — and individuals are in as good a position as professionals to see that. So sometime in your lifetime, stocks, equities as a group, will be cheap by most of the standards that have worked in the past. Professor Shiller, in his books, he’s got current multiple of trailing ten-year earnings. Good measure — sort of takes the cyclicality out of earnings and you can see over history how that multiple has varied.

You’ve done very well — you’ve done poorly if — for the most part, if stocks have done much better if you’ve bought them at a point that looks cheap on that graph than one that looks expensive. Sometime in your lifetime, you’ll get an opportunity for stocks to look cheap on that measure. They’ll probably, at the same time, look cheap on a price-to-book basis, on a dividend yield basis — they tend to move together — and you can sort of look at them and say, equities as a class are cheap, I have a compelling reason to take money out of cash and put it into equities now.

I mean, I think a few years ago, as the housing bubble was taking off and going full board, as it was easier and easier for more and more people who normally couldn’t have bought houses to go from renting to owning homes, residential REITs, apartment house REITs were again, on obvious historical measures, interesting, maybe even compelling. So, you could buy apartment buildings for way less than it would cost to replace them. You could, with public apartment REITs, you could get between a 5% and 9% current income — compound interest rates were down at 2% or 3%. That was pretty compelling as an asset class and worked really well. Municipal bonds right now — municipal bonds yield more than the equivalent Treasuries — approximately 1.1, 1.2 times — that’s pretty compelling. The only other time that happened was when there was sort of talk of their losing their tax exemptions and tax rates were going down. Tax rates are going up — there’s no talk about losing their exemption — that’s pretty compelling.

Professor Robert Shiller: You said that individuals’ default investment should be cash. I just want to point out that contradicts one of our readings. Jeremy Siegel, Stocks for the Long Run, says the default should be equities. Am I misunderstanding you or are you —

Mr. Andrew Redleaf: I disagree with him. Ben Stein, I think, is the only person who sort of agrees with me. He wrote a book, Yes You Can Time the Market, and he sort of basically says, only buy things when you have a good reason — a really compelling reason to own them. I think — I don’t know what he says about this, but I think most of the equity — to me, the historic kind of case for equities is survivor — is U.S.-centric and it’s survivor bias. Obviously, the U.S. went from a kind of average agrarian country to the industrial colossus of the world, so obviously — or as a corollary to that — equities did really, really well. It’s not 100% clear that over the next hundred years that Asia might not — China, India, the tigers, collectively — might not surpass us or the world might not do that well for the next hundred years. The last hundred years, in the U.S., don’t really have that much predictive power.

Student: We talk a lot in this class about trying to correlate to the equity premium. Can you talk a little bit about what you see the advantages of bonds, why you focus so much on bonds — getting a little bit away from the securities — and what advantages do you think would make good investments?

Mr. Andrew Redleaf: Here, I’ve convinced some people, though David Swensen really disagrees with me. If you read his Pioneering Portfolio Management on the syllabus, he really has a preference for equities. What I liked about fixed income, I think fixed income is inherently more analyzable because you have, sort of, specified coupons and matured — a specified coupon and a specified maturity and you have a fixed income. Either they pay you or they have to reorganize and — they either pay you interest or they have to reorganize and they pay you principle or they have to reorganize. It’s inherently more analyzable.

Stocks really have to be cheap because, in general, they don’t pay out their earnings and sometime in the future they’re pretty apt to do something stupid and you can’t tell. On the one hand, I do think if there’s a stock that is selling for four, five, or six times the earnings and you have good reason to believe that the earnings are going up, something’s — when a stock sells for a mid-single digit earnings multiple, the market is telling you that — the market is saying that earnings are coming down. If you have good reason to believe that earnings are going up, if in fact you’re right — in that case, when you buy the stock you are making a bet on the earnings going up. If the earnings go up, you’ll get paid twice because the multiple will go up too; that’s sort of the way things trade. When you just — you buy something at a — RIM, the maker of Blackberry, sells for fifty, sixty, seventy times earnings; when you buy that stock, earnings can go up.

You could think, I’m buying the stock because I think earnings — you have to think earnings are going to go up twelve-fold to get it down to four times earnings, which will take a long, long time. They are — if you know earnings are going to double, you really don’t know very much about what will happen to the stock price because if they’re going to double over the next two years, hypothetically — if you’re right on that, it doesn’t matter because the multiple could very, very easily go from fifty to twenty-five. So, it’s — and in the end, they’ll never pay you any dividends. How do you collect — How do you ever collect a coupon? How do you ever get a hold of cash flow? I just hate owning stocks and I love people sending me checks, which is what a bond —

Student: Tell us — the criticisms that I often read about in the news media [inaudible] is that in an industry that [inaudible] a service that benefits society, in a sense, hedge fund managers they [inaudible] the markets because they have a better understanding of how the world works a lot better than [inaudible]. I was wondering how you feel about that?

Mr. Andrew Redleaf: Well, I think I — a couple of points. First, I do think it helps the world to have security prices that are closer to their accurate value than further away and more tending towards their fair value over time than gyrating completely randomly. If hedge funds could obsolete themselves — if hedge funds could make markets completely efficient, it would benefit the world a lot — is one. And to the extent that they help make markets efficient, I do think they help the world. I do sort of agree. I think involved investors also improve the performance of the country’s fixed assets and that helps the world too. Hedge fund people aren’t — I think more and more that’ll be a part of what hedge funds do. I mean for — we gave it up, but we owned Sun Country along with the Petters Group, which is a Minneapolis based point-to-point airline — competes with Northwest. It was kind of an experiment, somewhat in behavioral economics.

We had distinct ideas about what their business strategy should be. We couldn’t — Petters and Whitebox actually did not disagree, but the — Whitebox got completely disillusioned with management and wasn’t — so we sold our stake to Petters. If our ideas were good, it really would have benefited consumers in the Twin Cities and I do think that people who have real money at stake are apt to — over time and on average, their ideas will be better than people who don’t have anything at stake. I mean, activist investors, which are mostly hedge funds, I think often either make management better via competition or on balance their ideas are right and they certainly challenge–force — management to at least consider alternatives. I think if — I wrote in my last letter — I just read Paul Krugman’s book — The New York Times editorialist — The Conscience of a Liberal. Like a lot of hedge fund people, I’m pretty free market, right-wing conservative, but I think unlike — hedge fund compensation is really a market result. It’s the result of negotiations between informed parties of roughly equal economic clout and sophistication. Executive compensation is not the result of arm’s length negotiations. There’s a new, I think a Yale study on executive compensation. Something like 96% of Fortune 500 CEOs get their full severance package, even if they’re dismissed for anything other than a major felony. That they can perform badly — they can be found to have breached their fiduciary duty, but they still get a lot, so I wouldn’t — I’m on the hedge fund side and against the sort of company management side.

Chapter 6. Speculating on Backdated Options [01:04:35]

Professor Robert Shiller: Can you tell the story of backdating of options? I started to tell it in class.

Mr. Andrew Redleaf: Sure. Sort of — the history — when bonds are governed by what’s called “an indenture,” which is the sort of legal agreement between the company and bond holders. In a typical bond indenture, if a company fails to file financial statements on time that’s an event of default under their bond agreement and usually the remedy for an event of default is you can demand immediate payment — acceleration and immediate payment. We — in general, people don’t read every — people own bonds without reading the indenture. They’re long, they’re not written in English; in most set of circumstances they are irrelevant.

So, we actually didn’t really know this until we owned a bond in the company that didn’t — that couldn’t file their financial statements on time. Somebody else owned them, and discovered them, and demanded that they get paid, and ended up negotiating with the company, and we got a kicker. So, that was kind of our first experience — the thing that made us aware that not filing financial statements was an event of default and, therefore, something that would entitle you to the payment immediately. So, for companies that could pay you back, but their bonds are trading below par, probably because they have a low coupon. So, if a bond was issued when interest rates were lower, they might have a 4% coupon when the prevailing rate is 6%. So, if it’s a four-year bond, it would trade at about $90, so it would be yielding 6%. But if they default, you can buy them at $90 and if they can’t file their financial statements, you’re entitled to par. We were interested in finding bonds trading below par where we thought there was a chance that companies would not file their financial statements on time. It turned out at the time, one of the big causes of companies not filing financial statements on time was if they had backdated the stock options. They know what back dating is?

Professor Robert Shiller: We discussed that.

Mr. Andrew Redleaf: If they had backdated their stock options, they’d have to restate their financials; they’d have to investigate — takes time and so forth — and they would delay filing their financial statements. We tried to identify companies that we thought had backdated their stock options. We bought a database, we cleaned it up, and we basically looked at their pattern of stock option issuance and tried to figure out the probability of it having been caused by chance. For companies that we thought had backdated stock options, that we could buy their bonds at what they would trade for without this potential event of default. That was kind of a riskless trade because if they filed on time, we hadn’t paid anything. If they were late, we had the prospect of getting par quickly.

In the very beginning, the kind of history — there was the first trade, where somebody else discovered that a company couldn’t file their financial statements because they had bad recordkeeping or whatever; that one was not option-related. That first one was kind of happenstance. The next couple of times, companies announced that they were apt to delay their financial statements. The first few times, you could buy their bonds at the same price as before they had announced that and potentially owed you par. But that did not–here, in terms of market efficiency, it didn’t last forever and after three or four times, companies would announce that they were going to delay their filings. Lo and behold, their bonds would go up because people had discovered that you might be entitled to par.

When it stopped working — like waiting — we tried to anticipate what companies might not be able to file and buy their bonds in advance. We gave the SEC our study and algorithm — they wouldn’t tell us what they’re out — exactly who they were targeting and how, though I got the sense that their approach was similar to ours. They sort of seemed — even though they didn’t say anything, when we were talking to them, they seemed sort of pleased that — when we did something, you could see they — when they were sort of pleased, we took that to mean that that was what they were doing. They were sort of happy or thinking that that got it right.

As it happens, so far that we’ve been involved, four companies have argued in court that failure to file financial statements is not an event of default. We won the first case, which we really thought settled it. We’ve subsequently lost two and one is pending. The wording is slightly different in all the indentures, but in general, we’ve settled eight or nine cases; companies sort of agreed and we negotiated a settlement. In terms of whether hedge funds are an instrument of social good or not, the litigation companies argue that we’re opportunists, and we went in and bought more bonds after they filed late, and we haven’t been injured, and it’s basically unfair that they should have to pay us par. I did consider this sort of noble work because I think companies should honor their agreements. It’s also the case that if a company paid off their bonds or settled them, they settled it for all bondholders and not just us. If anything, other bondholders get to free ride on us but I think hedge funds–again, it’s sort of a good thing if documents and agreement have meaning and that requires active engaged parties; otherwise, the party that’s active and engaged will take advantage of the other.

[end of transcript]

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