The best arbitrage play on Wall Street may simply be working on Wall Street.

The WSJ is on fire today. What more can you really say? This is exactly right.

Bankers and traders get their big bonus checks every 12 months. But the risks created by their work are spread over a longer time frame. By the time the risks are revealed, be they bad loans or bad deals, it's too late for real accountability. The checks have been cashed, and the charters booked for Nantucket.

Overreaching is an American pastime, and virtually a Wall Street birthright. And that's fine, given that ambition drives innovation. But this current credit mess -- or "equilibrium-finding" as the hopeful put it -- dredges up an issue the Street has yet to solve: just how to pay short-term for long-term performance.

Last year, bankers were praying for the deals market to "just hold on" until bonus season. They got their wish, passing around the biggest pot of fees in history, some $79 billion split among the investment banks, 20% higher than during 2005.

The prayers were even more fervent this summer as the deal business was reaching a record-setting crescendo. Only now are the gambles becoming embarrassingly evident, with the Street scrambling to finance some $220 billion worth of leveraged buyout deals.

Some bankers talk publicly as if the inventory will vanish after a few weeks of vacation. In private, though, the mood has gone from Nantucket holiday to Bataan Death March. As one top merger banker put it on Friday: "I'm underwater on every single loan on my book." Translation: He's stuck with deteriorating loans that he was supposed to sell to others.

Despite the fallout, both bank and hedge-fund investors are willing to pay upfront money without seeing back-end results. The consequence is a free-rider's paradise, where individuals can stack up the short-term benefits for themselves, while letting the institution bear the brunt of their actions.

The result is a banker getting handsomely rewarded in January for making a loan that blows up in August. The hedge-fund manager, meanwhile, is able to buy up billions in suspect subprime real-estate loans and derivatives, clipping a 2% management fee along the way.

There is a market trade-off to these high rewards. Bad decision-makers can get yanked from their jobs at a moment's notice. But this can have the effect of creating still more incentive to land the big score.

Given the dollar amounts in play, that's getting increasingly possible, says Alan Johnson, managing director of Johnson Associates, which advises Wall Street firms about compensation. "The sums are getting bigger and bigger," Mr. Johnson says. "You've got young people doing aggressive things that have never been done before. What if it turns out really badly? It's what keeps CEOs up at night."

Full article here

Sowood Gets Taken Out

In what is easily the highest profile victim to date of the newly awake credit markets, Sowood is gone. Jeff Larson came out of Harvard Management Company a few years ago when many of the investment professionals were semi-forced out because of faculty anger at their performance-based compensation scheme. So all the managers left, set up their own funds and put in place standard pay for performance schemes that far exceed the cost of the internal comp needed to pay the managers. The distinguished faculty at Harvard were not able to make the mental leap that whether you pay the fees internally or externally, it still costs the same (and in fact more) and so quieted down.

Sowood lost 50% of its NAV in one month.

Sowood Letter to Shareholders (PDF)

The manager writes

Our actions over the weekend followed severe declines in the value of our credit positions and non-performance of off-setting hedges...the NAV [of their funds] will have declined 57% and 53% month to date. During the month of June, our portfolio experienced losses mostly as a result of sharply wider corporate credit spreads unaccompanied by any concomitant move in equities and exacerbated by a marked decline in liquidity.

So without knowing anything about anything:

a) Sowood was leveraged in some way through the structure with which they held their credit portfolio (you would not have lost 50% in one month otherwise)

b) It hedged based on some predictive model of how equities would perform when credit spreads widened. The model probably predicted that equities would decline in that scenario which they did not last month. We would have thought by now that we would have learned that these probabilistic hedges fail with some regularity exactly when you want them not to fail...eg when markets turn messy illiquid.

LTCM fell victim to the same belief in their models.

This is the "picking nickels in front of a bulldozer" of Nassim Nicholas Taleb (website; wikipedia)

That said, we can't be too harsh with Sowood. Like all hedge funds risk is asymmetric between manager and shareholder to manager is always tempted to take "too much" of it. Alternatively Sowood might have made a perfectly sound bet that went bad, but on the face of it, that is not what it looks like.

Anyway, must watch Citadel now. They did the bailout and are turning into a real force for distressed assets.

Corporate Buyers Hit Gas on Deals

From the WSJ ($) This is something closer to the natural order of the universe.

With deal-related financing markets in disarray, private-equity buyouts are being delayed around the world, giving corporate buyers an advantage over the cash-rich private-equity firms for the first time in years.

Consider Virgin Media Inc. The British cable-television operator is proceeding with an auction of the company after already having received this month a nearly $10 billion takeover approach from Washington private-equity firm Carlyle Group. That could benefit the cable-industry players exploring a bid, a list that includes Liberty Global Inc., Time Warner Cable Inc. and Comcast Corp.

Carlyle and a competing consortium of four private-equity firms will likely have trouble making a firm bid until credit markets calm and banks are able to sell the stockpile of debt building up on their balance sheets, people close to the matter say. The cable companies, though, likely could plow ahead.

"It's still early in the process, and there is a good amount of time for debt markets to stabilize as the auction proceeds," a Carlyle spokesman said. "It's premature to say strategics have an advantage at this point."

Corporations, known as strategic bidders, historically have had an advantage over private-equity acquirers in vying for deals, because they can use stock, cash or both to pay for deals. They also have the ability to eliminate overlapping expenses to justify a higher price tag.

The balance shifted in recent years as private-equity firms, coffers flush and with ready access to cheap capital through the debt markets, pushed the deal-price envelope with their all-cash bids. This year, 70% of deals for U.S. publicly traded targets have been all-cash transactions, according to FactSet.

Now, the pendulum may be swinging back.

"Strategic buyers were losing out on auction after auction," said Brett Barragate, a partner at law firm Jones Day in Cleveland. Now they "should be better positioned than they have been in these auctions because of their ability to finance deals using a variety of different means."

Bill Gross on a rampage, firing up his asset class

Bill Gross in on fire today.

Some wonder what squelched the hunger of potential lenders so abruptly, while in the same breath suggesting that the subprime crisis is "isolated" and not contagious to other markets or even the overall economy. Not so, and the sudden liquidity crisis in the high yield debt market is just the latest sign that there is a connection, a chain that links all markets and ultimately their prices and yields to the fate of the U.S. economy. The fact is that several weeks ago, Moody’s and Standard & Poor’s finally got it into gear, downgrading hundreds of subprime issues and threatening more to come. "Isolationists" would wonder what that has to do with the corporate debt market. Housing is faring badly but corporate profits are in their prime and at record levels as a percentage of GDP. Lenders to corporations should not be affected by defaults in subprime housing space, they claim. Unfortunately that does not appear to be the case.

As Tim Bond of Barclays Capital put it so well a few weeks ago, "it is the excess leverage of the lenders not the borrowers which is the source of systemic problems." Low policy rates in many countries and narrow credit spreads have encouraged levered structures bought in the hundreds of millions by lenders, in an effort to maximize returns with what they thought were relatively riskless loans. Those were the ABS CDOs, CLOs, and levered CDO structures that the rating services assigned investment grade ratings to, which then were sold with enticing LIBOR + 100, 200, 300 or more types of yields. The bloom came off the rose and the worm started to turn, however, when institutional investors – many of them foreign – began to see the ratings downgrades in ABS subprime space. Could the same thing happen to levered structures with pure corporate credit backing? To be blunt, they seem to be thinking that if Moody’s and Standard & Poor’s have done such a lousy job of rating subprime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs and CDOs? That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving.

Bond managers should applaud. It is they, after all, who have resembled passive owls for years if not decades. If, as I pointed out in my opening paragraph, wealth has always wound up in the hands of those that take risk with other people’s money, then private equity and hedge fund managers have led the charge in recent years. Of course they have been aided and abetted by those monsoon forces of globalization and innovation, producing worldwide growth that led to escalating profits and equity prices, often at the expense of labor. But the Blackstones, the KKRs, and the hedge funds of recent years also climbed to the top of the pile on the willing backs of fixed income lenders too meek and too passive to ask for a part of the action. Covenant-lite deals and low yields were accepted by money managers as if they were prisoners in an isolation ward looking forward to their daily gruel passed unemotionally three times a day through the cellblock window. "Here, take this" their investment banker jailers seemed to say, "and be glad that you’ve got at least something to eat!"

Well the caloric content of the gruel in recent years has been barely life supporting and unhealthy to boot – sprinkled with calls and PIKS and options that allowed borrowers to lever and transfer assets at will. As for the calories, high yield spreads dropped to the point of Treasuries + 250 basis points or LIBOR + 200. Readers can sense the severity of the diet relative to risk by simply researching historical annual high yield default rates (5%), multiplying that by loss of principal in bankruptcy (60%), and coming up with an expected loss of 3% over the life of future loans. At LIBOR + 250 in other words, high yield lenders were giving away money!

Full article here.