Archive | April, 2010

Function and Purpose as it relates to Securities and Disclosure

30 Apr

In trying to explain myself on Kid Dynamites blog (link later…) regarding my explanation of material disclosure, I made the following argument (Going to edit it a bit when I have some time):

I’ll try one last way. A much more philosophical construction. Function versus purpose.

Function is the properties of an item as it relates to what it does and is.

What are the functions of a ferrari?

If you press down on a gas pedal the wheels spin. It is constructed from metal. Turn the steering wheel left and the tires turn left. It is red. It can go from 0-60 in 3 seconds…

Each property above is quantifiable/verifiable by any party. These functions are the same and as true for you, for me, or even a cow you might run into on the road. Function is absolute and the same in all frames of reference. It describes who, what, where, when and how.

The purpose of something on the other hand is the narrative applied to items in the world. It is an entirely human construct.

What is the purpose of a shoe?

For most people a shoe protects your feet while you walk. For others a shoe is a fashion accessory or a collectors item. For a dog it’s a chew toy. For the bacteria living in the sole, the shoe is home.

Purpose is relative. It is frame of reference dependent. It is different for everyone. The purpose of an item describes Why it is. That we’re having this discussion illustrates that why as it applies to the item is impossible to define. Purpose does not exist without the person. Statements of purpose dont describe the item, they describe the person using the item.

Look at the difference in sentence construction between the ones under function vs the ones under purpose. In “function” the subject in the sentences is the item. The sentences tell the story of the car. In “purpose” the subject in the sentence is not the item. The item is the object here. As statements of fact these sentences describe you, me, the dog, and the bacteria.

The argument that KD, I and others are making is that since function is absolute, it can and must be the only way we evaluate materiality. The subject of disclosure is the item.

Setting the standards of disclosure as an item’s purpose is to make it relative, making the subject all the people using it and therefore impossible to accomplish. Even if the great majority of the population shares the same why. Purpose is never a shared statement of fact.

The functions of a security, what a security is, is a representation of assets. So long as the disclosures are a truthful representation of the assets, then materiality and the responsibility of an underwriter is fulfilled. While Paulson thinks the assets will go down is a fact, it is a fact about paulson and not the assets nor its representative security.

I understand why this discussion is so difficult. Humans have a propensity for applying narratives and purpose to everything. We then believe that these purposes are elements of the world, rather than elements of us. We are interested in the human aspect and perspective of the world. While we may find it of little import, these perspectives still never change what the world is.

Thousands of years ago, humans built a large ring of giant stones was built in Northern Ireland. This is stonehenge. In the absense of its builders everyone can still understand what was built. To this day no one really understands why it was built. We debate, and research and study ancient relics not because we want to know about the relics. Stone henge is and forever will be a pile of rocks. We pursue these studies to understand the people. It is the interest in other humans.
Knowing why stonehenge was built doesnt tell us about stonehenge, it tells us something about the people who built it.

This is probably worth at least some decent grade in a Ivy league philsophy course.

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GS… Fiduciary Duty,Materiality, Price vs Value vs Quality, Social Value, Markets

29 Apr

I’ve recently spent sometime reading and commenting on a number of financial blogs, discussing the current firestorm surrounding Goldman Sachs. Between the SEC suit and the senate hearings Tuesday the two major roles of GS are at the heart of these discussions.

The primary issue and the one that the SEC’s suit involves is the failure to disclose material information regarding the ABACUS synthetic CDO transaction/deal/offering. This is a legal matter on what defines something being material.

The second issue that has arisen and which gets mixed into the discussion is that Goldman as a market maker / seller of securities will often have an opposing and adversarial interest with the clients to/from which they buy and sell securities. This has thus far not been a legal matter but rather a question of ethics, as well as a topic in the regulatory/reform debate.

Lastly the entire question about the social value of financial firms and trading activity is brought up, asking what exactly does all this trading do for society?

Fiduciary Duty

Fiduciary duty deals with the question of ethics as applied to the second issue.

A large part of the Senate hearings dealt with the following: How can Goldman sell securities to clients that it thinks are poor and/or has positions against? (We will ignore offerings for now and concentrate on pure market making activities.) The confusion here lies in the belief that a market maker / broker has a fiduciary duty the same way a lawyer or investment advisor would. The fiduciary relationship rests upon the idea that one party, acting on behalf of the client will work to maximize the clients interests. As a market maker this cannot possibly be true. For one the incentives of both parties in a buyer / seller relationship are by nature adversarial, anyone selling a product invariable benefits from a higher price while the buyer benefits from a lower price. There is always going to be a conflict of interest and thus impossible to ever believe a principal trading market maker is your fiduciary.
What GS ‘sells’ as a market maker is the ability to transact, to find a price someone will buy at, and a price someone will sell at.

Consider even the instance of agency trading. Where a desk at Goldman has no positions of it’s own but merely matches orders. Many times in the day an agency trader will receive buy and sell orders on the same security from different parties. If we assume his role is fiduciary in nature, how can he accomplish this to the best interests of his clients? If the sell order is large the sales at the beginning of the order will likely come at the beginning of the day will come at a higher price than those at the end. Knowing this, if the agent performs to the best interests of the buyer, he should wait until the end of day to purchase securities at the lowest price. This however contradicts his duty to get the best prices for his seller as his holding of the buyers orders lowers demand and makes price drop quicker. One may argue that he could try to balance out their interests, but that also means that he’s sacrificing the interests of one party to maintain his relationship with the other. In fiduciary terms, this is an inherent conflict of duties, which makes being a fiduciary impossible.

In it’s very nature acting on behalf of multiple parties which may be diametrically opposed makes being a fiduciary impossible. It is impossible for a trader/agent/broker to run a successful business representing only 1 client. It is therefore impossible to ever assume that anyone executing a trade, principal or agent could ever have a fiduciary duty.

Materiality and Price vs Value vs Quality

We must make a distinction between the price of an item, the value of an item and it’s quality. Price is a number, it is what you need to pay to buy a service of product. The value of an item is not. Value is completely dependent upon the perspective of the buyer of any good, service of security. What an individual chooses to buy is ultimately determined by if the perceived value of the item intersects and exceeds the price required. Some people buy a $1000 Prada purse because they believe its value is greater than or equal that price. For many others of us, we would think this a ridiculous price to pay because we find little value in a purse. Now what is of concern when we make our decision about a purchase is it’s qualities. Quality as used here defined as: it’s inherent and distinguishing characteristics and properties. What an item IS. This too is absolute. Our concern when making this decision is that what the item as advertised in this case the designer bag, is actually a real Prada bag. The material information when it comes to buying a bag are the veracity of its qualities.

The same is true regarding securities. Too often people confuse the value of a security with its price, this is not true. We buy securities we believe have value exceeding it’s asking price, and sell securities that have prices exceeding its value. How we determine may depend upon a number of theoretical models / opinions (dividends, expected appreciation etc.). Because of uncertainty in the future, the value is something unknown and is completely dependent upon the perspective of the individual. (The value of a stock of DISNEY may simply be having a piece of a company someone loves) The qualities of a security are the assets and properties that define what it IS. This may be the company a stock represents, the cash flows / loss divisions in a CDO, the payoff and reference security on an option. The job of a banker/underwriter in an offering is to assure investors about these properties, verifying the numbers and the facts. While someone’s opinion (short of having material non-public information) may change our perceived value of these assets, it never changes what the assets represent.

In the case of ABACUS the argument is that Paulson’s view is material because it would change someones perceived value of a security. It moves the standard from the qualities of a security, to how information may effect its perceived value. While an opinion may change the price and even the associated value it changes none of the basic properties of a security, its long term performance nor what it represents. For every investor there are a different set of perfectly reasonable opinions and factors which would change the perceived value of a security. This is the problem with such a standard. After all an investor could want to know what the underwriter or manager thought the likelihood of default was, their view of the economy or any other pieces of information useful in our financial decision making. All these would clearly impact our value perception. A crazier investor may want to know if managers wore blue underwear, because he felt it was lucky. Where do you draw the line? No disclosure would ever be adequate. This is why material information has to be constrained to a securities qualities. (Management knowing that they lose a large contract effects what the security represents and therefore why it is material)

Social Value

The last question, how does trading securities add any social value. After all when you trade on the stock market, trade derivatives, you’re certainly no longer providing capital to companies that need it. So how does this activity create value for anyone.

The answer is liquidity.

When an investor puts capital into a company the expectation is that he will earn something from this investment eventually. This may come in the form of dividends or selling the shares off to someone for more than you invested. The markets provide the necessary function of helping someone sell off their existing investment. If it’s harder to find buyers for your shares and therefore exit your investment you will demand a higher return for committing your money. This means that businesses that the cost of capital for a business is significantly higher and makes growth harder. The markets create liquidity, helping to ensure that someone who puts capital into a business can find a flexible way to exit and be rewarded for their investment. Obviously this in turn relies on the principle that the new buyer of the shares can themselves exit their position. In essence the ability to transfer risk lowers the cost of investing and growing business. Derivatives, bonds, CDOS etc are all instruments used to spread and transfer risk between parties and increase liquidity.

TV, The Internet and the Future of Video(Part 1)

15 Apr

Recently I began consulting at a media/cable/advertising firm trying to introduce new technology into the way we consume traditional TV and TV ads. In my discussions with friends I’ve realized that most people don’t understand many of the business or technological constraints revolving around video. I’ve decided that I would explore some of the basic ideas here and look at what i believe will change in the future.

The Basic Economics

In Cable TV there are four essential parties in a business relationship with one another that allows you to get your weekly allowance of Lost or Gossip Girl. The advertiser (Ford/Coca Cola) , the programming network (Cable:TNT, TBS Broadcast Networks: ABC), the cable operator (Comcast, Cox , Time Warner) and the Consumer (You).

The advertiser buys time during the TV shows you watch in the hopes that any ads seen by viewers will make them buy more of their products, or pay more for their products. Generally the price they pay the networks is related to the number of people the ad will be seen by as well as the type of audience. Younger is generally better than old, and higher income better than low. For any company TV’s appeal is the ability to reach a mass audience. There are approximately 114million TV households in the United States. Few other mediums have the opportunity to reach nearly the entire population of the country.

The programming networks are the guys responsible for creating all the shows us consumers spend their evenings in front of the screen watching. They’re responsible for the reality shows, the dramas and even broadcasting sporting events. Programmers make money in two ways, the first as stated above is by selling advertising. The more popular (I’m not sure popular shows are always better shows), the more they can charge for all the 30 second ads shown during. The second are through something called affiliate fees which is what your local cable operator must pay the network to be allowed to broadcast it. (Sometimes if you pull up the financials of a public programming company, this will fall under ‘distribution revenue’) Networks generally charge some dollar amount per subscriber to the cable operator. The programmers with more popular content generally get away with charging more per person. More on this later.

Cable Operators are in the business of delivering video and nowadays data. After spending millions if not billions of dollars to put wire and fiber into the ground in your neighborhood, Time Warner sells you access to their networks so you can enjoy your TV.  Their primary concerns are the number of subscribers as well as how much each subscriber pays (ARPU: Average Revenue Per User). The more services you sign up for the more the cable company makes. And since a huge amount of the costs were part of actually building the system rather that to pay for operating the service, they’re hoping you max out as much as possible.

The Consumer: If you’re like me you’re just hoping theres something good on TV. You pay the local cable guys a monthly fee so you can watch the shows, maybe see an ad for a car you’re going to buy and if you’re really splurging pay for a cable modem so you have broadband access.

For a very long time the relationships between these four parties were pretty good. Recently however the family of four is finding itself more unhappy with one another. We’ll take a look at why.