It’s Just a Matter of Equity

By GRETCHEN MORGENSON

Published: September 16, 2007

The moribund private equity market stirred a bit last week as Kohlberg Kravis Roberts dredged up some buyers for loans to finance its $22 billion purchase of Alliance Boots, a British drugstore chain. But lingering investor wariness toward private equity maestros and their deals is far from the only problem facing the buyout business. There are graver threats that are, no surprise, the industry’s own making.

This is not just your humble research assistant talking. It is the view of Michael C. Jensen, professor emeritus at the Harvard Business School, leading scholar in finance and management, and the man whom many consider to be the intellectual father of private equity. In other words, a person uniquely qualified to opine on the matter.

“We are going to see bad deals that have been done that are not publicly known as bad deals yet, we will have scandals, reputations will decline and people are going to be left with a bad taste in their mouths,” Mr. Jensen said in an interview last week. “The whole sector will decline.”

Mr. Jensen was elaborating on the trenchant comments he made last month in a forum on private equity convened by the Academy of Management. There, he excoriated private equity titans who sell stock in their companies to the public — a non sequitur in both language and economics, he said — and warned that industry “innovations,” like deal fees that encourage private equity managers to overpay for companies, will destroy value at these firms, not create it.

He also said that private equity managers who sell overvalued company shares to the public, whether in their own entities or in businesses they have bought and are repeddling, are breaching their duties to those buying the stocks.

“The owners who are selling the equity are in effect giving their word to the market that the equity is really worth what it is being priced at,” he said. “But the attitude on Wall Street is that there is no responsibility to the buyers of the equity on the part of the managers who are doing the selling. And that’s a recipe for nonworkability and value destruction.”

Mr. Jensen’s interest in private equity goes back to 1989, when he wrote a seminal article titled “Eclipse of the Public Corporation.” In it he argued that new and more effective organizations were emerging that unified the interests of managers and owners, eliminating value-destroying practices so common at public companies.

These practices, examples of the so-called agency problem, are a product of corporate structures that allow managers — i.e., agents — to feather their own nests at the expense of owners — i.e., investors — whose interests they are supposed to serve.

For years, private equity firms seemed superior to the public company model, Mr. Jensen said. But recent developments, he said, have wiped out many of the advantages in private equity’s original design. Agency problems, precisely what private equity was supposed to eliminate, are cropping up as a result of the disastrous changes made by these firms, Mr. Jensen argues.

Raising permanent capital by issuing stock in a private equity firm is a prime example, because it destroys powerful incentives that kept these firms working hard for their investors, Mr. Jensen said. In traditional form, private equity firms raise capital from investors for a finite period of time, agreeing to pay them back, typically after 3 to 13 years. This not only provides a reasonable time horizon for gauging how well the firms perform, it also contains an implicit threat that if they don’t produce for their partners then they won’t be able to raise additional funds.

“This gives the capital markets a chance to say no,” Mr. Jensen said. “When you liquidate a fund if you don’t have very good returns, you’re going to have a tough time on the next fund. That’s a very, very important constraint that has played a significant role in the success of the private equity model.”

Mr. Jensen also deplores the newfangled fees that private equity firms are levying on their clients. Among the worst? Deal fees that rise in tandem with the size of the buyout, and special dividends that go only to the private equity firm, not its investors.

“Deal fees that are going to pay them to do deals whether they are good or not — now that’s nuts,” Mr. Jensen said. “And this notion of taking special dividends out only for the private equity firm — you can see the conflicts of interest that creates.”

Under the original model, private equity managers got annual management fees, but their biggest payout was supposed to be on the back end, based on the performance of the companies they had operated. But waiting for a back-end payday is not enough for today’s titans. They want their money up front.

“I can predict without a shred of doubt that these fees are going to end up reducing the productivity of the model,” Mr. Jensen said. “And it creates another wedge between the outsiders and insiders, which is very, very serious. People are doing this out of some short-run focus on increasing revenues, and not paying attention to what the strengths of the model are.”

Who cares about the model when there’s a mountain of money to be made?

Short-term thinking like that can do genuine damage, and Mr. Jensen fears such a result. “The sector is going to take a reputational hit of nontrivial proportions,” he said. “Private equity is not going to go away, but it’s going to take a hit.”

A sunny side to this dark view is that public company managers may begin applying parts of the private equity model to their own operations, according to Mr. Jensen.

“In principle, one ought to be able to duplicate virtually every aspect of the private equity model in a public company, except the actual going-private part,” he said. “It’s very difficult, but I think public corporations may begin to think about running themselves in this way.”

Now that’s something to hope for.

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New Worries for Small Banks

By FLOYD NORRIS

Published: August 31, 2007

For America’s small banks, the changing financial landscape of the last decade meant that many opportunities were no longer available. The big national banks went after consumer lending and came to dominate the market for credit cards. Lending to big companies had long since migrated away from local banks.

What was left? Real estate. That included home mortgages, of course, but in that business there was more and more competition from independent mortgage brokers and from national companies that packaged the loans and sold them to investors. The banks’ share of such mortgage lending was still large, but it was declining.

Still, one part of the real estate picture remained dominated by local financial institutions: lending to local land developers. It was a market where local knowledge mattered.

A result has been a steady increase in commercial real estate loans, particularly loans secured by raw land that a developer plans to build on.

By the middle of this year, 15 percent of the assets of smaller financial institutions in the United States — defined as those with less than $1 billion in assets — were in construction loans, quadruple the proportion a few years ago.

Now, the banks that were most dependent on that strategy are being questioned by investors — in some cases to the irritation of bank executives who say they are being tarred by fallout from lending excesses in which they had no part.

“Everything about Colonial is speculation, and rumor and fear,” Robert E. Lowder, the chief executive of Colonial BancGroup, a bank holding company based in Montgomery, Ala., complained in a conference call this week.

Of Colonial’s $15.5 billion in loans, 42 percent are construction loans. Most are in Florida, where the real estate boom has faltered.

“Everybody’s down on Florida,” Mr. Lowder said. “Everybody thinks Florida is going to fall into the Gulf of Mexico. Trust me, Florida is still a great place to be.”

The chief executive of another bank heavy in construction loans, the Las Vegas-based Community Bancorp, was in New York this week assuring institutional investors that they should not worry. “We’re doing great,” the executive, Edward M. Jamison, said in an interview. “We see a lot of vitality in our markets.”

With home prices falling and mortgage delinquencies rising in many areas, banks now feel a need to prove their loans are safe. Mr. Jamison emphasized that his bank lent to commercial, not residential developments, principally strip malls. Mr. Lowder, whose bank does finance residential developments, said it had avoided speculative projects.

Few construction loans are behind in interest payments, but that fact may be less reassuring than it seems, since many such loans do not require payments until the project is completed.

Bank regulators are at least a little worried. The Federal Deposit Insurance Corporation keeps track of banks that are heavily dependent upon commercial real estate loans — either because construction loans are greater than the capital of the bank or because total commercial real estate loans, including mortgages on commercial properties, are at least three times the bank’s capital. By this June, 37 percent of all banks met one or both criteria, triple the figure of a decade ago.

Early last year, the regulators proposed new rules on such loans, but the watered-down policy that finally came out did little more than to warn that “rising commercial real estate loan concentrations may expose institutions to unanticipated earnings and capital volatility in the advent of adverse changes in commercial real estate markets.”

In the stock market, banks with such concentrations have done a little worse than other banks this year. Short-interest on those stocks is up sharply, a sign that hedge funds think banks will end up owning a lot of vacant real estate, having to pay taxes on land that brings in no income.

Mr. Jamison, the Las Vegas banker, scoffs at such a forecast.

“It would,” he told me, “be almost a perfect storm to have a meltdown in the real estate market.”

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Running an Empire? No Sweat

By JOE NOCERA

Published: August 25, 2007

Richard D. Parsons sat down at a quiet table by a window at Porter House New York, the fine year-old steakhouse on the fourth floor of the Time Warner Building, and looked at his watch. It was 7 p.m. “I’m going to have to leave at 8:30,” he said. “I’ve got another meeting.” He shot me a small, pained shrug. “It’s the middle of August, and I’m still busting my chops.”

We had come to this restaurant, to be blunt about it, to drink Mr. Parsons’s wine. In addition to his day job as chief executive of Time Warner, Mr. Parsons owns a small vineyard in Italy called Il Palazzone, which makes a high- quality Brunello di Montalcino. He acquired his taste for wine, he told me, back when he worked for Nelson Rockefeller.

Porter House’s sommelier, Beth von Benz — clearly no dummy — had the wit to get some of the Il Palazzone Brunello on her wine list. Mr. Parsons has since become a semi-regular and usually orders the Brunello di Montalcino Riserva for his guests, at $185 a bottle. “Our motto is, ‘We drink all we can, and we sell the rest,’ ” he chuckled.

A line like that — funny and low-key and mildly self-mocking — is classic Dick Parsons. True, the winery doesn’t make any money, but the wine is very good. A spokesman for Domaine Select, the importer, said that Mr. Parsons has been “heavily involved with the winery,” an assessment the man himself did not dispute. It’s just that, well, Dick Parsons would prefer that you never see him busting his chops. All his professional life, he’s wanted to be seen as someone who never seems to break a sweat.

Of course, there are plenty of people on Wall Street who believe that Mr. Parsons doesn’t break a sweat — and that’s been the biggest problem in the five years he has been running Time Warner. Why hasn’t he followed the example of his fellow media mogul Rupert Murdoch, scooping up hot Internet companies like MySpace, and buying coveted brands like Dow Jones? Why hasn’t he spun off Time Warner Cable? Why can’t he figure out what to do about AOL? And why, oh, why can’t he get the stock price to rise?

“At the beginning of 2005,” said Richard Greenfield, a media analyst with the independent firm Peri Research, “the stock was at 19. Right now, it’s around 18. When do they start taking shareholder value seriously? They have had long enough to make this thing work.”

There is another view about Mr. Parsons’s tenure as Time Warner’s chief executive, though. According to this view, which is held almost universally within Time Warner, when he first took over the company, he performed nothing short of a miracle, rescuing it from the single worst deal in modern business history, the AOL-Time Warner merger.

In 2002, when he became chief executive, Time Warner stock had dropped so precipitously that the company was in danger of violating its debt covenants. AOL and Time Warner executives were at war. The company was being investigated by the Securities and Exchange Commission and the Justice Department. “It was a mess,” said Don Logan, who was one of Mr. Parsons’s top lieutenants until he retired at the end of 2005. “It needed a calming influence to get it stabilized so that people could get back to running their businesses.” Mr. Parsons is a listener, a persuader, a diplomat — and those qualities made all the difference. To the chagrin of his critics, though, that’s still what he is.

•

It’s a little odd to be in the spot Mr. Parsons is in right now. Not yet 60 years old, he’s getting ready to retire, and everyone knows it. He doesn’t deny it, either. “When you find the right person to take over,” he said, referring to Jeffrey L. Bewkes, his No. 2, “and that person is ready to rock ‘n’ roll, you’ve got to get out of the way.” He added, “I want my legacy to be simple: I left the place in good shape and in good hands.”

I can see his Wall Street critics rolling their eyes. Where is the expansionist drive that fuels competitors like Rupert Murdoch? Where is the fire in the belly? “News Corp. is Rupert’s life’s work,” Mr. Parsons replied calmly. “He inherited a fairly small newspaper operation in Adelaide 50 years ago and has been relentlessly building it into a global media goliath. I think of myself as a professional manager. I am not trying to build a dynasty or create a monument. I know this comment will upset some people, but this is my job. It’s not my life. I don’t define myself by this.”

Sitting across the table from me was his press aide, Edward I. Adler, who didn’t look very happy as Mr. Parsons spoke. He had clearly briefed Mr. Parsons on the talking points he wanted the boss to get across — a list of all the things he had done during his time at the helm: the divisions he had sold ahead of the crowd, like Warner Music; the way he had deftly handled the long-running government investigations (“Now that took some diplomacy,” Mr. Parsons acknowledged); the way he had eased out Stephen M. Case, while ending the culture wars raging within Time Warner. It was a long list, and Mr. Parsons duly recited it, though not, I thought, with any particular passion.

Still, he had to acknowledge that the stock price has been “a huge source of frustration,” and that he hoped it would not be the only prism through which he would be judged. Given the world we live in, however, it seems likely that that rap that he didn’t do enough to “enhance shareholder value” will stick to him. This will be especially true if Mr. Bewkes — more of a money guy by background and inclination than Mr. Parsons — moves to shake up the company and its stock price. In which case, it will probably be right to say that Mr. Parsons was the right man for the first part of his tenure, but maybe not for the latter part. That’s not going to bother Dick Parsons, though. Nothing really bothers him. Or, to put it more precisely, nothing ever rattles him.

Never was this more obvious than a few years ago when the feared investor Carl C. Icahn ran a very public proxy fight, trying to put pressure on Mr. Parsons to break up the company. One thing Mr. Icahn does exceedingly well is get under management’s skin, but that never happened with Mr. Parsons. “I came home one day,” he said with a laugh, “and my wife said, ‘Who’s the guy calling you a moron? That’s my job.’ ”

No matter how many times Mr. Icahn described him as incompetent, Mr. Parsons never took it personally. Instead, he did two things. He ran what amounted to a political campaign, pressing his case with the 600 or 700 institutional investors whose votes most mattered. Secondly, though, instead of giving Mr. Icahn the back of his hand, he embraced him.

“Carl is not stupid and he is not crazy,” Mr. Parsons told me, after he had ordered a second bottle. (Don’t worry: The Times paid.) “And I agreed with him that the company was undervalued. I just didn’t agree with his prescriptions.” So he began to wine and dine Mr. Icahn, hearing him out, and diplomatically devising a solution that allowed his adversary to save face: Mr. Parsons agreed to a huge stock buyback. All the talk of breaking up the company went away.

“I don’t believe it ever serves anyone well to try to crush the other guy or leave him in a position of being humiliated,” Mr. Parsons said. As the well-known mutual fund manager and media investor Mario J. Gabelli put it, “He handled Carl Icahn by saying, ‘Let’s have lunch.’ ”

When I called Mr. Icahn, he denied ever calling Mr. Parsons names. “He lived up to everything,” Mr. Icahn said. “He did the buyback. The stock went up and our fund made a large profit. People thought we gave in, but he agreed to do a lot of things that helped shareholders. I saw it as a victory.” He continues to have occasional dinners with Mr. Parsons and Mr. Bewkes. “I like the guy,” he said.

Mr. Greenfield, the analyst, however, believes that if some new activist hedge fund manager made the same breakup proposal today, it would get a far better reception, because the Street’s patience has largely run out. In the last quarter, for instance, when Time Warner reported that AOL’s advertising growth had suddenly slowed, the stock took a big tumble, reverting back to around $18. (It closed yesterday at $19.01.) The truth is, though, that Mr. Parsons is in his victory lap, and the Street’s frustration notwithstanding, there is a real sense among Time Warner executives and even board members that Mr. Parsons’s work in those first critical years as chief executive has earned him some slack.

It was around 8:45 when Mr. Parsons got up to leave our dinner. Though already late, he seemed a little reluctant to leave. “We haven’t talked enough about wine,” he said. “Do you know what I like about that?” he asked, pointing to the empty Brunello bottle on the table. “Some time ago, those were grapes. We picked them, we fermented them, we bottled them. There is something to show for your effort. We have a product.”

Rumors abound about what Mr. Parsons will do when he leaves Time Warner, the loudest being that he will run for mayor of New York, something he staunchly denies. But I can guarantee he’ll be spending more time at his winery — and doing all the other things he enjoys doing. He’ll live well.

When I was talking to Mr. Icahn the next day, I asked if he had ever drunk any of Mr. Parsons’s wine. Carl Icahn is more than a decade older than Dick Parsons, but he is never going to retire: he remains as maniacally focused on doing deals and making money as ever. Unlike Mr. Parsons, his work really is what he lives for.

“I don’t know,” Mr. Icahn replied. “I guess so. He chooses the wine.” He paused a minute. “Wine really isn’t my thing,” he said.

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Funds Stopped Playing Before the Game Got Ugly

By GRETCHEN MORGENSON

Published: August 19, 2007

TAKE-TWO INTERACTIVE SOFTWARE, the maker of Grand Theft Auto, the shoot-’em-up video game, disclosed last week that it had received a Wells notice on Aug. 9 from the Securities and Exchange Commission, alerting the company to a possible enforcement action.

Take-Two said the notice relates to long-ago option grants that have been under scrutiny for months by the S.E.C. and Robert M. Morgenthau, the district attorney in Manhattan. Three former Take-Two executives pleaded guilty this year to falsifying records related to the options, a result of the investigation by Mr. Morgenthau’s office, which continues.

Well-timed option grants to executives have been a focus of investigators and journalists for the last year or so. But other, more recent developments at Take-Two are noteworthy: the recent selling by some big hedge funds that only last March got together to install new management at the company, and the suspicious trading just ahead of the company’s early August announcement that it could not deliver the newest version of Grand Theft Auto to stores this October.

The delay of the wildly awaited game has certainly hurt Take-Two. Throughout the year, its management repeatedly promised investors that the game would be delivered on time. It did so in April, in June and again on July 9.

But on Aug. 2, the story suddenly changed. Grand Theft Auto IV would be delayed until the second quarter of 2008 because extra development time was required, the company said after the close of trading. Take-Two’s stock fell 16 percent the next day and has declined further. It closed on Friday at $12.25, down 31 percent on the year.

Trading patterns, however, indicate that somebody may have known about the bad news ahead of time. Heavy sellers on Aug. 1 took Take-Two’s shares down almost 5 percent on more than double this year’s average daily trading volume. It was the heaviest trading in the company’s shares since the second-quarter earnings report.

ON an Aug. 2 conference call with investors to discuss the game’s delay, Strauss Zelnick, Take-Two’s chairman, said when asked about the suspicious trading that because the company is so closely watched and its game so anticipated, some leaks are normal. “Leaks aren’t wonderful,” he added. “Having said that, it’s not really the focus of our attention.”

Mr. Zelnick is right. It really is more of a regulator’s issue.

Perhaps more intriguing is the recent dumping of Take-Two shares by SAC Capital Advisors, run by Steven A. Cohen, and the Tudor Investment Corporation, overseen by Paul Tudor Jones. Documents filed by the two funds last week with the S.E.C. report sales they made in the second quarter of 2007. Both funds were involved in a boardroom coup that ousted Take-Two management and directors last spring, but they seem to be abandoning the very management and board they put in place.

Let’s go back to March 20, when Take-Two shares hit a high of $23.79. That was just three days before the annual shareholder meeting at which the company’s management and board were booted.

The removal was the work of three big hedge funds and one mutual fund that got together March 4 with the goal of bringing in a new broom to clean up the troubled Take-Two.

In the effort, SAC Capital and affiliates, which had amassed a 15.6 percent stake in Take-Two, much of it in January and February, and Tudor Investment and affiliates, with 18.7 percent, were joined by D. E. Shaw, a hedge fund, with 9 percent, and OppenheimerFunds, a longtime Take-Two investor, with 23.7 percent.

The foursome reported their collaboration to the S.E.C., as required, and on March 7, they said Mr. Zelnick, chief executive of ZelnickMedia, would lead the cleanup crew. Mr. Zelnick had run BMG Entertainment, the global music label, and 20th Century Fox, the movie studio. Since the funds controlled so many Take-Two shares, Mr. Zelnick was a shoo-in at the annual shareholder meeting on March 23.

Oddly, on April 2, shortly after the group put its new executive and directors in place, it disbanded. Usually, investors who install executives and board members stick around to watch them increase the values of their stakes.

Not SAC and Tudor. By June 30, SAC had dumped almost all its shares; only 10,300 shares remained, worth $123,000. In the same period, Tudor sold almost half its stake, leaving it with 1.9 million shares, valued at around $23 million. D. E. Shaw has not filed for the quarter; Oppenheimer still has a very large stake.

Had the funds gotten wind of problems with Grand Theft Auto IV when they dumped the huge stakes they had only recently amassed? Interestingly, while these professionals were selling their shares, takeover rumors regularly buoyed the stock.

Edward Nebb, a spokesman for Take-Two and Mr. Zelnick, said the funds could not have known because top management discovered only on Aug. 1 that the game was not ready. It told the public the next day. “The process of developing a game such as Grand Theft Auto IV is extremely complex,” Mr. Nebb said. “At some point, management had to make a decision to either ship a game that was not up to the Grand Theft Auto standards or to delay the launch until it was. And that point occurred immediately prior to the public disclosure on Aug. 2.”

So why did SAC and Tudor get out so quickly after they drafted Mr. Zelnick? Representatives for the funds and for D. E. Shaw declined to comment.

Then there is the timing of a recent grant to Mr. Zelnick. Under the terms of a management agreement made in March, he was to receive a large stock option grant at an unspecified date between June and late August. The grant was to be made at the prevailing market price.

The significant drop in Take-Two’s shares since the agreement was struck makes its grant date interesting. Had Take-Two given Mr. Zelnick his options in July, for example, they would have carried a strike price of around $20 a share, well above recent levels. But under an amended agreement made July 26, the stock option grant owed to Mr. Zelnick will now be struck on Aug. 27, reflecting the depressed prices related to the Grand Theft Auto IV delay.

The date is certainly within the time frame of the original agreement. But given that the amendment came on July 26, less than a week before Take-Two disclosed the game’s production delay, one wonders about the timing.

MR. NEBB said the board considered the date to be prudent.

“ZelnickMedia employees did not participate in the board of directors’ decision regarding the date of the option. Independent members of the board made the decision to set the date and announce it well in advance, and they chose Aug. 27, 2007,” he said.

Now Mr. Zelnick must deal with the disappointment of a delayed game and the missed revenue it would have produced in the latter part of the year.

Still, he is doing what he can to calm investors.

On Aug. 9, the day Take-Two received the Wells notice, Mr. Zelnick and other company officials were meeting with investors at an invitation-only event in Beaver Creek, Colo. The event, sponsored by Janco Partners, a brokerage firm in Greenwood Village, Colo., that has been a big bull on Take-Two’s shares, included a reception and dinner and, the next morning, a 45-mile bicycle trip to the Vail pass with Andy Hampsten, a former professional cyclist.

At least that pesky Wells notice didn’t ruin the fun.

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Markets Quake, and a ‘Neutral’ Strategy Slips

By JOE NOCERA

Published: August 18, 2007

“We have to atone to our clients, but we have no right to whine for ourselves,” said Clifford Asness, the co-founder of AQR Capital Management, a money management firm that has been much in the news recently. “When we succeed, we make a boatload of money, we get imitators, and our risk increases. That’s how capitalism works.”

We were speaking on Thursday, a week after one of the lousiest market days of his life. Along with James Simons of Renaissance Technologies and David Shaw of D. E. Shaw, Mr. Asness is one of the leading practitioners of what is called quantitative investing, using computer models to buy and sell thousands of stocks (and bonds and derivatives and commodities and currencies and country indexes and just about anything else that can be traded). Mr. Simons, Mr. Shaw and Mr. Asness, in particular, use these quant models to run what are called in the business “market neutral” hedge funds, meaning that their gains (or losses) are not dependent on whether the market goes up or down.

AQR has about $37 billion under management, with $27 billion of that in plain vanilla equity funds. The rest is invested in its quant hedge funds, its best-known operations. Indeed, over the last seven years, AQR’s flagship hedge fund has been up, on average, 13.7 percent a year, after fees, handily outperforming the Standard &Poor’s 500, which gained only 1.9 percent annualized during that time.

Mr. Asness himself is known for being ridiculously smart, highly engaging, and funny, with more one-liners than Henny Youngman. I got to know him, and to like him, a few years ago, when I wrote about him for The New York Times Magazine. He can get a little full of himself, but most of the time he can be brought back to earth with a small, friendly jab. In other words, he’s the rare hedge fund manager you’d like to have a beer with.

Anyway, back to that awful Thursday. As you may recall, the market ended Aug. 9 down more than 380 points. That kind of day isn’t fun for anybody, but it was an especially brutal day for firms that are supposed to be indifferent to market ups and downs — namely, quant funds like those run by Mr. Asness and his partners. What made it especially painful is that their troubles on Thursday really had nothing to do with the market’s fall.

In the days leading up to Thursday, Mr. Asness’s fund — and most other quant funds — had gotten clobbered. When the AQR flagship fund opened for business on Friday, Aug. 10, it was down 13 percent for August. Mr. Simons’s famed Medallion fund, which has rarely had a down month during nearly two decades of incredible performance, lost 8.7 percent in early August. By mid-August, Goldman Sachs’s flagship Global Alpha fund was down 26 percent for the year. Everywhere you looked in the little town of Quantsville, it was ugly.

And then, in the blink of an eye, it turned around, at least for the moment. As of today, Mr. Asness’s fund had gained back half of what it lost in the previous two weeks, and was at break-even for the year. I hear through the grapevine that Mr. Simons has already made back every penny Medallion lost in early August. During its conference call earlier in the week, Goldman announced that it had rounded up $3 billion for one of its battered hedge funds; I’ll bet a steak dinner that that fund has seen some gains this week as well.

All of which poses some big questions: What really happened during the Great Quant Meltdown of early August? More to the point, should it scare us or reassure us?

•

Let’s be honest here. You hear the words “quant fund meltdown,” and one firm comes to mind: Long-Term Capital Management.

Back in 1998, that now infamous quant fund really did melt down, not only liquidating, but shaking the entire global financial system. Long-Term used complex computer models that failed to anticipate some severe once-in-a-lifetime market events, and it was shockingly leveraged — it was using $100 of borrowed money for every dollar of its own capital — which magnified its losses. It was also run by some of the smartest people on Wall Street. “When Geniuses Fail” was the apt title to Roger Lowenstein’s fine book about that fiasco.

Ever since, whenever quant funds stumble, it’s “When Geniuses Fail Redux.” Wall Street wags begin to wonder if those losses will lead to something truly cataclysmic, while newspaper reporters take a certain undisguised glee in reporting on really smart people losing money. Even now, there’s enough Luddite schadenfreude in the air that rumors continue to circulate that AQR is continuing to absorb substantial losses — which is the exact opposite of the truth, Mr. Asness says.

What is scary in this case is not that the quant funds were the initial source of a ripple effect on the rest of the market; they weren’t. The quant funds were the recipients of a ripple that began in a corner of the market that they had little to do with —namely, the subprime mortgage crisis. It’s the way the subprime contagion shook the quants, whose subsequent downturn then added to the ripple effect, that’s what is nervous-making.

Mr. Asness’s hedge fund offers a case in point. Does his fund deal with the subprime business? Not in any significant way. Rather, the securities that cost AQR so much money were good old-fashioned equities.

To oversimplify (sorry: you can’t explain this stuff without oversimplifying), AQR’s market neutral funds use computers to sort through a set of complex but common-sensical criteria to identify all sorts of assets — including stocks — that it believes are undervalued but gaining some momentum, which means that both price and fundamentals are improving. It buys, literally, thousands of those stocks. Then it seeks out stocks it believes are overvalued and starting to lose momentum. It shorts those stocks. What makes the fund “market neutral” is that it always tries to have the same amount long as short. Mr. Asness likes to say that it’s not really rocket science but intuitive investing; the computers mainly allow him to do it across thousands of stocks at the same time.

Mr. Asness does not suggest that he is going to be on the winning side of every trade. Not even close. Nor does Mr. Asness suggest that his strategy is risk-free. It’s not. “If you don’t take any risk, you won’t make any money,” he said. Even when things are going swimmingly, he’s going to have almost as many losing trades as winning ones. But over time the winning trades will add to better-than-average gains. In a down market, he hopes that his shorts will fall more than his longs, and in an up market, he wants the longs to rise more than the shorts.

As for risk, he adds leverage to bolster returns; indeed using borrowed money to calibrate risk is a major part of his strategy. But it’s not crazy stuff like Long-Term Capital Management, and it would be hard to argue with his results over time.

What happened in August is something that happens to every investor at times, even Warren E. Buffett: his strategy stopped working. So did Mr. Simons’s strategy and that of all the other quants. Mr. Asness’s trades weren’t just a little off — they were hugely off. The undervalued stocks he was buying were dropping steeply, but he wasn’t getting any help from the short side of his portfolio. Several “quants” I spoke to — market veterans who had been through the 1987 market crash and the 1998 Long-Term Capital disaster — told me they had never seen anything quite like it.

Why did it happen? In the immortal words of the market sage, James Grant, “On Wall Street, every good idea is driven into the ground like a tomato stake.” Quant investing, as practiced by the likes of Mr. Asness, Mr. Simons and others, has been enormously successful. And anything that’s successful on Wall Street is invariably going to be copied by others. That is exactly what’s happened in many cases at firms that did other things besides quant investing — like trading in derivatives built around subprime loans.

As these subprime instruments have cratered, investors have lost faith not just in them but in other credit derivatives. The holders of these securities had to meet margin calls and make other payments. So they had to start selling more liquid securities like, well, the kind of easily traded securities held in their quant equity portfolios, like Microsoft or I.B.M. or General Electric. And as they sold, other quant shops, like AQR, which held many of the same stocks, saw huge drops instead of small gains. Is it any wonder traders are calling this a contagion?

One line making the rounds on Wall Street is that the events of last week show that, just as with Long-Term Capital Management, the quants’ models didn’t work — that bloodless computers simply can’t anticipate events outside the norm. That line drives Mr. Asness bonkers. “In theory, what just happened is impossible, so if we stuck to the theory, we’d be dead,” he said. “We know this stuff happens.” Once they realized the magnitude, he and his partners quickly began a mild “deleveraging” to protect against even bigger losses. Eventually, AQR started buying cheap stock again — which had become even cheaper thanks to the short-term panic.

In the view of several big-time quants I spoke to, their big mistake was in not realizing that their little corner of Wall Street had become so crowded with imitators — and that when others were forced to sell, they were going to get hurt. Now they are all trying to figure out how to factor that into their thinking for the future — Mr. Asness very much included. “We have a new risk factor in our world,” he said.

So how should the rest of us feel about what just happened? Even though the worst seems to be over, I still think we should still be worried. But not because computer-driven quant funds took a tumble. That’s a symptom, not a cause. The larger issue is the contagion itself — the fact that something so out of left field, like subprime, could wind up hurting the quants.

Richard Bookstaber, a former quant manager, has recently written a book, called “A Demon of Our Own Design” (Wiley, 2007), which has become a small sensation on Wall Street. In it, he argues that the proliferation of complex financial products like derivatives, combined with use of leverage to bolster returns, will inevitably mean that there will be a regular stream of market contagions like the one we’re having now — one of which, someday, could be calamitous. To him, last week’s quant crisis is a classic case in point. “I think crises become inevitable when you have a financial structure like ours,” he said. “How deep or how frequent they are, I wouldn’t want to predict.” Well, who would?

So yes, it really is a scary world out there. But quants like Mr. Asness aren’t the reason.

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Floyd Norris: Notions on High and Low Finance

With Markets Moving Wildly, Insight Suffers

By FLOYD NORRIS

Published: August 17, 2007

Twenty-first-century financial markets react with lightning speed to events halfway around the world. Investors in China can immediately see what happened in New York and make trades in London based on the news.

So why is the credit panic of 2007 being played out in slow motion?

One reason is that those involved have never seen anything like this before. Information may arrive instantly, but insight takes longer.

It seemed unlikely, if not absurd, that the American economy and credit system could be shaken because a few people with poor credit fell behind on their mortgages. Why should that slow consumer spending? Why should it affect companies that made mortgage loans only to people with good credit? Why should it bring a halt to the leveraged buyout boom?

Perhaps none of those things should happen. But fears that they may take place have sent the stock market on a wild ride over the last month, culminating yesterday with the Dow Jones industrial average falling more than 300 points before gaining nearly all of them back in the final hour of trading, amid speculation that the Federal Reserve would find a way to keep troubled financial companies from failing. Not long ago — four weeks, to be exact — Larry A. Goldstone, the president of Thornburg Mortgage, a real estate investment trust, was feeling good. He had seen the subprime mortgage disaster unfold, and believed it was good for his company.

“The current credit crisis is the market environment today,” he said in a conference call on July 20, as the stock rose above $27. “The liquidity issues in the marketplace are creating a very, very nice opportunity for us. This is not a big surprise to us.”

The way he saw it, the crisis was shaking out his competitors, the ones who had made those imprudent loans. With them gone, he could make more money.

Within days, he bought 10,000 shares. The chairman and chief executive, Garrett Thornburg, invested almost $13 million in company stock. Four other insiders, including the chief financial officer, were also buyers.

But last week, things got dicey. Thornburg Mortgage owned a lot of AAA-rated mortgage securities, and had borrowed up to 95 percent of their value. Now the lenders, suspecting the securities were worth less, wanted more cash. To get it, Thornburg had to sell securities, and few wanted to buy. Suddenly the commercial paper market, so willing to lend to Thornburg at small margins just weeks before, was not interested in lending even at much higher rates.

As for the share price, it went into a free fall on Tuesday, amid rumors that the company could not meet its obligation. Trading was halted with the stock under $8. On Tuesday night, it conceded it was having trouble raising money to finance mortgages. It said the dividend it had promised to pay on Wednesday would be delayed by a month.

But it insisted that it was not bankrupt. Even marking down the value of its assets to current market value, it said, it was worth $14.28 a share on Monday, down from $19.38 at the end of June.

That provided some reassurance, and since then the shares have climbed back above $12.

Thornburg has prospered until now with a fairly simple formula. Organized as a REIT, it paid big dividends representing all of its taxable income. It grew by issuing more shares, which it could sell at prices above its book value because individual investors valued the high yield. The shares wound up in a lot of retirement accounts, and the fact that people paid more than book value enabled the book value per share to grow.

The insiders profited hugely from that. The company gets away with not disclosing how much the bosses are paid because it is managed by a separate company owned by some of the bosses. That management company gets incentive fees based on the company’s total book value and profits, a formula that would seem familiar to a hedge fund manager. Effectively, the bosses get a cut every time the company sells new stock, and keep getting cuts from those sales every year.

Now Thornburg, like many other companies, needs a quick unfreezing of the credit markets. But even if they get it — if the Fed tells banks to rescue them with emergency loans — many may find that they cannot safely operate with such high leverage. And without the leverage, profits will be harder to make even if Thornburg can charge more for mortgage loans.

The unfortunate series of events that got us here — remember the proverb in which a kingdom is lost for want of a nail — began with a weakening housing market. That caused some mortgages to go into default, which raised questions about the value of mortgage securities and the credibility of the ratings that enabled the securities to be sold.

That led to the questioning of other types of loans that had been financed by selling packages of securities that were structures in similar ways to ones that had financed the mortgages. It became more difficult for companies to borrow. Now it seems to be spilling over to the real economy, with consumers getting nervous.

“We are going through a psychological event,” Mr. Goldstone said. “It has everybody in a panic. There is nothing fundamental here.”

He may be wrong about that last part. There may not have been a fundamental change in the health of his business, but such a change is taking place in the credit markets. There, buyers with available cash are few, and many of them are in no hurry to buy when so many need to sell.

It is sort of like a game of musical chairs in which the music stops and it turns out that all the chairs have vanished.

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Mortgage Mania Didn’t Grip Everyone

By GRETCHEN MORGENSON

Published: August 5, 2007

THE seized-up United States mortgage market claimed more victims both here and abroad last week. The American Home Mortgage Investment Corporation, once a big lender, closed its doors, laying off more than 6,000 workers. In Germany, IKB Deutsche Industriebank received a $4.8 billion bailout from a government-owned group that said it would cover potential subprime losses at the bank.

In a report last week, Charles Peabody, an analyst at Portales Partners, an independent research firm in New York, characterized the state of the mortgage market this way: “Investors finally realized that there is such a thing as a bad mortgage loan. As a matter of fact, there is such a thing as a whole bunch of bad mortgage loans.”

As a result, Mr. Peabody noted, investors are no longer interested in most of the risky loans that mortgage bankers have been creating lately. Bankers can sell only the highest-grade pieces of those wonderful securities pools that were so popular among investors until about five minutes ago.

That gives two choices — neither one felicitous — to the bankers who originated the low-grade loans. They can either sell them at a loss, reflecting the market’s view of such debt, or hold them on their own balance sheets and watch them decline in value.

It is never pretty, watching a mania come undone. Unless you are one of the folks who never bought into the madness in the first place.

Michael A. J. Farrell, chief executive of Annaly Capital Management, a high-grade mortgage real estate investment trust, is one such man. And with a perspective on the residential mortgage and credit markets extending back to the 1970s, he is an excellent person to consult on what is likely to happen next.

Annaly is an investment management company that oversees a portfolio of strictly high-grade assets. The company invests solely in mortgages backed by government-sponsored entities like Fannie Mae, Freddie Mac and Ginnie Mae. Investors understand that it has little exposure to the current credit crunch and have bid up its shares almost 8 percent this year. The shares also pay a generous dividend of 6.4 percent at current prices.

For his conservative approach, Mr. Farrell confirms that for about two years beginning in 2003, he took plenty of abuse from more aggressive counterparts in the industry and from potential investors who urged him to buy lower-quality assets for their greater returns. Some of those ridiculing Mr. Farrell were the same people who jeered at investors who did not get the new paradigm, espoused in 1999, that any-Internet-company-is-a-good-Internet-company.

“I definitely took heat not only in my professional life but in my personal life,” Mr. Farrell said. “I had people stop me on the street while I was walking my dog saying, ‘Where is your dividend going?’ ”

During the crazy years, Mr. Farrell and his team decided against increasing the size of Annaly’s balance sheet. Investors willing to throw money into anything mortgage scoffed when the company turned them down. “We decided to withdraw from the market until the end of 2005, when we thought investment risk was being recognized by the market,” he said.

Mortgage real estate investment trusts came public like weeds during the boom, of course. But the strategies they use can vary widely. Some originate mortgages — New Century did, for example — and others buy mortgage loans in the secondary market, whether risky or not.

Most mortgage REITs do a bit of everything, explained Jeremy Diamond, a managing director at Annaly. As a result, investors in these companies must rely on their managers to put the right emphasis on credit risk and interest rate risk at different periods in a business cycle.

But because Annaly shuns credit risk, its investors are trusting its managers to bet appropriately on interest rate risk only. In this they are also conservative, holding assets with a duration of six months to two years. They also have one-third of their portfolio in fixed-rate assets, with the rest in adjustable- and floating-rate assets; this allows the portfolio to work well whether rates decline or rise.

“There is no official Annaly interest rate forecast,” Mr. Diamond said. “We manage the portfolio with no significant directional bias because we could be wrong.”

Annaly’s biggest challenge comes when rates plunge, as they did in 2004, pushing mortgage holders to refinance. But it has reduced its exposure to refinancing risk in recent months by raising about $2.5 billion in capital and reducing the premium-priced mortgages in its portfolio. While the company paid an average of $102.50 per $100 worth of bonds in its portfolio in 2003, its average is now $100.50.

When the mortgage market started to regain some of its sense in 2006, Annaly began raising money from investors. It made two stock offerings in 2006 and two more this year. Each time, the deals carried a higher price tag, reflecting investors’ appreciation of Annaly’s conservative business model. Even those who bought into the company’s most recent offering last month — at $14 a share — are ahead. Annaly’s shares closed Friday at $14.98.

Mr. Farrell and other Annaly executives also align themselves with their investors by not taking performance fees as most REITs do. Instead, the executives’ compensation, just 0.12 percent of assets under management, comes out of the company’s revenues.

So what does Mr. Farrell, who has been through at least three mortgage market seizures in his career, see on the horizon for the credit markets? More of the same turmoil, alas.

“I look at this sort of like 1990 and 1991,” he said, referring to the savings-and-loan crisis. “Against that background you had a $7 trillion economy that gave birth to the $300 billion Resolution Trust Corp. Now we have an $11 trillion economy and we’ve already seen $2 trillion of market capitalization going away” before many loans in the pools have actually defaulted, he said.

WHAT about the people who argue that the impact of the mortgage mess will be muted because risks have been spread well beyond the banks and into many parts of the financial world? Mr. Farrell takes the opposite view. Spreading the risk beyond the banking system will make the task of fixing the mess much harder.

“Even if the Fed eases, it is probably not going to help the housing market,” he said. “This repair cycle is going to take a lot longer because it is not concentrated in the banking system like it was in the 1990s. Back then, they could repair the banking system by dropping interest rates. Now they can’t bail out rich hedge fund guys in Greenwich.”

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Summer School for Investors Is in Session

By GRETCHEN MORGENSON

Published: July 29, 2007

It’s still summer but as the financial markets declared last week, back-to-school season for United States investors has arrived.

With the equity markets off sharply for the week and the credit markets seizing, investors are being forced to relearn some of the basics forgotten during the private-equity, easy-credit, corporate-buyout boom of recent years.

Our lessons for today:

HIGH GRADE DOES NOT NECESSARILY MEAN HIGH QUALITY Wall Street’s ability to spin straw into gold rivals that of Rumpelstiltskin, to be sure. But that doesn’t mean investors should buy it. They did with gusto, however, as the subprime mortgage mess starkly shows.

WHAT LOOKS LIKE A DUCK MAY NOT QUACK LIKE A DUCK In the burgeoning world of financial derivatives, where mortgage traders and investors play, a security’s structure — especially its use of collateral to cushion buyers from losses — can earn it a blessing from rating agencies. But that structure may not be enough to withstand a credit shock like the one now gathering momentum, which threatens even the higher-grade market for mortgages. These structures look even shakier when the collateral cushion is, as is often the case, risky bonds — not cash.

DON’T SWIM IN THE DEEP END OF THE POOL Investment pools known as collateralized debt obligations have been all the rage, and many of them contain oodles of mortgage-backed securities. (Derivatives of derivatives, in other words.) As Josh Rosner, an expert on mortgage securities at Graham Fisher in New York noted in a research piece last week, the leverage used to put such securities pools together can amplify losses. For example, a 4 percent loss in a mortgage-backed security held by collateralized debt obligations can turn into almost a 40 percent loss to the holder of the C.D.O. itself.

LOSSES CAN BECOME VIRAL Lang Gibson, a Merrill Lynch analyst, characterized the potential for losses in C.D.O. pools in a recent report. After Standard & Poor’s notified investors that it had raised its loss forecast to 11 percent to 14 percent for subprime mortgages made in 2006 (the previous estimates had been 6 percent to 8 percent), Mr. Gibson said that such a rate would put most classes of asset-backed C.D.O.’s at risk of principal loss. The only class not at risk in such a scenario is the highest-ranked securities. But the junior AAA-rated classes, as well as those rated AA, A or BBB, are all at risk as well, he said.

Investors bought into the myth of highly rated securities even though their generous yields should have alerted them to risks. We have not yet seen the downgrades of collateralized debt obligations, because they typically don’t occur until loans in the underlying securities are close to default. But we will.

EARNINGS ACTUALLY HAVE TO BE EARNED Corporate profits are healthy, but that doesn’t mean stock prices can’t drop. As stocks raced to new highs this year, many investors felt their prices were justified by robust corporate earnings. They were only partly right. Other powerful forces were at work as well: corporate buybacks and mergers, both of which require access to E-Z credit. For instance, the Standard & Poor’s Index Services Group estimated that almost $118 billion was spent on stock buybacks during the first quarter of 2007, up 17.5 percent from the $100 billion registered during the first quarter of 2006.

In the first quarter, S.& P. said, 101 companies reduced their actual share count by at least 4 percent, while 72 cut their average diluted shares, used to determine earnings per share, by at least 4 percent. That means that at least 4 percent of the growth at those companies came from share count reductions, not operating earnings.

The S.& P. data also show that information technology companies were the biggest buyers of their own shares, accounting for almost 23 percent of the total buybacks and 15 percent of the market value of that stock during the first quarter. Consumer goods companies were another major player in the repurchase arena last quarter, accounting for almost 15 percent of stock buybacks and 10 percent of the market value.

Merger frenzy has also contributed mightily to the bull market. According to Thomson Financial, $3.1 trillion in deals have been announced so far this year, almost as much as the $3.6 trillion conducted during all of 2006. Many investment banks, including Lehman Brothers and Deutsche Bank, have already advised on more deals, on a dollar basis, than they did during all of last year.

Private equity investors played a major role in this mania. During July, United States private equity investors did $90 billion worth of deals, Thomson reported, the second-highest monthly number on record.

DIVERSIFICATION IS NOT A PANACEA Many investors who bought securities backed by prime mortgage loans made to creditworthy borrowers thought that they would be fine no matter how disastrous subprime loans turned out to be. But as officials at Countrywide Financial confirmed in their quarterly results last week, mortage problems are now firmly in “prime” territory.

“There is no diversification,” declared Steven Eisman, a portfolio manager at FrontPoint Partners, during a July 19 conference call the investment firm sponsored on the subprime mortgage debacle. “If there is a problem with underwriting, there will be problems everywhere. The entire capital structure from equity all the way to AAA can go to nothing.”

Not one to mince words, Mr. Eisman added: “It is going to be many months before this market clears. The freakathon is yet to come.”

EVERY CLOUD HAS A SILVER LINING There are still bright spots in what looks like a very dark market scenario. Shutting off the credit spigot means profit opportunities for investors who were awaiting a return to sanity in the debt markets, especially those looking to pick up damaged goods. And with fewer acquisitions being made, the insider trading that seems to occur ahead of almost every deal will no longer produce easy profits for chiselers.

Finally, the slowdown in the credit market may mean that we will be spared some of the gushing accounts of merger deals and the brilliant stars who make them. Financial engineering is fun and all, and so delightfully lucrative. But reporting on the people who actually run companies is surely of greater value to the world at large.

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Mr. Vranos Has a Deal for You

By GRETCHEN MORGENSON

Published: July 22, 2007
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HEDGE fund managers are not short on chutzpah, as a rule. But it takes a special kind of cheek to ask investors at this very tender moment in the housing market for $750 million to fund a new company specializing in subprime residential mortgage loans.

Michael W. Vranos, celebrity bond trader and founder of Ellington Management, has that audacity. And then some.

Mr. Vranos oversees $5.4 billion in hedge funds and private accounts, and an additional $1.2 billion in a managed account, while also managing almost $23 billion in collateralized debt obligations (pools of loans backed by assets like home loans or credit card debt).

That might be enough to keep others busy. But Mr. Vranos is also peddling shares in a new entity called Ellington Financial LLC. An offering statement, dated July 12, began circulating on Wall Street last week; it is a private placement aimed solely at institutional investors, like pension funds and insurance companies. Friedman Billings Ramsey is the underwriter.

On its face, it may sound like a promising deal for speculators. Subprime loans are in the tank, as everyone knows. Surely there is money to be made picking up distressed properties for pennies on the dollar.

And isn’t Mr. Vranos one of the world’s leading experts on mortgage securities? The Ellington prospectus certainly confirms this. “He was praised during the difficult bear market of 1994 by Jack Welch, chairman of Kidder Peabody’s parent company, General Electric,” it noted, “who said that Mr. Vranos ‘has done a better job than 99 percent of the managers at G.E. at managing a cycle.’ ”

When Mr. Vranos was head of the mortgage securities trading desk at Kidder Peabody back in the early 1990s, Fortune magazine called him “one of the best bond traders on Wall Street,” the filing boasts.

The filing is silent, however, on a near calamity Mr. Vranos had with his fund during the financial crisis of 1998. When Long Term Capital Management imploded that fall, credit markets seized. Three hedge funds run by Mr. Vranos lost about 25 percent of their value but stabilized after he auctioned $2 billion in securities to meet margin calls.

ELLINGTON MANAGEMENT has obviously thrived since then. The filing shows that since 2000, Mr. Vranos has handily beaten the fixed-income average, producing double-digit gains in all those years but two.

His performance so far this year is not as stellar. At the end of May, his mortgage-backed credit funds were up 1.8 percent; his “composite” hedge fund return for the period is 3.81 percent.

But is now the time to raise $750 million in permanent capital on a subprime spending spree?

Subprime mortgage loans are certainly far cheaper now than they were just a few months ago. Still, the shakeout in the industry may have only just begun. Last week, major lenders like Washington Mutual and Countrywide Financial said they would no longer offer the most popular subprime loans, those carrying low two- or three-year fixed rates that then reset to much higher levels. As access to those loans is cut off, subprime borrowers will have greater difficulty refinancing billions in mortgages whose rates are shooting up right now. Defaults are likely to rise, even from today’s high levels.

Granted, timing is everything in market matters — and Mr. Vranos certainly has been through his share of up and down cycles.

Yet the timing of Ellington Financial’s hoped-for debut is intriguing because it appears to be a way for Mr. Vranos to unload subprime assets he bought a few months ago at higher prices than they would likely fetch today on investors.

Some $70 million of the offering’s proceeds is expected to go toward buying equity in something called Spyridon Holdings, which owns a real estate investment trust that Mr. Vranos’s management company formed in May 2007. It bought $345 million of the riskiest portions of mortgage pools, known as equity residuals, issued by the New Century Financial Corporation, a subprime lender that declared bankruptcy in April. New Century made the loans from 2003 to 2006, the filing said.

The $70 million earmarked from Ellington Financial’s investors to buy those assets will cover about 40 percent of the roughly $170 million Spyridon put up to buy them — it borrowed the rest. In return, Ellington Financial investors will receive 40 percent of Spyridon.

But what inquiring Ellington investors should want to know is exactly how those New Century residuals are being valued and whether that amount reflects reality or fantasy.

The Ellington prospectus says that the amount to be paid, estimated at $70 million, will be based “on fair market valuations of the New Century residuals provided at the time of purchase by one or more independent third parties.” But Ellington goes on to say that it expects any difference between those valuations and the $345 million purchase price to reflect only whatever cash the assets have distributed to Spyridon since they were bought and “any changes in interest rates over the course of such period.” Some $50 million in cash has been distributed by the New Century residuals, the filing said.

No mention is made about the decline since May in the values of subprime loans over all and in New Century loans in particular. Even the lender’s high-grade paper is taking a hit — last week, Standard & Poor’s downgraded by one notch several AAA-rated New Century securities consisting of second lien assets.

The problem, traders say, is that residual interests in New Century mortgage securities are not trading, so any valuation of the $345 million stake will likely be based on a model, not a true market. Besides, if the assets were such a good trade for Mr. Vranos, investors might be wondering, why is he sharing that largess?

Asked Friday whether the offering is a way to dump poorly performing securities onto investors for a higher-than-market price, Mr. Vranos first said that I should not have obtained a copy of the prospectus because it is a private placement. All he would say about the New Century residuals is: “I don’t know if they’ve declined. I’m not responsible for pricing them — we use third-party pricing. That’s obviously a question that potential limiteds ask all the time. Obviously we have an answer.”

Josh Rosner, an authority on mortgage-backed securities at Graham-Fisher, an independent research firm in New York, looked at the Ellington Financial filing details that I forwarded to him. He said: “If you are exposed to significant losses on a mark-to-market basis, your goal is, within the legal framework, to avoid having to take that mark. One of the ways that people are starting to avoid that is to resecuritize assets and put them into other vehicles at par. I think there is a strong chance that may be what’s happening here.”

So in addition to jettisoning some of the New Century residuals, the transaction with Ellington Financial may allow Mr. Vranos to value those that he owns elsewhere in his financial empire at a higher price than he otherwise could.

Hedge funds are unregulated entities and they want to remain that way. That is fine with me. But transactions like this one seem almost certain to draw scrutiny. And hedge fund managers as smart as Mr. Vranos should know that.

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Subprime, Subpar: For Sale?

By GRETCHEN MORGENSON

Published: July 15, 2007
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NOVASTAR FINANCIAL, a subprime mortgage originator based in Kansas City, Mo., has had its share of setbacks. That’s not surprising, given the carnage in its industry.

What is surprising? NovaStar’s stock has been on a tear lately, rising from $3.80 in February to $7.63, at Friday’s close. Even though the mortgage lending business continues to sink and shrink, NovaStar’s market valuation has risen.

Perhaps that is because, last April, NovaStar said it was seeking “strategic alternatives” — otherwise known as a “lifeline.” The stock is up about 50 percent since then. Some investors may believe a buyout lies ahead. Last week, there were whispers that the MassMutual Corporation, a financial services firm that trades as a closed-end investment company, might put money into NovaStar.

The two companies are already connected. Babson Capital, a money management unit owned by MassMutual, is a big NovaStar shareholder; it owns about 770,000 shares, or 2 percent of the company. Most of those shares were bought in 2006; the average cost to Babson is $27.85 a share.

Another interesting tie: Howard B. Hill, a managing director at Babson since 2005, was a vocal bull on NovaStar for years, posting messages on Yahoo and other stock boards until about the time he joined Babson. Like John P. Mackey, the chief executive of Whole Foods Market, who used Internet chat rooms to promote his point of view, Mr. Hill has been an avid poster on stock message boards.

Unlike Mr. Mackey, Mr. Hill used his last name while posting. He urged investors to buy NovaStar shares, with the stock symbol of NFI, for its dividend. One post that Mr. Hill made on Yahoo was headed “NFI gets positive returns every year.”

Mr. Hill pretty much quit posting messages about NovaStar after he joined Babson. But on June 6, 2006, he wrote on the Yahoo board: “I’m more bullish than I’ve been for more than a year on the group and NFI, but that’s all I can or will say on that.” NovaStar’s shares were at $31.29 that day.

Officials at MassMutual Financial Group and Babson, including Mr. Hill, declined to comment. NovaStar declined to comment as well.

While NovaStar might appear to be a unlikely takeover target, we all know that anything can happen in mergerland. Still, NovaStar’s business is plummeting, and it faces a number of legal challenges. Its monthly loan figures for June, disclosed last Thursday, show total originations of $254 million, down from $1.06 billion for the same period last year. The company generated an average of $12.1 million in loans each day last month; in June 2006, that daily figure was $48.2 million, albeit with one more day in the month.

Delinquencies among the company’s loans, meanwhile, are rocketing. In June, some 12.4 percent of loans in pools less than one year old were more than 30 days delinquent. That’s up from 5.2 percent at the end of 2006.

Furthermore, NovaStar has problems that other lenders don’t. On June 27, for example, the company lost a lawsuit in California that will require it and two other lenders to pay $46 million. A jury ruled in favor of American Interbanc and its contention that NovaStar Home Mortgage Inc., a subsidiary, used bait-and-switch practices in its mortgage-quote Web site. (NovaStar shut down its subsidiary in mid-2006.) Lanny J. Davis, a lawyer at Orrick, Herrington & Sutcliffe who represents NovaStar, said the company believes the verdict is incorrect and has sought to have it reversed.

On other legal fronts, the company settled a class-action suit in Washington State on June 27, paying $5 million to some 1,600 borrowers who contended that NovaStar hid loan fees, according to Ari Brown, the lawyer at Bergman & Frockt in Seattle that represented them. A $5 million settlement certainly doesn’t cripple NovaStar, but it may just be the beginning of such suits. While NovaStar had only a small presence in Washington, it generated more loans in California than in any other state. And Mr. Brown has also sued NovaStar on behalf of two California borrowers who contend that its loan carried hidden commissions — meaning that the suit may become a class action there.

THE Washington case was settled to avoid unnecessary legal expenses, Mr. Davis said, “but there was no admission whatsoever that any of the claims made in that case were meritorious.” The company maintains that loan fees were fully disclosed to borrowers and that they did not suffer actual damages because they would have had to pay those fees or more in any event.

“Regarding the California case, we are confident it is utterly baseless, its allegations misstate facts and have no merits, and that the transactions referenced in that case were entirely consistent with California law,” Mr. Davis said.

If MassMutual does indeed invest more in NovaStar, it would be a vote of confidence in the company and in subprime lending. Mr. Hill, the Babson managing director, is, as his online postings show, a fan of NovaStar and its industry. On Jan. 24, he published a report on Babson’s own Web site about subprime mortgage securities. Calling the press coverage of the sector “unrelentingly depressing,” Mr. Hill argued for a more upbeat view.

“We look at the glass as being 90 percent full now, with the potential to drop to only 80 percent,” he wrote. “What we find is that people do not generally lose their homes to foreclosure, even if the mortgage balance is higher than the market price of the house. Basically, if they have jobs, they pay their mortgages.”

That rule of thumb worked in previous periods but seems not to be working now. In the more than six months since Mr. Hill wrote his report, foreclosures have risen significantly, notwithstanding strong employment figures.

Mr. Hill declined to talk with me last week about NovaStar, his postings on the company and Babson’s investment. But in an interview with Bloomberg News on Friday he called coverage of the subprime mortgage meltdown “a bit overblown.”

Certainly NovaStar’s shareholders would love to see MassMutual, or anyone whose money is green, throw them a line. But would it be good for MassMutual’s investors?

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"Subprime, Subpar: For Sale?" >>

A Board That Knows Two Words: No Sale

By GRETCHEN MORGENSON

Published: July 8, 2007
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IT is the kind of takeover bid that shareholders dream of, with a suitor offering a healthy premium and the potential for postmerger success. So why is the target’s board dead set against it?

The bid in question is a nearly $400 million offer that AirTran Holdings, the discount airline with headquarters in Orlando, Fla., is making for the Midwest Air Group, based near Milwaukee. While Midwest’s stockholders are jumping up and down for the deal, its directors have staunchly rejected it. As a result, some Midwest shareholders wonder whether the board is performing its duty to the company’s owners or acting instead to benefit a management with whom it has long been associated.

Timothy E. Hoeksema has been chief executive of Midwest since 1983 and is also chairman of its board.

Some shareholders say their concerns begin with the fact that the Midwest directors refused for six months even to meet with officials of AirTran to hear their proposal. The board has not appointed a special committee to look at the bid. The company also has a poison pill in place to thwart a takeover.

“I don’t think management wants to sell the company at any price to anyone and I think the board has been supporting management,” said Joe Leonard, chief executive and chairman of AirTran. “It has been extremely unusual for the board not to hear what we have to say. We have said we were willing to pay for additional value if they could show that the value is there.”

Last month, at Midwest’s annual meeting, its shareholders rose up, booting out the three Midwest directors up for re-election and replacing them with AirTran’s nominees. Only then did Midwest’s directors agree to sit down with AirTran officials. That meeting will be on July 16.

AirTran said it first approached Midwest with a merger proposal more than four years ago. Rebuffed, it returned in 2005, and again last fall. Confronted with opposition from Midwest’s board, AirTran has raised the price on its most recent bid three times. The offer now stands at $9 in cash and 0.5842 shares of AirTran stock, equal to $15.43 at Friday’s close.

Midwest’s shares closed last week at $14.93. The AirTran deal reflects a 65 percent premium to Midwest’s stock price the day before last fall’s offer was publicized; it is set to expire on Aug. 10.

Before the AirTran offer came along, Midwest’s stock languished in the single digits, reflecting a string of losses at the company. Midwest was not alone in its difficulties — most airlines have shown losses in recent years. The company turned a $5.4 million profit in 2006.

AirTran says the merger would result in increased departures for the combined airline, an expansion of Midwest’s hubs and new markets. It would also bring 1,100 new jobs to Milwaukee, Midwest’s main hub.

But Midwest says the merger is not in the best interests of the company’s shareholders or the employees because it does not reflect the value of a strategic plan recently put in place by Midwest’s management.

“The board spent a lot of time and resources evaluating the AirTran offer and consistently concluded that it underrepresents the long-term value of the company,” said Carol N. Skornicka, Midwest’s general counsel and secretary. “The offer was so substantially inadequate the board did not engage in negotiations.” Ms. Skornicka declined to make Midwest directors available for interviews.

But Mr. Leonard said he is not persuaded that the Midwest board has responded properly to the offer. “In a normal merger-and-acquisition transaction, the board would appoint a special committee of independent directors,” he said. “They referred it to the governance committee. It has nothing to do with M. & A., but it does have as chairman Dave Treitel, who has been advising the company for a number of years.”

Mr. Treitel, a Midwest director since 1984, is chief executive of Simat Helliesen & Eicher, an aviation consulting firm that has worked for Midwest in recent years.

Midwest shareholders certainly seem fed up with the nine-member board. More than two-thirds of the votes at the annual meeting were cast against the Midwest directors who were up for re-election. With the exception of a new board member in 2006, there had not been a board change at Midwest since 1997. The new directors nominated by AirTran are not affiliated with it.

More Midwest directors might have lost their seats in the recent election if not for the fact that membership on the company’s board is staggered, meaning that only a few directors stand for election each year. In general, shareholders do not like the staggered terms for directors because that makes it difficult to oust an entire board that is seen as not performing.

Midwest’s outside shareholders have also resoundingly supported a tender offer for the company’s stock that AirTran started earlier this year. Almost two-thirds of the shares held by outside investors have been tendered.

Still, regardless of the shareholders’ support for the offer, a merger cannot happen without the board’s approval, Ms. Skornicka said. “Under Wisconsin law a board can consider other stakeholders, it can consider the interests of customers as well as employees,” she said. “While those things are difficult to quantify, they can impact the decision of the board.”

By agreeing to hear the AirTran proposal later this month, Midwest’s directors are by no means expressing an interest in negotiating, she said.

Mr. Hoeksema is undoubtedly less than eager to sell the company because he might lose his job as chief executive, a post that earned him $1.25 million in 2006. Mr. Hoeksema would also not receive an enormous windfall if Midwest changed hands — possibly giving him more of an incentive to hang on to his job so he can keep drawing a paycheck.

Documents show that if a change in control had occurred last December, Mr. Hoeksema would have received $2.6 million from a key executive employment agreement. Based on current prices, he would also get roughly $3.6 million when options and restricted stock vested as a result of a deal done around $15 a share. Not bad, but it is a far cry from the tens of millions and more that many other chief executives have received when their companies were sold.

Ms. Skornicka said Mr. Hoeksema’s relatively small payout in a merger reflected the modest compensation paid by the company in line with its industry and size. She said the payout played no role in the board’s response to the deal.

It will be interesting to see how Midwest’s newly configured board responds to AirTran’s offer.

“The shareholders who tendered their shares are saying, ‘I want you, the Midwest board, to remove the obstacles so I can get my money,’ ” Mr. Leonard said. “The shareholders didn’t vote out of ignorance. They’ve seen our plan, they’ve seen the Midwest plan and they knew what they were voting for when they tendered their shares.”

Certainly Midwest’s shareholders have spoken, and plainly. Now it becomes a matter of whether the Midwest board is listening.

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"A Board That Knows Two Words: No Sale" >>