Ponzi finance and asset values…

When the present phase of the stock market is written, we believe it will be referred to as ‘the era of projected inflation’ … the period when enthusiasm for future profits obscured actual earnings to an excessive degree. We are on the way towards the age of reason of several years ago when stocks had to show substantial earnings power, reasonable book value, and dividend returns comparable to the cost of carry.

Barr, Cohen, and Co, October 21, 1929

Rainbow’s End: The Great Crash of 1929, Maury Klein

The financial instability hypothesis, therefore, is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated…

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell  assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.

Hyman Minsky

Ponzi finance is happening in the rig market. And it is certainly the form of finance that McDermott got from Goldman’s (yielding over 14% today and essentially locking MDR out any future financing). This never ends well.

When this goes wrong it goes really wrong because unlike equity people thought they were getting their money back for 100c in the dollar. Banks in particular. When these rig and asset deals go wrong, and the banks shut down the loans books, and indeed contract the asset side of the balance sheet to compensate for the lost equity, things will really get tough in the financing market and force restructurings and supply side contraction.

A very small number of companies have been buying “assets” at inflated prices, cheered on by self-serving analysts, at rates that bear no relationship to their ability to generate cash. Some banks appear to be  lending against these nominal asset values when the underlying entities do not have suffient order book, yet alone cash flow, to pay them back. This is the classic dying throws of a credit boom and we know how this script ends. When someone asks you how do these moments of clear financial irrationality occur you are looking at one. No one wants to admit the madness or remove the punch-bowl.

Charle’s Ponzi’s original idea was actually legal and profitable… just not at the scale he wanted:

Ponzi emigrated to the United Sates in November 1903 moving from city to city working different jobs and serving prison sentences at least twice before settling into Boston in 1917. Employed as a typist and answering foreign mail, in August 1919 Ponzi discovered his path to the wealth he had always envisioned for himself. He was going to trade in postal reply coupons. What Ponzi identified was a flaw in the coupon system that he could use to his advantage. He realized the value of the International Reply Coupon (IRC) had been set at fixed exchange rates that had not changed since 1919, creating a market in which he could parlay the IRCs into profit if he exchanged coupons from countries with deflated valuations into the higher valued US dollars ostensibly buying low and selling high.

The flaw in Ponzi’s coupon scheme was that he probably could have earned a 400 percent profit on individual coupon redemptions but in absolute terms, the net would be infinitesimal. To amass the millions of dollars Ponzi alleged, an enormous amount of coupons would have to be traded. Two important reports were about to emerge that would ultimately lead to panic and a run on Securities Exchange Company. First, after examining Ponzi’s operation, financial analyst Clarence Barron reported that to be making the money that he was, 160,000,000 IRCs would have to be in circulation when, in fact, only about 27,000 were. Second, the United States Post Office announced that IRCs were not being purchased in large lots (Zukoff, 2006). Therefore, Ponzi could not hold the millions dollars of liquid assets he claimed. Charles Ponzi was arrested on August 12, 1920.

 

The same could almost be argued for the rig and asset deals going on… If you could sell these assets for 520 days a year at twice the market rate you could make a fortune. It’s the execution of this that is causing problems not the math…

But when loans are made, or rolled-over, to companies with no hope of paying them back eventually things stop. You can feel the credit noose tightening in the market now and the equity market is closed no matter how good the summer season. Expect the effects throughout the market to get progressively worse. 

I made this note today to remind me when I look back that some of the credit deals being announced for rig companies are literally insane. People who should know better who are simply not prepared to accept their original thesis of a recovery in rig market was correct and continue, again all the evidence to the contrary, to do anything other than continue to go long on something that cannot be true. Credit committee’s becoming equity investors by accepting that markets have to change before they can be paid back for a few hundred basis points above LIBOR. Nuts.

McKinsey came out with this recently for those who want a dose of big data rationality:

As non-national-oil-company operators shift focus to deepwater fields because of increasing break-even costs of shallow-water fields, jack-up demand should grow 1 percent per year through 2035. Following this trend, utilization will recover to above 80 percent by 2023, driven by a large number of retirements and continued deferment of the order book. The chronic jack-up oversupply appears set to end, as extensive retirements of older and lower-spec rigs in the near future are expected to lead to a 9 percent decline in the overall jack-up fleet by 2035.

Over the course of 2019, floating-rig demand will drop slightly because of unstable oil prices, but growth—to the tune of 6 percent per annum between 2019 and 2027, then 2 percent per annum until 2035—is expected to follow. Key growth regions will be Africa, Brazil, and the Gulf of Mexico. We anticipate that supply will remain relatively stable through 2026, leading utilization to recover to 80 percent by 2026 and long-term floater-supply growth to reach about 13 percent by 2035. [Emphasis added].

Most rig companies will be bankrupt long before those recovery times at current day rates.

When all these guys stop running around congratulating themselves for buying rigs at 70% of their build cost, when day rates have gone down by 50% and utilisation the same, and actually have to pay for them, chaos is going to ensue in the financing market. The start of which is clearly visible now.

Presenting the results, Van Eden gave a plain spoken account of how Anglo had come to rack up such losses. ‘There was no substance behind the borrowers,’ he said. ‘They had nothing but the collateral (property assets) they were providing. There was no equity in the system. They took all the equity out of deals and replenished it in new deals. It was one big leveraged play. It was one big Ponzi scheme’.

Anglo Republic: Inside the Bank that Broke Ireland, Simon Carswell

[This blog is largely becoming a storage post for what I hope will be a PhD in economic history that argues the offshore boom was largely the conjunction of a commodity boom but also, and importantly, a credit boom combined with structural industry change. The consequences a credit boom are well understood for asset heavy industry backed by high debt and it is not a comforting picture for anyone long in assets at the moment.]

My Uber rant and the Gold Standard…

If a man has good corn or wood, or boards, or pigs, to sell, or can make better chairs or knives, crucibles or church organs, than anybody else, you will find a broad hard-beaten road to his house, though it be in the woods.

– Ralph Waldo Emerson
“I landed in this country with $2.50 in cash and $1 million in hopes, and those hopes never left me”
Charles Ponzi

As someone who has predicted 9 of the last 0 housing crashes in NZ I like to think I know an investment bubble when I see one… and nothing gets me more confused than the valuation of Uber at a cheeky USD 69bn. I should point out a clear conflict of interest here: I own a taxi license: Auckland Coop 466 is mine, a legacy and one I am reluctant to give up mainly for historical reasons (my father left it to me rather than economic reasons).

But Uber does my head in… I don’t think I am a Luddite, but it’s just so transparently not what it says it is: namely I don’t see any innovation just regulatory arbitrage and the collision of money and politics. The main thing they seemed to have achieved is to avoid the classification of a smartphone as a taxi meter, and therefore any of the regulatory costs that come with that. Taxis have always been defined by the meter, which enabled them fairly and transparently to show people how they were charging, combined with a host of regulations (including safety) they pushed the costs up far above what anyone with a private license and car could offer their services at. It was seen as collectively better for society to ensure that you knew a safe and regulated car was turning up, that was insured etc. Uber drivers also don’t get the same levels of insurance as licensed hire cars, nor undergo the same sort of licensing checks.

In other words, Uber’s costs are cheaper not because they have invented a better mousetrap but because they operate in an environment where the smartphone that catches the mouse is not called a mousetrap (with apologies to Emerson) even though it catches mice. I am not sure any of the reductions in regulations and insurance are in the long-term interests of consumers, but I may be biased, but then again I also know someone who lost their private hire license after a stroke and considered driving for Uber instead as he only needed a normal drivers license without a health check.

The constant need of Uber to fight it out in court, where they seem to be losing a number of battles such as Denmark, Brazil, and cities like Prague, show this isn’t minority view. And maybe that is what grates the most, the whole corporate mien of Uber. I read this today from INET (please read the whole thing):

In one of these countries live members of what Temin calls the “FTE sector” (named for finance, technology, and electronics, the industries which largely support its growth). These are the 20 percent of Americans who enjoy college educations, have good jobs, and sleep soundly knowing that they have not only enough money to meet life’s challenges, but also social networks to bolster their success…

Politicians increasingly influenced by the FTE sector turned from public-spirited universalism to free-market individualism. As money-driven politics accelerated (a phenomenon explained by the Investment Theory of Politics, as Temin explains), leaders of the FTE sector became increasingly emboldened to ignore the needs of members of the low-wage sector, or even to actively work against them.

When David Cameron was Prime Minister he claimed to be looking after the little guy. But the little guy was a tax paying guy from Essex who had done three years training to get “the knowledge” who then found his income dramatically cut by a fleet unregulated and unregistered drivers. Coincidentally his head of strategy, Steve Hilton, was married to Rachel Whetstone, who headed up Uber’s PR department in London… and behind closed doors… Which explains why a traditional group of self-employed business, traditional Tory voters were hung out to dry. It’s why Travis Kalnick can yell at an Uber driver… I could go on…

I get it: Uber is cheap, and in the new gig economy we all like cheap. But is it economic? For a thorough demolition of the business model read Naked Capitalism. I really like this part:

By contrast, in the hundred years since the first motorized taxi, there has been no evidence of significant scale economies in the urban car service industry. That explains why successful operators never expanded to other cities and why there was no natural tendency towards concentration in individual markets. Drivers, vehicles and fuel account for 85% of urban car service costs. None of these costs decline significantly as companies grow. As the P&L data above demonstrates, Uber has not discovered a magical new way to drive down unit costs.

The whole thing is worthy of a read. Nothing beats a good bit of iconoclasm when it’s grounded in fact.

I especially like the revelation that two investment banks passed on marketing the private company to their high-net-worth customers after reviewing a prospectus with no revenue or profitability data (at 290 pages!). Not all did: caveat emptor!

The words Ponzi scheme are used, and the Uber valuation clearly is one. Not because there is any fraud involved, but because the last people in depend on more people coming into ever show a profit. With a 2bn operating loss those people will get harder to find… eventually… The cynic would argue the investment banks have gone through the institutional money making small portfolio bets, then moved on to individuals who are much less astute…

I prefer the arbitrage comparison. Charles Ponzi’s original scheme  had the basis of sound economics (more so than Uber after reading the Naked Capitalism posts), if it worked; but it was also based on regulatory arbitrage and the slow adaptation of international systems to economic change. In 1906, in the classical Gold Standard era , by agreement at the Universal Postal Congress (held in Italy) , world postal organisations agreed to a system of International Reply Coupons to make it easy to send funds abroad: as exchange rates were fixed to a pre-agreed formula the prices for the coupons were pre-agreed and locked in as well. When in 1919, under the interwar gold standard (where there was some exchange rate flexibility), someone sent Ponzi an IRC from Spain that cost 30 centavos that could be exchanged for US 5c and Charles Ponzi realised there was a riskless profit to be made as the Spanish currency had recently devalued.

And Ponzi was right, but like Uber part of the economic problem rested with scale, and Ponzi simply couldn’t organise to purchase enough of these coupons to make the profits he had promised investors. The mistake, the fraud,  he then made was to claim he had a network of agents buying IRCs in various countries and that there was a viable business underpinning this that could go on indefinitely; he then hired a network of agents in the US, paid them more than the arbitrage profit levels to collect “investments”, and collected the money coming in paying out those who wanted to be cashed out with the money coming in. (One could also add the stupidity of investors was not realising that riskless profits would be traded away).

Uber does appear to be a business that takes advantage of regulatory arbitrage on a global scale and it obviously, based on five years of operating performance and financial results, requires massive scale if it is ever going to work at all.   I buy the argument that actually the industry structure and economics don’t work that Naked Capitalism make so eloquently so I won’t bother doing anything other than quoting some more of it:

If rapid growth could not drive major margin improvements between 2012 and 2016, there is no reason to believe that Uber will suddenly find billions in scale economies going forward. Fundamentally digital companies like Amazon, EBay, Google and Facebook had massive operating scale economies because the marginal cost of expanded operations was close to zero. Aggressive pricing fueled the growth that drove major margin improvements and also created major consumer welfare benefits.

What all the other big names like Google, Facebook and Amazon achieved were increasing returns to scale where fixed costs remain virtually unchanged even as revenue grew massively and hence dramatically lowered unit costs. Unless Uber could find some way of changing this equation they simply cannot trade forever on at the same price level as a company that does this as they require dramatically more cash (mainly in subsidies by the look of it). The next pricing round promises to be extremely interesting because if Naked Capitalism is right it’s not simply that it should be done at a lower number it’s clearly that there is no inherent economic value in the business at all… which is also like Ponzi…