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June 16, 2011

VC as Stock Picker

Filed under: Finance,Healthcare — Steve Krupa @ 4:17 pm

Many members of my family, and probably some of my close friends, think I am something akin to a stock broker (not that there is anything wrong with that).  In truth, I am on the private investment side of things, often selling investments to public companies, but not actively investing in publicly traded healthcare stocks.

Recently David Whelan, a reporter for Forbes magazine, took an interest in Psilos’ healthcare investment strategy and he asked me to apply that strategy to public company stock selection.

Here is a link to David’s Forbes article that discusses five stock picks, companies that, as David points out, compare nicely to some of Psilos’ private investments.  Invest at your own risk!


May 5, 2011

Psilos Group’s 2011 Outlook on Healthcare Economics & Innovation

Filed under: Finance,Healthcare,Venture Capital — Steve Krupa @ 2:01 pm

It’s been a while since I’ve written, and my excuse is typical, I’ve found any number of work projects overwhelming my time to sit, and write, and blog.  One such project was the composition of Psilos Group’s 2011 Outlook on Healthcare Economics & Innovation, which I put this together with one of my business partners (and awesome blogger) Lisa Suennen (you can check out Lisa’s blog, Venture Valkyrie, here, where she proves to be a much more consistent correspondent than yours truly).

For those of you that come to these pages for the pop-culture commentary (more to come on that too, I promise), you may note that I manage to get a few words in on healthcare and investing, and after all, this is what I spend the majority of my time on.  With that, the Psilos Group report outlines what we see as some of the most significant impacts on healthcare investing of the implementation of the new health reform law.

Chief among these are:

  • The reality that we should expect a doubling, and potentially a tripling of the individual health insurance policy market, which will result in a dramatic shift in the relationship between insurers, employers and consumers.  In many cases, employers will simply stop buying group health insurance, leaving the consumer to directly purchase coverage (partially or fully funded by the employer) on their own through a newly established public or private health insurance exchange.
  • Health insurance plans will have to become superior consumer marketing and service organizations to thrive and survive, acting more like Starbucks or Apple if they are going to expand consumers’ trust in their brands and grow while their sales process evolves from a primarily business-to-business market towards a much larger business-to-consumer market.
  • Health plans will have to proactively manage clinical and financial risk through active care coordination for those with chronic illnesses.  This dovetails with the need for such organizations to make a quantum leap forward in their commitment to utilize modern information technology to change their business dynamics.
  • Provider organizations who seek to become Accountable Care Organizations will have to learn to think and act like next generation insurance companies (financially, clinically, technologically) to avoid becoming a repeat of yesteryear’s physician practice management debacle.

If these subjects are of interest to you, the entire Psilos 2011 Outlook on Healthcare Economics & Innovation can be found by clicking HERE.  Let me know what you think.

January 24, 2011

The Budget Balancing Puzzle

Filed under: Finance,General,Healthcare — Steve Krupa @ 12:57 pm
Tags: ,

I assume President Obama is going to spend at least some time in his state of the union speech talking about the budget deficit, and maybe even the notion of balancing the budget.  It was something that was done before, long ago, in the Clinton administration.  Today, polling results indicate that most Americans want Congress to balance the budget without tax increases, i.e., with spending cuts, except most Americans do not want to see significant cuts to Social Security and Medicare.  However, it just might be that this proposed combination – a balanced budget with no tax increases and no cuts to Social Security or Medicare may be impossible.

Don’t believe me?

Try this budget balancing puzzle put out by the New York Times that puts you (the puzzle doer) in the position of balancing the budget now and over the long-term. Let me know how you do.  I got my budget to balance in the long run without raising taxes by significantly reducing the size of the military and making a lot of long-term cuts to Medicare, among other things.

I’d be interest to know if you were able to do it and if so, how.

August 4, 2010

PPACA and the Medical Loss Ratio


The role of the health insurance company is changing rapidly, accelerated by many of the provisions in PPACA, including new regulations regarding Medical Loss Ratio.

What is Medical Loss Ratio?

One of the key tenets to healthcare reform is the requirement that health insurers maintain a minimum Medical Loss Ratio, which historically has been defined as the ratio of medical expenses to total insurance premiums (it should be called the medical expense ratio, but claims expenses in the insurance industry have been called “loses” since, well,  forever, and hence the convention sticks).  Insurers that fail to achieve a minimum MLR, expected to be somewhere in the range of 80-85% depending on whether the plan is large group (85%) or small group/individual (80%), will be required to provide a refund to policy holders.

Some numbers, please…

Suppose that in a given year a health insurer has 20,000 members that are charged an average premium of $4,800 per year ($400 per member per month or PMPM in industry parlance), equating to Annual Premium Revenue of $96 million per year.

If the regulated MLR is 85% the amount of money this health plan is required spend on medical expenses equals $81.6 million per year (85% of $96 million).

Suppose it turns out that medical claims actually equal $74.8 million or 78% of premium for that year.  Prior to healthcare reform the excess $6.8 million would be considered profit for the health insurance company.  Under reform the $6.8 million must be refunded ratably to the policy holders for that year, resulting in an average rebate of  $340 per member ($6.8 million divided by 20,000).

If the opposite occurs and medical claims are $88.4 million (92% of premium), the insurance company covers the $6.8 million shortfall out of its capital (profits).

This brief, simplified example illustrates an important aspect of MLR regulation, it effectively eliminates any potential for unexpected upside to the health insurer for underwriting the risk.  If the insurer does better than expected, i.e., the MLR is low, the excess profits inure back to the policy holders.  This has similarities to the model of a mutual company, wherein the policy holders are actually owners of the company, without the downside of unexpected losses accruing to policyholders.


The purpose of Minimum MLR is to regulate the “value” provided by health insurance companies.  The theory is an insurance company provides greater value to its policyholders when a higher percentage of premiums is used for healthcare costs, versus, say administrative expenses or profits.  By demanding a minimum MLR legislators and regulators believe they are protecting consumers from potentially uncompetitive or collusive insurance markets, among other things.

Issues Arise

This regulation presents a myriad of issues, some of which are actuarial, but most of which derive from the definition of Medical Expense.  The exact components of Medical Expense are left to HHS to decide, but PPACA (specifically Sec.2718. BRINGING DOWN THE COST OF HEALTH CARE COVERAGE) does provide some guidance, declaring Medical Expense to be equal to (paraphrased): (i) reimbursement for clinical services provided to enrollees plus (ii) costs for activities that improve health care quality.  It is very clear what (i) above means, i.e., the money paid for medical claims.  It is in (ii) where the debate begins.

Defining “Costs for Activities that Improve Health Care Quality” will be left to the bureaucrats, and from what I can tell they are taking an open minded approach to the types of services that will be included.  Over the weekend the Wall Street Journal published an Op-Ed piece by Newt Gingrich and David Merritt titled Who Decides on Health-Care Value? (New rules to micromanage insurance companies could cost patients).  I present it to you not as a position that I support but rather as an introduction to the debate on this subject.  Please give it a read (along with some of the comments, pro and con) and I will come back to this subject soon to take a look at some of its ramifications for investors in the healthcare sector.

July 30, 2010

Socially Responsible Investing 101

The first day of the RFK Compass Conference presented by the Robert F. Kennedy Center for Justice & Human Rights just ended.  The purpose of the conference is to explore expanding and modernizing the interpretation of fiduciary duty in a way that considers the sustainable long-term success of both corporations and pension funds.  This is a complex subject that spans the law and prudent financial practices.

As part of the discussion two progressive investment philosophies emerge, Sustainable Investing (SI) and Socially Responsible Investing (SRI).  The website provides this definition and distinction:

“SI vs. SRI


The desire to “do well by doing good” is common to both Sustainable Investing (SI) and Socially Responsible Investing (SRI). The key difference between the two approaches is that SI investors tend to give more weight and attention to environmental issues than do their SRI brethren.”

“Doing well” – means making an investment profit.

“Doing good” – means investing in companies that: (i) have a strong track record on environmental issues; (ii) offer their employees affordable health benefits; (iii) practice humane labor policies and nondiscriminatory employment; (iv) locate some of their operations in distressed communities; (v) have an established culture of product and workplace safety; (vi) promote ethical corporate governance and transparency; and/or (vii) establish fair and measurable standards for executive compensation, among other things, investment factors often given the “softer issues” label.

SRI theorizes that companies that possess these qualities will be more sustainable in the long-run because they will, as examples: (a) be less prone to industrial accidents, fines for environmental violations, and product recalls; (b) have a stronger, healthier, more productive and loyal workforce; (c) be supported and promoted by their communities; and (d) be less likely to commit corporate malfeasance.

It is not weird to be contemporaneously supportive and suspicious of these ideas.  SRI standards make sense as a model for business behavior, but as investment criteria do they require sacrificing some amount of risk-adjusted return to “do good,” i.e., social work at the financial expense of the investor?

David Blood used to run Goldman Sachs Asset Management.  Today he runs Generation Investment Management, a firm dedicated to SI investment and research.  Steve Strongin is the current Head of Goldman Sachs Investment Research, a group that publishes research called the GS Sustain, an analysis of 35 leading global corporations recommended for long-term investment based on an investment framework designed to evaluate sustainable competitive advantage.

Blood and Strongin argue that the principals of SI and SRI should not be used alone, but as additional criteria to investment selection.  Investors should seek out corporations that first and foremost have superior risk-adjusted returns, great management and a compelling strategic direction.  When these traditional metrics are contained within an enterprise that consistently acts as a solid corporate citizen, i.e., demonstrates the “doing good” characteristics of an SRI, you have the basis for earning superior returns over the long run.  This makes sense – along with great returns and a great strategic position, great behavior provides a risk umbrella, a hedge to social, environmental and health issues within and around the enterprise that should brace performance over the long run.

July 6, 2010

Inside Value-Based Healthcare – Part 2: Who Pays for Health(care) Insurance

In my previous post, Value-Based Healthcare Part 1, I talked about the two primary business risks faced by insurers, Moral Hazard and Adverse Selection.  Recall that for health insurance markets to work effectively they must be structured to mitigate Adverse Selection (i.e., the reality that the very fact that someone is seeking insurance might make them uninsurable in the first place).  This means that the healthiest people must stay in the market as part of the risk pool, otherwise the underwriting will not work at affordable premium rates.  As such, employer-based Group Model health insurance has evolved as the prevalent distribution method.

So who pays for employer-based health insurance?

Today health insurance costs average about $4,800 per person per year.  While this expense is paid for by employers, it is essentially part of salary costs, and so it is really money that would otherwise be paid to employees were it not for the mandatory participation required in most Group Model plans.

Employers offer to buy the coverage on behalf of employees because they believe that having their employees insured improves productivity and it is viewed by prospective employees as a competitive perk.  This works out well from a risk pooling perspective, making Group Model insurance less expensive on average.  But what really drives the Group Model is its income tax subsidy.  The federal government does not assess income taxes on the value of Group Model health insurance (this subsidy does not exist for individual purchases of health insurance).

This tax subsidy is massive.  The average employee is in the 25% federal income tax bracket, making the subsidy worth about $1,200 per year (25% of the $4,800 average annual premium).  Approximately 180 million people participate in Group Model plans, meaning the total amount of this annual subsidy is about $216 billion per year.

So who pays for employer-based health insurance?

According to these calculations 180 million employees cost a total of approximately $864 billion, $648 billion is paid for by employees through payroll deductions and about $216 billion is paid for by the federal government through income tax subsidies.  These amounts exclude out-of-pocket expenses, which are by enlarge paid for by employees.


Let’s get back to Moral Hazard.

Have you ever noticed that people are very hesitant to make claims on their automobile and property insurance?  Rarely do the costs of minor fender benders result in an insurance claim.  Why?  Because people fear that claims on their auto policies will result in either their premium increasing or their policy getting cancelled.  People tend to reserve that type of insurance for major catastrophes, paying the cost of minor accidents out of their own pockets.

Most people do not behave this way when it comes to health insurance.  A very high percentage of healthcare expenses become insurance claims.

Few people lose their insurance because of high insurance claims.  As claims increase, the burden of the higher premium is shared among the risk pool.  As a result, Moral Hazard (changing your ethics because you don’t pay for the consequences of your bad behavior) in Group Model plans is severe, and many believe it contributes significantly to the 8-12% average annual healthcare inflation rate.  Despite the reality that employees pay for more than 75% of the cost of their health insurance, they are fearless when making insurance claims.


So, returning to the thread that ended Value-Based Healthcare Part 1.

Employer-based health insurance suffers from Moral Hazard.  Despite the fact that it seems obvious that employees pay the most of the tab, the cost is not individualized and the consequences of bad behavior are not perceived as even remotely severe.

Research backs the notion that when an insured party pays a higher percentage of the total cost of the service Moral Hazard reduces.

So the question becomes, if we are looking for an employer-based health insurance model that will counter increased healthcare consumption why not just increase the out-of-pocket payments and reduce Moral Hazard?

In some cases higher out-of-pocket costs can lead to Unintended Consequences, namely people forgoing necessary treatment.  For example, the medicines necessary to treat Type-2 diabetes are much less expensive than the costs associated with the side-effects of untreated diabetes like heart attack, stroke, amputations, blindness, etc.  A health insurer wants Type 2 diabetics to take their medications, however high out-of-pocket charges often impose barriers to compliance.

Medications like Glucophage, a treatment for Type 2 diabetes, have a high value.  The treatment costs about $400 per year, real money for an individual, but a small investment for a health insurer given that compliance with the drug should mitigate a number of side effects of Type 2 diabetes, saving money on hospitalizations and other forms of expensive healthcare.  Further, Type 2 diabetics should see podiatrists and ophthalmologists regularly.  Again, high co-pays for these services could mitigate compliance and increase adverse events within an insured diabetic population.

Value-Based Healthcare: Definition #2:

Value-Based Healthcare involves designing insurance benefits with economics that encourage (or remove the barriers to) the utilization of high-value healthcare services.

So why is Value-Based so new?  What are the barriers to implementing Value-Based?

These questions will be covered in future posts.

To leave you with something to think about, it was only until recently that the information technology necessary to begin experimenting with the implementation of Value-Based Healthcare became available.

June 25, 2010

Inside Value-Based Healthcare – Part 1: Moral Hazard

Value-Based Healthcare.  There, I said it…

I had fun on Wednesday sitting on the healthcare reform panel at the Dow Jones Limited Partners Summit.   The conversation centered on investment trends in healthcare as updated for the passage of PPACA, during which I blurted out the concept of value-based healthcare, a pretty complex and to some extent novel concept, and a cornerstone to many of Psilos’ VC investment strategies.  This was subsequently reported, and to Jennifer Rossa’s credit, she provided enough detail around my comment to correctly convey the concept.

There are important nuances, however.  This post is the beginning of a series that will explore the ins-and-outs of Value-Based Healthcare.

Value-Based Healthcare: Definition #1:

Value-Based Healthcare, or more specifically, Value-Based Health Insurance Design, its sobriquet being simply, Value-Based, intends to mitigate the Moral Hazard inherent in low cost-sharing health insurance coverage.

If we were to take an insurance or advanced finance class together we would spend a lot of time talking about Moral Hazard and Adverse Selection, the two primary business risks that underpin managing financial institutions, insurance companies and banks included.  Failure to manage these risks properly can lead to disaster (in fact, recently Moral Hazard and Adverse Selection got the better of the mortgage banking business, a primary cause of the financial crisis).

Moral Hazard reflects the reality that a party insulated from a risk (like an insured or a borrower) will behave differently than if it were fully exposed to the risk.

Adverse Selection reflects the reality that the very nature of a party’s desire to seek insulation from risk reflects a greater risk of loss.  For example, parties that are either sick or expect to get sick have a higher demand for health insurance.  Similarly, parties in the market for a mortgage that have a concern that they may default are more attracted to low-down-payment mortgages.

Underwriting models are designed in part to set prices to countervail the risks of Moral Hazard and Adverse Selection.  This is more easily accomplished in an underwriting model where each policy gets priced individually, like automobile insurance.  In this model individuals are placed in broad price cohorts based on age, gender, style of car, etc., and then adjustments to the policy price are made based on individual attributes like historical driving record.  Moral Hazard and Adverse Selection are less prevalent in insurance markets where policies are individually underwritten and where the underwriter will be the party that ultimately pays the claims on any policy.  Absent these conditions the risks of Moral Hazard and Adverse Selection will always be lurking.

Such is the case in the current market for employer-based health insurance (also called Group Model health insurance).

Let’s start with Moral Hazard.  Today many employer-based health insurance models feature low cost-sharing, meaning that patients pay a very small amount of the health resources they consume.  Here the economic question is whether the value of a healthcare service exceeds the out-of-pocket cost to the patient, which is a small fraction of the actual costs.  Moral Hazard comes into play because the insurance insulates the patient from full payment, thus altering behavior toward increased healthcare consumption, a phenomenon some believe is encouraged by the fact that providers (doctors and hospitals) are generally not at risk either and are paid on a fee-for-service basis.

Consider what might happen if the out-of-pocket costs to the patient were raised.  In insurance markets where patients could opt out and choose not to buy insurance, an increase in out-of-pocket costs would certainly result in some people, probably the healthiest, declining coverage.  This would cause premiums to rise, because the insured pool would be sicker on average, causing more of the healthiest people to decline, increasing the risk of the pool, increasing the premiums, and so on, into an Adverse Selection spiral.

In health insurance markets we need the healthiest people to stay in the market in order for the underwriting to work at reasonable levels of insurance premium.  This is one of the reasons why health insurance is provided by employers.  Employers, or coalitions of employers, are able to deliver large enough populations of sick and healthy people for the underwriting to work.  The participation of large numbers of employees mitigates Adverse Selection and as a result many large employers choose to self-insure (tax incentives is another reason employer-based health insurance dominates – more on this another time).

Nonetheless, in employer-based health insurance we are still left with Moral Hazard, and research seems to back the notion that its degree is inversely correlated with the percentage out-of-pocket paid by patients (low out-of-pocket = high Moral Hazard = high healthcare consumption).

So the question becomes, if we are looking for an employer-based health insurance model that will counter increased healthcare consumption (and believe me, we are), why not just increase the out-of-pocket payments and reduce Moral Hazard?

It turns out not to be that simple.  Please give this some thought and we’ll dig a little deeper next time…

May 25, 2010

Defending the Carried Interest (Capital Gains) Tax Incentive

Filed under: Finance,Venture Capital — Steve Krupa @ 8:41 pm
Tags: , , ,

Today I intended to write an editorial, of sorts, in opposition to the US government’s proposal to raise the tax rate on Carried Interest earned by investment partnerships.  This tax increase targets partners of VC and Private Equity funds and is imbedded in a current bill proposed by the House of Representatives called The American Jobs and Closing Tax Loopholes Act of 2010 (H.R. 4213).

Under the category of closing individual loopholes, the House provides the following summary of the provision:

Taxation of carried interest.  The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund… the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income (50% for taxable years beginning before January 1, 2013). This proposal is estimated to raise $18.685 billion over 10 years.”

In the course of my beginning to research this topic, I remembered that my partners and I had already addressed this issue in a letter we wrote back in March of 2009.  Below is an edited version of that letter, altered slightly to bring it up to date.  It reads much like an editorial, but I believe it succeeds in making its point.


Venture Capital and Carried Interest 

The Congress proposes to increase the capital gains tax rate on Carried Interest earned by principals of venture capital firms from the current standard capital gains rate to a hybrid rate weighted more toward the marginal tax rate on ordinary income.  As with all tax rate increases, we believe that this one will serve as a long-term disincentive, in this case to the formation of capital around innovative start-ups, one of the key historical drivers of job creation in the US economy (according to National Venture Capital Association, in 2005 companies that received venture capital from 1970-2005 accounted for 10 million jobs – approximately 9% of the private workforce – and $2.1 trillion in revenues – approximately 17% of GDP).

Unlike other forms of investing, venture capital investment does not involve intricate financial engineering and it does not rely on financial leverage and market arbitrage to generate gains.  Venture capital is about investing equity in young companies for long-term results.  Most venture capital investments are made in companies with less than $50 million in revenues and are held for periods between 5 and 7 years (although some are held much longer), distinguishing them as intrinsically unique, long-term, growth oriented equity investments.

It is expected that for the foreseeable future venture capital will be deployed in clean and alternative energy technologies, a host of computer science-oriented businesses, bio-medical technology and healthcare services and information technology.  These are the precise areas of innovation necessary to solve some of the key issues in our economy and these are the very businesses that seek employees with advanced skills in biology, mathematics, engineering and computer sciences, a major thrust of our government’s education initiative.

In a well-run investment model the venture capitalist operates in partnership with the entrepreneur, focusing on long-term company building, as opposed to the buying and selling of portfolio securities.  The venture capitalist puts its own capital at risk and raises additional funds by advocating investment in the sector to large institutional investors, many of which, like endowments and pension funds, are tax-exempt.  Once the funds are raised, the venture capitalist screens an enormous pool of new ideas to tease out those with the best investment prospects (less than 1% of venture ideas ultimately get funded by venture capitalists).  After the initial investment is made, the venture capitalist supports each new company and its entrepreneur by providing follow-on financings and working with the company as a board member and advisor on matters of strategy, human resources development, sales, marketing, finance and business development.  It is not until the long-term success of the company is achieved that the venture capitalist earns a financial reward for its efforts in the form of a capital gain, known primarily as Carried Interest.  Along the way there are plenty of chances for failure.  Despite the best efforts of all involved, most venture-backed companies ultimately fail, but those that do succeed pay-off well in excess of the failures, rewarding entrepreneurs and venture capitalists for working through substantial financial and operating risk.  Venture capital investment represents absolute value creation, not “zero-sum” value transfer.  The resultant output to the nation is permanent innovation and job creation. 

So why would the House propose to penalize venture capitalists with a tax increase to Carried Interest?  It seems counter productive and will not lead to stimulating innovation (further in and of itself it doesn’t raise much money – $18 billion over 10 years is less than 0.04% of the federal budget over that same period time).  During the campaign President Obama committed to eliminating the capital gains tax for investment in small businesses, clearly supporting the notion that tax incentives stimulate investment activity.  Yet, a carried interest tax increase on venture capitalists would operate in complete opposition to this goal.  The truth is, the venture capitalist and the entrepreneur are long-term partners and should be treated the same.

Today venture capital is a highly competitive global business.  Innovation will develop where there is unity between the talent available to build new innovative businesses and the incentives for capital investment.  We see other countries narrowing the global education gap and providing very compelling capital incentives (e.g. – China is investing heavily in education and does not tax capital gains at all).  Currently, the United States has the most advanced and effective venture capital infrastructure in the world and we believe that this is one of this country’s great competitive advantages, portending future success beyond our current financial difficulties.  As such, we would urge Congress to look for ways to maintain and enhance venture capital as the National Asset that it is and not to penalize suddenly those venture capitalists whose past and ongoing work is in complete harmony with America’s long-term economic objectives.

April 29, 2010

Demagogues v. Goldman

Filed under: Finance — Steve Krupa @ 6:36 pm
Tags: , , , , , , , , ,

In 2008, Bear Stearns (founded 1923) and Lehman Brothers (founded 1850) were destroyed, after being in business for 85 and 158 years respectively, because they were not smart enough to reduce their long exposure to RMBS (Residential Mortgage Backed Securities) when there were clear signs of a potential market downturn.  Evidence, once again, that Wall Street plays a high stakes game where proper risk management is essential.   


Oddly, the Senate and the SEC have decided to make the best managed firm on Wall Street, Goldman Sachs, the focus of a witch hunt apparently designed to place Wall Street’s business activities front and center as the primary cause of the 2008 financial crisis (or what is now being referred to as the Great Recession).  The Demagogues (read: the Senate and SEC) seem determined to accuse Wall Street of fraud and unethical behavior designed to profit from a crashing housing and mortgage market.  It is a bold move, brilliantly timed in the midst of congressional debates around financial market regulatory reform.


Back on April 1, I got a little cheeky blogging about Matt Taibbi, the crazy-wonderful Rolling Stone journalist who is as passionate about vilifying Wall Street (and Goldman Sachs in particular) as Wall Street is about making money.  Matt’s claims of conspiracy are interesting (and funny).  On the serious side, I admitted concern over Wall Street’s political power, agreeing that Wall Street needed to take aggressive steps to reform itself, and expressing concern over whether unethical or criminal behavior might be discovered.


W/r/t unethical or criminal behavior, or lack there of, there is more accusing and not a lot of proving going on, especially if the SEC’s recent case against Goldman Sachs is representative of the best evidence gathered.  There is little doubt that Goldman Sachs pursued every possible angle to profit on a housing market run wild without demonstrating public concern regarding the systemic risk being created and its potential burden on society.  But is there any real evidence that they did anything unethical or illegal in the process?


The SEC thinks Goldman committed fraud in the issuance of a synthetic CDO (Collateralized Debt Obligation), called ABACUS AC-1, to ACA Capital and others in early 2007 because they did not disclose to investors the role of Paulson & Co. in the transaction (Paulson bought the short side of the deal and proposed several of the Reference Securities included in the CDO).    


Many in the Senate seem to think Goldman’s trading activities during the advent of the sub-prime mortgage crisis intentionally disadvantaged its clients, raising the specter of ethical violations, at a minimum.


I am not sure the SEC or the Senate can prove anything other than the inherent dog-eat-dog nature of financial trading, a little understood activity that for better or for worse is the bedrock of liquid markets and financial capitalism.


In the sales and trading business Goldman is not giving financial advice to its Clients, it is making a market in securities their Clients want to buy and/or sell.  That means they stand at the ready to provide a price at which they will execute a trade.  Goldman will attract Clients to their sales and trading business if they can be relied on to provide consistent pricing and liquidity.  The Clients, largely very aggressive and sophisticated financial institutions, recognize that Goldman may either be transacting for their own account or acting on behalf of a Client on the other side of the trade, and so it is accepted and known that Goldman is not financially aligned with their sales and trading Clients.  Further, Goldman’s Clients are trying to extract the best deal for themselves from Goldman in the trade.  These are big boys playing a high stakes game of I win and you lose.


So when a Client, like Paulson, comes to Goldman with interest in shorting (profiting from falling prices) RMBS, Goldman’s job is to find another Client interested in going long (profiting from rising prices) RMBS, put a deal together acceptable to both, and execute on the transaction by acting as its underwriter.  It seems to me that this is exactly what Goldman did w/r/t ABACUS AC-1.


Further, daily market making activities are inherently done with either a long or short bias depending on the condition of the trading book and the subjective preferences of the market maker.  Goldman clearly adopted a short trading bias near the advent of the sub-prime collapse, a business decision that seems to have contributed to saving the firm and its shareholder value (applause for the Goldman executives please), and an approach most other financial institutions (like the now dead Lehman) would have been wise to adopt at that time.  To argue that Goldman’s short bias acted against the interest of their Clients is as absurd as it is to suggest that Goldman should have purposely lost money on their trades.  Goldman’s Clients were clearly willing buyers and sellers and thought that they were getting the better of each of their trades with Goldman.  As with any trade, only one side will be right.


So I continue to wait for credible evidence that proves fraud, and given the weaknesses of both the SEC and Senate positions, I am doubtful it exists.  It seems I am left only with the opportunity to wince at the naked demagoguery.

April 1, 2010

On Wall Street: Is Matt Taibbi Wrong?

 Talkin’ Wall Street…


 A couple of opening points:

 (a)       I am a Wall Street alum (1994-98), I loved it there and it was my stepping stone to venture capital, my dream profession.

(b)       I believe that historically Wall Street’s financing of corporate growth and innovation has been a huge competitive advantage to the US.

(c)       On the one hand I think that Henry Paulson (as former US Treasury Secretary) is a patriot and helped save our country from economic collapse; on the other hand I think that he (Paulson) aided in creating the conditions for the crisis while he served as CEO of Goldman Sachs.

(d)       Wall Street is all about money, and that will never change.  It attracts extremely smart people who spend all of their time thinking of ways to make money.  Unfortunately many times Wall Street creativity spawns behavior that crosses ethical lines and on occasion becomes illegal.

(e)       Today, Wall Street has gotten completely carried away and needs to reform itself fast.  It is becoming an uncontrolled burden on the stability of its own milieu, the global financial system.


 This post catches me in the middle of reading two books on the financial crisis of 2008: On the Brink, by the aforementioned Henry Paulson, and Too Big to Fail (or maybe too big to carry or read, for that matter, we’ll see) by Andrew Ross Sorkin, a business reporter for the New York Times.  Both chronicle the action of what happened in the days before, during and after the financial crisis, but neither delves into the real causes for the crisis, or the questionable actions of its key participants. 

 This cannot be said for one Matt Taibbi.

Matt is the irreverent, liberally-biased, smart-ass, misanthropic, and, for many, insufferable contributing political editor (sports too) of Rolling Stone magazine.

 And I have grown to love him.

 Not for his technical grasp of Wall Street and all of its acronyms and crazy financial structures (he lacks this), but for his unmitigated, bone-quaking outrage.  As extreme as Wall Street is with its obsession with money for money’s sake, Matt is obsessed with Wall Street and its leader Goldman Sachs, marking it (them) the villain(s) in a calculated plot to control the world.

 The (once?) venerable Goldman Sachs provides Matt Taibbi with not only a villain, but also a synecdoche for Wall Street, which has now, unfortunately, become itself a populist synecdoche for anti-ethical greed, instead of the engine of capitalism and national wealth creation we all hope it would be.

 So let’s have some fun for a moment.

 Here is how Matt describes his villain:

 “The first thing you need to know about Goldman Sachs is that it’s everywhere. The world’s most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money…  What you need to know is the big picture: If America is circling the drain, Goldman Sachs has found a way to be that drain, an extremely unfortunate loophole in the system of Western democratic capitalism, which never foresaw that in a society governed passively by free markets and free elections, organized greed always defeats disorganized democracy.”

 – From Rolling Stone – Matt Taibbi – Inside the Great Bubble Machine

And its plot to rule the world:

“The mistake most people make in looking at the financial crisis is thinking of it in terms of money, a habit that might lead you to look at the unfolding mess as a huge bonus-killing downer for the Wall Street class. But if you look at it in purely Machiavellian terms, what you see is a colossal power grab that threatens to turn the federal government into a kind of giant Enron — a huge, impenetrable black box filled with self-dealing insiders whose scheme is the securing of individual profits at the expense of an ocean of unwitting involuntary shareholders, previously known as taxpayers.”

From Rolling Stone – Matt Taibbi – The Big Takeover

 And post-bailout:

 “The question everyone should be asking, as one bail-out recipient after another posts massive profits  – Goldman Sachs reported $13.4 billion in profits last year [2009], after paying out $16.2 billion in bonuses and compensation – is this:  In an economy as horrible as ours… where the hell did Wall Street’s eye-popping profits come?… A year and a half after they were minutes away from bankruptcy, how are [they] not only back on their feet again, but hauling in bonuses at the same rate they were during the bubble?”

 – From Rolling Stone – March 4, 2010 – Matt Taibbi – Wall Street’s Bailout Hustle

Matt’s writing is fun(ny), but his accusations, one being that Wall Street has obtained massive global power, seem pretty close to the truth, even if the details of his analysis bump against errors of nomenclature and the disadvantages of financial inexperience (Many a business reporter revile Matt and his errors.  For example see Megan McArdle  from Atlantic’s diatribe and its many links for a technical debunking of Matt’s work.  For what it is worth I don’t think Matt makes that many technical mistakes, and unlike most conspiracy theories his are worth considering and his writing is well worth reading as long as you can tolerate some cussing here and there.) 

Wall Street used to be about corporate finance, raising capital for corporations by selling debt (corporate bonds) and equity (e.g. IPOs) to public investors and providing liquidity by creating markets for the day-to-day exchange of these securities.  The firms made their profits by charging fees for underwriting new securities and trading in existing ones.

While corporate finance is still a part of Wall Street’s business, it has become small potatoes to its derivatives and proprietary trading businesses, businesses where rather than serve their trading customers, they compete with them.  In this business, not surprisingly, like Vegas, the “house” is set-up to win, and it does, unless your firm gets high-on-its-own-supply of risky underwritings, as was the case with Bear Stearns, Lehman, et al, in which case you go down in flames, unless of course you get bailed out…   

Essentially Matt Taibbi claims:  (1) that these firms have figured out more ways to bilk their clients than their clients could even imagine (again smart people obsessed with making money); (2) that many times these techniques cross ethical lines and might even be illegal; (3) that they are more than willing to bilk each other as well; and (4) that there are so many ex-Wall Streeters with regulatory and legal power that there is no chance for systemic punishment of, and thus no deterrent to, continuous bad behavior.

On this last point, it’s important to remember that it was a huge team of ex-Wall Streeters-in-government that engineered the bail-out and that the bail-out went well beyond the TARP money that was invested in firms like Goldman Sachs.  These ex-Wall Streeters-in-government also engineered: (a)  the bail-out of AIG, which was effectively the bail-out of all of the companies AIG owed money to (yes, Goldman was one) and (b) the conversion of Goldman Sachs and Morgan Stanley into bank holding companies that overnight allowed them to borrow massive amounts of money from the Federal Reserve (read: the US government) without the need for congressional approval, a move that effectively solved any threat to their liquidity.

All for the good of the nation and the world (of which I agree and approve, yes, we needed to save the finanical system).  And all for the continuation of massive profits and pay packages of the banks and their senior management, repsectively (no we did not need to save Wall Street’s plush lifestyle).

It confuses me to this day as to why the government does not own 85% of the equity in most of Wall Street.  Shouldn’t that have been the “market terms” for all of the bail-out investments, a la AIG?  (I will someday calculate how much profit the US government would have made if it would have taken meaningful equity stakes in these firms and sold it at today’s prices.)

You tell me – do you think Matt might have a point or two?  Is this not some kind of conspiracy?

Like most finance guys, I get most of my financial news from the Wall Street Journal, New York Times and CNBC, and I don’t hear any of them pursuing these questions in any meaningful way, and I wonder why?


Today I had coffee with an old hedge fund friend of mine and we came to the same conclusion.  Not different from the horror described by Arthur Jensen (played by Ned Beatty) in Paddy Chayefsky’s 1976 film Network, the world capital markets have become larger than and span well beyond the borders of sovereign nations, and the 2008 financial crisis proved more than ever that they carry much of the weight of the world.  Who do you think buys, markets and trades the debt and currencies of all sovereign nations?


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