Private Equity Firm to Beat the Public Markets

Financial stocks are getting whacked. With good reason. Merrill Lynch, for example, wrote off nearly half its book value in the last half of last year. UBS wrote down 40%. Morgan Stanley a quarter. And no one knows where it will stop.

"The leading players in the greatest credit expansion of all time were the financial companies," we explained to Elizabeth on our way back from Geneva. "They were the debt mongers. They made their money by leveraging up the entire world - from people living in trailers on the outskirts of a godforsaken town in the middle of nowhere... to the masters of the universe themselves in Manhattan and London. Now that the world is de-leveraging itself, it's only natural that the financial industry takes the biggest hits."

Yesterday morning alone, Fannie Mae and Freddie Mac - who played a starring role in the leveraging spectacle - saw their own stock marked down. The companies lost some $4.5 billion worth of capitalisation before lunch was served.

And you remember Blackstone? The private buyout firm was so much in demand during the boom times that even its founders decided it was time to sell - to the public. You may recall; we were suspicious. The idea of Private Equity was that the hotshots could outsmart the public markets. It was an idea completely at odds with Modern Portfolio Theory, which holds that price movements are random; therefore it isn't possible for a Private Equity firm to beat the public markets for long. If they seemed to do so, it was just, well, a fluke.

MPT was always a fraud, but it more than a little cheeky on the part of Blackstone to pretend that it could beat the public markets while at the same time becoming part of them. If they could really outperform the public markets, we wondered, why would owners ever want to sell? What could they do with the money? And if someone who actually could outsmart the public markets offered to sell you a piece of his business... shouldn't you be a bit suspicious? Unless you've got some pretty racy photos that you're planning to show to his wife, it makes no sense. Obviously, the seller has a better idea of what he's unloading than the buyer does of what he is getting - especially if he's such a great judge of investment value. Wouldn't it be like challenging a world master to a game of chess, in which you were blindfolded? Wouldn't the buyer likely be the loser?

Well, as it turned out, the buyer was a chump. People who bought Blackstone shares when it went public last June have lost 55% of their money.

Of course, it's not just Blackstone that is getting beaten up. The whole capital structure is getting hammered. "Margin calls pummel hedge funds," says one headline. "Peloton [a prominent hedge fund that seems to be going bust] puts its offices up for sale," says another.

Meanwhile, Japanese financial regulators say direct losses from subprime troubles have risen to $215 billion. One estimate says they'll grow to $1 trillion before it is over.

While the geniuses are taking their lumps so are the lumpen. That is, ordinary homeowners are being beaten up too - not only by falling house prices and high debt, but by rising consumer prices.

Yes, dear reader. This is a two front war. In the middle, the middle classes are taking incoming from two directions. The value of their main assets - houses and their own labor - are being deflated, while their cost of living goes up. In terms of oil, gold, Swiss francs, euro or pounds - Americans earn substantially less per hour than they did 5... 10... or even 30 years ago. And they own less of their houses too. Americans' percentage of equity in their homes has fallen below 50 percent for the first time on record since 1945, the Federal Reserve said last Thursday.

But while they have less... and earn less... they still have to pay more. Gasoline is up to $3.20 a gallon, we reported yesterday... and oil hit more than $107 a barrel today. The dollar lost more ground too; it appears to be heading for $1.55 to the euro this week.

Producer prices are shooting up too. The PPI rose to 6.6% in China. And in Britain it's at a 17-year high.

"Consumer gloom as spending power fails," says the headline item in the TIMES of London today.

The Fed is fighting back, of course. But it's turned its guns only in one direction - against deflation. Inflation can run wild.

Investors have figured out what is going on. They're still buying U.S. Treasury bonds, but now they favor the TIPS - bonds adjusted to inflation. TIPS have been bid up so high that they now produce a negative yield. That's right, yields have fallen below zero... indicating how eager investors have become to protect themselves from defaults and inflation. Nothing is less likely to default than a U.S. Treasury bond... heck, the feds print the money used to redeem them. Ah, there's the catch - they tend to print too many, which results in inflation. As long as the inflation was going into house prices and stocks, no one complained. But now, housing and stocks are going down - while consumer prices rise. These TIPS provide protection from both enemies - inflation and deflation. The feds won't default. And the TIPS adjust to losses in consumer purchasing power - as calculated by, well, the feds themselves. But so great is the demand for this kind of protection that investors are willing to give up all hope of a current yield in order to own them.

Bill Bonner
The Daily Reckoning Australia

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