Is the Facebook IPO a good deal?

IPOs are exciting. They can give investors a chance to get in on the ground floor of a new venture. They often move 20-30% in one day. And, in the case of Facebook, they can become cultural events—in the news, in the papers, in everyone’s conversation.

But they’re also financial events. And with all financial events, the numbers really matter. The first number of note is the value of the company. Rumors are that they might value the company at $100 billion. That’s 30 times revenue and 100 times earnings. It would take a lot of growth to grow into that sort of valuation.

Facebook claims to have 800 million monthly users and 400 million daily users. With $3.7 billion of sales last year, that’s only $9 / per active user per year. There would seem to be some growth potential there. After all, Google makes about $200 per user. But Facebook isn’t Google. What’s their plan for growth? Selling data? And where is their subscriber base growing fastest (and slowest)?

Beyond the Facebook-specific issues, IPOs themselves can be a mixed bag. For every Google that becomes a six-bagger there seem to be 4 or 5 Pets.com or Webvans that flop. Even household names like Boise-Cascade or Hertz Rent-a-Car can fail.

But managing a public company is hard. It takes a different skill-set than starting or growing a company does. So there’s often a lot of management turnover shortly after an IPO. In addition, hot IPOs are, well, hot. The price soars. Recent offerings like Dunkin Donuts, GM, and Linked-in all declined significantly after the first few days of trading.

Usually, it’s best to wait until the sizzle of smoking IPO wears off and emotions settle down. Only the in the cold light of the numbers should you decide whether you want to take a stake.
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 In Your Facebook [1:30m]: Play Now | Play in Popup | Download

Why are there banks?

Oh, I know the “It’s A Wonderful Life” answer of “Fred’s money is tied up in Joe’s house.” Financial intermediation was a way that banks functioned in the past, transforming a large number of short-term deposits into a few longer-term loans—and providing some financial expertise along the way. At their best, banks recycled cash within the community and helped it invest in new ways to make the economy grow.

But that social compact frayed a long time ago. Now mortgages are underwritten by Federal agencies; commercial loans are syndicated or sold; financial expertise is available via the latest app or streaming video. Today banks make a lot of their money just by taking on risk: investing short-term borrowings from the Home Loan Bank into mortgage securities issued by Fannie Mae. While those profits are real, it’s hard to see what social function they serve.

Banks do add value by providing banking services: deposit-taking; check-clearing; credit card and debit card services. For these services they charge modest fees. But the real value that banks serve in their communities—and in the nation—comes from their risk-management. Banks can provide appropriate loan pricing for local businesses; or more competitive rates for mortgage loans on properties where they know the neighborhood—and the borrower.

Asymmetric information is a problem in finance: the borrower often knows more than the lender, and fraudulent losses can result, leading to more expensive financing. By knowing their customers and reducing the asymmetry, borrowers can get more efficient financing and the bank earns a fair risk-adjusted return.

That’s the new face of banking: risk-management. Not through some arcane black-box statistical spreadsheet, but by shoe-leather-intensive customer knowledge. And that will never be replaced by a model.
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 The New/Old Face of Banking [1:30m]: Play Now | Play in Popup | Download

Is private equity evil?

Private equity is in the news. It’s a way to invest in operating companies that aren’t listed on an exchange. It sidesteps the SEC and exchange-driven rules, because those rules are written to protect investors, and private firms are owned directly by the investors without an intermediary.

How did it get to be so important? In the ‘60s and ‘70s a lot of management consultant firms were formed, offering advice on how to improve corporate performance. Sometimes this advice was taken, sometimes not. When their advice wasn’t taken and the consultants were convinced that there was corporate value that could be unlocked, they formed partnerships that could buy out the company and implement the reforms.

As you might expect, the returns on private equity are a mixed bag. Better, more disciplined firms tend to do better; other firms, worse. It’s hard to tell what the aggregate performance has been, since high-performers (like Bain) tend to get all the press, while the dogs quietly dissolve. Some claim it’s no better than the aggregate public markets, since the same economy drives the return from both private and public firms.

But there is one way that private firms have an advantage: corporate governance. If investors question a firm’s accounting, they can bring in their own accountants. If CEOs behave badly in the morning, they can be fired in the afternoon. If you’re worried about pollution, you can bring a soil-testing unit right into the company’s main campus. Private equity investors control their companies. Better accountability usually means better results.

Private equity hasn’t boomed in the last 20 years because it milks companies dry and then casts off the empty shell. It’s boomed because it has created profitable firms that provide goods and services that people want at affordable prices. Nothing evil about that.
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 Equity’s Privates [1:30m]: Play Now | Play in Popup | Download

Is Freddie Mac eating the country’s lunch?

A recent story by NPR breathlessly reports that Freddie Mac is profiting from the continued troubles in the housing market. They reported that the mortgage giant retained interest in some mortgage derivatives while selling off the super-safe portion. If mortgages refinance more slowly, these bonds do well. And of course, Freddie has tightened their credit standards over the past couple years. So doesn’t this represent a conflict-of-interest?

On the face of it, yes. Owning derivatives that benefit from lower prepayments when you set underwriting standards that permit or deny prepayments for millions of homeowners is a conflict. It looks lousy—and demonstrates the political tin-ear that the mortgage giants have often displayed to the world.

But there are many reasons to own these securities. One reason could be that you can’t sell them. When an originator slices and dices mortgages into various pools, some can be left over. With interest rates at record lows and defaults running high, it might be pretty hard to sell tranches that lose money if prepayments accelerate. So Freddie might have to hang onto them.

Also, the analysis of underwriting overstates Freddie’s control of the market. Fannie Mae is much larger; banks also underwrite a significant portion of the market for their own portfolios. Underwriting standards are part of the competitive banking landscape. If Freddie is too restrictive, they’ll lose business to someone else. Could a .6% portfolio position lead them to tighten them? Not likely.

Once you look at the details, you see a lot of reasons to own these bonds that have nothing to do with profiting from keeping borrowers in “mortgage jail.” Owning the bonds may be foolish, but it isn’t evil.
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 Lions And Tigers and Mortgages [1:30m]: Play Now | Play in Popup | Download

Are big stocks safer than small stocks?

The answer to this question is far from obvious. In the past ten years we’ve seen some spectacular failures among large companies: Lehman, Fannie Mae, Enron. And even more companies fell dramatically in price never to recover, like Citigroup and AIG. Small stocks have typically been pegged as a volatile asset class. But when the giants fail, where do you go for safe, blue-chip growth?

The short answer is, there is no such thing as safety. Our selective memories erase the spectacular failures of the ‘90s and ‘80s because—well, they haven’t been in the news for 15 or 20 years, and we just forget. And our minds tend to recall facts that have strong emotional associations. For good or ill, the sound made by a random tree falling in the forest a mile away isn’t as likely to make an impression on us as a limb from the maple out front crashing down on our car in the driveway.

The fact is that small companies have less experienced managers and more volatile business conditions. They tend to be regionally focused so local economies affect them more intensely. Since they slip under the radar screen of many auditors, accounting fraud and malfeasance are more likely. As a result, business failures among small firms are more common. They also grow at a faster rate, however, since expansion is not limited by the size of the economy. It’s much easier for revenue to double from $5 million to $10 million than from $500 billion to $1 trillion.

So small stocks are more volatile. Investors who buy them need to pay close attention to their balance sheets, business plans, and manager integrity. But there are no sure things in investing. It’s all a matter of managing your risk while you look for returns.
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 Strong Safety [1:30m]: Play Now | Play in Popup | Download

Why are cell phones so expensive?

One reason is taxes. The typical cell-phone user pays an FCC tax, a couple of state taxes, a 9-1-1 charge, and a couple other charges. Those tax bills can add up: in New York City the average burden is over 20%!

And it’s not like people have a lot of choice about paying them. Sure, you can monitor your usage and choose plans, but for many people cell phones are an essential part of doing business—like having a driver’s license or using a computer.

What we seem to have here is a tragedy of the anti-commons: lots of small, overlapping tax jurisdictions taking a small slice of an overlapping pie, with no central authority tasked with the charge to minimize charges. That’s up to the individual. And the monthly bill is so confusing that consumers are lucky if they get the right payment to the right address, much less figure out who’s billing which usage fee or status charge.

The same kind of overlapping tax burden can be seen in with rental cars, hotel rooms, and other services. Often the expense is borne by the business, which passes it on to the consumer via a regulatory charge or service fee.

The tragedy is that all these overlapping fees are likely high enough that they actually reduce the underlying activity. That is, some people just say the heck with it, it’s too expensive to rent a car or or use a cell phone. They never use the underlying service, and the economy misses out. Economists call this a “deadweight loss.”

Congress could invoke the commercial clause and simplify things, but don’t plan on it—the Feds are short of cash, too. Instead it’s up to each of us to read our bills, watch our usage, and plan our lives.
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 Tax Man [1:30m]: Play Now | Play in Popup | Download

The Fed has come up with an inflation target. What does this mean?

In their post-meeting statement, the Fed explicitly acknowledged that their long-run inflation target is two percent. This has long been suspected by Fed-watchers. But now the Fed is publishing its goal. Are there problems with this uber-transparency?

One issue is that we are now drowning in data. We’ve gone from guessing what Fed policy is based on “system rp’s” and “coupon passes” to a turgid, 500-word essay. What’s next? Stream-of-consciousness writing a la James Joyce? Live tweets from the FOMC’s Board Room? There’s so much disclosure that observers can now see whatever they want to see in the Fed’s releases. TMI!

The Fed is also playing with words. Along with its 2% inflation target, the Fed is also defining full employment as 5 ½ to 6% unemployment. This gives an “Alice In Wonderland” impression: full employment means 7 million people are looking for work and stable prices means they double every 35 years. I know there are good economic reasons for these goals, but still!

Finally, excessive visibility has its downside. Arguably, the Fed’s “extended period” language of mid-decade (when Fed Funds were at 1%) led to an over-leveraging of the economy as investors safely borrowed short and lent long. This leverage was disastrous when the economy turned down.

I’m afraid the collegiality of the Princeton faculty lounge is not right ambiance for the nation’s central bank. Bernanke is overseeing a grand experiment in openness. Let’s hope it doesn’t backfire.
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 The Open Market Committee [1:29m]: Play Now | Play in Popup | Download