Some Thoughts on 2009

So much promise, so many risks. This is how 2009 is shaping up. While euphoria surrounding the Obama Administration's fiscal stimulus plans will drive the markets early in the year, I believe this rally will lose steam as massive deficit spending begins to shine a light on the greatest risk facing the US: debasement of the currency. The power we will be handing our creditors is stunning, and in an unstable and highly politicized environment it may well be wielded to the detriment of the US economy. Can you imagine the prospect of China and Japan balking at buying more dollar-denominated assets? While some might say "Well, it wouldn't be in their (US creditors') own self-interest to precipitate a massive decline in the dollar," depending on the political stakes at hand I wouldn't put it past them. This is a very unstable manner in which to run a country and an economy, where we've lost control of our balance sheet and, potentially, our political standing.

Michael Lewis and David Einhorn penned an insightful Op-Ed in yesterday's New York Times. In effect, they raise several reasons for why the financial crisis happened and what can be done to address the problems. Interestingly, many of their root causes (mis-aligned, short-term Wall Street incentives, rating agencies' conflicts of interest, regulators' personal self-interests, etc.) and prescriptives (consistent, well-communicated Treasury policies, creation of healthy institutions through Government takeovers, sale of healthy assets and the long-term workout of bad assets, long-term emphasis separate from stock market impacts, etc.) are in line with the thinking I've put forth on this blog over the past 18 months. One part of the article really got my back up. The Madoff meltdown and the existence of a whistleblower, Harry Markopolos, who had notified the SEC years before of his concerns is reminiscent of Einhorn's indictments of both Lehman Brothers and Allied Capital Corp (ALD). Like Markopolos, Einhorn spent years seeking to educate the SEC about the wide-ranging fraud taking place at ALD but to no avail.

This kind of regulatory breakdown is absolutely stunning, but not when one considers the mis-aligned motives of those doing the regulating. It is no different than the prevalence of short-termism on Wall Street, Corporate America and in our Government. While it is maddening, it only highlights the enormity of our task; to restructure the essence of how incentives are set in order to calibrate human nature with the good of society. This doesn't mean that what is good for you can't be good for society and vice versa. To the contrary, I believe we can balance self-interest with overall good. But when self-interest pays off in short-term ways, how are people going to act? You got it. This is among the biggest and most important challenges facing our Government, our companies and our citizens in 2009 and beyond.

So, here are a few trends that I think should - and will - prevail during 2009:

• Increased financial statement transparency. The "fair value" crowd will win the day. Investors are sick of surprises, and the only way these can be mitigated is through disclosure. Notwithstanding their poor performance over the past several years, the SEC recently supported the continued application of the fair value framework.

• The "exchanging" of credit derivatives and interest rates swaps. Keeping with the theme of transparency and adding a dose of simplicity, the trillions of dollars of exposure require far better tracking, disclosure and collateral management than has been in place up to now. Standardization is something that could and should have been addressed five years ago, but here we are. The time is now to liquify and demystify these opaque instruments.

• An explosion in illiquid asset trading. Given the magnitude of the stranded venture investments, private equity and hedge fund LP interests seeking to be offloaded and hundreds of billions of illiquid and "side pocketed" hedge fund assets, new venues will emerge for trading these risks. Venture capitalists and other early investors will want liquidity well before the IPO market comes back, and markets will spring up to handle these deals. And fund-of-funds, pensions and endowments in desperate need of liquidity will want as many options as possible for selling their LP interests and other illiquid holdings. This is a boom area for 2009 and 2010.

• A wholesale re-thinking of the role of rating agencies. If it wasn't before, it is now abundantly clear that rating agencies did neither a good job nor were free of bias while serving in a quasi-fiduciary capacity. Their work, an essential element in the due diligence process covering trillions of dollars of paper, was found to be wholly inadequate at precisely the time it was most needed. Given that ratings put forth by the major agencies are suspect, might not a new system be called for? Or perhaps a scrapping of the role of rating agencies entirely? At this point why would issuers pay rating agencies for their imprimatur when it has been shown not to be worth much? I don't know.

• Good Bank/Bad Bank (or a variant) will prevail as the financial services bailout tool of choice. The Treasury's hundreds of billions of capital injections into sick institutions with sick managements made absolutely no sense then and it makes no sense now. There are two ways to help the system and minimize moral hazard: (1) engineer a wholesale takeover of failing firms, wipe out common shareholders and unsecured creditors, kick out management, sell good assets to the highest bidder and warehouse bad assets for an organized liquidation over time; and (2) replace management at failing firms, wipe out the common and unsecured debtholders, isolate the illiquid, "bad" assets and sell them at market value to a Government-sponsored liquidating trust, recapitalize the "good" assets with either private (preferred) or public funds and let it go forth and prosper. Either way the outcome is both logical and far superior to that which has been engineered by the current Administration. Let's get a move on.

• The US stock market's return profile will look like a parabola, rising early and then falling late. Excitement over Obama and his stimulus package will drive prices higher, bringing money off the sidelines that is afraid to miss the recovery. Problem is, the combination of a plunging real economy and tax receipts coupled with trillions in Treasury issuance to cover the bailout, fiscal stimulus, war operations and refinancing of existing debt will crush the dollar. If the emerging markets begin to recover and the US "flight to quality" trade falters, US stocks could be a laggard for quite some time. Dollar assets simply won't look that attractive relative to developing nations with far more attractive growth prospects and with demographics to sustain this growth well into the middle of this century.

• Early-stage investing will be in its Renaissance. First is was private equity. Then it was hedge funds. Now I believe early-stage investing will create untold fortunes in this next cycle. Enabling technologies have made it so cheap to pursue new ideas that it is unleashing a wave of brainpower this world has never seen. Have an idea? Code it up. Processing power is cheap. Storage is cheap. And accessing customers has never been cheaper. There is a vibrancy across the early stage community - entrepreneurs, investors and customers - that simply doesn't exist at other points along the investment spectrum. Investor fear notwithstanding, good ideas are getting funded, and those that get funding and survive in today's hostile climate will emerge strong, game-tested, and ready to rock it when the economy recovers.

• The hedge fund industry "barbell" will only become more pronounced. I started writing about this in mid-2006, where I posited that the middle of the hedge fund industry would be squeezed. This has been borne out over the past few years, and represents a trend that will continue unabated in 2009. Institutions are redeeming out of funds large and small, but the largest funds will survive. Between sheer mass, long-term investor relationships and lock-ups the largest brand name funds will continue. Those funds that once populated the middle will not. Small funds will always exist, either as launch-pads for managers with grand visions or for investors content to run small, tightly-knit shops without the ever-present need to focus on marketing and customer relations. Bottom line, I think the fund with several hundred million under management will go the way of the dinosaurs.

• Market regulation will be revisited in spades. The key question is, are the changes incremental or wholesale? I'd argue that the current system combines the worst of many worlds, and headline-grabbing Congresspeople who think they look good by saying "increase regulation" without really understanding what that means could make things materially worse. We need to take a big step back, look at the tangle of regulations and regulatory bodies, pull out a piece of clean paper and say "What would a prudent regulatory framework look like?" It would likely emphasize transparency and disclosure, and be in sync with the accounting rule-makers at FASB. This is a huge undertaking, but one that needs to begin in earnest in 2009.

We'll see how it goes. Regardless, 2009 should prove to be a very, very interesting year.

Happy New Year and Help Wanted

Happy New Year, everybody. I hope you all had a good break and are ready to get back at it in 2009. While I believe that the US public markets will generally suck this year, I continue to feel that we are the cusp of a historic opportunity in the early-stage investment arena. Fortunes will certainly be made in the liquid markets, but REAL fortunes and REAL value will be created through innovation, entrepreneurship and sheer will in the private markets. I intend to participate actively in this portion of the wave.

I was kindly (and unexpectedly) asked to be the keynote speaker at the 2009 SIIA Previews on January 26-28. Last year's speaker was my friend Kevin Ryan of AlleyCorp. I can see why they wanted Kevin; he is a serial entrepreneur with an impressive track record and one of Silicon Alley's brightest lights. Though I had a pretty successful career on Wall Street, in the entrepreneurial world I am probably best known for my role in the failure of Monitor110. So I figure I will discuss what we can learn through failure, and how we can ultimately turn negative events into positive outcomes. I think this will make for an interesting and topical discussion.

That said, I would be interested in other's thoughts on the topic of Learning from Failure. It could be quotes, cartoons, pictures, videos, whatever you believe would contribute to the presentation. I certainly do not corner the market on insight or have every relevant metaphor at my disposal, so any help would be much appreciated. You know where to find me.

The Real Credit Crisis

The US is at a “strategic inflection point,” with the opportunity to re-assume global leadership on both diplomatic and economic fronts or to become mired in its own problems, losing influence, power and pride both at home and abroad. Andy Grove, the former CEO of Intel and author of the seminal business text Only The Paranoid Survive, provided us with this useful prism through which to view the environment currently facing the US.

A strategic inflection point can be summarized as “…a time in the life of a (business) when its fundamentals are about to change. The change can mean an opportunity to rise to new heights. But it may just as likely signal the beginning of the end.” It is tempting to view the US’s current plight as merely another bump in its inexorable ascent, but I believe the environment tells a different story. It transcends the stock markets, the credit crisis, proliferation of terrorism and warring nuclear powers. A healthy nation, a sovereign power that can effectively use diplomacy to achieve positive ends requires a stable economic foundation, and the economic underpinnings of the US have become so fractured that it risks being marginalized on the global stage. This "change in fundamentals" that is creeping up on us? Our creditor's willingness to hold dollar-denominated assets in general and to finance our persistent budget deficits in particular. This is the real credit crisis facing the US.

Why are things different this time? The Great Depression is held up as the singular economic event in the US to be avoided at all costs. The Government put  "safety nets" in place to help those who cannot help themselves in difficult times. But this doesn’t tell the whole story. We, as a nation, have been spending far beyond our means for generations; so much so, in fact, that the purported safety nets place a greater risk to our future than the risks they were created to avoid. The Social Security system is bankrupt. Medicare and Medicaid represent looming obligations that will swallow a progressively greater share of US taxpayer dollars that subsequent generations will have to fund. Institutions such as the Federal Deposit Insurance Corporation (FDIC) are woefully under-capitalized. The Pension Benefit Guaranty Corporation (PBGC) will be bankrupted in the current economic downturn.  And the trillions committed to bail out our financial institutions has further weakened the integrity of the US dollar, regardless of its benefiting from the “flight to quality” rally that has pushed Treasury yields to historically low levels.

Reliance on foreign oil is a popular issue with voters. The price at the pump and the threat of hostile nations are things most citizens can relate to. Yet it is hard to argue that the dependence on foreign cash poses a far greater risk to US security, stability and power. It is a much more complicated problem with a broader impact, but it is hard to understand how it effects our daily lives. Each poses huge threats to our well-being and takes power out of our own hands.The US has created a very unstable situation where it is no longer in control of its destiny; the Governments of China, Saudi Arabia and Singapore, among others, hold the keys to its future unless it can reverse the trend.

The US manufacturing sector is in shambles. The financial sector is still badly damaged and in need of repair. The US infrastructure base in is dire need of investment. Promises have been made to workers who have paid into a flawed Social Security system for decades that will not be kept. Health care costs continue to spiral out of control, with skewed and inefficient incentives that penalize prevention and reward acute care. Our military is overextended, ill-equipped and consuming hundreds of billions of dollars per year. The charade has to end. Every day the President and Congress avoids dealing with the root cause problems makes them harder to address. Yet it may be that they are too close to the problems to actually see them, and too personally invested in the past to push for aggressive and necessary change.

Andy Grove makes the point that middle managers, those in the trenches doing the hard work day in, day out, are better able to see the coming tsunami of a strategic inflection point before their bosses do. And a good senior manager will incorporate the input of these colleagues, arrive at a new strategic vision, create a set of required actions and clearly communicate them throughout the company. The hallmarks of a leader who can manage through a strategic inflection point include: open-minded and humble; a good listener; a critical thinker; decisive and strong once a decision has been made; and an effective communicator. Leading through a strategic inflection point is a scary, often lonely experience when the future of your company – or your country – hangs in the balance. Yet the risks of inaction almost always outweigh the risks of being too early. 

We need the creation of interdisciplinary teams to study, analyze and propose strategies and actions in each of these critical areas. And the marching orders from the President should be to come back with solutions grounded in fiscal reality, and with zero input from lobbyists with agendas that morph based on who’s paying. Quite simply revenues need to go up and costs need to go down, and unfunded promises need to be restructured to match hard-dollar contributions with benefits payable. We need a redo. Nothing can be viewed as sacred. A “do nothing” strategy is a recipe for disaster, an almost-certain path down the road of nations who struggle to meet their external obligations with predictable and unpleasant effects. But most importantly, the US citizen needs to understand this shadow threat that lurks in the background, with the possibility of damaging their quality of life in ways previously unimaginable.

Our success as a nation poses the greatest risk to addressing these monumental issues. We are plagued by inertia both due to partisan politics, a lack of understanding of the magnitude of the threat and the relative comfort most citizens enjoy. The US has been and still is a great nation, and has accomplished a staggering amount in its relatively short life. But as the disclaimer states, "Past performance is no guarantee of future results." Resting on our historic achievements and hoping that time will solve our problems is both foolish and harmful. Hard and painful changes are absolutely necessary, and will require sacrifices from everybody. But for the good of our country and the life we want for our children and subsequent generations, we have to take decisive action - now.

A Happy 2009 to All

Friends, old and new and readers of all stripes, thanks for making 2008 an interesting, provocative and challenging year at Information Arbitrage. While my blogging ebbed and flowed, and at times I needed to check out to regain my inspiration, you were always there. Thanks for the emails of encouragement, suggestions, questions and deals, and most of all for participating in what has become a vibrant community around the topics of business, politics, technology and musings on life. I've shared happiness and tragedy, feelings of admiration and disgust, and generally just put out there whatever stoked my fires at the moment. So thanks for bearing with me. Whether or not you know me personally, I can assure you that as a reader you definitely have a window into my mind and my heart.

I'll be traveling with my family for a bit and won't be focused on writing while I'm away, so my next post may well be in 2009. Unless I can't take it and shove one more in there for good measure, that is. But assuming my discipline holds, I just wanted to wish all of you and your families a happy, healthy, peaceful and prosperous 2009. Peace out.

Recovering Our Sense of Accountability and Shared Responsibility

Honor. Integrity. Trust. Pride. Hard work. All elements of a job well-done. Why did people do this? Because they cared. Because they wanted to provide for themselves and their family. Because it was simply the right thing to do. It didn't require a lot of explanation. People just did it. You worked hard for your employer and they took care of you. This applied to positions in both the public and private sectors. Somewhere along the line, at the upper echelons of Corporate America and within our Government, we lost our way. Incentives became skewed. The moral absolute of working hard and working honestly fell by the wayside. The impact of ones' actions were not part of the equation. Material rewards came too easily for many. This change in culture permeated our institutions and has contributed to the numerous crises we are witnessing today.

Many in the US became intoxicated with money. Money and consumption. Of the conspicuous variety. The phrase "Keeping up with the Joneses" that used to characterize the dreams of the middle class morphed into something quite different among the wealthy. At some point it because a competition involving vacation houses, cars, jets and art - even charitable giving. At the upper echelons of the economic ladder, the great partnerships of Wall Street used to reflect a quiet sense of privilege, power and philanthropy accumulated over years of carefully shepherding partner capital; this has been replaced by public relations, personal branding and egocentricity reflective of a compensation structure and a culture that rewards big risk takers and punishes the prudent. If you really think about it, nausea is sure to follow. 

It seems as if we've lost a few critical genes over the years, such as those representing Accountability and Shared Responsibility. Look at Congress. Wall Street. Corporate America. How many of our breakdowns are due to a lack of these genes, where agency effects have dulled the senses against individual behaviors and so many are unable or unwilling to think beyond themselves? Whether it was the mortgage banker cuttting corners on loan applications to generate larger commissions, the senior capital markets executive who continued packaging CDOs even as credit quality rapidly deteriorated or the Congressperson who just didn't think about the impact of compensating the GSEs for making trillions in loans to unqualified borrowers, they all blew it. Money. Power. Influence. And all for the wrong reasons.

Blogger David Feldt penned an interesting post on a related topic today. While he takes a decidedly spiritual angle in addressing today's problems, his thought process is very consistent with my own and I find his take to be both very refreshing and important.

We have been seduced by the “American Dream” for the past 20+ years, borrowed money we couldn’t afford, bought things we didn’t need and speculated wantonly in the pursuit of more and more. Avarice and stupidity at their respective best. Humanity at it’s collective worst.

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I believe we are being given a huge opportunity to change the game. To abandon the dominance of our selfish nature and to embrace a new world where giving back and caring for others is the path to our redemption. We have the opportunity to temper the destructive nature within ourselves where personal gain triumphs over everything else. We are being given the change to balance it with empathy, concern and care for others.

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The quantum opportunity we have before us is to democratize this “giving” mindset beyond a select few. We have the tools to enable this change literally at our fingertips.  Technology and the Internet has provided a platform that connects all 6 billion of us on this planet like never before.  Let’s use it to serve others and thereby serve ourselves. Let’s elevate this world together via the enormous power our collective connectivity affords us.

Interestingly, my friend Peter Bloom has gotten very involved in a fantastic charity called DonorsChoose.org. It is just the kind of giving that David has in mind. Technology-enabled. Extremely tangible. A direct connection between the donor and the recipient with minimal friction. I donated a microscope to a high school class in Queens for students from largely immigrant families, and every single student in the class sent me a thank you note. Children from all over the world, so thankful that someone cared enough to help with their learning. But this is only one of many worthy organizations that offer the giving opportunities contemplated by David. The point, however, is much bigger than giving to charity; it's about being a giving member of an interconnected world. And from embracing the concept of shared responsibility, I believe the concept of accountability springs naturally.

This has been a lousy week and an even lousier year on so many levels, but 2009 need not be the train wreck that 2008 has become. If we can insist on shared responsibility - recognition of the needs of multiple stakeholders, focus on the impact of ones actions,  behaviors that are ethical and moral - and hold those in Government and business accountable, perhaps we can apply the same high standards to our own lives. It is in facing our own shortcomings that we can all rise to a higher plane. Let's all resolve to be better in 2009 - for ourselves, our families and society at large.

The Market Treads Water While Short-Termism Continues to Dominate

The Fed push rates towards zero. The White House stretches the intent of TARP in order to bail out the automakers. Bernie Madoff dominates the headlines. What do all three things have in common? Brutally short-term thinking.

Fed policy: This last leg down in Fed policy is only sure to do one thing: lay the foundations of another credit bubble and hyper-inflation when consumption resumes. The impact on consumers of short-term rates approaching zero is limited. Most consumers care about term rates generally, and mortgage rates specifically. Banks and other financial institutions, however, are heavily reliant on the short end of the yield curve to finance operations, where ultra-low borrowing rates help them rebuild their capital positions by holding term Treasuries, financing short and riding the yield curve. This is what helped banks in the early 1990s. But short rates are now so low that a river of money is building, a river that will eventually become so powerful that it will ignite inflation at the first sign of economic activity. Did the Fed need to ease policy any further than it already had? No. They are focused on the wrong thing. Keep term rates low (while preserving an upward-sloping yield curve) without pushing short rates down to Japanese circa 1990s levels, in order to strike a balance between supporting consumer and institutional balance sheet rebuilding and sowing the seeds of future inflation. In sum, a perfect example of short-term thinking.

TARP for autos: The White House perceived a game of political chicken and caved. Consider the $17 billion flushed down the toilet. Punting to make a hard decision another day with yet more taxpayer money. Call it a premium payment for an intelligence option. Hopefully, somebody in power will grow another lobe on their brain in order to develop a fundamental solution to the automakers plight. I've blogged about this before and won't repeat it here, but mine is a fervent view that an organized bankruptcy process is the only chance we have to both create a smaller, yet viable US auto industry and to prepare displaced workers for roles in other companies and initiatives (such as the looming infrastructure projects on Obama's mind). These incremental solutions simply won't work and represent yet another squandering of your money and mine (see Citigroup, $25 billion down the toilet).

Bernie - money for nothing, returns for free: So many are looking for the free ride, the easy way to fame and fortune, and Bernie Madoff gave them the chance. The fund-of-funds entrusted with people's money for whom their only job is to perform due diligence and asset allocate, neither of which they did very well? Greed and incompetence are now the adjectives characterizing the industry. The SEC? Their work was effectively done for them by a whistle-blower, and even with this they couldn't shut down what we know today to be a fraud on an historical scale. The number and breadth of entities that failed in the Madoff scandal are truly mind-boggling. But, as usual, the reason for the "miss" was pretty clear: Madoff's purported returns made doing the job really easy, and I look like a connected genius for getting in and staying in. Too bad by not doing the work you lost. Big time.

Citi to Integrate Corporate and Investment Banking - 10 Years Too Late

Citigroup is creating a unified global banking group? This is almost a joke - talk about anti-climactic and too little/too late. I wrote about this very issue two years ago when I did a compare/contrast of Citigroup and Deutsche Bank, my two former employers. One of the most destructive features of the Citicorp/Travelers merger was that nobody in power wanted to make a hard decision, especially as it related to integrating the banking franchises. Instead, senior management (of Travelers, who had the keys to the car) let deception, politics and in-fighting take its toll. Many great people left, clients were often confused, and product people we left to either ignore the situation entirely or to get embroiled in a popularity contest between the RM (the legacy Citibank Relationship Manager) and the IB (the Salomon Investment Banker). It was the antithesis of customer-centricity.

This was what I said in my original post:

Illusions of equality and fairness. Duplicate functions were preserved on the relationship side, with Citi commercial bankers and Salomon investment bankers covering the same accounts. There was supposed to be transparency, sharing, etc. Bullshit. It was a confusing, painful mess, especially for the Citi bankers who were relegated to second-class status and the Citi product people, who had once ruled the roost (and who were loved by the bankers who made lots of money by supporting their efforts). This duplication carried on for years and years, long after my run at Citi had ended. It would have been better, in my opinion, to make the hard and painful changes upfront, get everybody in banking and the products following the same strategic plan and GET AFTER IT. Otherwise, immense time is wasted on internal politics, positioning, and basically a whole lot of non-revenue generating activities. Life is too short and shareholders can't wait. Get on with it.

Well, they didn't like my thoughts ten years ago and they blew me off two years ago, but now it's big news. Yawn. I guess they figure it's best to make changes when no business is getting done so they don't look like fools if it flops. Citigroup is still a very large, very political place. It will be interesting to see if the integration holds. Think the Hatfields (RMs) and the McCoys (IBs). Or perhaps the Israelis and the Palestinians. It may be that the embedded cultural differences and historic grudges and injustices are simply too great to be overcome, leaving them with a clear option: wipe out all who can't (or won't) be team players, regardless of performance. Negativity (as opposed to constructive disagreement) is a cancer that can't be allowed to remain in a body, in a company, in an organization of any kind. After a decade of never-ending battles, the time has come for Citigroup senior management to finally take a stand. Saying you're merging the org chart is one thing: effecting cultural change is another. Eye on the ball, guys. It's too late for window dressing. Either make it work or force out the non-team players. Because enough is enough.

Stocktwits Closes its Series A a/k/a Building a Long Tail Meritocracy

I, @infoarbitrage, am pleased to announce that we just closed a Series A round for Stocktwits, providing the resources to get to break-even while preserving the small, tightly-knit, scrappy company culture that has served us so well. Soren (@sorenmacbeth) and the team have gotten us pretty far along on very little money; the time has come to give them some more resources to continue building the vibrant, intelligent, active and valuable community that has emerged. IA Capital Partners, LLC led the round and I am joined by an All-star group of investors who bring huge value to the company. Stocktwits community leaders. Media mavens. Search experts. Twitter gurus. Here is a slice of our syndicate:

• James Altucher: Founder, Stockpickr; Columnist at TheStreet.com; author; hedge fund manager;
• betaworks: A leading NYC-based early-stage media and technology investor; Investor in Summize, sold to Twitter;
• Bill Bishop: Co-founder of Marketwatch; based in China, provides 24-hour perspective;
• Eric Bolling: NYMEX trader and Board member; Financial Analyst, Fox Business News;
• Gerry Campbell: Former President, Search & Content Technologies at Reuters;  SVP of AOL Search;
• Michael Parekh: Former Head of Global Internet Research and MD, Goldman Sachs; uber-blogger;
• Todd Stottlemyre: 2-time World Series Champion pitcher, stock fanatic and active Stocktwits community participant;
• Rikki Tahta: Co-founder, Covestor;
• Alan Warms: Former VP and GM of Yahoo News; Founder, BuzzTracker, sold to Yahoo; and
• Power bloggers/Stocktwits community leaders such as Andy Swan (@andyswan) and UpsideTrader (@upsidetrader).

You know how people always say "We want value-added investors" but this seldom comes to pass? I'm not sure if I've ever been part of a deal where so many of the investors are either domain experts, power-users of the product or super connectors with rolodexes filled with relevant contacts. In short, it is an exciting time to be working with the company.

Harnessing the power of vertical communities is one of my passions, and Stocktwits has been a real-life, real-time incubator. How do you best engage the community? How do you continue to drive value and build greater "stickiness?" How should you prioritize new features and functionality that meet the community's evolving needs? Since we started with a blank slate we were able to be intensely customer-focused from Day 1, and it is a culture that runs through everyone that is formally or informally affiliated with Stocktwits. I draw this distinction because there are lots of bloggers and community participants that have been incredibly helpful as we've built the platform, and while they are neither investors nor employees have had a profound impact on the product and our roadmap. Building for the community by listening to the community: makes sense, but I've seen it done other ways, usually to that company's detriment. At Stocktwits, Soren, Phil (@ppearlman) and the team are doing it right.

We are also working on deals with distribution partners who are eager to bring the Stocktwits commentary into their feeds. One such partner is Bloomberg. We are working with them to create a filtered feed of high-value Stocktwits commentary, that can be incorporated into their already large and growing pipe of alternative content such as online news, blogs other non-traditional sources. Who says you can't teach an old dog new tricks? Bloomberg is getting it, and Stocktwits can be part of their answer. Why? Real Investors. Real Ideas. Real Time.

The amazing thing to me is how, in such a short time, a group of powerful Stocktwits influencers has emerged. Who knew the wisdom of Gregor MacDonald (@GregorMacDonald) before he starting blasting away on Stocktwits? His prescient calls on energy have been unreal, well ahead of conventional Wall Street sentiment. Now he has a huge following and his reputation has skyrocketed. UpsideTrader has made his presence known, also commanding a large fan base eager to read his comments at the open and throughout the day. The information is actionable. The insights, often contrarian (and accurate) relative to mainstream commentators. These thought leaders were not household names or even recognizable in the blogosphere - until now.

Stocktwits massively leverages the power of the long tail, but the reason followers are able to rapidly identify value is because of reputation. THE STOCKTWITS COMMUNITY IS A MERITOCRACY. Those that hem and haw and say little don't get followed. Those who are insightful, sharp and decisive command large readership. And this is the way it should be. We've only just seen the tip of the iceberg of what the Stocktwits community can and will become.  But the power of the platform is clear.

The best is yet to come, my friends. Oh yes, the best is yet to come.

The Madoff Saga: Perils of Fraudulent Conveyance

Say you were an investor in Madoff's funds. A few years back you decided to diversify. You asked Madoff for your money back and you got it. You then invested the proceeds in an array of other assets. Madoff then goes bust in a massive fraud. One day you get a letter from a bankruptcy trustee. The letter says that you need to repay a large chunk of your original investment in order to satisfy the claims of other investors who were less fortunate (or smart) than you. Is this fair? Is this right?

The concept being applied by the Court and the bankruptcy trustee is called Fraudulent Conveyance:

The basic structure and approach of the Uniform Fraudulent Conveyance Act are preserved in the Uniform Fraudulent Transfer Act. There are two sections in the new Act delineating what transfers and obligations are fraudulent. Section 4(a) is an adaptation of three sections of the U.F.C.A.; § 5(a) is an adaptation of another section of the U.F.C.A.; and § 5(b) is new. One section of the U.F.C.A. (§ 8) is not carried forward into the new Act because deemed to be redundant in part and in part susceptible of inequitable application. Both Acts declare a transfer made or an obligation incurred with actual intent to hinder, delay, or defraud creditors to be fraudulent. Both Acts render a transfer made or obligation incurred without adequate consideration to be constructively fraudulent - i.e., without regard to the actual intent of the parties - under one of the following conditions:

(1) the debtor was left by the transfer or obligation with unreasonably small assets for a transaction or the business in which he was engaged;

(2) the debtor intended to incur, or believed that he would incur, more debts than he would be able to pay; or

(3) the debtor was insolvent at the time or as a result of the transfer or obligation.

In my career I always thought of this as being something brought about by corporations in an attempt to disadvantage certain investors, e.g. the split of Marriott International and Host Marriott, with Host Marriott bondholders getting an instant downgrade by being left with a heavily leveraged capital structure. A different example in the investment world is when hedge funds enter into "side letter" agreements with certain investors, providing them with preferential redemption rights in order that they can exit without regard to the customary lock-ups to which other investors are subject. The aggrieved parties in the Madoff case, however, are individuals and firms with no knowledge of the fraud being perpetrated and with no preferential rights. Every investors' right to redeem (or not to invest) appeared to be just the same as any other. So why should those who got out be forced to suffer the same fate as those who didn't, even though they were operating with exactly the same information and with the same rights?

The template for this kind of treatment was set in the Bayou case, where the fraudulent conveyance concept was used to claw back funds from investors who had exited as far back as two years prior to its implosion. It seems to me that this interpretation could have a chilling effect on asset managers in general and hedge funds specifically. I recently redeemed from a few hedge funds because, well, I wanted to. I don't know anything special. I just want to deploy my assets elsewhere. Does this mean that I need to be worried that I might get a letter in a few years asking me to repay a portion of what I've redeemed because a fraud was subsequently determined to have taken place? Investors can't place money worrying about stuff like this. If there is an even playing field, the chips have to fall where they may. It is no different than a game of musical chairs: everyone has an even chance, but when the music stops some are left without chairs. It sucks but it is what it is.

The Madoff fraud is a tragedy of epic proportions, and there is almost no punishment sufficient for the monster that caused this widespread damage. However, those who innocently exited the situation should not have their lives turned upside down on a retrospective basis due to a highly legalistic ruling with little appeal from a common sense perspective. What Madoff did was bad enough and the numbers who are suffering is massive: to enlarge the circle of damage to those who long left the fund seems neither fair nor just. Sometimes law and common sense just have to come together. This is one of those situations.

The Real Take-away from the Madoff Scandal

Shocked? Yes. Surprised? No. This "stuff" (scandals so shocking that they practically take your breath away) can and does happen for a variety of reasons. The Madoff scandal is so interesting not for the classic reasons - abhorrent due diligence practices by fiduciaries, basing enormous financial decisions on the word of friends, wanting to be part of an "exclusive" club, etc. - but for the gaps it highlights in our regulatory apparatus.

Hedge funds, the purported touchstone of the unregulated entity, are far more regulated and subject to many more checks and balances than Madoff ever was. I've long made the argument that hedge funds are actually heavily regulated, not directly but indirectly through their relationships with the heavily regulated prime brokers. Forget about the negative PR and spin - it's true. Prime brokers have full transparency into the books of hedge funds, contribute data to the reporting of Net Asset Value (NAV), which is generally pumped out by the hedge funds' administrator. There is a further layer of protection offered by the hedge fund's auditor. Unless everyone is in cahoots it is pretty hard to see how a hedge fund is systematically mis-reporting NAV (except with repect to illiquid assets, but this is another issue entirely).

Some of the biggest non-market risks of hedge funds include style drift (veering from the strategy outlined in the prospectus, such as when Amaranth's natural gas trades ceased to make it a multi-strategy fund), creeping illiquidy (taking advantage of the illiquid asset carve-out in the prospectus only to see the value of the liquid assets fall, resulting in a prospectus-breaching concentration in illiquids),  overuse of side pockets (concentrated, balky public positions that don't fall under the rubric of illiquids yet result in a similar risk profile) and manager fatigue ("If I'm down 50% and it will take me years to dig out from under my high water mark, I'll just shut down"). Note that these risks have to do with the character of the manager, things that a good due diligence process should ferret out. But they really don't have to do with the veracity of the firm's positions, books and records, as third-party involvement together with the regulatory oversight of the prime brokers makes the Madoff kind of fraud highly unlikely.

But Madoff is a completely different kind of firm. It is a broker/dealer with an asset management division, enabling it to rely entirely on itself for trading and settlement. Further, it used a no-name, three-person accounting firm, unheard of for a firm of Madoff's size, scope and complexity. A purely rational trader of Madoff's stature would have set up a hedge fund business to extract 2/20 from his clients. I guess we now understand why; it would have subjected his portfolio to the unwanted scrutiny of his prime brokers. By keeping his game completely in-house and on the down low, it essentially fell through the cracks of our regulatory structure. Will this cause the SEC to redouble its efforts in regulating broker/dealers? Force changes in transparency, similar to what I've pushed for in the OTC derivatives market to the broker/dealer community? Or is it simply a matter of creating rules that ensure credible third-party involvement in the validation of assets under management/NAV in order that Madoff's brand self-dealing couldn't be sustained?

When it comes to client funds, I believe the involvement of multiple third-parties in the validation of positions and NAV is critical. Checks and balances have to be built into the system, and by employing a structural approach to regulation as opposed to simply adding more regulations, I believe we can minimize the friction in the system while providing the necessary protections to individuals and institutions. The lack of trust so pervasive in today's financial markets just took another hit. But let's take a moment to think of the right way to address the issue (better due diligence, higher standards for fiduciaries, imposition of checks and balances with broker/dealers and asset managers working under the same roof), rather than the way that plays best for PR purposes.