Fractals of Change

When Angels Fear to Tread

It's the lack of exits that's a problem amid the deadly clamp of panic throughout the economy - a far cry from the irrational exuberance that drives entrepreneurs (and their investors) and which brings us trouble and fraud as well as greatness and "slumdog millionaires".

No matter how much we bailout the auto industry, there'll be less jobs making cars next year than there are this year – in fact cutting jobs is a condition of the bailout funds. There are going to be less bankers a year from now, too. New jobs will come from new industries, not from the ones on life support. So it is essential that there be some source of funds for entrepreneurs so that they can do what they do best (when they succeed) – create good jobs for future markets.

Tom Friedman suggested bailout money for VCs; Fred Wilson articulately pointed out that only the incompetent VC firms would take the money and that skilled VCS actually do have money and can raise more. Entrepreneurs pointed out in comments on Fred's post that there IS a shortage of money from entrepreneur's POV. In a comment on my post on the subject, Fred suggested tax breaks for angels.

Angels are motivated by fear and greed just like everyone else – angel investors, that is, who, in better times, are a source of funds for entrepreneurs launching the businesses of their dreams. Angels (I've occasionally been one) are just as perverse as all other investors; we're more likely to invest at market tops when everybody else is and less likely to invest in scary times like the present even though there's greater opportunity now.

There is a way to get angel money flowing again but it's not by subsidizing angels – even with tax breaks. Angels are claustrophobic; don't like going into investments without exits.

Angels generally step aside (but don't get cashed out) when a company gets its second round of financing. Often VCs step in with money, advice, and contacts for the next round of a company's growth. The angels and VCs (and entrepreneurs) generally get some reward when the company is either bought or goes public. But companies aren't getting bought or going public right now.

The result is a logjam. The VCs are concentrating their time and attention on companies which would have – in better times – been long out of their portfolios. It's true, as Fred said, that the good VCs can raise more money; but they can't clone themselves. Fred can only serve on so many boards at a time. That means that venture funds can't take responsibility from angel investors at the rate they used to – they have last years' hatchlings still in the nest.

An angel looking at a potential new investment not only confronts the risk of failure – that's always been there – but also the risk that he or she will be in an active role with the company – and perhaps its only source of capital –for a long time to come. We angels, like the VCS, still have the companies that we previously incubated in the nest. So we're not looking for new investments either. We're scared and there are no exits.

Only greed (the dream of an outsized return) can conquer fear. Tax breaks don't do it; you need to have some gain before you can use them.

An opinion piece in the Wall Street Journal today by Tom Hayes and Michael Malone entitled "Entrepreneurs Can Lead Us Out of the Crisis" suggests not only tax breaks for angels and entrepreneurs but also eliminating Sarbanes-Oxley to make it easier to be a public company. This has the virtue of appealing to greed (the IPO dream) and opening up exits; but even I'd agree that, in the dotcom generation, companies went public much too soon – eventually to the detriment of the companies as well as their investors.

We investors have to give up the dream of a QUICK outsized return. We can dream but we have to dream the patient dream. We probably even have to wait for companies to be profitable before we can make any money. That's OK; we can live with that as long as we can have the dream.

Turns out there is something government can do, however, to get investor juices flowing again: invest in infrastructure that creates opportunity rather than subsidizing zombie companies which are blocking the way. When the Erie Canal was built (funded by private investors buying government bonds), private money flowed to boat people and businesses all along the canal. Same kind of thing when the railroads with built with healthy doses of land grants and other subsidies – fortunately government DIDN'T elect to subsidize the canal boats which the railroads put out of business. DARPA (government) had a lot to do with inventing and funding the Internet; the Internet enabled and encouraged a wave of privately funded innovation.

I wish more of the bailout were focused on infrastructure – especially new enabling infrastructure. If transmission lines actually do get built, "alternative" power'll flourish with much less government intervention than is planned. The government does have a role in building those power lines. If the United States can become an e-nation with every citizen having access to a highspeed persistent connection whether at home or on the road, that infrastructure of connectivity will light the exuberance lights for a new generation of connected services. Government's role there is to create telecommunications competition we don't have today and to subsidize the last five or ten percent of connections as we did with rural electrification and telefonication because the network as a whole gains value when it is universal.

We investors and entrepreneurs have to relearn patience. Fair enough. We'll come back into the game once we can't stand to be on the sidelines any longer and when we see a future – almost no matter how distant – in which there is an exit.

A VC Says No to VC bailout

"Thanks but no thanks" is Fred Wilson's prompt response to Tom Friedman's column suggesting that $20 billion in bailout funds be made available to the top 20 VC funds so that they can invest in the future rather than the past of failed banks and auto manufacturers. Fred says:

"…the top 20 firms in the venture capital business are the least in need of a bailout of any group I've ever thought about. These firms, the Sequoias and Benchmarks and Accels and Kleiner Perkins [Fred modestly didn't add his own Union Square Ventures but could have] etc etc can raise a fund anytime they want. Accel raised a ton of money last fall in the midst of the worst global financial meltdown in my lifetime…

"The worst firms, on the other hand, will gladly accept government money. And that is what is going to happen with all of these government efforts to pour more money into the "innovation sector". That money will go to bad investors and weak entrepreneurs and management teams for the most part. It's a problem of adverse selection."

If anything, Fred is understating the danger in flooding the venture market with government money. It's a corollary of Gresham's law that bad investment drives out good. Suppose you're thinking about investing in software or green tech or something else…. and suppose you know the government's about to dump a lot of dumb money in the field, well then you don't invest because someone who's good at grants but probably not good at software or green tech or whatever is likely to wipe out the market for whatever you were going to invest in. If you're going to invest at all, you try to figure out who's going to get the government money and you put your money there. In other words, the smart money ends up front running the dumb money. Not good.

Of course the damage from government "investment" isn't limited to venture funding. Governments around the world have carefully been "investing in" the very banks which should get out of business and out of the way of better run and smaller (and less dangerous) banks. The better and smaller banks can't get investor money in this climate because the investor money would be competing with government money. Same, of course, in the manufacturing sector.

There is one part of Fred's post where he and I do have a slightly different POV: "… the venture capital business, thankfully, does not need any more capital. It's got too much money in it, not too little. Just ask the limited partners who have been overfunding the venture capital business for the past 15-20 years what they think." From an entrepreneur's POV, we like the VCs to be what they consider over-funded – more chance for entrepreneurs to get funded themselves on better terms than otherwise even though we then run the risk that our competitors will get funded as well. But neither as an entrepreneur nor as a limited partner in VC firms would I want to see government money poured or even dribbled in at the top. "Thanks, Tom Friedman, but no thanks."

 

    

Bailing out Investors Threatens Savers

Dow at five-and-a-half year low! That's the 4PM headline which inspired this post. Actually, of course, that's no reason for general panic in itself. No one ever said the Dow was supposed to go straight up. However, if you put a substantial part of your "savings" into stocks directly or indirectly, you may have a very good reason for individual panic.

If the government continues to insist on baling out investors, however, savers will be exposed to a risk they don't deserve.

Saving means protecting your principal while earning a very low return (zero in some cases). Investing means risking at least some of your principal in the hope that you'll make a better return than you will by saving. Once of the great innovations since the Great Depression is FDIC insurance. You can SAVE a reasonable amount of money without risk to the principal assuming that inflation isn't greater than your interest after taxes (hold onto that thought). If we don't have a rerun of the 1930s (and I don't think we will), we will be spared to a large degree because we had no reason to panic and take our savings out of banks (assuming that we didn't have more than $250,000 in any one account name in any one insured institution).

Unless you're a rock star, an athlete, or a vastly over-paid executive, it's hard to get rich just based on savings. Most of us don't earn enough to be able to put aside enough to build what we would consider wealth even with the miracle of compound interest. So we're tempted to invest some of what we were saving so that we can get a better return and live or retire in a grander style then we would have been able to based on savings alone. Nothing wrong with that so long as we remember that investing means taking a chance on losing the principal AND we're prepared to deal with that loss. Of course it's easy to forget the risk when you invest in a stock market that seems headed for the sky or when you "invest" in real estate by buying a house that costs more than you can justify paying EXCEPT for the fact that it is "sure to" appreciate. But it really hurts when you realize that your retirement will be much more Spartan than you planned because luck went against you, especially you're near the end of your working life and/or have no opportunity to restore the savings you lost. If we weren't out-an-out swindled, we make these choice and we live with the consequences – MAYBE.

But if a large constituency (recent home-buyers and refinancers) or politically powerful constituencies (bankers, automakers, for example) are feeling the pain of bad investments, then a democratic (small "d" deliberate) government is tempted to offer a bailout even though the investors were never promised nor did they pay for any insurance against failure. If there happens to be a recession going on at the same there's lots of clamor for bailout (and that's likely, of course), then tax revenues are also down. The only way a sympathetic government can bailout the unfortunate investors is by borrowing or printing money.

But borrowing or printing money eventually leads to inflation which erodes the value of what the savers saved. That's NOT FAIR. The savers made the choice to forgo large possible gains in return for safety. It's simply wrong as well as very bad policy to use inflation as a way to tax away their savings to provide a bailout to investors who decided to take a risk.

Note that a "stimulus" bill is not necessarily a bailout and can be very good policy. If the government spends money now on infrastructure or anything else which it would eventually pay for anyway but is cheaper now, then the spending helps flatten out the economic cycle and can naturally decelerate when many needs have been met for the next few years. The government can recoup this spending by not competing as much with the private sector for scarce resources doing boom periods.

The TARPs, aid to AIG, the "loans" to the automakers, and many plans which have been floated to help homeowners with mortgage payments are bailouts. They protect investors against losses. Since they don't create demand, they don't create jobs – just shuffle them around from one sector to another. These are the bailouts which rob savers to pay investors. They are a bad idea.

Mortgage Cramdown Key to Banking Crisis Unwinding

Democrats want Federal bankruptcy judges to have the authority to reduce the balances outstanding and/or rates on residential first mortgages in the same way that these judges can already reduce outstanding payments and balances on almost all other forms of debt; Republicans are opposing the legislation required to make this change. In my humble (and usually Republican) opinion, the Democrats are right and actually aren't going far enough. This strange treatment of these mortgages, first legislated in 1979 as one of many often misguided attempts to making housing more affordable even for those who couldn't afford a house, is a key cause of the logjam which is preventing the home mortgage toxic security mess from working itself out.

Banks already can negotiate reduction in principal with home owners and sometime do. Chances of repayment go up when the equity isn't underwater. An owner can make a rational decision to sell if he or she doesn't owe more on the mortgage than the house'll bring on the market. But financial experts say that many current mortgages can't be renegotiated because the creditors are split into mind-bewildering tranches of differently securitized investors who have no way or desire to reach agreement. Bankruptcy can cut this Gordian knot and let the mortgages be "marked to market" not only on the books of the banks but also on the books of the homeowners.

It may be that some banks are reluctant to mark mortgages to market because they haven't yet reflected the full loss of value of the underlying assets on their books. If this is the case, the sooner the true value is known, the sooner we know, for better or worse, which banks need to be liquidated.

As with other debts, the debtors and creditors are more likely to reach agreement if they know that a judge will eventually resolve any disagreements in a way neither of them may like. Many more voluntary agreements between mortgagors and mortgagees will be reached if the bankruptcy court is a known option – this is how almost all other situations where a debtor can't pay are resolved. With bankruptcy as a possibility, I'll bet the same Wall Street rocket scientists who figured out the maze of securitizations will get to work and figure a path out of the maze for many of their clients.

The Wall Street Journal, which was very right about the dangerous doings of Fannie Mae and Freddie Mac, is adamantly AGAINST the proposed amendment to the bankruptcy law. Below from an op-ed by George Mason University law professor Todd J. Zywicki:

"Mortgage modification would indeed provide a windfall for some troubled homeowners -- but its costs will be borne by aspiring future homeowners…

"In the first place, mortgage costs will rise. If bankruptcy judges can rewrite mortgage loans after they are made, it will increase the risk of mortgage lending at the time they are made. Increased risk increases the overall cost of lending, which in turn will require future borrowers to pay higher interest rates and upfront costs, such as higher down payments and point…"

Let's dispense with the rhetoric first. Bankruptcy always results in a "windfall" to a distressed debtor. When credit card and car loans are written down in bankruptcy, when the principal of a second home loan is written down, all of these writedowns result in "windfalls". More accurately, the pain is distributed between the creditor and the debtors. The idea is that this court-enforced sharing of pain results in better recovery for everyone overall than simple collapse. One reason the court has to get involved is to enforce requirements for future payments, make the appropriate garnishments, etc. Another reason is that it's often impossible to get 100% agreement from creditors so the final Solomonic decision on pain-sharing needs to be made by a judge.

We have commercial bankruptcies all the time (which the WSJ doesn't rail against) . Here's a description from the NY Times of the bankruptcy of Charter Communications: "Charter, one of the nation's largest cable television operations, said on Thursday that it would file for bankruptcy by April 1 as part of an effort to handle $21 billion in debt. Under the plan it has worked out with some of its creditors, Charter will be able to shave about $8 billion from that amount." $8 billion is quite a "windfall"; note that only "some" of the creditors agree. The purpose of bankruptcy in this case is to reach a settlement which determines the status of all debt and all creditors.

The second assertion in Zywicki's op-ed is that the cost of mortgage credit will go up in the future if banks have to take the risk that a bankruptcy judge will reduce the mortgage at some time in the future. Even if that's true, all that it means is that mortgages rates will fairly price in the ability of the debtor to repay just as other loans do already. That's good and not bad. If it forces the banks to think more about the credit-worthiness of the applicant and not just rely on the value of real estate (which we now know can down as well as up), that's a good thing. This mess was partly caused by giving loans to people who shouldn't have gotten them, remember.

Many of the proposals for making first mortgages on residences subject to bankruptcy deliberately only do this for EXISTING mortgages. This is a misguided attempt to make future mortgages cheaper by eliminating the threat of bankruptcy. We got into the mortgage part of the current mess by deliberately mispricing mortgages compared to other debt. It would be really dumb to sow the same seeds and not expect the same disastrous crop. There shouldn't be an exemption for mortgages or any other kind of private debt in the bankruptcy law.

Buy Local, Sell Global

It doesn't scale. We can't all buy locally and sell globally. The less politically correct sounding version is "beggar thy neighbor".

Last week when we were vacationing in very friendly Apalachicola, I was mildly offended by a banner one block off the tourist street advising everyone to buy local. "What, no Vermont maple syrup? No ski vacations?"

This Thursday the front page of the "what's happening"" supplement of the usually excellent Stowe Reporter , the section tourists presumably read to see what to do with the rest of their money when the ski day is over, is all about taking a "Stay-CATION" – that's a vacation taken from the convenience of your own home. I doubt if people'll just pack up and go home because the skiing's still pretty good. But Stowe'd be in a pretty pickle if all our visitors had decided to take stay-cations instead.

In Vermont neither our university nor our state colleges would be economically or educationally viable if they took only in-state students. We would be a very insular place if all our own kids were educated here in the State (and stayed). But there's constant pressure to limit State financial assistance to Vermonters who attend college in Vermont.

On a larger scale, undeterred by the example of the Smoot-Hawley tariff (a Republican idea) which some economists believe greatly deepened the great depression, pandering legislators are trying to sneak protectionists measures into almost every piece of bailout legislation.

Labor leaders are pushing to restrict immigrant visas. "We don't have enough jobs for our own people." If an immigrant does a job, she spends most of the money she earns here. If a job is outsourced, the money is really gone. Someone in India suggested, only partly tongue in cheek, that the US should expand the number of visas for foreign workers because the Indians who come here to work will buy houses and stabilize the housing market. They may also know how to spend without massive consumer credit.

But, people argue, if US taxpayer money is going to a company, should it then be used to pay foreign workers? Good question. The answer is in the premise of the question, however. US taxpayer money shouldn't be going to corporations as aid unless it's meant to help in the orderly dismembering of a corporation that's too big to fail on its own.

We are spending fortunes in US taxpayer dollars to bail out US corporations. Other countries are doing the same for their corporations. The bailouts preserve capacity but don't increase demand. To a large extent the bailouts by different countries to their own industries cancel each other out leaving taxpayers poorer and erasing current or future demand. Failure to recognize that the economy is global was catastrophic in 1930. It would be really dumb to double down on that mistake.

"Buy Local, Sell Global" makes no sense at all. In the context of a recession which could easily be deepened by a panic, it's a dangerous idea.

Save The Economy – Legalize Drugs

Torrents of cash gush destructively through the underground economy. Liquidity is never a problem there, just violence. Piles of money are diverted from the real economy to fight the failed war on drugs. Our neighbors to the south are getting tired of paying a bloody price for our drug efforts. Our efforts in Afghanistan are undermined by the money in opium.

It's time that we end prohibition and legalize drug sales to adults. We can and should have draconian penalties for selling drugs to children but it's easier to protect minors against a legal substance than an illegal one since the legal distribution chain is out in the open and has something to lose if caught acting illegally.

It's hard to quantify the economic stimulus that would come from surfacing the drug trade; at the very least it would be a major new source of tax revenue to struggling states and greatly reduce the cost of keeping drug users – including those who commit other crimes to feed their expensive habits - and small time dealers in jail. Huge amounts of police manpower go to attempting to solve drug related crimes.

A story in today's Wall Street Journal by Jose De Cordoba reports that a commission led by three conservative Latin American former presidents - Fernando Henrique Cardoso of Brazil, Ernesto Zedillo of Mexico, and César Gaviria of Colombia "blasted the U.S.-led drug war as a failure that is pushing Latin American societies to the breaking point."

"The report warned that the U.S.-style antidrug strategy was putting the region's fragile democratic institutions at risk and corrupting "judicial systems, governments, the political system and especially the police forces.""

It's surprising that Latin American societies have put up with the cost to them of our war on drugs for as long as they have.

So legalizing drugs is a stimulus package (pun intended) that comes at a negative cost to the taxpayer, punishes the bad guys by ruining their business, creates new business opportunities for good guys and lets us treat drug problems as we do alcohol and other addictions. The only problem is that it's political dynamite and will cause a huge anti-Obama surge from the right (but not from real conservatives like me).

Probably more change than it's realistic to believe in but much better economic policy than bailing out banks or shoveling pork. And good social and foreign policy as well.

Bankers and Oak Trees

From the POV of longleaf pines, oak trees are weeds – vicious competitors. Original stands of longleaf pine have charred bark from the many fires they've survived and there are no mature oaks among the pine. Seems that the oaks burn up in the periodic blazes which pine forests are particularly prone to and which pine trees can survive. The fires also decimate the insects in the lower bark of the pines.

Florida, where we've been hiking through the swamps and forests of the panhandle, now recognizes that the former policy of zero toleration for forest fires was destroying the remaining stands of longleaf pine because the unburned oaks were taking over. Now there is a policy of controlled burns – not sure what the long term unintended consequences of that will be but seems to be better for now than no burns.

When the Fed forcibly prevented recession by super-charging the money supply following the dotcom meltdown and 9/11, we created an environment in which parasitic portions of the financial industry grew like kudzu. Many of the rest of us jumped in by grabbing all the credit we could get and "investing" in over-priced assets. Leveraged buyout firms sucked the equity out of businesses and replaced it with debt; second mortgages did the same thing for housing. Ponzi schemes flourished. State and local governments spent booming revenue on ever more dubious programs.

The long-postponed recession hit with savage fury, fueled by the under and over growth that had gone too long unburned. The lesson from the pine forest is that we don't want to stop all of the destruction, just mitigate the damage to people the best we can. We do want to deleverage; we do want houses to become affordable because their purchase prices are affordable, not because teaser rates on mortgages are available. We do want businesses to live with less credit and more creativity. We do want to burn away the ravenous super-structure of finance with its inflated salaries and unnecessary financial products. We do want government to cut back where it isn't effective; we don't want Congress to continue buying our votes with our money through earmarks.

So parts of the stimulus package are fine; extended unemployment benefits, for example, or spending on counter-cyclical job creating projects (if they're both needed and can really be done quickly). There will be more people on Medicaid. With a little more stretch you can justify tax cuts for those with the lowest incomes; that does get money moving and help counteract the panic that has cash frozen in virtual mattresses. These measures are the equivalent of evacuation from a fire zone.

We DON'T want to preserve the financial industry in its current overgrown form. Sure we need banks; but we don't need TARP to keep them all alive. TARP installment 1.0 was sold on the premise that we'd collapse without more lending. We didn't get more lending; we're still alive although hurting. Now TARP 2.0 promises more lending through more accountability (even though that isn't in the law). But in a contracting economy businesses don't need to borrow for expansion; we don't need loans to help us flip real estate; cheaper houses mean less demand for home credit. We're not going to go back in debt up to our eyeballs for the sake of short-term economy. We're replacing our cars less often. So we can do without so many banks. Let them go.

We DON'T want home prices to surge back up. The Republican plan for a homebuyer tax credit is somehow supposed to both drive home prices up AND make it easier for people to buy homes. It obviously can't do both. Home prices'll stabilize when the fire finishes burning through and buyers aren't still waiting for yet one more government program.

Fires and recessions happen. You can postpone them but you eventually pay the price. You can mitigate some of the damage. But excesses still need to be burned away.

The World is Overbanked

We have too many financial institutions and too many people working in the financial trades. "Saving" banks is an even worse idea than saving car manufacturers. "Dusting ourselves off" means taking our losses and moving on; even the losses we incurred in the most recent round of bank bailouts. Sure, we need credit and capital; we just don't need so many people and institutions slicing, dicing, securitizing and providing it.

The goals of bank bailouts have become surrealistic. Check the logic this paragraph from a New York Times story about the UK's plan for an expanded bank bailout:

"Speaking at the prime minister's 10 Downing Street residence in London, Mr. Brown placed the blame for the financial crisis on 'irresponsible lending' by the banks and said institutions that took advantage of the new measures would have to sign a legally binding agreement with the government to provide more credit to consumers and businesses."

In the same sentence the British Prime Minister accuses banks of making too many loans and promises to force them to make more. And he used to Finance Minister.

A few days earlier both Citigroup and Bank of America got more TARP funds. Citigroup got the money so it could sell off its brokerage operation; Bank of America got the money to help it survive its deal to buy brokerage firm Merrill Lynch. Huh?

When we were being sold the enormous bill of goods called TARP, we were told that bank lending would collapse without it and that all business would grind to a halt. Turns out bank lending collapsed even with TARP and the economy staggered but didn't fall. Now the proposed solution is more bailout for those same banks who both lent too much and are lending too little.

In fact the USA economy is massively deleveraging itself. This is a good thing; it's facing reality; it's dealing with the consequences of past over indulgence. It's doing us all the things President Obama told us (correctly) we are going to have to do. But, since we are deleveraging, we don't need as much credit as we had before. We are making bigger down payments on cheaper houses; the price of filling oil storage tanks and the credit needed to finance that has plummeted; our lower credit card balances soak up less credit while our higher savings rate makes more money available. New economy companies like Google run on cash balances, not on credit.

The fact that we are saving more – helped certainly by Federal Deposit Insurance – supplies fuel to banks to make loans. But Federal Deposit Insurance makes us oblivious to whether we put our money into good or bad banks. We shouldn't repeal Federal Deposit Insurance since it may well have saved us from a far worse crisis. We should end all other subsidies to banks. The ones that are too big to fail turned out to be too big to save – it's time to dismantle them responsibly with managed bankruptcy and a quick sale of the their assets.

When the badly run banks are gone, the survivors will be much stronger. They'll get all of our deposits. They'll need to put this money to work. They'll be able to pick among worthy credits (if the government isn't doing all lending) and take a prudent amount of risk.

Further bank bailouts will simply damage the creditworthiness of the whole country. The pound plunged against the dollar and the euro when the latest round of British bailouts was announced. Interest on US Treasury bonds and notes rose from very low levels with the approval of the second round of TARP funds here. Ironically, higher treasury yields compete with bank interest rates and make it harder for banks to gather deposits and investments.

The sooner the financial sector right-sizes, the better. Because we are all now investors in AIG and the zombie banks, we are all going to have to take losses in the downsizing. The alternative is throwing good money after bad AND making it harder for well run banks to succeed and to resume offering credit to well run businesses.

Beware the Coyote Syndrome

Wylie Coyote sometimes runs over the lip of a cliff but doesn't start to fall until he looks down and sees that there's nothing but air under his feet. Same thing happens with companies and industries: if they're big enough, they keep on going even long after they're really dead.

Talked to someone today who'd googled me first (wouldn't you do that with a stranger?) and found a Red Herring interview in which I'd predicted Nortel's bankruptcy:

"Tom Evslin… compares the recent changes in the telecom landscape to the shift from mainframe computers to PCs. In that transition, dollars came out of IBM's pockets and into the coffers of Microsoft and Intel. Mr. Evslin predicts a similar redistribution of wealth in the telecom industry. Dollars that once went to Lucent Technologies and Nortel Networks will find their way to companies that make soft switches, voice-over-IP equipment, and replacements for expensive hardwire switches that route phone calls…"

Trouble with this prediction is that it was made in 2002. The rest of the     quote: "It will be a painful transition. Even the most optimistic don't expect things to settle down before 2004. For many companies, that will be too late." It wasn't until the next bubble burst that Nortel went chapter 11.

You can be right about trends and get the timing very wrong. Nortel WAS already toast back in 2002 but they (and their customers and their stockholders and their bankers) didn't know that so they kept going on sheer momentum. Maybe they could have used that momentum to scramble back on the cliff as the coyote's trying to do in the picture but they didn't and companies usually don't.

So what companies and industries today are really walking dead? It's a very important question because we live in a time of bailouts when zombies are kept walking with public money and may be crowding out the startups that should take their place.

Old style investment banks have already declared themselves dead and turned into regulated banks in order to get handouts. But do we really need financial supermarkets which are "too big to fail"? I don't think so. Do we need as much credit as we've been using? No. Do we need all the exotic credit instruments? No. Do we need all the people who sell all the credit we don't need and construct the exotic credit instruments? We don't need them to do that. Perhaps we need a retraining program.

Manufacturers of cars powered by internal combustion engines, particularly manufacturers with huge unfunded liabilities for past promises and huge debts, are certainly already over the cliff. Interesting article the other day – I can't remember where – about how many less parts there are in an electric or even a plug in hybrid electric where the gas engine only drives a generator than there are in a traditional gas powered car. Point is that it's much easier for an upstart to get started up building the electrics than it would have been to compete with those who are really good at building gas engines. Now where's that cliff?

Readers say I'm way too early in targeting the extinction of copper-based voice service by the end of Obama's first term. Maybe; there is the coyote syndrome to think about. But it's also possible that the coyote (or the coyote's customers or the coyote's bankers or the coyote's stockholders) happen to look down.

Past Performance Is Not an Indication of Future Results

You don't need to invest in a Ponzi scheme to lose all your money; most arbitrage strategies will get you sooner or later.

Let's say there's this absolutely fair and honest and even profitable investment. You, of course, do some diligence and find that the investment has returned .6% per month on the average every month for the past four years since it was founded – sometimes .55%, sometimes .65% - but variance you can live with. Moreover, you absolutely know (don't ask me how but you know) that it's not a Ponzi scheme.

You prudently invest a bit and, sure enough, for the next two years you get this nice return between .55% and .65% per month. The return isn't great but it beats the money you've been losing in the stock market. You're going to retire in five years and you figure that, if you put all your liquid assets into this and let them compound until you retire, you'll be able to live comfortably on the interest plus your pension and social security and even sleep at night. Why take any more risk?

What you don't know is that the investment strategy, which earns these consistent returns in good years and bad, has a half percent chance of losing all the fund's capital in any given month. Usually, of course, that doesn't happen. Statistically, it'll happen every seventeen years or so with an 50-50 chance that it'll happen in any eight year period although the occurrences are random. Bad luck, it happens just before you retire.

Were you defrauded? Only if someone said there was no chance of losing your capital. But probably the prospectus said that capital is at risk and past performance is not indicative of future results (right under where the past performance is displayed). If you do the math, you'll find that an investment with a 99.5% chance of returning .6% each month and a .5% chance of losing the principal (returning minus 100%) has a positive expected value - about .1% per month. That's the MEAN return but you've been looking at the MEDIAN return. We get fooled by the usual.

The investment described above is better than most hedge funds because it has a positive expected value – the real return on whatever the underlying investments are is greater than whatever management fees are being charged. In most cases hedge funds are like lotteries in that the expected return for all participants over time is less than zero because there are fees coming out of the pot. We usually loose when we play a lottery so, unless we have a gambling addiction, we don't get sucked in or tempted to bet our retirement on a single ticket. With many hedge funds we win most of the time (the usual return) but, when we lose, we lose most or all of our investment. The only hedge funds which are around to invest in are the ones which haven't yet lost all of their investors' money; they have positive track records or they'd be gone (as many are). Our brains are wired to think that past performance is THE indicator of future results no matter what it says in the prospectus.

In fact there are an infinity of arbitrage strategies which USUALLY have small positive returns; but, when they fail, they fail spectacularly. I think the promoters of funds based on these strategies even believe themselves that these are good investments. Maybe some are. But, unless there's an underlying investment in something that creates value, the expected return over time is less than zero after the fees come out. Since the returns are positive the vast majority of the time, the infrequent blowups are huge to keep the statistical books balanced.

Remember, this caution is about NON Ponzi schemes. It doesn't take a crook to part you from your money.

Nassim Nicholas Taleb explains these things much better than I do.