by guest blogger Ken
Wow, so all of the chickens are coming home to roost and those who created the problem want to fob the guano off on the public at large. Anyone who has been reading my postings since the beginning of the year knows how I feel about the situation, especially since I work at one of the places that cleans up messes. Now I hear the government wants to become a competitor, and they’re willing to pay “above-market prices” with your money for assets that we invest the time and effort to determine a real risk profile for and appropriate return and bid accordingly.
But that’s not what I want to talk about. What I want to talk about is how the space field is likely to be affected by all of this. Please be advised that this is free-flow analysis, with no intention of taking position or making judgment. I just want to see what the facts tell us.
Looking at NASA and the government side, I don’t see good things. The government budget is going to face increasing pressure from debt service, as most gov’t borrowings are shorter term, and so will follow interest rates up much more quickly than if it were longer term debt. I don’t remember if it was David Stockman who got the ball rolling on that process, but the practice has been around for a couple of decades. In my view debt needs to be tenored against whatever obligation by the gov’t/asset of the people that it is financing.
There are a lot of those obligations by the gov’t that are going to be coming due by the time we get to the 2020 time frame. The Baby Boomers seem to have a strong predilection for retiring early, which moves forward in time the obligation pressures. I hate to say it, but I think we need to fundamentally rework the way we go about social security. The cap on contributions needs to be lifted immediately, and the retirement age set at 70 with no early retirement (except for things like ‘differently-abled’ and survivors), crawling up to 75 by the time I would get there. I’m at the front end of Gen X, for the record, and really not looking forward to inheriting the standard of living of my grandparents by the time my generation rolls into power.
Medical entitlements are also a problem area to address, and I long ago gave up trying to understand how that medical stuff works. I just basically don’t go to the doctor unless I really need to do so. It needs to be fundamentally reworked into a General Practitioner-oriented system (i.e. networks of family doctors), not an ER-driven system. How to do that I have no clue.
These two items are the biggies facing our government, coupled with paying down the debt, that are going to put extreme pressure on discretionary spending. I think the military is going to have to do exactly what Ron Paul said and scale back our presence overseas, though I don’t believe they’ll end entirely and we’ll still have regional facilities. But the days of empire are over.
I think the military will continue to have a significant presence in space operations. Imagery and communications have proven key to having global warfighters, especially special ops. These two should do fine whatever happens. On the NASA side, I think vested interests will try to continue the cash flow to ATK et al for ARES for as long as possible. Hopefully it won’t be for too much longer, so that we can start applying those cash flows to alternate solutions and beefing up the science again. We need to look at alternative solutions.
By alternative solutions I am of course referring to the private sector. In two forms – transportation and finance.
In transportation the private sector has to show success. That really hasn’t happened yet, and so the investment capital is sitting on the sidelines. I think suborbital is interesting, but I think the real money is waiting on an Earth-to-LEO solution to get into the game. I’m hoping that Boeing and LockMart have aces up their sleeves, but I’m not counting on it. I think rather they’ll wait for some opportune moment, like when NASA gets delirious and asks American industry for transport to orbit just like everyone else. Then you might see some miracle solutions, but otherwise don’t hold your breath. That leaves SpaceX, and I’m waiting for the IPO, as I’d certainly like to have some skin in that game.
If the transport problem can be overcome relatively quickly, then I see micro-g science payloads as the next field to open up. This is an area where the U.S. can excel, and should be pursued vigorously. Again, investor money will sit on the sidelines until there are a few successes, but once the Bigelows are up and running things should proceed fairly smoothly and added investments will bring added successes. Some are skeptical, but I think there is promise in things like micro-g foamed metals.
Y’all have to realize, there is an enormous, huge amount of cash that is sitting on the sidelines as things unfold, and looking for something good to invest in. Space is something good to invest in that will, over the long term, have innumerable benefits to those of us stuck here on Earth. The problem is how to make that something to invest in now. That’s where crisis = opportunity. Again, it all revolves around transport of humans to LEO. For the military it makes sense to have some sort of…never mind, I don’t think it’s a good idea to publicly speculate in such areas. For the private sector it provides access to leased Bigelow facilities. For NASA it means continued access to the ISS, and staging for future trans-LEO missions.
Over the near term a focus on things like in-space infrastructure that enables more than just NASA, and independent access to orbit because you have multiple sources is really what is required. NASA can certainly help by providing industry-useful services like universal docking standards, space comm protocols, safety measures and standards, and transport to orbit purchases.
Successes in the space field will attract investment capital. Translating that into an institution-friendly investment vehicle is a tougher call.
Let’s take a stroll down fantasy lane of how that might come about, which touches on some of the things I’m going to talk about later…
Banker Ken sets up the U.S. Bank for Space Development. The U.S. B.S.D. is woefully under-capitalized (because I put the initial set-up on my credit cards), but clever fakery makes it look like a million bucks. Sucker money men (a/k/a pension and mutual funds) stroll in and they get the pitch. B.S.D. is structured through various holding companies, LLCs, S-Corps, and SPVs, and will invest in/make loans to the space sector for the purpose of providing a steady return on assets comparable with money-center banks. Here are various models of how investments would have fared had we had your money invested in them, and so we can assure you that these projections provide a reliable indication of what your future return will be. You can use them when preparing future financial statements…we will. We have some friends in the appraisal field who will be more than happy to provide “As-If” appraisals, and so we can have these companies valued as if they were actual space-faring companies engaged in space trade. With bank status B.S.D. will have unique access to global capital markets, and so will be able to borrow money to leverage your returns. We’ve got a Century Bond issue lined up that pays interest quarterly based on money-market rates, which are almost always the lowest, so we’ll be able to provide that leverage at low cost throughout the period of your investment. Our lawyers are working on special papers to get B.S.D. recognized by the UN, so you can count on special tax treatment to boot.
Through savvy investment, Banker Ken rides the front edge of the growth curve into space. New industries are enabled. Men and women provide for their families while building a better future for everyone in space. Kids are inspired to pursue scientific and technological futures so that they can fly rings around Uranus. Our basic electrical needs are eventually satisfied by Solar power sats. Broadcast sats are finally big and powerful enough to punch through the storm clouds so you can watch the game on your satellite dish. (If you’re going to fantasize, fantasize big)
In reality, space is quickly falling by the wayside as the attention of America is led by the media from focus to focus. Space is not seen as providing solutions, nor is it yet a real investment opportunity. It could be one, if America can be convinced that the space industry is one of our hopes for a better tomorrow. They need to see evidence. To the extent these successes can be achieved over the next year or so then an effort should be made, especially in the dark times of what is to come.
Do you want to know what the government bail-out is going to be investing your money in? At above market rates? Here’s the deal on what’s going down:
[Note: What follows is not pretty, and so not for the faint of heart]
Over the last five to ten years, actually maybe even 15+ for the early adopters, private equity and hedge funds have been doing leveraged buy-outs of small to medium-sized U.S. companies. Leveraged because they borrowed the money to do it. How did they do that? Easy! Let’s use a hypothetical example.
I’m Private Equity Guy (PEG). A bunch of rich folks have given me a bunch of money to invest in a way that gives them a significantly above average return, and they’re not too concerned with the particulars. I use part of that cash to buy a business. This business is a…let’s say a resort, located in a resorty part of the U.S. or it’s territories. I pay the owners a nominal amount to cash out their equity position. I get my good friend Helpful Appraiser Guy (HAG) to get me an “As-If” appraisal on the property. With the existing hotel and golf course it might be worth $100Mn, which I’ve just given the owners.
If we add a another golf course over there, build another hotel or two, and flesh it out with some high end houses and boutiques and concierge services, the property might be worth $500Mn, says HAG. I take this $500Mn “As-If” appraisal from HAG to Bank Underwriter Guy (BUG) who puts together a loan for $250Mn with a nice five-year term and not too bad interest rate. At a 50% Loan-to-Value (LTV), it’s an easy sell for BUG to put together a Syndicate of Lending Investors (SLI) that includes other banks and bonds that invest in Collateralized Debt and Loan Obligations (CDOs and CLOs). BUG only has to hold a small portion of the loan on his books, especially with all of the demand from the CDOs that are being snapped up by the big investment pools like mutual and pension funds.
So as PEG, I’ve just bought a company for $100Mn, and borrowed $250Mn. My exit strategy is to sell the equity about four years down the road, well before the debt comes due. Having learned from the Enron Error (wherein Enron bought companies and reported modeled profits even if the companies weren’t performing to the model), I promptly dividend $150Mn of the loan to my Private Equity Fund and park the cash on my balance sheet. It is now protected by the corporate veil, which I like to call a Leveraged Equity Grab (PEG-LEG).
Over the the four-year life of the $100Mn investment I am now assured a 37.5% per annum return ($150Mn/4 years = $37.5Mn/$100Mn investment = 37.5%, easy because the cash is already in my bank account, so I don’t have to worry about the company actually earning it, SLI has to worry about the company actually earning it), which is well above average. Another way to look at it is that I retrieve my initial investment and provide a 12.5% return, but with a bonus of the equity sale cash after four years.
The problem is that the cash from all the looted companies is burning a hole in my balance sheet, and I’ve got to put it to good use. Check it out though. Our friendly investment banker is willing to sell us these Credit Default Swaps. We can use them to hedge our investments because we can bet on bonds issued by our acquired companies’ peers (and so should perform similarly to our investment) and we don’t even have to own the bonds! We can just buy the insurance on whether the other company is going to go belly up, and we can get intelligence on that through our acquired company in that industry.
Around 2006, perhaps before, the CDS market became huge. Not just big, HUGE! I’ve seen the number $1.2Qn bandied about (that’s $1.2 quadrillion in notional value, $1,200,000,000,000,000, netted would be much less). I was staffing the trading desk and had to collect bond prices frequently. Bond trades and quotes were few and far between, whilst CDS quotes were everywhere, from everyone. Now let’s get this straight. This is like ME buying insurance on whether YOUR house burns down. I need have no association with you whatsoever. I just buy the insurance. I consider purchase of CDS default protection for a bond not owned to be speculation. The regulators completely abnegated their duty in this regard.
This is the heart of darkness of the problem. I’ve been trying to think of a good way to describe it, since Jon says most of this stuff is going right over his head. Let’s try this, all examples are entirely hypothetical:
Murphydyne Space Systems (MSS) issues a $1,000,000 bond to finance a new launch pad they can also lease out to other companies for launch use. This would be considered good debt if the company is credit-worthy. Pension Fund X (PFX) likes MSS’s prospects and buys the entire debt issue of $1Mn. PFX is not entirely comfortable with the space industry, and so decides to swap out the risk of MSS defaulting on the $1Mn bond. PFX goes to Investment Banking Dude (IBD), who happens to know someone who is willing to take the risk, Counterparty X (CPX). CPX sells PFX a Credit Default Swap (CDS) for an initial and periodic premiums. This comes out of the interest, so the return that PFX is getting on the bond investment is lower, but the principal invested is protected from MSS not repaying the bonds.
This is the classic definition of a hedge, where the focus is on keeping the principal intact. There is absolutely nothing wrong with a bondholder buying insurance to protect their principal, and it is often considered a smart thing to do (until the counterparty can’t pay up).
Here’s the ugly wrinkle: You do not need to own the underlying bond to buy the insurance. So IBD now has a structure he can use to sell additional CDS on MSS bonds. In my view, if you do not own the bond from which the CDS is derived (making a CDS a derivative), then you are speculating. IBD doesn’t care, he just knows that investment professionals want to buy CDSes on MSS debt, and so hooks them up with counterparties (for a fee). In this way, Investment Guys A, B, C, D, E, F, G, H, I, J, and K (IGA, IGB, you get the picture) also purchase CDS protection on MSS paying the $1Mn bond. Hapless Insurer A (HIA) happens to have sold all 11 of these CDS contracts because the money was so good, and MSS’s prospects are bright.
If MSS goes into BK (forced or voluntary) and technically defaults on the $1Mn, then CPX pays $1Mn to PFX. HIA pays $1Mn to each of IGA through IGK. Total cash flows associated with the MSS default? $12Mn on a $1Mn bond.
Because CDS are unregulated (thanks to our compliant government employees of both political parties), there are no requirements that counterparties actually prove they can pay out on the claims, and any number of investors can take a position on the viability of a debt instrument. In effect, the risk of MSS’s default on their penny-ante $1Mn bond has not been spread around, it has been magnified. Well, leveraged from the point of view of the investors, who love that juice to their returns.
Poor HIA is driven to its knees by having to pay out on its no-longer-contingent liabilities. It goes into bankruptcy. Here’s where the heart of darkness descends into the brimstone depths. Thanks to the way that the rules have been rewritten by our compliant legislators of both political parties, when HIA goes into bankruptcy that triggers a credit event on each and every CDS contract that HIA has written, requiring them to be netted out and settled on the spot. Since derivatives get special treatment in bankruptcy, they get first dibs on the cash and assets of HIA. Given the financial diarrhea that would be triggered, lots of little people like creditors and equity and policyholders would get nada.
Not all of the CDS settlements would go against HIA, and some would go against various counterparties, driving them into bankruptcy, which then triggers a credit event on that counterparty’s other CDS contracts. Each time a counterparty runs out of capital, a new round is triggered. After settling over several rounds a company that might otherwise have done okay will find itself teetering. Rather than mitigating risk in the market place, exercise of CDS once again magnifies the risk in the market. That these instruments are unregulated is less disturbing only when compared to the fact that they were willfully unregulated, and even enabled (such as by the BK provision).
It was fun until the market started drying up because the smart money started to figure out that something was up and starting parking more and more money into cash trying to stay clear of the shenanigans.
Luckily, says PEG, our good friends the regulators are ignoring the off-shore commodity exchanges setting up shop on our shores but reporting to European and Middle Eastern regulators, so we can play in that market and no one will know. Let’s go!
Meanwhile, employees of small sold-out company are starting to notice a dip in attendance, as gas prices start climbing. Management of small sold-out company is starting to freak out about servicing the debt. $250Mn in debt on $100Mn in assets (maybe) is a 250% LTV, and SLI is starting to wonder how he’s going to get repaid on yet another loan.
Oops, folks are starting to sniff around the oil markets. We need to go somewhere else, says PEG. Hey, we’ve got all this CDS protection on financial firms, let’s go do some naked shorting of the financial firms to drive them out of business, and then the idiots on the other side of the CDS will have to settle up, making us even more money! Personally, I consider naked selling to be a financial weapon of potent force. That the regulators would allow people to sell things they didn’t have to deliver T+3 is an enormous risk in the market, irrespective of the enormous return potential for the speculator of a naked short.
If I were going to scam the market using these tools, here’s how I’d go about it. Find a publicly-traded company and buy a CDS on their debt, then go into the market and sell naked shorts on the equity. The downward pressure on the stock price creates uncertainty about the viability of the company, which drives up the cost of protection from debt default. I sell my CDS at the higher market price for a profit, and use the cash to cover my naked shorts, profiting there as well. Since both transactions are unregulated and I don’t report any financials or holdings, there is no way for the market to know that it has just been manipulated. How could I not have seen this! This is brilliant! Dang I wish I had some capital to play with and a complete absence of any kind of moral foundation whatsoever.
Meanwhile, small sold-out company can’t make it in the economic downturn and has to file for bankruptcy, leaving crumbs to the creditors (unless small sold-out company was stupid and played with derivatives in which case q.v. brimstone depths, supra). All of sudden CDOs that had bought the debt of small sold-out companies are not getting payments, and have to be re-valued down to the current Net Present Value (NPV) of the demonstrated (i.e. made their last payments) remaining cash flows from the instrument. Remember, CDOs and CLOs are bonds and purchasable loans collateralized by pieces of other bonds and collateralized loans; your last auto loan would have ended up as a piece of a CDO. This revaluation translates into lowered returns and investment values for all of the mutual fund investors whose investments were poured into these vehicles. That’s where this mess hits middle America in the pocketbook. These are the investors who took the risk on repayment of the loans taken out for the PEG-LEGs.
The BUGs ended up not being able to unload the worst tranches of these structured debts and had to keep them on the bank’s books. The bank being forced to write down capital for all of the loans it underwrote suddenly going bad hurts the balance sheet, making the company look weak and subject to feral market forces. They effectively got left with the bong tar (the piece that doesn’t get paid first if things don’t work out), and that’s what the government wants to spend above market rates buying with your (and my) tax dollars.
I find the whitewash kabuki that’s going on in Washington to be an absolute farce, but it doesn’t negate the fact that the moneyed interests are going to make sure that Joe Taxpayer is stuck with the bill for their looting. The bailout is merely a greasing of the wheels to make sure that the unwinding doesn’t happen Right Now. If they are successful, do not look to NASA for space leadership. And I would advise space companies to think twice about taking money from folks who are more concerned with value extraction than value creation. Space does not need to be yet another sucked-dry husk of an industry littering the looted American landscape.
Waiting for all of this to settle is a LOT of very nervous cash. It wants something solid to invest in, an honest opportunity, not another paper house of cards. Can space be that industry? I don’t know. We’re entering a very, very uncertain time and the paths to the future become muddled. Government simply cannot provide the leadership we need in this field given its existing and future obligations, however much we may wish it to be otherwise. Only American industry can do so, but who is to provide the leadership? The old space names are firmly ensconced on the government teat (with a trickle of ITAR-proof traffic from the commercial sector), whilst the newer ones march towards success but have not yet arrived (and some won’t).
To what extent can the space sector provide a viable investment vehicle that nurtures and grows the industry whilst pleasing funders? Perhaps a ‘space bank’ is one solution and not entirely a fantasy. I think long-term bonds should be considered for things like Solar power satellites.
But without transport to LEO, all of our space dreams are nothing and there will be plenty of indentured servitude back here on Earth to keep us all busy.
Solve the problem, guys.
P.S. For those who are feeling a bit glum by the revelation of these shenanigans that you and I are going to pay for, I can tell you that in reorganization bankruptcies BK Courts are pretty good about making sure the employees who remain get paid. They might lose everything else, like retirement funds, but they’ll still have cash flow to the extent it’s available.
I consider the solution to this problem to be in the courts, where contracts are disputed, not in Congress. The courts won’t be able to handle the huge influx of cases, but that just means more employment opportunities. People will still need haircuts and groceries. Mail needs to be delivered and the buses need to run. This is a performing-on-your-contract issue. In a free market those companies that make promises they can’t keep are supposed to pay the price, and that’s why we regulate insurance companies and banks. It just doesn’t help that these jokers have NPVed and monetized a significant portion of our future.
This is not the end of the world, except for maybe some folks who thought they were rich on borrowed money. Life will go on, though the landscape is going to change significantly. Everyone just needs to have courage and be tough. Pioneers are supposed to be the strongest and toughest of us, space pioneers should be no different, and I suppose this could be considered a test of our tenacity. I just think that having a space future provides the strongest and most prosperous future for everyone. This crisis is an opportunity for the space sector, if it can show that it has the value. I’m convinced that corporate Earth-to-LEO is the key that opens the door to much greater investment capital in the field, and success instills confidence (necessary for investors). There’s money looking for a good place to go that’s away from all of these paper shenanigans going on. There are plenty of sane people left in the world, and they have cash to invest, they just can’t find anything decent to invest in. Space could be that place.
Crisis = Opportunity, y’all.