*Sigh* No Forest

In a move that should surprise no one, Canadian/Chinese forestry company Sino-Forest filed for bankruptcy in Canada yesterday. The timing of the filing shouldn't be a surprise either, since the company was due to deliver its 2011 audited financial statements and also unsurprisingly couldn't find an auditing firm willing to sign off on them.

Thus, the saga which began ten months ago when short-seller/analyst Carson Block put out a report stating that the company was a fraud, is winding down.

In the interim, we've seen a famed hedge fund manager (John Paulson) humbled, a kiwi billionaire (Richard Chandler) lose a $100 million+ bet and a committee of Sino-Forest's own directors spend $50 million to investigate itself, concluding in a nutshell that the trees exist, but they're not sure if the company owns them in any way.

We've also seen a criminal probe by the Canadian authorities, which is likely to end in the conviction of no-one.

Lawsuits abound, including class-actions against the company (good luck with that), the former auditors (Ernst&Young), directors and executives. Not to be outdone, Sino-Forest is suing Mr. Block for $4 billion  dollars. As one internet poster put it "That will teach him to expose fraud".

The lesson here, children, is not that fraud doesn't pay, It's that you have to do it right.

Be sure to set up in impenetrable and incompatible jurisdictions. When you're exposed, deny, deny and then deny some more. Countersue your accusers and/or the authorities. Pay yourself millions to investigate yourself, giving time to put your person and your assets well out of reach of those greedy lawyers and their needy victim clients. Blame your boss or your subordinates.

Remember, the truth will not set your free. The opposite is much, much, more likely. /sarcasm

Stanford Bowled Out

It was three years in the making, but this morning in Houston a jury found Robert Allen Stanford guilty of 13 charges of conspiracy, obstruction and fraud, stemming from the operation of Antigua-based Stanford International Bank.

For a while there, I was wondering if "Sir Allen" was going to weasel his way out of this one, the same way his scam escaped detection for over two decades: hiding behind lawyers and other highly compensated professionals. Just yesterday, it had been announced that the jury was split on some issues. Apparently, that was only splitting hairs. Like many, I followed the trial on twitter (great job by the Houston Chronicle and KUHT...still going on at #stanfordtrial). Some the defenses expert witnesses' declarations were to put it mildly:  "far away from conventional wisdom". It's amazing what a few hundred thousand dollars in professional fees can do to your technical knowledge base.

Luckily, the jury didn't pull an OJ, and took the evidence for what it was worth.
On the side of the prosecution they showed detailed confession by a co-conspirator plus a money trail backed by documental evidence. Stuff that you just can't make up.

On the side of the defense, a two pronged alternate theory: that CFO James Davis worked alone or that there wasn't really a fraud. They brought in experts to state that taking out $2 billion in loans from your own bank (fraud), not disclosing the fact (fraud squared) and flatly denying any loans to anyone (fraud cubed) was all Ok. What's more, everything would be made right again when the pieces of the Stanford empire were put together in a "consolidation" plan. As if consolidating several piles of crap would yield something other than a larger pile of crap.
They didn't address the shortfall in investment returns, which was what gave the whole scheme away ultimately. Anyway, the jury didn't buy it. Unfortunately, we taxpayers will still have to pay for those experts' "work".

Naturally, this is not the end of the Stanford saga. There are still the criminal trials of the Chief Investment Officer (Pendergest-Holt), the accountants (Lopez and Kuhnt) and the Antiguan regulator (King), in addition to the certain appeals for Stanford and perhaps others. It does seem that if there were others in on the scheme, they mostly likely will get away.

For those who were caught in this web and lost their money, the journey towards closure is far from over. A trial currently taking place pitting the SEC vs. the SIPC, may give relief to some or perhaps yield just another disappointment. In the meantime, the process of asset recovery in Antigua and the US, has been so far fruitful only to the legal scavengers, for whom time is money and delay is profit. For now, investors have only received frustration.

So Stanford now joins Madoff, Rothstein, Nadel, Pearlman and many others in the Ponzi Hall of Convicted Felons.

He did manage to beat one of the wire fraud charges, the one relating to the purchase of Super Bowl tickets for Antiguan Regulator Leroy King in 2006. That botched my plans for a blog title reading "Stanford Bowled for a Duck".

Cricket fans would get it.

Crowdfunding gets its game on

(My daughter Astrid brought this to my attention. I found it interesting and asked her to write a Post about it. Enjoy!).

On Wednesday, February 8th, 2012 at 8:52 pm, the gaming world and the world of publishing any kind of media tilted ever so slightly on its axis. The main culprits of this shift are a small California based video game developer known as Double Fine productions and almost 50,000 fans and gamers who banded together to make the change.

For those of you not familiar with the gaming world, game publishing is a risky and unwieldy beast. Games, especially big name mainstream titles, take a lot of money to make and most publishers would never want to back a project doesn’t have 100% certainty of paying back the funds they’ve dropped into it.

Right here is where Kickstarter steps in. For those of you who haven’t heard of it, Kickstarter is a webpage that brings creative projects out into the public eye and allows people to crowd-fund them. Projects range form comic books, to documentaries. The amounts requested vary small $1,000 projects to much larger projects up in the hundred thousand range. The projects don’t receive the funds until the goal has been met and once the project is complete, depending on how much you donated, you might get a sweet little bonus for helping them out. It’s a small, but useful set-up for creative people to be supported by the internet at large.

So when Double Fine Productions decided to ask for $400,000 in order to produce an old school point-and-click adventure game and a documentary about its creation, they didn’t expect much. Point-and-click adventure games are considered a ‘dead’ genre in the games industry. According to the industry, these games don’t sell, so in turn they don’t get funded or get made. At best, the company was hoping to barely reach their goal and be able to produce a game, realistically, they barely expected to make $2,000.

But the internet has a mind of its own and once word got out, things got off the ground in a very big way. Within 8 hours, the Double Fine Adventure project had reached its intended goal of $400,000. In 24, they’d climbed all the way up to $1,000,000. That’s one million going towards a game for a ‘dead’ genre, a genre the mainstream doesn’t care to even touch.

At the time of writing, there’s still almost a month left to continue to fund the project and once the money is assigned, Double Fine is looking at almost $1,800,000. And that number is still climbing.

Admittedly, a lot of the success of the project can be attributed to Double Fine’s impressive pedigree (Founder Tim Schaffer is a huge name in the point-and-click gaming world, and their staff is a veritable all-star lineup for this sort of project) and its loyal fan following (who are still waiting patiently for Psychonauts 2, if anyone out there is listening).

But despite that the impact of this on the gaming community, and any creative medium, is almost mind-boggling. Kickstarter had already been funding smaller independent projects, but this proves that it can be done at a much larger scale. It could open up a new avenue of pay-to-create media that would take a lot of gamble and guesswork out of a normally outrageously risky project. Double Fine proved that if there is an audience, funding can be found, and it changes the basic way we can think about something being a risk, or sellable, or viable, or anything. The internet is changing the world, my friends, and I like the way this looks.

Reverse Combustible

FINRA has recently launched a probe into what they are calling yield chasing instruments, among which are derivative-linked CDs. 

http://www.bloomberg.com/news/2012-02-07/finra-examines-cds-tied-to-derivatives-as-banks-increase-sales-to-a-record.html

Banks have been selling a lot of these products, which tend to be quite profitable for them. Here’s a short explanation of a popular product called “reverse-convertible”, “barrier” or “knockout bond”, so you can understand why these are popular with the banks.

The standard Reverse Convertible  product works something like this:

Joe, a 65 year old retiree. is looking to invest $1 million, but is unhappy with the yields offered on short term CDs and other similar products. So his banker or broker offers him a "reverse convertible", sporting a 10% yield over six monhs with stock XYZ as underlying and subject to certain conditions.  Joe is enticed by the yield and buys in. 

In six months, Joe expects to get his $1 million back plus $50.000 in interest. Those $50.000 are normally to be paid regardless of what happens to XYZ. 

The principal, however, is only guaranteed if certain conditions are met. In this hypothetical case, the condition is that XYZ, which is currently trading at $20, doesn’t trade 20% lower at any point in time during the 6 month period. That is, if XYZ trades at $16 or lower, even briefly  intraday, the “knockout” feature is activated and the instrument is no longer principal-protected.

Once the knockout feature is activated, it means that instead of Joe getting his $1 million back, he might get 50.000 shares of XYZ instead (its the banks option). 

Since XYZ is a nice company and Joe doesn’t think it will go down that much, he invests, thinking that the bank is dumb to give him such a great deal. Ten percent interest in these days of low yields is great, right? And in the worst case, he gets some shares in a great company like XYZ. 

Ah, but the bankers smile, because they have this covered. Here’s what they do:

They sell puts 6 months in the future at that $16 strike. Five hundred contracts, which should net them at least $1 each, possibly more. That’s $50.000 for those who are doing the math. That covers the interest that needs to be paid to Joe when his product matures in 6 months. So in case XYZ stock behaves nicely and Joe’s bet pays off, the bank doesn’t lose a cent. They also have $1 million to play around with for 6 months, so you can assume they make some interest on that, too. 

Of course, if XYZ tanks, Joe stands to lose some serious cash . Let’s say it goes down to $14.The bank will get its puts assigned buying 50.000 shares at $16 per share which they will give to Joe in exchange for his million dollars. Net profit for the bank: $200.000.

Net loss for Joe is $250.000: the $300.000 in lost market value for his shares of XYZ minus the $50.000 in interest he collects. 

If XYZ closes somewhere between $16 and $20, the bank can still make a tidy profit, if somewhere along the line XYZ traded under $16 triggering the knockout provision and allowing the bank to assign the shares to Joe at $20/sh. In this case, since the stock has settled above $16, the bank would buy the shares in the market and then “sell” them to good old Joe at the agreed upon $20, earning the difference.

Of course, if the stock trades higher, or never breaches the $16 limit, Joe simply collects his interest and the bank might make a small profit. But Joe now feels like a winner, and armed with his new "knowledge", you can be pretty sure he's going to try his luck again on one of these products. He'll probably lose one of these bets eventually, and even if he doesn't the bank is still making small profits on each sale. 

Naturally, there are numerous variations of the product, including with multiple strikes and underlying instruments. The underlying doesn’t have to be a stock, it could be an index, or a commodity. If the bank doesn’t have the product you want, if you have enough cash, they will build it for you. That’s how much they like these things, and after this explanation it should be clear why.

Of course, times are hard for yield-seeking investors and many opt for these products, given the dearth of interest-producing alternatives. And to make a little, you have to risk a little, right?

Perhaps, but the problem is that the investor is bearing all the risk here and reaping only a fraction of the potential reward. If he were to sell those puts himself, he could pocket the $50,000 premium and tell the bank to take a hike. Heck, he doesn't even need to put up the whole $1 million in collateral.

What’s more, his risk in XYZ stock would be lower since the puts are assigned at  $16 (as opposed to $20 in the RC) .

Ah, but selling naked puts is complicated and brokers and regulators (including entities like FINRA) feel that Joe, who isn’t all that sophisticated, shouldn’t be allowed to take on that risk. So its not something that fits with Joe's profile and if a broker puts him in that trade (the naked put) and it goes wrong, he (the broker) could be looking for trouble. 

They have little problem, however, with Joe buying a reverse convertible. “Go ahead Joe. Knock your self out with a knockout bond”.