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”. 

In Jefferies we Trust.

With the Euro crisis as a backdrop, as opposed to the housing/mortgage crisis of 2008, this year's Lehman Brothers has been MF Global, a medium sized commodities broker-dealer, spun off from Man Group a few years ago and which had actually purchased the business from REFCO back in 2005.

REFCO, as many may remember was the subject of a famous meltdown of its own. 

MF Global's demise came reportedly due to large leveraged bets on European sovereign debt which didn't pan out.  That's tough for MF's stockholders and bondholders, who are probably looking at steep losses.

Here's the graph for MF's 6.25% 2016 bond, issued in August 2011, which basically fell off a cliff in two months.

Like Lehman, MF Global's debt was "investment grade" (Fitch, S&P and Moody's), right up until the nasty stuff hit the fan in late October. Of course, MF was just a triple B, as opposed to a Lehman's AA at the time of its collapse, so I guess we're getting better in the ratings biz. Off topic, this is why I really don't invest a whole lot in debt of financial companies. Very difficult to analyze and foresee these meltdowns. 

Still, if it were just the stock and bondholders losing, no biggie. The problem is that the issue is affecting customers also. When brokers go down, customers don't normally lose their money or securities, because these assets are (or should be) segregated and separated from the broker's own. It can be a hassle to get everything set up again at new broker/dealer, but competing firms are normally more than happy to bring those customers on board. Sure beats wining and dining them.

The problem with MF is that apparently those customer funds were not well segregated. There is a reported $600 million "missing" from customer accounts. Big problem. 

First off, this isn't supposed to happen. You'd figure that this was a lesson learned from the Madoff scandal (BLMIS was first and foremost, a broker-dealer). Second, this didn't happen with Lehman, where customers were taken over by Barclays and their assets were there. It didn't even happen with Stanford Financial's brokerage arm (other stuff happened there).

So, big black eye for regulators once again. Hopefully the money shows up, but this is kind of like with missing persons. After three weeks, the chances aren't good.

This leads us up to the old crisis equals opportunity adage and the title of this post: Jefferies (JEF). Jefferies is a mid-sized broker-dealer. Not a household name, but well known and regarded in the industry. While checking the company's Sec filings, an analyst at Egan-Jones noticed that the company was long European sovereign debt in an amount equal to close to 80% of JEF's equity and proceeded to downgrade. 

The company said "Whoa, wait a minute. We make markets in those bonds and we're short (as in we have to deliver to clients) pretty much the same amount." (they didn't actually say THAT, but that was the message). JEF even went as far detailing positions and showing how they could change their inventory levels if the wish too. In short, JEF pretty much did everything right to control the damage. (Frankly, if  you used this same yardstick, where does that leave every European bank?)

However, stock and bond traders have not been understanding and much less forgiving lately and JEF's securities have sold off sharply, opening up what appears to be an opportunity. On the very short end,

JEF's 7.75% 2012 bonds (due March 1) are trading below par, for what would look to be nice pickup for less than four months. On the other end, some of the longer dated maturities are yielding at or close to double digits. JEF is still "investment grade" (FWIW, I know).

While the selling could still get worse, I like the odds on this one and am willing (and have) put down some coins on JEF bonds. Drawing on the 2008 parallels, buying Morgan Stanley or Goldman Sachs bonds while Lehman went down in flames, proved to be an excellent investment. We'll see how this one goes. With 2012s, we'll know soon enough. For the long run, the broker-dealer business model is obviously "under review". Bear, Merrill, Lehman and now MF can't all be aberrations. For now, however, "In Jefferies we Trust". 

Sino Forest Epilogue

Since I already did two posts on Sino, might as well make it three and out.

Last Friday, the Ontario Securities Commission suspended trading in Sino Forest stock, alleging that the company may have defrauded investors by exaggerating its profits and assets.
Initially, the order also called for the resignation of the company's CEO Allan Chan and other officers and directors. That portion of the order was then excluded (apparently the OSC doesn't have such authority), but the CEO and several others resigned anyway.

This would appear to be the argument that ends the discussion concerning this case. But you never know, there are always dissenting opinions and conspiracy theorists.  This announcement followed a flurry of news which included a very strange second quarter earnings report in which the company's erst-while rock solid operating margins evaporated, a three-month delay of the "independent review"  and downgrades from the major ratings agencies.

Carson Block is looking like a champ. For his part, John Paulson took his lumps like a man. It was big loss for his fund, but he showed he could recognize when he was wrong.
I do feel for the analysts who came out to support the company. Lesson learned, hopefully. Don't trust everything they tell you, sometimes the numbers are simply a lie. Company officials are NOT your friends.

As for the bond angle, there is a bright spot. On Aug 17, Sino paid its 2011 bonds in full. So whoever took a flier on that trade I mentioned in my previous post, made out like a bandit. I wasn't that brave.

Sino stock may be suspended, but the bonds can be traded OTC, as far as I can make out.
My Bloomberg is indicating a 26 bid on the 2014's (the ones I luckily sold at 72). Ouch!