The New Robber Barons Read online

  Jim Clark of Netscape and Silicon Graphics fame was irritated that Goldman wanted to fee stuff its Facebook offering with a 4 percent placement fee, a half percent expense fee, and a snatch-back of 5 percent of investors' potential profits.

  A few months earlier, Clark had invested in Facebook through another financial firm at a lower price, and the other firm wouldn't potentially gouge him with Goldman's 5 percent pleasure-of-your-company tax. "I don't think it's reasonable," Clark told Bloomberg. "It's just another way for [Goldman] to make money from their clients." The question remains whether Clark bought his stake at a reasonable price.

  "Blankfein Flunks Asset Management as Clark Vows No More Goldman," by Richard Teitelbaum, Bloomberg News, January 24, 2011

  In January 2011, SharesPost Inc. valued Facebook at $82.9 billion on the secondary exchange. Whatever price the market will pay today, one has to be concerned about what it will pay tomorrow. Even if the future value of Facebook is say, $4 billion, Goldman will rake in fees.

  Impermanent Value

  Both Facebook and Groupon became successes because they are web based networks that required few management skills, minimum capital to start, and there were no barriers to entry. That is also their biggest problem. The ugly truth is that no one can tell you what they are worth as businesses.

  Groupon's successful-so-far revenue model is its curse. It's both trying to hold its position in "established" markets, and it's trying to expand. The problem is that web users in other countries have noticed Groupon's success and the fact that Groupon has been paying high premiums for local established discounting web sites just to get at the client distribution lists.

  Groupon's competitors are both buying sites for the same reason as Groupon, and local entrepreneurs can easily copy Groupon's business model. It seems all it takes is a good web developer, a two-page merchant agreement, and an accounting firm that can handle the taxes as a site expands internationally. Groupon may have a head start, but it has no long-term competitive advantage. That puts its margins, its market share, and its ability to expand and hold its position in new markets at risk.

  Smart investors look for highly skilled managers in industries with a long-term competitive advantage in a stable industry run by decision makers with a "here-today, here-forever" mentality. Between Groupon and Facebook, it seems Facebook has the better chance of making a case, but it hasn't made one so far.

  Facebook seems to be thinking of ways to create a loyal user base by penetrating deep within its user base. It certainly has a shot, but it is unclear whether it can maintain a competitive advantage.

  Users are fickle, and young users will gravitate to the next exciting new thing. The rapid success of Catherine Cook's myyearbook.com has to give investors pause. She started the site 6 years ago as a 16-year old high school student with a $250,000 investment from her brother, and the site is valued at $20 million. While it's no threat to Facebook, it has a fresh look, is responsive to users, and offers new spins such as allowing users to buy each other gifts and "lunch money."

  Investors may wonder when the next bright young kid will eat Facebook's lunch and make it look like a site for old fogies. Facebook may adapt, but it would do itself favors by disclosing its revenues, and how it plans to face up to potential competitors.

  Update: "Groupon Singled Out in Lawsuit: Man Claims Chicago-based Website Offers Illegal Gift Certificates," by Lacy McCraney, NBC Chicago, March 2, 2011.

  Mark Zuckerberg’s Value Problem: “My” Facebook Profile Was a Fraud, So Was “Warren Buffett’s”

  July 14, 2011

  I don't use Facebook. Neither does Warren Buffett, but phonies have used his name on Facebook. Earlier this month, an imposter created "my" profile on Facebook. In order to get the fake removed, Facebook required an uploaded scan of a government issued I.D. that shows a photo and birth date (for example, a driver's license or passport). Facebook suggests one black out the most sensitive information and claims it will delete this scanned information from its servers once identity has been verified.

  In other words, after an impostor faked my identity, I was the one who had to put myself further at risk by providing a verifiable scanned government I.D. to prove I had the right to complain about the fraud enabled by Facebook.

  The Antisocial Network

  There was no mechanism to email a human, who could have easily verified my identity without the need for me to upload a scan of a government issued I.D. (after blacking out the document number). There was also no way to even submit the report using the "Reports" link without the upload.

  Christopher Soghoian, a privacy advocate at the Center for Applied Cybersecurity Research at Indiana University told the Wall Street Journal: "People do not like Facebook. They do not trust Facebook. Facebook gets people to give up information under the claim that it's private and then it's made public. And your only option is to shut down your account."

  I now completely agree with Mr. Soghoian. I don't like Facebook, and I don't trust Facebook. You don't even need an account to be punked by Facebook. When you've been impersonated, Facebook asks for private information and claims it will delete it from its servers, but given that it has failed to protect private information in the past, why should anyone trust this claim? Yet I had no choice but to supply the information in order to get cooperation from Facebook to take down the fraudulent profile.

  The Facebook Team responded three days later reporting it had removed the profile. If you expect niceties such as "sorry for the inconvenience," forget it. That might be fine if you are imposing on Facebook, but when Facebook's protocol has imposed on you, something more is required, if Facebook ever wants to be taken seriously as a valuable business.

  Investors Should Take Note of Phony "Users"

  Mark Zuckerberg said that Facebook is "free" and always will be. But it isn't true for all of its users. Facebook claims "750 million active users," and some, the "whales," must eventually provide profitable business.

  Facebook requires revenues, and it requires an eventual demonstration of ongoing profits to keep investors happy. That means it needs users to buy goods and services so that Facebook gets a cut of the action. It's an indirect cost imposed on the Facebook users that support the network. If Facebook loses those willing buyers, it loses the whole ballgame.

  Eventually investors will want to know the number of profiles of people in the demographic sectors that are most likely to buy goods and services. If one had a mind for mischief, then one could mislead investors by, intentionally or otherwise, allowing phony profiles of whales. In my case, Facebook did just that. Investors should ask if this is a habit.

  Reasonable Questions

  What is Facebook's strategy? Where is its audited balance sheet? Which users provide the most revenue? Of target demographic profiles, how many are fakes? How many authentic users does Facebook actually have? Does Facebook know how many user profiles are genuine, and if so, how does it know?

  Based on my experience, Facebook doesn't know who is real and who isn't real. Many people may not even be aware there is an impostor profile of them on Facebook, and if they are aware, they may resent the hoops they have to jump through to get it removed. I know I was tempted to shrug and let it go, but I didn't.

  Investors should take that into account when evaluating Facebook's "users" and the potential for revenues they represent.

  The "Social Network" Broke the Social Contract

  If you eat in a cafeteria that asks you to dispose of your trash and put away your tray after you eat, you cooperate, because you are holding up your end of the social contract. You clean up for the next person, whom you've never met. You trust that others understand and honor this social contract, too. You trust that someone who has never met you will have the courtesy to clean the table before you arrive for your next meal. It doesn't make you superior. It just means you understand the utility of honoring the social contract. On your next visit, you won't have to carry your tray to a table covered wit
h trash. But if others break this social contract, you'll find another place to eat where the people are smart enough to cooperate with the social contract, because it is a nicer place to hang out.

  Facebook may think it's too cool to honor the web's social contract. It may believe its image says "we are the Borg," but to me it says "we are the slobs," and we're not interested in running a business. Facebook's attitude is futile, and I won't be assimilated.

  Users who believe they're getting something free may tolerate it, but people who spend money, actual customers, will find a better place to hang out as soon as an alternative becomes available. As I mentioned in an earlier commentary, "The Biggest Headache for Groupon and Facebook," bright young people are doing interesting things on the web that may one day challenge Facebook on features alone. If newcomers are trustworthy and courteous, Facebook will lose its revenue generators.

  Facebook will have a hard time keeping its inflated stock market valuation -- currently roughly $84 billion for its privately traded shares -- once investors face up to its flawed business model. For my part, I can say that if you ever see a profile of "me" on Facebook, it will be another impostor.

  Endnote July 17: Tavakoli Structured Finance, Inc. has an authorized website which includes Janet Tavakoli's bio, recent news, and selected televised appearances. It actually is free. It does not require a log in, does not spy on visitors to obtain commercially valuable information (or for any other purpose), and any downloadable articles are free of charge.

  CHAPTER 4

  Gold and Silver: Glaring Irregularities

  Washington Must Ban U.S. Credit Derivatives as Traders Demand Gold

  March 8, 2010

  Congress should act immediately to abolish credit default swaps on the United States, because these derivatives will foment distortions in global currencies and gold. Failure to act now will only mean the U.S. will be forced to act after these "financial weapons of mass destruction" levy heavy casualties. These obligations now settle in euros, but the end game is to settle them in gold. This is so ripe for speculative manipulation that you might as well cover the U.S. map with a bull's-eye.

  Credit default swaps are not insurance. If you buy fire insurance on your home, you must own the house. If you buy credit protection on the United States, however, you do not need to own U.S. Treasury bonds. If your protection gains value after you buy it -- not because the U.S. defaults, but because of market mood changes -- you can resell that protection and make a profit.

  Lower credit risk means a lower price for protection. Zero implies zero risk. The higher the basis points, the higher the implied risk. When U.S. credit default swaps were first introduced, the price of protection was around two basis points. According to Bloomberg, the price for five-year protection was around 38 basis points (per annum) on Friday. But the price in the over-the-counter market -- where this stuff actually trades -- was almost double or around 75 basis points.

  Since most traders in U.S. credit default swaps don't think the U.S. will default any time soon, why are they trading U.S. credit default swaps? They are speculating on price movements the way a day trader buys and sells stocks to speculate on stock price movements.

  Volume in U.S. credit default swaps is relatively small, but it can explode rapidly, just as volume expanded rapidly for credit default swaps on mortgage debt in 2006 and 2007.

  Speculators Want U.S. CDS Payoffs in Gold

  Remember AIG? When prices moved against AIG on its credit default swap contracts, AIG owed cash (collateral) to its trading partners. AIG paid billions of dollars and owed billions more when U.S. taxpayers bailed it out in September 2008.

  U.S. credit default swaps currently trade in euros. After all, if the U.S. defaults, who will want payment in devalued U.S. dollars? The euro recently weakened relative to the dollar, and market participants are calling for contracts that require payment in gold. If they get their way, speculators on the winning side of a price move will demand collateral paid in gold.

  The market can create an unlimited number of these contracts very rapidly. The U.S. wouldn't have to ever default to trigger a major disruption in the gold market. Spreads (or prices) on the credit default swaps could simply move based on "news," and demand for gold would soar.

  If this speculation drives up the price of gold, and the available gold supply becomes limited, are you willing to post your children as collateral? I am pushing the point so that we put a stop to this before it is too late.

  Global Disaster in the Making

  More than a year has passed since former Treasury Secretary Henry Paulson went to Congress in September 2008 to plead for special powers and TARP money to bail out U.S. financial institutions. Yet there has been no meaningful financial reform.*

  The European Union has its own challenges. German Chancellor Angela Merkel recently called for limits on credit derivatives on Greece, since the European Union is concerned about misuse of credit derivatives for speculation. Chancellor Merkel did not go far enough.

  World leaders shouldn't merely ask for limits on sovereign credit derivatives. They should demand a ban on all sovereign credit default swaps.

  Washington Must Bank U.S. Credit Derivatives: Games and Gold

  (Part 2) - March 12, 2010

  In an earlier post, I wrote that Congress should act immediately to abolish credit default swaps on the United States, because these derivatives will foment distortions in global currencies and gold. Credit defaults swaps on the United States currently settle in euros, but there is talk of creating new contracts calling for settlement in gold. This is just a trial balloon discussion at the moment, but it is one that Congress should immediately deflate along with all credit derivatives on the United States.

  Most traders in U.S. credit default swaps don't think the U.S. will default as long as we have money printing presses, so they are speculating on price movements. If speculators manage to get contracts to settle in gold, speculators on the winning side of a price move will demand collateral paid in gold.

  Gold is Collateral on the London CME

  Presenting gold to satisfy demands for Performance Bond Collateral is already allowed on the London CME in a limited way since October 2009. [Hat tip to Hilary Till, co-founder of Premia Capital.] This is an excerpt from the announcement:

  CME Clearing is introducing an enhancement to the existing Performance Bond Collateral schedule. Effective October 19, 2009, firms will be able to post physical gold to CME Clearing to cover non-segregated (NSEG) Performance Bond requirements. Initially, gold will be able to be posted to JPMorgan Chase Bank in London, England. In the near future, we hope to add additional depositories.

  There will be a firm asset limit of $200 million. These guidelines are subject to change and will be evaluated on a regular basis.

  Sovereign Credit Default Swap Contracts: Tower of Babble

  The credit default swap market has a history of conflicts, and the worst of them occur when it is time to settle up. For example, hedge funds Eternity Global Master Fund Ltd. and HBK Master Fund LP thought they purchased protection against an Argentina default and sued when J.P. Morgan refused to pay off on Argentina credit protection contracts Eternity had purchased.

  J.P. Morgan's posture was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed the slightly different contract language met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.

  Regulators "Can't Find" Evidence of Market Manipulation

  European regulators said they saw no evidence of manipulation in the Greek credit default swap market, because they examined DTCC data. DTCC doesn't capture all trades. Regulators wouldn't have found evidence of the rampant manipulation in the U.S. mortgage backed securities market, either, since those trades were not captured on any clearing exchange. Moreover, already flawed "ISDA standard" documentation does not have to be used for opaque credit derivatives, incl
uding those that may reference sovereign debt. Allan Sloan at the Washington Post asked the right questions:

  How much of this stuff do the Street people own? Where is it? What kind of securities has it been pushed into? No one knows. The one thing you can bet on, though, is that unraveling it all is going to be horribly complicated. Why? Because for Wall Street, complexity equals profitability.

  I am not against covered short selling or puts, and some short sellers have done better work than main stream media in uncovering accounting manipulation and over-borrowing. (Click here to see David Einhorn's early warnings about Lehman Brothers.) But the credit default swap market has a history of manipulation, and we are in the middle of a global financial crisis. Speculators can potentially destabilize a country or a company that's already in trouble.