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GameStop Frenzy Lessons: Don't Bet the Milk Money
(Unless that's the only way to pay for the milk)
As I mentioned in my prior post, I have a bunch of concepts I want to write about in reaction to the frenzy over GameStop and the various parties affected.
First lesson is something we should all know: don’t bet the milk money.
In concrete terms, it’s okay to speculate with part of your money, but you should reserve some cash outside the speculation to cover your living expenses… or, if you’re a company, that operating expenses are covered.
Now I’m not actually talking about the /r/wallstreetbets folks, but others caught up in the frenzy, who are supposed to be responsible and professional.
How was Gilbert able to secure such a sweet deal for his client? They can both thank disgraced financier Bernie Madoff and Mets owner Fred Wilpon.
The Mets wanted to part ways with Bonilla in 1999 but he had $6 million left on his contract. Wilpon believed he was getting a huge return on his investments through Madoff but the Mets owner turned out to be a victim of Madoff’s infamous Ponzi scheme
Well, let’s see what the current Mets owner has been up to.
What is it with the Mets and bad finance?
Less than a decade after the Bernie Madoff scam roped in the Wilpons and supposedly handcuffed the New York Mets payroll as a result, the team’s fans are panicking that new financial market weirdness in the form of bizarre trading in video-game retailer GameStop is going to harm new owner Steve Cohen’s ability to make the Mets amazin’ again.
In comes Steve Cohen. Melvin Capital founder Gabe Plotkin used to work for Cohen and already had $1 billion of Cohen’s money in his fund. To help Melvin weather its awful month, Cohen and another hedge fund billionaire invested another $2.75 billion into Melvin this month.
That in turn is why Mets fans are now freaking out. One Reddit poster claimed yesterday Cohen’s fresh capital must be gone, burned in Melvin’s desperate need to cover the short bet on GameStop. Suddenly, visions of a super wealthy new owner who could finally spend money on the team were replaced with another Wall Street catastrophe. Mets fans worried while GameStop pumpers teased Cohen.
“Rough crowd on Twitter tonight. Hey stock jockeys keep bringing it,” Cohen tweeted last night.
In reality, Mets fans probably don’t need to worry: Cohen is baseball’s richest owner at $14.6 billion in wealth, and he didn’t serve as inspiration for the brilliant, ruthless Bobby Axelrod of Billions by losing money so easily. He even survived seeming permanent regulatory banishment from managing other people’s money.
First, let us recognize that if the Mets were an actual profitable property, the personal wealth of the owner would be irrelevant. Too many pro sports teams have become hobby assets for rich guys who always loved whatever team, and they’ve got enough money to buy a team.
Second, from the story itself, Steven Cohen has (had) about $3.75 billion with Melvin Capital… and his total wealth was approximated at $14.6 billion.
Basically, about a quarter of Cohen’s wealth is exposed to this one fund.
That doesn’t seem prudent.
To be sure, while GameStop’s stock has come way down from its high, it’s still at a much higher price than when Melvin started its leveraged shorting strategy on it.
The “game” isn’t over yet.
As for the Mets, the operating income has been negative $41 million in its worst year, 2011 [I have no idea what the 2020 result has been]. $41 million ain’t nothing compared to $1 billion.
The question is: what is the Mets’ cash position? Their cash flow situation? How much of the owner’s wealth is needed to keep the Mets running?
Harvard bet the milk money
In my establishing video, I mentioned an episode where Harvard “bet the milk money”. Let me provide the narrative and some links.
October 2009: Harvard admits to $1.8b gaffe in cash holdings
Harvard University, one of the world’s richest educational institutions, stumbled into its financial crisis in part by breaking one of the most basic rules of corporate or family finance: Don’t gamble with the money you need to pay the daily bills.
The university disclosed yesterday that it had lost $1.8 billion in cash – money it relies on for the school’s everyday expenses – by investing it with its endowment fund, instead of keeping it in safe, bank-like accounts. The disclosure was made in the school’s annual report for the fiscal year that ended June 30.
But Harvard placed a large portion of its cash with Harvard Management Co., the entity that runs the university’s endowment and invests in stocks, hedge funds, and other risky assets. It has been widely reported that Harvard Management’s endowment investments were battered in the market crash – down 27 percent in its last fiscal year. Not revealed until yesterday was that the school’s basic cash portfolio had also been caught in the undertow.
“I think that was an interesting way to handle the grocery money,’’ said Harry R. Lewis, a former Harvard dean who is now a professor of computer science at the university. He said the loss raises a basic question: “Did Harvard administration and Harvard Management have the kind of conversation that ordinary households have with their investment managers – about risk and liquidity and what they need the money for and when?’’
So, there is a lot more to this story.
First, endowment money is often invested in very risky assets, but yes, there is usually a “treasury” or cash account separate from this, intended to cover current costs. That’s what this is about.
Harvard chief financial officer Daniel S. Shore said the practice of having the endowment managers invest part of the university’s cash had paid off in previous years, when the stock market was rising. But it had a disastrous effect when the financial markets collapsed last year, causing huge losses.
This is not good asset/liability management. And it had consequences.
The Harvard endowment losses prompted university president Drew Faust to issue a sudden, jolting warning about the school’s finances in December. Since then the school has laid off 275 staff, offered voluntary retirement to others, imposed salary and hiring freezes, halted its campus expansion in Allston, and borrowed $1.5 billion with a bond offering to boost its cash position.
Not a good look.
November 2009: Felix Salmon had this to say: How Larry Summers lost Harvard $1.8 billion
Summers, amazingly, wanted to invest 100% of the university’s cash in the endowment, and had to be talked down to investing a mere 80%. No wonder Meyer and El-Erian tried to talk him out of it: the Harvard endowment was never designed as a place to invest sums of cash which might be needed immediately. Instead, it’s designed to invest for the very long term, taking advantage of the higher returns on illiquid investments.
Update: Brad DeLong, in the comments, does some back-of-the-envelope math and reckons that Harvard came out ahead of the game, on net, even after accounting for that $1.8 billion loss. But that’s exactly the difference between a long-term endowment, on the one hand, and a “cash account”, on the other. If you have money in a cash account, you spend it. And money you’re spending should be liquid, not tied up in an endowment which can drop 27% in one year.
I don’t think the 275 people laid off consider this being “ahead of the game”.
Part of the problem is that the timing of cash flows does have a value of itself — the value of liquidity is not zero, but in too many of these stories, those coming up with their “brilliant” investment strategies totally ignore it. It’s part of what put the squeeze on Long Term Capital Management, which I will write about more in a later post.
Last bit, from November 2009: Harvard ignored warnings about investments
Investing cash from the general operating account in the endowment wasn’t new under Summers, nor was it unique to Harvard. It had been done as far back as the 1980s at the university, officials say, but on a smaller scale. The aggressive investment of cash accounts is part of how the university has long run its “central bank,’’ an account that holds funds from its various schools and pays them a modest US Treasury rate of return. The “bank,’’ in turn, has invested the lion’s share of that money with the endowment, generating returns that are used to pay for shared needs, like graduate housing and financial aid.
The strategy paid off handsomely for years, as the endowment reaped big gains, providing Harvard presidents with a checkbook for ambitious efforts. Under Neil Rudenstine, Harvard’s president from 1991 to 2001, cash was heavily invested in the endowment and surged from $290 million to $2 billion. Under Summers, the figure more than doubled again, according to a compilation of the data obtained by the Globe.
The cash in the general operating account exceeded $6 billion by the time Bok and El-Erian left. Problems were starting to surface in housing and the credit markets in 2007. But still the cash policy went unchanged. It wasn’t until early 2008 that a chorus of concern was rising from members of the financial staff, professors on advisory committees, and the board. They decided to start pulling some of the cash out of the endowment – in $250 million chunks – quarterly, according to Harvard officials briefed on the plan. But it was too late. They got one slug of money out in March 2008, and then the markets seized up.
The very thing that the former endowment chiefs had worried about and warned of for so long then came to pass. Amid plunging global markets, Harvard would lose not only 27 percent of its $37 billion endowment in 2008, but $1.8 billion of the general operating cash – or 27 percent of some $6 billion invested. Harvard also would pay $500 million to get out of the interest-rate swaps Summers had entered into, which imploded when rates fell instead of rising. The university would have to issue $1.5 billion in bonds to shore up its cash position, on top of another $1 billion debt sale. And there were layoffs, pay freezes, and deep, university-wide budget cuts.
Even with the losses, Rothenberg said, the cash strategy has earned Harvard returns averaging 8.9 percent over the past 10 years. He and other university officials say the cash pool is still ahead of where it would have been, if invested more conservatively all along. But no one could be specific about what that net gain has been.
Again, the timing of those returns was key. You can have an internal rate of return of 8.9%, but it does matter that there was a 27% loss in a specific year, reducing Harvard’s ability to meet payroll.
Obviously, Harvard has weathered this loss, but many people were negatively affected by this cash loss at the time.
Frankly, the operating cash never really had any business being invested in the endowment.
No, it doesn’t maximize the potential returns …. but you know what? Absolute returns should not be the goal for the cash account. It should be that the cash is available for covering operating expenses when you need it. The endowment has different goals, and absolute returns may be appropriate for the endowment.
If nothing else, an endowment has a long-term investment horizon; a cash account has a short-term horizon. The strategies differ greatly when the investment horizon differs that much.
Betting the milk money is not always foolish
I do want to give an alternative point-of-view. Speculating riskily with all of a firm’s cash has worked out before…. but I will address the situation (and yes, there’s a public pension angle, too).
FedEx, the world’s first overnight delivery company, delivers more than 1.2 billion packages every year in over 220 countries. Yet, in its early days, founder Frederick Smith was so desperate, he had to rely on gambling in Vegas to fund his company.
In 1971, Smith founded the company with $4 million of inheritance and $80 million in loans and equity investments. FedEx started out with eight planes, covering 35 cities, and it had plans to add more each month.
But in the first two years, primarily due to rising fuel costs, the company found itself millions of dollars in debt and on the brink of bankruptcy. Even worse, Smith’s vital pitch for funding to the General Dynamics board was rejected.
When FedEx’s funds dwindled to just $5,000, Smith realized he didn’t have enough to fuel the planes. The company had already gone to many extremes, from pilots using their personal credit cards to fuel planes to uncashed paychecks.
So what’s a desperate founder to do? Smith impulsively flew to Las Vegas and played blackjack with the last of the company money.
Amazingly, when he came back the next week, he had turned the remaining $5,000 into $27,000 — just enough for the company to stay in operation for another week.
Basically, when the alternative is guaranteed bankruptcy, what the hell, go to Vegas!
This is part of the argument for public pensions, specifically the deeply underfunded ones, going into riskier and riskier fund allocations as they dip into deeply underfunded territory.
To be sure, these pension funds think that they don’t have a real bankruptcy outcome. There’s always the taxpayers to pony up, right? And then there’s borrowing money from the yield-hungry muni bond buyers, and taking those proceeds to speculate with ever more leverage! The sky’s the limit!
Or… it can end another way.
Risky speculation and institutional investment
FedEx could have just ended up in bankruptcy if Frederick Smith was not able to gamble his way to operating cash.
For this type of thing – trying to keep a start-up going – we really only hear about the survivors. Basically, we don’t hear about the failures, mainly because a start-up failing by running out of cash isn’t news.
The nature of start-ups is to be precarious, with a high failure rate. Fine, gamble with your seed money… you can get away with that… once. Funders may not be interested in helping you on your second start-up if you failed.
The failures we hear about are when staid institutions that have existed for centuries have done something incredibly risky, leading to serious consequences.
When it comes to institutional money management…. this kind of speculation is not really in keeping with professional standards, depending on the institution.
We may find that some institutions were betting the milk money by putting too much of their cash in very risky investment strategies. But really, only if they have to absorb the losses. Perhaps various players will save Melvin Capital et. al. You never know.
This isn’t over, yet.