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Two Toxic Bubbles In One


Martin Hutchinson

Goldman Sachs’ $2 billion deal for Facebook, valuing the social networking site at $50 billion, combines the worst elements of the 1997-2000 and 2004-07 bubbles. It sets a grossly excessive valuation on an Internet company with modest revenues and prospects. It also involves an investment bank structuring a complex deal to maximize its own fees, while driving a truck through two major elements of financial services regulation. Add a third element, that it places a company controlling personal information on 500 million users in close business partnership with a Russian billionaire with a criminal record and you can see the deal is truly groundbreaking. It should also raise important red flags about current market conditions.

General market opinion is that the U.S. stock market is not currently overvalued, because it has not broken through its 2007 highs. I would argue that U.S. fiscal and monetary policies are unsustainable, making the foundations of the economy far more fragile than in 2007. In any case, the Facebook deal in terms of valuation is reminiscent not merely of 2007 but of 1999. However good a company’s prospects a valuation of 30 times revenues is excessive. After all, there is not much more for Facebook to go for in terms of recruiting new members; with 500 million it already has 7% of the world’s population and well over half the global population of young affluents that advertisers drool over.

If with this customer base and a fashion-level second to none Facebook can’t gross more than measly $2 billion, with net income not much above break-even, its business model is not worth anything like $50 billion. At this level it is at best JDS Uniphase, destined for painful post-bubble deflation. More likely it is Pets.com, destined to disappear in a puff of smoke when the market turns down, leaving only a sock puppet behind.

However the Facebook deal has overtones of the excesses of 2006-07 as well as those of 1999-2000. One of the solidest rules in the SEC book, dating back to 1960 in its present form and to the 1934 Securities and Exchange Act in its principle, is that a company cannot continue to shelter behind the non-disclosure of a private company once it has acquired a broad base of 500 shareholders. Facebook and Goldman Sachs are evading this rule, by having buyers invest in a special purpose vehicle, which then buys the Facebook shares. This is exactly equivalent to shareholders investing through a nominee account, whatever fancy dress Goldman Sachs’ high-priced lawyers put around it. It is a direct attempt to evade the 500-shareholder rule and if the SEC doesn’t take strong action forthwith it will prove beyond doubt that the U.S. investor protection system has been eviscerated by regulatory capture.

Goldman’s action in evading the 500-shareholder rule is as destructive of market integrity as its notorious “Abacus” deal, whereby it colluded with a bearish hedge fund to select poor-quality mortgages for securitization and sale to European investors who were not part of Goldman’s “in” group. Shenanigans of this kind, in which investment banks favor certain investors at the expense of the market as a whole, are common in bubble periods; they appeared in great numbers in 1873, in 1929, in 1968 and in 1999. Their appearance again, so shortly after a major market meltdown, is another sign that lunatic monetary policy has caused a new bubble to appear immediately from the bursting of the last one, without any intervening period of sober reflection and sound investment.

Goldman’s contempt for regulation is also demonstrated by its principal investment in the Facebook deal. Such an investment would be entirely appropriate for a brokerage partnership, in which partners shared the risks, but Goldman Sachs is now officially a bank, and subject to the strictures of the Dodd-Frank Act, which prohibits such investments from 2013. No doubt that’s why Facebook has promised faithfully to go public by April 2012. One can’t help hoping that the market has crashed by then, preventing Goldman and its insider investors from unloading this rubbish at even more inflated prices to suckers among the general public and forcing them to take the losses and write-downs themselves.

A further unpleasant feature of the Facebook deal is the participation of Russia’s Digital Sky Technologies, controlled by the billionaire Uzbek Alisher Burkhanovich Usmanov. It would be unfair and pejorative to call Usmanov a member of the Russian Mafia. Suffice it to say that he has a fortune of $7.2 billion according to Forbes, was imprisoned for fraud in the 1980s, has excellent connections with the current Russian regime through his majority ownership of Metalloinvest, Gazprom’s metals interests, and is attempting to take over a British football club, in his case Arsenal.

Facebook has already alienated privacy purists and many of its customers by its cavalier approach to revealing members’ data. The participation of Usmanov as a major shareholder does not increase one’s confidence that data openly or inadvertently revealed through Facebook participation will be treated with the respect it deserves. For a fully responsible private company in Facebook’s business, allowing Usmanov to become a significant shareholder would surely have been unthinkable. The deal can thus only reinforce the suspicion that Facebook’s Mark Zuckerberg, Time’s “Man of the Year” or not, has some further growing up to do.

More interesting than nitpicking the Facebook deal is however determining what it says about the current state of the global economy and stock markets. So large a valuation on a company whose product may prove as ephemeral as the hula-hoop, which attracts excess investor demand into Goldman’s $1.5 billion share offering, suggests that the market is again in a state of witless euphoria. (It may also suggest the extreme gullibility and foolishness of the multi-millionaires who form Goldman’s “insider” clientele.) Even though the U.S. and global economy appears now to be recovering, there is nothing in its current state that would remotely suggest witless euphoria to be in any way appropriate. Hence one is led to the conclusion that excessively easy money policies, which led to an only moderately irrational bubble of euphoria in the late 1990s and a much more irrational bubble of housing euphoria in 2004-07, have now led to a bubble of euphoria that is completely without basis in reality, based on projections of corporate growth that can only be regarded as science fiction.

Cheap money always does this; it feeds the worst instincts of the Wall Street crowd. When prolonged for almost 16 years, as currently, it cements the Wall Street speculative worldview into revealed truth, against which no contradiction can stand. The opposing approach, of sound investment only in projects that make economic sense, appears quaint and outdated, like Republicanism in the late 1940s or Marxism in the 1990s. After all, in a period in which leverage and speculation have proved generally profitable for 16 years, who’s to say that they may not indeed be the appropriate way to finance economic expansion? A bubble that lasts for almost two decades becomes increasingly difficult to distinguish from reality, because skeptics have been marginalized and battered for so long.

Like all bubbles, this one will end. What’s more, it will end fairly quickly because there is a limited remaining supply of rocket fuel to give it impetus. Commodity prices have now risen to levels mostly above the peak of the 2008 boom, and in doing so have fueled inflationary and contractionary forces that will destabilize the U.S. economy within a matter of months. No doubt Wall Street, the Fed and the politicians will use every artifice to prolong the mania, but it may not be prolongable. Nobody wanted the housing bubble to burst in 2007, or Lehman Brothers to fail in 2008, but market forces eventually proved too powerful for the optimists. Similarly in this case, the market will prove too strong for those attempting to keep the bubble inflated. By the end of this year, the bubble’s contradictions will already be fully apparent, although judging by past experience it may be late 2012 before catastrophe finally hits.

One can only hope that, unlike in 2008, the response of the political class will not be to try and re-re-inflate the bubble by any means possible. It is long past time for sound monetary policy, for sound fiscal management and for investment driven by solid value rather than by speculative excess. Leverage must become eye-wateringly expensive, as it was in the early 1980s, and the foolish wealth of Wall Street’s acolytes must be replaced by solid Main Street accumulation. Only when risk-free bonds (which may well not be those of the U.S. government) earn solidly positive real after-tax returns can we be sure that savings will begin once more to accumulate rather than dissipate and the U.S. economy return to investing in the productive rather than the meretricious.

The Facebook deal is important mostly as an indicator that the current economic recovery is unsound and that the bubble of higher commodity prices and stock valuations is approaching its maximum inflation. We should heed its message.

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