Thursday, December 02, 2010

Is Netflix Streaming Its Way Towards Disaster?

Netflix, through the simple device of using the post office to bypass video stores, has become one of the great success stories of the new entertainment economy. It now claims 16 million subscribers who pay a monthly flat fee for an unlimited number of rentals. For this mail-in business, Netflix did not need the approval of the studios. It simply buys DVDs, as does anyone else, from retailers such as Wal-Mart then mails them out to subscribers. What makes this form of rental legal is the “first sale doctrine,” which holds that once a person buys a DVD, he can rent it out to others without the permission of the copyright holder. Through that court-approved doctrine , Netflix created its mail-in empire. For a monthly charge of as little as $9 a month, subscribers get any movie they choose on the Netfix website. Whenever a subscriber mails back his DVD in a stamped address envelope provided by Netflix he receives the next DVD he has ordered. There are no late fees.
Rather than backing its trucks up to Wal-Marts, Netflix buys most of its DVDs from wholesalers. Its average price of about $15 per copy. (Some studios also supply lower priced DVDs in return for Netflix delaying its mailing them until a month after they are in video stores.)
Last year, Netflix took in $1.67 billion in subscription fees. For its mailing business, its major expense, other than purchasing the DVDs, is postage and handling. It sends out about 2 million discs a day, which requires maintaining 50 distribution centers and buying over a half billion dollars worth of postage. Because of these expenses, its operating profit was only about 12 percent.
Netflix is now attempting to reduce its vulnerability to postage rate hikes by streaming movies over the Internet. Reed Hastings, the chief executive and co-founder of Netflix, explained that this new strategy is part of his concept that Netflix is not just as a mail-order house but a full-service home entertainment distributor since streaming provides movies in digital form on everything from Ipad, and Iphones, to game console and TV sets. Over the last three years, this streaming experiment has garnered a growing number of subscribers partially because it has been absolutely free to the subscribers of its mail-in service. Next year, however, it plans to charge for its streaming service. If it succeeds in converting its mail subscribers to streaming, it will in effect create a virtual channel that directly competes with the three major Pay-TV channels, HBO, Showtime, and Starz.
The problem here is that while streaming movies is a more efficient way of delivering movies than the mail, it requires a radically different business model. Unlike with mail-in DVDs, the first sales doctrine does not apply to streaming. So Netflix needs to license the electronic rights from the studios, and that is extremely expensive. In the case of new movies, studios license slates of 20 or so titles in so-called output deals for hundreds of millions of dollars. The average cost for a single title in such a deal is about $16 million for a two year license. Where Netflix can buy 10,000 copies of a major title for $150,000 to mail out, it will need to spend about $16 million to license it for streaming. Such a 100 fold increase in price can obviously be deleterious to profits especially since Netflix still has to maintain its mailing centers, and buy DVDs, for the subscribers who elect to continuing using the mail-in service either because they prefer DVDs’ higher quality and features or they don’t have the apparatus to receive digital streaming.
For the past 3 years, while building up its streaming service, Netflix found a temporary way around the licensing issue by making a sub-licensing deal with Starz Entertainment, a subsidiary of John Malone’s Liberty Media, which has its own output deal with Disney and Sony. paying Starz only $25 million a year for electronic sub-rights. Disney sued Starz claiming that such a deal violated the output agreement, but Starz held that it could sub-license these rights because Netflix was merely a “content aggregator.” No matter what happens in the litigation, the loophole will certainly be plugged in 2012 when Starz’ output deal expires. Not only will Disney likely demand on a payment for sub-licensing, but Starz itself has recently informed its other licensees that it will no longer discriminate in pricing, which means that Netflix will have to pay what everyone else pays for content.
And Netflix’s renewal problem is not merely with Starz. It also managed to license in 2008 the electronic transmission rights until 2012 for television programs, such as “The Office,” from networks. At that time, syndicators were only interested in the broadcast rights for re-runs of these series, and, as the streaming rights had little value, they licensed them at bargain prices. But the networks now have streaming, and video-on-demand of these programs on their own website, making it highly unlikely they will renew the expiring agreements.
The brutal reality is Netflix’s bargain days for streaming movies and television are coming to an end. As everyone else in the licensing game, Netflix will have to pay real world prices for content. Just the output deal it announced with three of the weakest studios, Paramount, LionsGate and MGM will cost it $200 million a year, a sum that exceeds its operating income last year. And if it wants the kind of output deals the other pay channels have, it will have to pay a great deal more than that.
Netflix, to be sure has brilliantly dominated the DVD mail order business. But, even aside from the immense cost of content, it must overcome three daunting challenges to succeed in the brave new world of cyber space.
First, it will have to compete directly with Pay-TV channels. HBO, which has nearly 40 million subscribers and a yearly cash flow of $1.8 billion, is not about to cede cyberspace to Netflix. It has just launched HBO GO which will stream to HBO subscribers “anything they want to see, anytime, anywhere, over their laptop, Iphone, tablet, Playstation”, according to Jeffrey Bewkes, the Chairman of HBO’s parent, Time Warner Communication. This includes not only the new titles, it acquires through its $500 billion output deals with Warner Bros, Fox, and Dreamworks but its prize-winning original series.
Second, since there are few barriers to entry to cyberspace, Netflix will also have to compete in pricing Internet savvy companies, including Apple, Amazon, Hulu and Youtube, all of whom can offer similar streaming services.
Third, as Netflix’s streaming consumes more and more of the capacity of broadband carriers such as Comcast, it will have to contend with either restrictions or usage charges that will increase the cost of streaming.
If Netflix fails to meet these challenges, its bold move into streaming might be nothing short of a prescription for financial disaster.

Sunday, November 28, 2010

Who Killed Hariri

The crime occurred at 12:56 p.m. on Valentine's Day, 2005. Rafik Hariri, the former prime minister of Lebanon, was blown up, along with most of his armored convoy, in front of the Hotel St. Georges in Beirut. The bomb had been packed into a white Mitsubishi van that had been moved into position by a suicide driver one minute and 50 seconds earlier; the powerful explosion tore a seven-foot deep crater into the street and killed 23 people.
The assassination caused an international uproar, and the Lebanese government turned to the United Nations for help. The U.N. Security Council appointed Detlev Mehlis, a German judge renowned for his pursuit of terrorist bombings, to head its investigation.
Now, after five years, indictments are widely believed to be imminent, and the investigation has recently focused on members of Hezbollah, the Iran-backed political and paramilitary terrorist group that has been a significant factor in Lebanon for decades—and whose rocket attacks on Israel precipitated the Lebanon war of 2006. Even the hint that Hezbollah might have been involved in the Hariri assassination threatens to engulf Lebanon in a civil war.
Early in the U.N. investigation, clues seemed to point to a jihadist suicide bomber. Various Islamist terrorists had used similar Mitsubishi vans in a spate of other Beirut bombings. Elements in the bomb traced back to military explosives used by al Qaeda of Iraq. A convenient videotape sent to Al Jazeera television showed a lone suicide bomber named Abu Addas claiming that he acted on behalf of an unknown jihadist group.
But the U.N. investigative team, which included forensic experts in explosives, DNA and telecommunications from 10 countries, found convincing evidence that the assassination was a cleverly disguised, state-sponsored operation. The Mitsubishi van had been stolen in Japan, shipped via the port of Dubai to the Syrian-controlled Bekka Valley where it was modified to carry the bomb, and then, only days before the assassination, driven over a military-controlled highway to Beirut.
One participant in the planning of the attack was Zuhir Ibn Mohamed Said Saddik, a Syrian intelligence operative. Saddik told investigators that the putative bomber, Abu Addas, was a mere decoy who had been induced to go to Syria and make the bogus video, and then was killed. He further alleged that the actual van driver had been recruited under a false flag in Iraq, so presumably if he defected or was captured he would wrongly identify his recruiters as jihadists.

Saddik said that the "special explosives" in the TNT had been intentionally planted there to mislead investigators in the direction of Iraq. Saddik was arrested for his role in the crime in 2005 and was released without reason the following year. He vanished in March 2008 from a Paris suburb.
Meanwhile, the U.N. team uncovered evidence that the actual conspirators had resources and capabilities—including wiretaps of Hariri's phones—that pointed to a state-level intelligence service. U.N. telecommunications analysts determined that eight new telephone numbers and 10 mobile telephones had been used, along with the wire-tapping, to follow Hariri's movements with split-second precision and move the van into place.
In addition, a former Syrian intelligence agent told investigators that he had driven a Syrian military officer on a reconnaissance mission past the St. George Hotel on the day before the bombing, and that the officer told him that four Lebanese generals, in collaboration with Gen. Rustam Ghazali, the head of Syrian intelligence in Lebanon, had provided "money, telephones, cars, walkie-talkies, pagers, weapons, and ID cards" to the alleged assassination team.
Judge Mehlis's report, issued in October 2005, concluded "there is probable cause to believe that the decision to assassinate former Prime Minister, Rafik Hariri, could not have been taken without the approval of top-ranked Syrian security officials, and could not have been further organized without the collusion of their counterparts in the Lebanese security services." Judge Mehlis had the four Lebanese generals arrested in 2005.
When the judge moved to question Syrian officials—including the intelligence chief, Assef Shawkat, who is Syrian President Bashar al-Assad's brother-in law—the Syrians stonewalled and protested the inquest's direction. In January 2006, the U.N. Security Council replaced Judge Mehlis with Serge Brammertz, a 43-year-old Belgian lawyer who had served as deputy prosecutor at the International Criminal Court in The Hague.
Mr. Brammertz was replaced in 2008 by Daniel Bellemare, Canada's assistant deputy attorney general. In April 2009, Mr. Bellemare requested that the four imprisoned Lebanese generals be released because of the "complete absence of reliable proof against them." And so they were.
Meanwhile, Lebanese investigators working on behalf of the U.N. team had re-examined cell phone records from 2005. They uncovered a network of about 20 mobile phones that had all been activated a few weeks before the attack and then silenced just afterward. This so-called second ring of phones had been calling the same phone numbers as the eight phones that coordinated the attack.
According to a report published by Der Spiegel in May 2009, investigators traced the second ring of phones to a command post of Hezbollah's military wing under the notorious Imad Mughniyeh, who had been responsible, according to U.S. intelligence assessments, for other spectacular bombing attacks, including the 1983 U.S. embassy bombing in Beirut.
But before this cell phone evidence could be further examined, the Lebanese chief investigator working on this complex network was killed in Beirut in 2009. (Mughniyeh, who might otherwise have been called as a witness, had himself been assassinated in 2008.)
In April of this year, U.N. investigators summoned 12 Hezbollah members and supporters for questioning. This spurred rumors that the Special Tribunal for Lebanon, which the U.N. set up in March 2008, was on the verge of finally issuing indictments.
The political reaction in Lebanon was fraught. Hezbollah's powerful chief, Hassan Nasrallah, said ominously in July that Hezbollah would not stand by idly if its members are accused of involvement in the assassination. He also denounced what he called attempts to "politicize" the tribunal—as if political consideration could be omitted from political crime.
Nasrallah then moved to discredit the U.N. by saying that its investigators come from "intelligence services closely linked to the Israeli Mossad." He demanded the establishment of a Lebanese committee to investigate "false witnesses." In September 2010 he went further, claiming that Hezbollah had "evidence" that Israel was behind the assassination. Syria, for its part, is claiming to be the victim of planted evidence.
Sadly, if the agents of Syria or Iran are finally named by the U.N.'s special tribunal, the half-decade delay in justice for Hariri's murder may be little more than prelude. Syria and Hezbollah, which both possess the power to destroy Lebanon's fragile government, will almost certainly denounce such a finding and shift the blame—as Hezbollah has already suggested—to their convenient bete noire: Israel. Such allegations and recriminations, meaningless as they may be, could drag on for another half-decade, if not longer.

Saturday, October 16, 2010

Role Reversal: Why TV Has Replaced Movies as Elite Entertainment

Once upon a time, over a generation ago, The television set was commonly called the “boob tube” and looked down on by elites as a purveyors of mind-numbing entertainment. Movie theaters, on the other hand, were considered a venue for, if not art, more sophisticated dramas and comedies. Not any more. The multiplexes are now primarily a venue for comic-book inspired action and fantasy movies, whereas television, especially the pay and cable channels, is increasingly becoming a venue for character-driven adult programs, such as The Wire, Mad Men, and Boardwalk Empire. This role reversal, rather than a momentary fluke, proceeds directly from the new economic realities of the entertainment business.

Consider what happened to Pay-TV. Back in the 1970s, HBO provided something home viewers could not get elsewhere: movies uninterrupted by commercials. It was, as a HBO executive put it, “the only game in town,” so its subscribers paid a monthly fee, no matter how little or often they watch it, to their local cable provider who in turn forked over a share to HBO. As the cable systems grew, so did HBO. By 2010, it had (including its Cinemax unit) over 40 million subscribers, and just the monthly fees produced cash flow of over $1.5 billion a year. Getting new movies was no problem. HBO simply licensed them from a few major studios for an exclusive period (which began a few months after they were released on video and DVD) in so-called “output deals.” To continue to harvest this immense bounty, HBO had merely to stop subscribers from ending their service.

But that feat became far more difficult as alternatives became readily available, including video stores, Netflix, and the Internet. Why should anyone pay a monthly fee to see movies on pay TV when it could get it else where cheaper and faster? The answer HBO executives found was to create its own original programming designed to appeal to the head of the house. Here it had several advantages over Hollywood. It did not need to produce a huge audience since it carries no advertising and gets paid the same fee whether or not subscribers tune in. Nor did it have to restrict edgier content to get films approved by a ratings board (there is no censorship of Pay-TV). And it did not have to structure the movie to maximize foreign sales since, unlike Hollywood, its earnings come mainly from America. As a result, HBO and the two other pay-channels, Showtime and Starz, were able to create sophisticated character-driven series such as The Wire, Sex and the City, The L Word, and The Sopranos. As this only succeeded in retaining subscribers and also achieved critical acclaim, advertising-supported cable and over-the-air network had little choice but to follow suit to avoid losing market share. The result of this competitive race to the top is the elevation of television.

Meanwhile, Hollywood went in the other direction. In the era of the studio system, the Hollywood studios opened their movies in a few dozen select first-run theaters, most of which they owned, and then, with the help of critical acclaim and favorable word-of-mouth, gradually moved them into local theaters. To accomplish this, they did not need huge advertising or print budgets. Nowadays, confronting a very different economic landscape, they open most of their major movies on 3,500 to 5,000 screens which are owned not by them but by a handful of multiplex chains. Multiplexes are in the “people-moving business,” as on multiplex owner put it, which means moving herds of movie-goers past the concession stands In return for providing their screens, these chains expect the studios to provide them with two things: first, lavishly-produced movies; second, and even more important, a national marketing campaign for each movie that will fill their multiplexes with consumers on opening weekend. Since such campaigns cost about $30 millions of dollars per movie, studios require that their marketing arm sign off on each project before it is greenlit for production. For the marketing executives, the deal-breaker is not the intrinsic merits of the film itself but the absence of the elements needed to build a marketing campaign both in America and abroad (where up to 65 percent of the revenue comes from.) Such campaigns typically require buying time on TV programs around which clusters an audience predisposed to going to the movies every weekend and then hitting it with 7 ads in the week leading up to its opening weekend. The target audience that fits this bill is tweens and teens, which are also the groups with the greatest propensity to consume popcorn and soda.
The least risky way to find movies that lend themselves to campaigns around which a global marketing can be built is to copy the movies for which marketing campaigns have succeeded in driving the requisite audience into the multiplexes; hence, the profusion of comic book-based movies and their sequels. In addition, studios must take into account that their movies must play in overseas markets, such as Korea, Japan, China, Russia, and Brazil, where visual action takes precedence over sophisticated dialogue. So the dumbing-down of movies is no accident.
Its after all show business.

Wednesday, September 29, 2010

The bank Job

The idea that Goldman Sachs, Citibank and other big banks duped Fed officials by getting them to buy their distressed pools of debt (CDOs) at 100 cent on the dollar has become a relentless part of the conversation about the financial crises of 2008. To be sure, the NY Federal Reserve Bank used a vehicle called “Maiden Lane III” to acquire billions of dollars of CDOs that had been insured by AIG through credit default swaps from 16 banks and cancel the AIG’s contractual responsibility for this insurance. By doing so, the 16 banks got these plunging CDOs off their books and AIG got rid of an albatross around its neck. But had the Fed made a deal with the devil? “Taxpayers not only ended up honoring foolish promises made by other people, they ended up doing so at 100 cents on the dollar,” the Nobel Laureate Paul Klugman wrote of the deal in the New York Times, “By making what was in effect a multibillion-dollar gift to Wall Street, policy makers undermined their own credibility — and put the broader economy at risk.” Eliot Spitzer, the former governor of New York, was even more severe, terming the payments to the banks a “real disgrace.” And when the Congressionally-appointed Financial Crisis Inquiry Commission held public hearings in July 2010, Brooksley Born, a Commission member, not only expressed bitter indignation that Goldman Sachs was "100 percent recompensed on that deal,” but said that “ the only people who were out money were the American public."

Such charges neglected three pertinent facts. First, the Fed did not pay “100 cents on the dollar.” It paid $29.1 billion for CDOs with a face value of $62.1 billion, which is about 48 cents on the dollar. Second, the Fed did not lose money on the CDOs. It bought these securities very close to their nadir in November 2008, and they went up in value in the bond rally in 2009 and 2010. Actually, as of September 8 2010, the Fed has a $7.9 billion profit on them– at least on paper. Third, these CDOs have continued repaying large amounts of principal and interest. As of September 8 2010, they had paid off $9.3 billion of the Fed’s $24.3 billion loan. At this rate, the remaining loan will be repaid in less than 4 years. Meanwhile, The Fed gets interest of one percent above London Interbank rate on the loan.

But the outrage over this deal is not about the damage it caused the Fed, or even the American tax payers, it is about the lack of damage it caused the 16 banks that had insured their CDOs. These 16 banks wound up getting back roughly all the insured amount they had invested in these CDOs. What happened was that when the CDOs began plunging in July 2007, and their ratings were downgraded, AIG, which had issued their credit default swaps, had a contractual obligation to send them “collateral payments” equivalent to the drop in the CDO’s market value. By November 2008, though AIG teetered on bankruptcy from making these payments, the 16 banks’ actual exposure on the CDOs was only their depressed market value. Consequently, when the Fed bought back the CDOs at their market value, the banks got back what remained of their insured investment. Not unlike Macaulay’s observation that the Puritans objected to the sport of bear-baiting not because of the pain it gave the bear but because of the pleasure it gave spectators, the critics’ complaint is that the banks, and especially Goldman Sachs, did not suffer enough pain in this Fed bail-out. They correctly pointed out that the US government had tremendous leverage over those banks that had received TARP funds and could have used it to force them to accept less than market value, or, a “haircut”in the parlance of Wall Street. Such a “haircut” would not only have allow the Fed to make even more money than it did on the appreciation of the CDOs, it would have benefitted AIG (now 78 percent owned by the US government), which was the Fed’s junior partner in the profits of Maiden Lane III.

Such an accommodation would required the agreement of all 16 banks, raising a problem. 12 of the 16 banks were foreign-owned and held approximately two-thirds of the AIG-insured CDOS. These banks had little incentive to accept anything below the market price for their CDOs because their AIG insurance would cover any further losses. Moreover, the single largest holder of AIG-insured CDOS, the French bank Societe Generale SA, informed the Fed that its regulators in France would not permit it to sell the CDOs below their market value and it was illegal for it to accept a “haircut” so long as the insurer, AIG, was still solvent. This position, which other European banks would also take, ruled out a voluntary “hair cut.”.

There still was the nuclear option: letting AIG go bankrupt. But such a move would open up Pandora’s box. It was not that AIG, with a trillion dollars in assets was too big to fail, it was that it was too interwoven into the skein of the global financial system. To begin with, its subsidiaries operating in 130 countries insured a large part of the commerce flowing between China, America, and Europe, and the seizure of them by state and government regulatory authorities could paralyze world trade. It could also could also cause a panic among those it insured. In the US alone, it insured 30 million people. It also held billions of state and local funds in its guaranteed investment programs that would be frozen. An AIG bankruptcy could cause an even greater financial crisis abroad since European banks depended on AIG, through its French subsidiary Banque AIG, to provide the “regulatory capital” that they needed to meet government-mandated capital-to-debt ratios. AIG did this feat through complex derivative swaps and . A bankruptcy, or even change of ownership in Banque AIG, would require major European banks to call in hundreds of billions of dollars in loans. Rather than risk financial Armageddon, the US government decided to save AIG. So the Fed could hardly threaten, or put, AIG into bankruptcy to pressure the banks to take a haircut.

So Goldman Sachs, Societe Generale, Citibank, JP Morgan Chase and the other counter parties won their huge bet on CDOs. This bet was not merely on the securities, or even on that the insurer AIG, but that, even if AIG’s obligations to pay exceeded their means, the US government would not allow AIG to fail. That assessment got correct. But the Fed which financed the purchase of the CDOs from the banks also not lose. That is because the market price it paid at the depths of the crises– 48 cents on the dollar– turned out to be much less than their actual value. So the Fed now stands to make a multi-billion dollar profit. AIG of course lost heavily, with the US Treasury getting 79.8 percent of the company, but that is the consequences of making a bad bet: that CDOs would not be downgraded and plunge in value. Whether or not the treasury recoups its investment in AIG is still an opened question, but, by saving AIG, it prevented the collapse of the international financial system. So where is the scandal?


Wednesday, August 04, 2010

Why Russia Spies On America

Anna Chapman (nee Anna Kushchenko) was a comely Russian agent living on Exchange Place in Manhattan and masquerading as a Wall Street real estate agent. In spytalk, she was an "illegal" because, unlike an agent working under diplomat cover, she had no immunity from arrest. On June 26, 2010, she met with "Roman," an undercover FBI agent, masquerading as an officer of the Russian intelligence service. He then assigned her a task that "illegals" are trained to do: to surreptitiously deliver a bogus passport to a putative Russian secret agent (who was actually another FBI undercover agent.) But instead of carrying out her assignment. she called her control officer in Moscow who instructed her to immediately turn in the fake passport to the nearest police station and report the fake Russian spy. This move effectively ended the cat and mouse game between Moscow Center and FBI counterespionage. When called by the police, the FBI arrested Chapman and 9 other Russian illegal agents, and then, after making a deal with Moscow, released them in Vienna in exchange for 4 Russian prisoners, three of whom had been for allegedly working for the CIA and British intelligence.While the 10 "illegals" were part of the Russian espionage apparatus in America, they were not spies, at least not in the sense that they stole secrets. Whereas their cover was sufficient for them to blend into American society, rent apartments, join Facebook, and get ordinary jobs , it was far too shallow to withstand the sort of security investigation necessary to get access to classified information. Indeed, if asked, these "illegals" could not even furnish their high school records. But they did not need a deeper cover to perform the courier work done by an "illegal": picking up data from a spy who has penetrated the US government– such as, for example, Aldrich Ames, Harold James Nicholson, Robert Hanssen and Earl Pitts-- and delivering it to a Russian case officer. For this basic mission, the "illegal" needs to be able to surreptitiously service a dead drop, make a so-called "brush pass," or make a delivery– as Anna Chapman was supposed to do with the bogus passport. Unlike a "legal"Russian diplomat in America, who is under 24/7 FBI surveillance, an "illegal," who only may be called upon once every few years to go somewhere, provides a relatively safe means of servicing a mole so long as the FBI is unaware of his or her existence.In this decade-long case, however, the FBI identified these 10 illegals via a source in Moscow soon after they began arriving in America in the 1990s, and had each of them under full surveillance. The fact that none of them ever led their FBI tails to a mole suggests that Moscow Center was not totally blind to its operation. After all, up until November 2000, the Russian intelligence service had its mole Robert Hanssen strategically placed in FBI counterintelligence. Sp it might have learned from him (or other sources) about the FBI surveillance.The criminal complaint filed in federal court against these 10 illegals shows just how transparent this spy game had become to both sides. The FBI gratuitously reveals that it had decrypted the Russian code used by Moscow Center to communicate with these illegals. Under most circumstances, security services such as the FBI go to extraordinary lengths to keep secret their sources and methods, especially communication intelligence that allow them to read adversaries' coded messages. It is even claimed that in World War II, the British city of Coventry was not alerted to an impeding German bombing raid because, according to Group Captain Frederick W. Winterbotham in his book The Ultra Secret, British intelligence feared that issuing such a warning could reveal to Germany that it had broken its cipher. Certainly, the FBI would only reveal that it had decrypted the Russian cipher if it had fully established that Russian intelligence already was aware that it had cracked its code and was reading itd messages. But this meant Moscow would likely use it to send messages to an FBI audience. Consider, for example, the mission statement it sent to its agent "Richard Murphy" in the final stages of the game in 2009 and which the FBI duly decrypted. It informed its audience which included the FBI: "You were sent to USA for long-term service trip. Your education, bank accounts, car, house etc. all these serve one goal: fulfill your main mission, i.e. to search and develop ties in policy making circles in US." What made this mission statement exceedingly odd was that the recipient had been operating in America for more than a decade and would not need to be told again at this late date over a compromised channel the nature of his mission. So its purpose may have been to divert the FBI focus away from the possibility that their mission was to service a mole.Whatever their actual mission, they were part of an ongoing Russian espionage enterprise in America. Though the arrests were largely treated by the media as some bizarre throwback to the Cold War, they show that the Russia intelligence has been expending resources over the past 20 years to install the plumbing necessary to service penetration agents and other sources. This raises the question: Why does Russia continue to spy on America after the end of the Cold War?The short answer is that the spy war never ended. The CIA still has a division dedicated to recruiting and managing moles inside the Russian government. And the Russian intelligence service, though it may have changed its name from the KGB to the SVI or FSB, continues to recruit its own moles such as Ames and Hanssen at the heart of American intelligence. Nor can either side stop without leaving itself vulnerable to undetected penetrations. The Game of Nations is thus self-perpetuating.

Saturday, July 31, 2010

Why The CIA went haywire on Iran

US intelligence proved disastrously wrong in concluding in 2007 that Iran had ended its quest for nuclear weapons, including, as it stated in a footnote, its "nuclear weapon design and weaponization work and covert uranium conversion-related and uranium enrichment-related work". In reaching this flawed verdict the CIA depended heavily on information supplied by its secret agents in Iran. This raises the question: was the CIA misled by its own spies into believing that the threat of sanctions had worked in ending Iran’s surreptitious effort to obtain nuclear weapons?When US intelligence analysts prepared to write the National Intelligence Estimate (NIE) for 2007, they were confronted much the same mountain of evidence that led their predecessors to conclude with high confidence in the 2006 NIE that Iran was secretly engaged in a nuclear weapons program. The CIA still had verified reports that Iran had experimented with Polonium 210, a key ingredient in the trigger of early-generation nuclear bombs. It had documents recovered from a stolen laptop describing Iran’s efforts to fit a warhead in the nose cone of its Shahab 3 missile that would detonate at an altitude of 600 meters, which is too high for anything but a nuclear warhead to be effective. It had a detailed Iranian narrative, written in Farsi, describing how a Russian scientist helped Iran conduct experiments to configuring high-tension electric bridge wire to detonate simultaneously at different points. And according to IAEA experts, the only use for such precise coordination is to detonate a nuclear weapons. It also had found Iranian technical drawings for a 400-meter long tunnel rigged with the kind of precise remote sensors used to measure pressure from a nuclear underground test. They had reports that Iran had most likely acquired a digital copy of a Chinese nuclear warhead design from the A. Q Khan’s network. It had further established that Iran had the blue prints for a high voltage block, called a TBA 480, necessary to assure the proper compression of the nuclear core in the warhead. And it had satellite surveillance of Iran’s crash program at Natanz to build a nuclear enrichment plant– a facility US intelligence estimated could house up to 50,000 high-speed centrifuges.To be sure, taken individually, such suspicious activities might have a non-nuclear explanation. For example, according to Iran, the purpose of its Polonium 210 experiments was merely to find a power source for an Iranian spacecraft (though Iran did not have ant known space program at the time of their Polonium 210 extraction.) But taken together these efforts added up in all the CIA’s estimations prior to 2007 to an inescapable conclusion: Iran was going Nuclear.So what had changed in 2007? One answer is that the CIA was the receipt of new secret intelligence from Iran. It provided convincing evidence that the facilities of the weapons-design program revealed on the stolen laptop, code named Project 111, had been closed down by Iran in 2003. This was confirmed by satellite photographs showing that a buildings involved in it had been bulldozed, communications intercepts revealing that scientists were no longer working at the location, and a high-level defector from the Iranian Revolutionary Guard reporting that "Project 111," had stopped functioning. Since the CIA had revealed it knew about Project 111, and even supplied technical drawings from it to the IAEA, it was not that surprising that the Revolutionary Guard, which runs Iran’s nuclear activities, would shut down a compromised project.The real intelligence issue was how to interpret the closure of Project 111. Had the design work been secretly moved to another location by the Revolutionary Guard to avoid further scrutiny by the CIA and IAEA? Had it been closed because the warhead design had been solved with the acquisition of the digital blueprints of the Chinese nuclear weapon which Iran got from the A.Q. Khan network? Or had the Revolutionary Guard closed it because Iran had abandoned its decade-long quest for a nuclear weapon?Deciphering the intentions behind a Revolutionary Guard action is no easy task in a closed and terrorized society in which the US has no diplomatic relations and little direct access to decision-makers. It therefore had little choice but to rely on the human "assets" in its espionage apparatus to illuminate the intentions behind the shut-down of project 111. Over the years, the CIA had recruited a network of Iranian agents which had, or claimed to have, access to nuclear work. These agents provided reports about Iran's nuclear program that allowed the authors of the 2007 NIE to cite secret evidence in support of the conclusion that "Tehran’s decision to halt its nuclear weapons program suggests it is less determined to develop nuclear weapons than we have been [previously] judging."As a result, in a stunning departure from the previous assessments on Iran by US intelligence, the 2007 NIE declared in its summary: "We judge with high confidence that in fall 2003, Tehran halted its nuclear weapons program." Even more astonishingly, It attributed the "halt" to "increasing international scrutiny and pressure resulting from exposure of Iran’s previously undeclared nuclear work" which meant that the threat of sanctions had worked in ending Iran’s surreptitious effort to obtain nuclear weapons.As we now know the Revolutionary Guard, instead of ending its secret nuclear program, was secretly completing new facilities in 2007. For example, at Fordo, 20 miles north of the holy city of Qum, it was reinforcing tunnels leading inside a mountain cavern designed to house a new uranium enrichment plant. (This underground facility was only disclosed by Iran to the IAEA in late 2009.) Clearly, Tehran’s intentions was not to abandon, a nuclear program in which it had invested tens of billions of dollars.What may have misled the CIA was a gaping flaw in its espionage apparatus in Iran after 2004. New York Times reporter James Risen reveals in his book "State of War" that since the CIA had no embassy base in Iran, it relied on state-of-the-art satellite transmissions to communicate with its agents. Then, in 2004, a CIA communications officer made a disastrous mistake. She accidentally included in a satellite transmission to an agent the data that could be used to identify "virtually every spy the CIA had in Iran." The error was compounded, , according to Risen, because the recipient of the transmission turned out to be a double-agent controlled by the Iranian security service. If so, the Iranians knew the identity of all the agents that the CIA had arduously maneuvered into positions of access as well as the technical methods by which the CIA communicated with them after 2004. The CIA's putative agents in Iran would have little choice but to allow the Iranian security service to control all the information they delivered to the CIA. If not, they would be eliminated and replaced. One of the agent who the CIA used for its 2007 NIE was Shahram Amiri. In 2004 and 2005, he had been working at Malek Ashtar University of Technology in Tehran, where research was done for Project 111. He reportedly provided details to the CIA about the termination of Project 111. Of course, to be credible, misinformation is designed so it will check out. And, according to the CIA, it did check out with the information it was receiving from its other sources. So it, and the 2007 NIE, had "high confidence" in its conclusion that Iran had given up on weaponization. In 2009, Amiri agreed to meet a CIA officer in Saudi Arabia. After that rendezvous, he was flown back to America (he now claims against his will.) The CIA, according to the Washington Post, offered to pay him $5 million. Meanwhile, Iran claimed he had been drugged and kidnapped. Then this July, he re-defected back to Tehran via a taxi trip to the Pakistan Embassy in Washington DC. Rejoined with his wife and young son at a press conference, Iran claimed that he had been operating as its double-agent in an espionage game. That he was willing to walk away from the CIA's $5 million bonus and into the waiting arms of Iranian intelligence officers leaves little doubt that the Iranian security service had the ultimate leverage over him. Did they control his secret reports when the CIA was preparing its NIE in 2007? That question no doubt will be hotly debated within the intelligence community for years to come. If Risen is correct that the CIA's sources and methods had been compromised after 2004.But the willful blindness factor should not be underestimated. The most effective deception tells an audience what it wants to hear. Members of the newly-reorganized Nation Intelligence unit who authored the NIE may have wanted to believe that Iran would quit its nuclear weapons program, since it confirm their hope that US sanctions were working.Whether the misleading conclusions in the CIA’s 2007 NIE proceeded from Iranian deception or American self-deception, they were not without consequences. The immediate effect of the 2007 NIE was to undercut the case for taking more drastic action. To the extent that it was believed that Iran had already ended its nuclear program, other countries had little incentive to join in imposing further sanctions. It also provided time for Iran to upgrade its centrifuges and increase its stockpile of lowly-enriched Uranium gas. Indeed, by 2009, it had enough fuel, if it chose to further process it in its centrifuges, for at least one nuclear bomb.The moral of this sad spy story is that the information exchanged in an espionage game cannot be taken for granted. Spies that are viewed "assets" in a closed country can turn out to be a very risky liabilities.***

Friday, May 21, 2010

The War on Wall Street

When President Obama signs the new financial regulation act the government will assume sweeping new powers over Wall Street. The passage of this bill did not occur in a vacuum. The administration carefully laid the groundwork by inculcating public fear that the great financial houses betray investors by rigging securities to fail. Exhibit A: the SEC's recent fraud case against Goldman Sachs.
The agency's complaint alleges that Goldman Sachs defrauded the investors in its Abacus 2007-AC1 fund by not disclosing the role played in the fund's creation by John Paulson, a hedge fund operator who stood to make an immense profit if the fund failed. It might be a great conspiracy case-if the SEC could come up with a plausible conspiracy.
Mr. Paulson wanted to make a billion dollar wager that subprime-backed mortgages would collapse. So he went to Goldman Sachs, which, like the other major financial houses, is in the business of creating such customized gambling products for clients.
For a $15 million fee from Mr. Paulson, Goldman created Abacus 2007-AC1. It provided exposure to a portfolio of 90 subprime home mortgage-backed securities. If the underlying securities did not default, those who took the long side of Abacus would collect handsome profits. If the housing bubble burst, those who took the short side would win heavily.
Goldman found three participants to bet long-ACA Capital Holdings, a bond insurer, IKB Deutsche Industriebank (a Germany-based specialist in mortgage securities), and itself. ACA went long on the deal. It sold a $900 million credit default swap on Abacus and even invested about $40 million in the Abacus deal itself. ACA's wholly owned subsidiary, ACA Management, had sole authority to pick every one of the 90 securities in the portfolio. IKB bought $150 million worth of Abacas's notes, and Goldman put up $90 million to complete the financing.
Mr. Paulson was the lone short, buying ACA's credit default swap from Goldman. All four participants in the Abacus deal had the same data about the 90 underlying securities. What separated them was their opinion of the direction of the housing market. Mr. Paulson felt it was headed toward a collapse; ACA considered this so unlikely that it gave nearly 20 to 1 odds on its credit default swap. Mr. Paulson won the bet.
So where is the fraud? The SEC says Goldman withheld material information from ACA and IKB by not disclosing the history of the deal, including Paulson's role in the creation of Abacus. Of course, ACA knew someone was short the deal, since it sold Goldman a $900 million credit default swap precisely for that purpose. Goldman did not say that Mr. Paulson was that counterparty. But his identity may not have been a mystery to ACA.
Mr. Paulson's top lieutenant in the deal, Paolo Pellegrini, testified to the SEC in its investigation of the matter in 2008 that he had informed ACA Management that Paulson's hedge fund was betting against the transaction. If so-and Mr. Pellegrini had no reason to perjure himself since he had no obligation to disclose anything-ACA possessed the information that Goldman withheld, and went ahead with the deal. IKB bank, which bought Abacus's AAA-rated notes, may not have known about Mr. Paulson's role in Abacus.
The real issue here turns on the term "material," which the SEC defines as facts an investor would reasonably want to know before making an investment. The agency contends that Mr. Paulson's role in suggesting securities to ACA was "material." Prior to this case, the SEC did not always consider a deal's history material, taking the position in hundreds of other such deals that how a fund was constructed, including how its rating was achieved with rating agencies, did not require disclosure. That was before Wall Street became a political bete noire.
Nevertheless, the SEC voted in split decision (all the Republicans voting against) to accuse Goldman of civil fraud. It alleges that Mr. Paulson "heavily influenced" ACA Management to pick losers but provides no theory as to why ACA Management, whose corporate parent was risking $940 million, would do anything but pick the least risky subprime bonds. As it turned out, the subprime securities ACA picked for the portfolio failed. But so did the vast majority of securities based on subprime mortgages. Since 99% of them were marked down by the rating agencies by the end of 2008, Abacus would have likely suffered the same fate had ACA picked 90 other such securities.
ACA's losses on Abacus were less than 5% of the $22 billion in losses it suffered in its other subprime funds (in which Mr. Paulson was not involved). When the time came to pay off the Abacus wager, ACA, hit by $68 billion in credit default swaps, couldn't make good. Its Abacus debt fell to the Dutch bank ABN-AMRO, which had back-stopped ACA. The Royal Bank of Scotland, which had the misfortune of merging with the Dutch bank, paid Mr. Paulson.
No one can fault the SEC for wanting to restore faith in Wall Street by ferreting out financial frauds. But its case against Goldman Sachs does not add up. It implies a conspiracy without co-conspirators. If Goldman had designed its own fund to fail, it could have retained the credit default swap it got from ACA for its own account rather than selling it to Mr. Paulson. Instead, it invested $90 million of its own money into Abacus. Goldman's records showed it lost $75 million (after taking its $15 million fees into account). The SEC has issued no complaint against Mr. Paulson in this deal.
Not only is there no motive or logic for Goldman to have sabotaged its own fund, but the SEC complaint fails to cite any evidence it did. Nevertheless, it has brilliantly succeeded in implanting that idea in the media. On April 18, Paul Krugman stated in his New York Times column that "the S.E.C. is charging that Goldman created and marketed securities that were deliberately designed to fail, so that an important client could make money off that failure. That's what I would call looting." In fact, the SEC complaint never alleges that Goldman deliberately designed any securities to fail.
Even though the widely echoed "designed to fail" charge is an invention, it helped convert a civil case of nondisclosure into one of Grand Theft Wall Street in the public imagination. The message-Wall Street deliberately betrays investors-served a political end. It helped provide cover for the government's desire to manage the financial universe.

(This piece was in Wall Street Journal May 22)

Sunday, March 28, 2010

The Dubai Hit

James Jesus Angleton, the legendary CIA counterintelligence chief, once discussed a series of suspicious deaths in Germany with me. "Any gang of thugs could murder someone," he said, "but it took an intelligence services to make a murder appear to be a suicide or natural death."
According to this precept, the assassination of Mahmoud al-Mabhouh in Dubai on the evening of Jan. 19, 2010 was almost certainly the work of an intelligence service. When Mabhouh's body was discovered the next day in his room in the five-star Al Bustan Rotana hotel, it appeared he'd died in bed of natural causes. There were no wounds, bruises or other signs of foul play.
Room 230 had no balcony or windows that could be opened, and the electronic door latch appeared to have been locked from the inside. If an ordinary tourist died under such non-suspicious circumstances, investigators would routinely assume he had died in his sleep from natural causes.
But Mabhouh was no ordinary tourist. He was a senior commander and a co-founder of Hamas's military wing, Izzedine al-Qassam Brigades. His activities including the abduction of Israeli soldiers, and he was wanted in three countries: Israel, Egypt, where he had been imprisoned for almost a year, and Jordan.
Based in Damascus, Syria, Mabhouh was also a key intermediary in the covert arms traffic between Iran's Revolutionary Guard, the Syrian intelligence service, the Hamas government in Gaza, and other militants. He was ordinarily protected by a team of armed bodyguards. But they had not been allowed to accompany him to Dubai on Jan. 19 because there was no room on the flight, according to a Hamas spokesman in Damascus, Talal Nasser. So whether by design or accident, he was stripped of his protection, making his assassination easier to accomplish.
When the Dubai police, under pressure from Hamas, looked more closely into the crime scene, they found that the electronic lock on the door of his room had been reprogrammed to allow others entry. The electronic lock can be accessed directly at the hotel room door by a sophisticated hacker.
Then a Dubai forensic lab retesting his body fluids discovered traces of succinylcholine. This is a quick-acting, depolarizing, paralytic drug that, by rendering Mabhouh incapable of resisting, could account for the lack of bruise marks on the body.
In February, Dubai's chief coroner, Fawzi Benomran, reversed his verdict of a natural death. Instead, describing the death as "one of the most challenging cases" in the history of the emirate, he concluded it was a disguised homicide "meant to look like death from natural causes during sleep."
Meanwhile, Dubai investigators examined 645 hours of videos from surveillance cameras at the hotel and elsewhere. They saw that, after Mabhouh left his hotel room, four suspicious-looking individuals got out of the elevator on the second floor near his room. Several hours later, at 8:25 p.m., Mabhouh returned to his room (according to the electronic lock). Shortly afterwards, the four men were seen via the cameras leaving the floor.
The police theorized that these men had surreptitiously entered Mabhouh's room while he was out, incapacitated him with the paralytic drug on his return, induced a heart attack by suffocating him with a pillow, and reprogrammed the electric lock to make it appear it had been locked from the inside.
With the aid of facial recognition software, Dubai police then identified 26 suspects. All had been in Dubai at the time of Mabhouh's brief visit. All had entered Dubai using fake or fraudulently obtained passports from countries not requiring a Dubai visa, including Britain, Ireland, France, Germany and Australia.
All the passports turned out to be stolen identities with faked passport photos. The charge cards, airline tickets, and pre-paid phone cards these suspects used were also in the name of their stolen identities. The only real clue to their real identities was that eight of the identities had been stolen from people with dual Israeli citizenship. As Mossad, Israel's national intelligence agency, had previously used dual citizens' passports to fake identities, Dubai authorities concluded the suspects were from Mossad.
Dahi Khalfan Tamim, the head of the Dubai police force, stated on a government-owned Web site, that he "is 99 percent, if not 100 percent, that Mossad is standing behind the murder." While this authoritative finger-pointing was largely accepted as am "aha" moment by the media, Dubai is not exactly an uninterested party in the Mabhouh affair. It is, after all, the principal transshipment points for the lethal arms trade between Iran and Hamas-and Mabhouh had been one of the major players in this trade.
The much-publicized hotel surveillance videos, while highly diverting on YouTube, do not show any of the 26 suspects engaging in any illegal activities other than using false identities, a practice which is not unknown in Dubai (Mabhouh himself reportedly had five different passports). Even if all 26 identity thieves were intelligence operatives, as seems the case, it does not necessarily follow that they were all in Dubai on the same business, or even working for the same side.
Since Iran maintains its largest offshore financing facility in Dubai-which is used by the Revolutionary Guard, among others, to support its traffic in covert weapons- more than one intelligence service might be interested in Mabhouh's trip. Consider, for example, the peculiar fact that two of the 26 Dubai suspects exited by boat to Iran, according to Dubai authorities; this is not a likely escape route for Mossad agents.
Two other individuals whom the Dubai police had named as suspects worked for the Palestinian Authority, an arch enemy of Hamas. (They were arrested in Jordan and turned over to Dubai). Another person wanted by Dubai for questioning returned to Damascus just prior to the killing. And then there is the question of who in Syria played a role in stripping Mabhouh of his protection just hours before his flight to Dubai.
The key missing piece in the jigsaw remains Mabhouh's mission to Dubai-apparently important enough for him to travel there without his normal contingent of bodyguards.
Mabhouh arrived from the airport at his hotel shortly before 3 pm, and after changing his clothes left for an unknown destination. He was gone for several hours. But even with its state-of-the-art surveillance cameras in Dubai, and extensive interviews with all the taxi drivers at the hotel, authorities claim they cannot determine either his whereabouts during these hours or the identity of whom he met.
The world-wide focus on the spooks-whose false identities allowed many of them to vanish in the intelligence netherworld-has diverted attention from the potentially embarrassing mission that brought Mabhouh to the Dubai. The real intrigue here is not who killed a wanted terrorist, but what he was up to. Without this missing piece, any rush to judgment about who his killers were may be premature.

Friday, February 26, 2010

The MGM Conference Call

The bad news came in a non-public conference call this Monday (February 22nd) to the 140 banks and hedge funds holding nearly $4 billion in MGM debt. MGM CEO, Stephen F, Cooper, the turn-about specialist brought in to save the one-proud studio, revealed in the call that the secret numbers memo circulated to potential buyers in the confidential deal had been seriously inflated by MGM’s own over-optimistic estimate of its 201o television revenue. The memo, which had been sent out by Moelis & Company to solicit offers from potential buyers, stated that "Television distribution has generated over $500 million of Library cash receipts in each of the last four fiscal years ," estimating it would produce "$529 million" for fiscal 2010 (which ends March 31, 2010). A library is made of two components: DVD sales and the licensing of movies and TV series to pay channels, cable networks and broadcast television. So, with the DVD market collapsing in 2009, the stability of television revenue, as represented in the memo, was (at least until Monday) a key selling point to the remaining potential buyers– Time Warner, Lionsgate, John C. Malone’s Liberty Media, Rupert Murdoch’s News Corporation, Ryan Kavanaugh’s Relativity Media, Anil Ambini’s Reliance ADA Group, and Leonard Blavatnik's Access Industries.lain . Now, Cooper had stunning news. He told the 140 creditors that the library sales had been anything but stable, and plunged in the fourth quarter (so far) to the extent that the estimate had to be reduced by almost $30 million for that quarter. If annualized, that would amount to a decrease of about $120 million in revenue. Even worse, this severely reduces the value of the library since, as those in the business know, when MGM renews its multi-year contracts, the money it will get for aging product will drop precipitously.In MGM’s case, as I pointed out previously, a large part of these revenues must be split with "third parties." This includes producers, stars, directors, writers and Hollywood guilds, and, in 2009, amounted to over 40 percent of the total take.
The forbearance that MGM’s creditors extended to MGM in October runs out in 10 weeks so Cooper can sell it. Now all the remaining bidders will have to drastically recalculate, if not, reconsider. the amount they are willing to gamble. The Wall Street investors who put up most of the equity for the 2004 takeover have already seen their investment effectively wiped out. The suspense that remains in this Hollywood thriller is the degree to which the bond-holders will suffer the same fate. The bond holders cannot put the company in bankruptcy without jeopardizing the valuable remake rights to James Bond movie. So if the bidders pull out, or offer only pennies on the dollar, the only alternative open to the bond holders is to themselves take-over MGM by swapping their debt for equity– but this is not the Hollywood ending they want.
My book The Hollywood Economist is out today.

Friday, February 19, 2010

The Secret Numbers Behind The MGM Fiasco

MGM, once the shiniest studio in the Hollywood galaxy, has fallen on hard times. Last October it failed to make the interest payment due on its $3.7 billion debt, and even with the six month forbearance granted by its creditors, it is hovering the threshold of bankruptcy. Its equity investors — including three big hedge funds — have been all but wiped out. The 140 banks that financed the leveraged part of the leveraged buyout deal are in danger of losing over $3 billion. With the creditors demanding their money, and the clock running on its forbearance, MGM had put itself up for sale, retaining investment bankers Moelis & Company to solicit offers from potential buyers that were due in mid January 2010. For a movie studio that was bought for $4.85 billion in 2004 (which is over $5 billion in 2010 dollars), the bids that have come in so far are shockingly low. Time Warner, for example, is offering under $2 billion and the bid from Lionsgate, once the leading contender, is worth even less.

The secret numbers in the confidential information memorandum sent out by Moelis explain the problem, which goes to the root of what is happening to the movie business today. MGM's main asset, as is true in the case of all Hollywood studios, is its library comprised of 4,100 film titles, including all the James Bond movies, and 10,600 television episodes. The money that comes in through this library comes from DVD sales — mainly older titles sold in discount bins at Wal-Mart and other retailers -– and television licensing packages to Pay TV, cable networks, and television stations around the world.

The bet that the hedge funds made when they put up most of the equity for the $4.85 billion LBO in 2004 was that DVD revenue from the library would hugely increase when people replaced their standard DVDs with the Blu-Ray high-definition format that was just being introduced. But their projections proved to be pipe dreams. Instead of expanding, MGM's DVD revenue plummeted, according to the confidential memo. MGM's DVD revenues fell from $394.7 million in 2008 to just $69.8 million in the 2010 fiscal year (which ends March 31).This huge drop was attributed to a host of factors, ranging from the worldwide downturn in DVD sales to fewer new MGM releases. What turned out to be the real killer for MGM's library was what the memo termed "significant price erosion." Wal-Mart, pressured by competition from Netflix, Red Box, and video downloading, drastically reduced the "price point" that it would buy older (or so-called "catalogue") DVDs, driving prices down to less than $5 a copy. So studios' saw the stream of profits from older DVDs wither away.As with other studios, the larger part of MGM's library's money comes from television licensing. At first glance, these revenues appear remarkably stable, declining a mere one percent from $535.1 million in 2008 to $529 million in 2010. But like other phenomena in Hollywood, appearances can be deceptive. MGM had structured its long-term licensing contracts so the cable networks wind up underpaying for the early years and overpaying for the later ones, which is a common practice at studio libraries. As a result, even as properties lose value over the course of the contract (old films are worth less than newer ones), the illusion of stability is maintained . Of course, when MGM renews these multi-year contracts, the money it gets will drop precipitously.And as impressive as $529 million in revenues may seem, it is not the amount MGM actually gets to keep since it must split these proceeds with various "third parties," including producers, stars, directors, writers and Hollywood guilds. For example, the revenues from the 24 James Bond movies — which are the library's most valuable asset generating nearly 30% of its revenue — have to be split 50-50 with Danjaq LLC, the holding company for the Broccoli family that originally created the franchise. These participations and residuals (which is what the guilds get for their pension funds) totaled $235.2 million in 2010. In addition, there were $33.2 million in other expenses, such as calculating and issuing more than 15,000 different checks per quarter to participants.MGM also had to pay Fox a fee of $22.2 million for distributing its DVDs. What MGM kept turned out to be not enough to pay its overhead — $135.9 million in 2010 — and other costs, leaving it with a negative operating cash flow of $52.4 million. The bottom line here is that MGM cannot pay off its $3.7 billion in debt. And even if a white knight gallops in to carry off the library, the investors and creditors will take a bath.

Monday, February 15, 2010

Will Nextflix Be The Next HBO?

Netflix, through the simple device using the post office to bypass video stores, has become one of the great success stories of the new entertainment economy. It now has 11.8 million subscribers who pay a monthly flat fee for an unlimited number of rentals. It gets its DVDS from wholesalers and even retail stores. It can then rent them because of a court-approved "First Sale doctrine," which says that once a person buys a DVD, he can re-sell it or rent it out. Last year Netflix took in $1.67 billion in subscription fees, but because of the high cost of mailing some 2 million discs a day from 50 distribution centers, it only eked out a profit of $115 million.
So it is moving onto the Internet, substituting digital streamed movies for ones that are delivered by the postman. Subscribers get them on their TV via a set top box or game console without any additional charge. This "Watch Instantly" service effectively creates a virtual channel that directly compete with Pay-TV for the wallet and clock of viewers. Such a challenge by Netflix could also result, as Frank Biondi the former head of HBO, terms it, "a terminal career decision if you get it wrong."
The problem is that the First Sale doctrine does not apply to streaming or downloading DVDS so Netflix must buy digital rights, which is exceedingly expensive for new titles. In late 2008, Netflix found a temporary way around this stumbling block by making a deal with Starz Entertainment, a subsidiary of John Malone's Liberty Media, to sub-license the streaming rights of the titles it had obtained from Disney, Sony and smaller studios in output deals. Starz held it could sub-license these rights because Netflix was merely a "content aggregator," but the studios took a dimmer view of this loophole. Disney, according to a top executive involved in the dispute, has warned Starz that it will not renew its output deal (which expires in 2012) unless it either cuts Netflix out or pays Disney a rich premium.
Netflix chief content officer Ted Sarandos portrays the issue as merely a communication glitch, saying, "We have to fight against their fear that we~ll destroy the ecosystem." Despite this well-meaning new-age talk, what is really at stake here is old-fashioned money. The most profitable part of Hollywood's "ecosystem" is the output deals through which studios license movies to Pay TV channels, cable networks and broadcast stations. According to the studios's internal all-source revenue numbers, the six major studio took in $16.2 billion from pay-TV and television licensing of their movies in 2007, which was almost all profit. So the threat of sub-licensing for Internet circulation involves a good more than studio paranoia.
As for HBO, a subsidiary of Time Warner, it is the undisputed leviathan of Pay-TV. It has over 40 million subscribers, $4 billion in revenues, and a cash flow of $1.3 billion. And, unlike Netflix, it owns the digital rights to a large amount of exclusive material, much of which it produced. Over the past decade it invested heavily in original programming, creating such series as The Sopranos (which cost $2 million an episode) to retain subscribers. This made economic sense because cable systems paid it about $6 a month for each subscriber. As a top Time Warner executive who had authorized much of this original production explained to me, the name of the game is subscriber retention.
So HBO is not about to cede cyberspace to Netflix. It's in the process of rolling out an Internet service called HBO Go which will allow all HBO subscribers to get, as the executive puts it, "anything they want to see, anytime, anywhere, over their laptop, Iphone, tablet, Playstation." Bolstered by its exclusive content, HBO will initially offer some 800 hours a month of programming a month. Its 40 million subscribers can get at no additional charge over the Internet the linenew titles HBO acquires through its output deals with Warner Bros, Fox, and Dreamworks, past and present original series, HBO boxing, and even so-called "late night" fare such as Alien Sex Files.
Netflix, on the other hand, has almost no exclusive content with which to compete with HBO. Back in 2006, it attempted to produce its own original content through a subsidiary called Red Envelope Entertainment, but closed it down in 2008. The brutal reality is that Netflix, with only one-eighth the cash flow of HBO, does not have the scale to produce its own material. Of course, whether or not the Starz deal is renewed, Netflix can exclusively license programming through output deals. But competing in this game, in which the licenses for a slate of two dozen movies can cost in excess of a quarter of a billion dollars, could prove prohibitively expensive. Last year Netflix reportedly spent $100 million on licensing just non-exclusive rights to movies for streaming from Starz and studio libraries. Although this saved postage, Netflix still has to pay the overhead for its distribution centers. Adding hundreds of millions of dollars in output deals to this equation could wipe out much, if not all, of its profits.
Netflix has brilliantly carved out for itself a niche audience who largely enjoy the convenience of receiving older movies, which accounts for about two-thirds of its revenue. It will no doubt continue to satisfy and expand this audience via mailing and streaming. But what it lacks is the wherewithal to do is to replace HBO.
Edward Jay Epstein is the author of 14 books, including two examining the movie business: The Hollywood Economist: The Reality Behind The Movie Business will be published by Melville House later this month, which follows his 2005 book The Big Picture: Money and Power in Hollywood.

Tuesday, February 02, 2010

How Wall Street Hedge Funds Got Taken On A Billion Dollar Ride in Hollywood

Back in 2003, after Kirk Kerkorian 1et it by know that he was (yet again) prepared to sell MGM, Viacom, which owns Paramount, considered buying it. Although MGM no longer had sound stages, backlots or other physical facilities, and now produced only a handful of movies, it owned an incredibly valuable asset: a film libraries with 4,100 motion pictures and 10,600 television episodes. The crown jewels of this collection was its James Bond movies, which was possibly the most valuable entertainment franchise ever created. By licensing these titles over and over again to Pay-TV, cable networks, and television stations around the world, and selling DVDs from it,, this library brought in roughly $600 million a year. But that gross was an elusive number as it had to be split with others who had rights in the titles. Each title had its own contractual terms governing payments to partners, talent, guilds, and third parties.. Just making these payments entailed issuing more than 15,000 checks per quarter. Not only did titles have different pay-out requisites, but their future revenue stream depended on factors specific to each movie, such as the age of its stars, its topicality, and its genre. To figure it out, Viacom assigned a team of 50 of its most experienced specialists to estimate the how much each and every title would bring in over a decade. The Herculean job took the team two months. From this analysis, as well as considering other benefits of merging MGM with Paramount, Viacom’s executives agreed MGM was worth between $3.5 and $4 billion. But before they could arrive at a bid price, Viacom’s President, Mel Karmazin, asked them whether the value of the MGM vast library go the way of the music industry, which had been decimated by Internet down-loading. When none of the executives could rule out that possibility, Karmazin said "In that case, we are not bidding on MGM." Disney, after a similar deconstruction of MGM’s complex library, valued it at $3 billion, and also opted not to bid on the company.
Sony had a very different agenda for MGM. Since it had staked much of its corporate future on Blu-Ray as a high-definition format, it needed to get other major studios to choose it over a competing format, backed by Toshiba and Microsoft, called HD-DVD. Sony had learned from bitter past experience that format wars are often decided not by superior technology but by side payments made to studios. Toshiba and Microsoft (which had X-Box) were already offering huge cash inducements– one studio would get $136 million– to put their titles exclusively on the HD-DVD format. Such a pay-off competition could prove extremely expensive given the deep pockets of Toshiba and Microsoft, so Sony, which needed to establish Blu-Ray for its Play Station 3 as well as its movies, sought another route to victory. If it could put the huge library of MGM titles exclusively on Blu-Ray, together with its own library and the Columbia Tristar library (which it also owned), Toshiba and Microsoft, no matter how many side payments they made, would not be able to establish their rival format. To this end, Sony did not need to itself spend billions to acquire MGM, it only had get effective control of MGM’s library for a few years. So it put together a consortium that would be financed mainly by Wall Street private equity funds. And it would lead the consortium.
Even though the LBO would wind up costing $4.85 billion, Sony invested only $300 million of its own funds (and for that it got the profitable right to distribute MGM movies). Another $300 million came from the Comcast Corporation in return for the rights to put the MGM’s library on Pay Per View on its vast cable system. The rest of the equity money came from renowned Wall Street investors Providence Equity Partners, Texas Pacific Group, DLJ Merchant Banking Partners, and Steve Rattner’s Quadrangle Group. These savvy funds put in a cool billion dollars. The leverage part of the deal was organized by JP Morgan Chase, which very profitably arranged, since it also got a fee, for the consortium to borrow $3.7 billion (or up to $4.2 billion, if needed) from some 200 banks. The deal closed in September 2004.
For Sony, the gambit succeeded brilliantly. Putting some 1,400 MGM titles exclusively on Blu-ray, helped established Blu-Ray as the industry standard for high-definition, and it won the format war. It also made back a large share of its $300 million investment just on the distribution fee it earned on two new Bond movies (Casino Royale(2006) and Quantum of Solace (2008). But for the Wall Street players, it was nothing short of a disaster. To cut to the chase, they lost almost all their entire billion dollar investment. They had relied, perhaps naively, on impressive-looking projections showing that the net cash flow from the MGM movie and television library would be sufficient to pay the interest on the nearly $3.7 billion of debt over s decade. What they had not counted on was a sea change in DVD sales. In the US alone, MGM’s net receipts from DVDs fell from $140 million in its 2007 fiscal year (which ends March 31st 2008) to just $30.4 million by 2010. As a result of collapsing sales, higher pay-out for participants, increased distribution costs and other distribution problems, MGM’s crucial operating cash flow catastrophically fell from $418.4 million in 2007 to minus $54.2 million by 2010. In addition, it owed Fox Home Video $60 million for an "adjustment" in the DVD distribution contract it had taken over from Sony. By October 31, 2009 MGM, sinking in a sea of red ink, found itself unable to make its mandated interest payments on the $3.7 billion it owed banks.
Ordinarily when a company fails to make such payments, its bank creditors can seek to recover their money by forcing the company into bankruptcy. With MGM, however, the bankruptcy option presented a real problem since many of its intellectual property rights, including those to make sequels in the James Bond franchise, stipulate that in the event of bankruptcy they would automatically revert to another party. In the case of the James Bond franchise, for example. the sequel rights would revert to Danjaq, LLC. (These bankruptcy clauses are not mentioned, even in a footnote, in the 38-page "Confidential Information Memorandum" that MGM sent out to prospective buyers in the winter of 2009.) So the creditors learning that bankruptcy would destroy a significant part of the remaining value of MGM, gave it a three month "forbearance," which meant it had until January 31, 2010 to come up with the money. The idea was that MGM would sell itself to a white knight and use the proceeds to repay the banks. The deal book was sent out to a dozen or so prospective buyers calling for bids by January 15th. The replies, according to a source close to Moelis & Company, which is MGM’s financial advisor, have, as of January 22nd, have been "disappointing," with none of the serious bids coming within $1.6 billion of what MGM owes its creditors. As for the hedge funds, they have already written down 85 percent of their billion dollar investment in preparation for what may be a near total wipe-out. The lesson here for Wall Street that when a Hollywood deal seems to good to be true– it may not be.

Thursday, January 21, 2010

Flirting With Disaster: Can Indie Movies Survive?

The Achilles’ heel of the independent movie business is American distribution. No matter how brilliant an indie movie may be, and no matter how many awards its wins at film festivals, it needs to get into theaters to be seen. That feat is no longer easy for an indie movie.
The Big Six 6 studios– Disney, Paramount, Universal, Warner Bros. Fox, and Sony– are also distribution juggernauts. They dominate both American and foreign distribution . Each of them employs a small army of salesmen, publicists, media buyers, theater-relations liaisons, merchandising specialists, and lawyers to get its movies and coming attractions on the best screens in theaters, its stars on the top TV shows, and its DVDs in the prime space at video stores. Because of their enormous clout with theater chains, the Big 6 can open their movies on 4,000 screens in the US and thousands of additional screens overseas. They also have long-standing merchandising deals with fast-food chains, toy companies, and other mass retailers to assist these global openings. Since their distribution machines have enormous overhead, the Big 6 studios need to confine their releases to potentially huge grossing movies. The size of the gross is crucial– even if there is no net profit– because studios, take a hefty cut of it off the top in the form of a distribution fee– typically, on movies that studios finance, it is 30 percent– which helps offset the overhead. The requisite, however, often leaves producers of smaller films out in the cold. Consider, for example. the sad story told to me by one of the most successful indie producer. In 2009, he brought to a major studio a project that had a budget of a mere $20 million with a well-regarded director and stars. After running the numbers, the studio estimated that its potential box-office was $100 million, which would yield it, just from the distribution fee and the output deal with HBO, a 100% profit on its investment. Yet, it flatly turned down the project because, as its executive told the producer, "We don’t do films that do not have a projected box-office of at least $150 million." The reason is that each studio has only a limited number of slots for their releases, and they have to fill them with so-called "high value" films with a potential to generating hundreds of millions of dollars in revenue to pay their overhead. Indie film, even if they return a profitable on a relatively small investment, cannot be counted on to do that job.
So how does an indie producer get an American distributor? Unlike studio producers, indie producers rarely, if ever, have a US distribution deal in advance of shooting. To raise the money to shoot a film, they must either find an outside investor or borrow it. As for the latter course, since the 1970s indie financing has used pre-sales agreements in foreign territories as collateral to borrow from banks. After the film is shot and edited, they then seek distribution either through screenings or by taking it to film festivals– a process that can take years. What made the gamble on finding distribution feasible was that, at least up until 2008, there were over a dozen so-called specialty distributors handling indie films, including both studio-owned "indie" companies, such as Miramax, Fox Searchlight, Fox Atomic Films, Paramount Vantage, Warner Independent Film, Picturehouse, New Line, Fine Line Features, Focus Features, and Sony Pictures Classics, and truly independent companies, such as Lionsgate Releasing, the Weinstein Company, and Summit Entertainment. Even those these specialty distributors have an order-of-magnitude less overhead than the majors, they still have to fund it. Since cash flows from indie films is erratic , they depended for a steady stream of revenue from "output deals" with the three pay TV channels. HBO, Showtime, and (later) Starz originally entered into these deals, offering to buy the entire output of a studio/distributor, to get new titles to attract subscribers to their pay channel. But as these payments were pure profit, since they entailed no expenses, they proved to vital for the smaller distributors. In 2008, for example, New Line Cinema, received slightly over $80 million for 8 titles from HBO, which paid its annual overhead. Bob Weinstein, the co-chairman of the Weinstein Company, not only described them in 2008 as "the bedrock of the business," but said "not one company in this business could survive and succeed without one." His words proved prophetic. When the pay-channels found they needed fewer titles, and began cutting back on their output deals, the bedrock crumbled into clay within a matter of months. In May 2008, as top tier indie producers gathered at the Cannes festival to seek distribution for their movies, they witnessed to their horror, as one put it in an email, "the landscape change before our eyes." In short order no fewer than six specialty distributors– New Line Cinema, Fine Line Features, Picturehouse, Warner Independent Films, Fox Atomic, and Paramount Vantage– closed while a seventh, the Weinstein Company, announced it was sharply cutting back on acquiring new titles because of cash-flow problems. A few months later another domino fell, when Miramax, which had been the linchpin of indie distribution for two decades, announced it was closing its main office in New York. Even the few players who remained moved to change their acquisition strategy, with Lionsgate, investing more heavily in exploitation films, such as Saw I, II, and III, and Focus Features, seeking co-production deals with Asian studios.
As indie distribution shrunk, financing through pre-sales became vastly more difficult. In the past, foreign buyers had been willing to make advance commitments for indie films because they assumed that they would get the sort of distribution in America that would provide publicity and credibility for their own release. Without such a prospect, European buyers were loathe to commit themselves to a pre-sales. As the executive of a major French distributor wrote me " except for auteur directors, such as Woody Allen, Wong Kar Wai, and Pedro Almodovar, we no longer make any pre-sales deals."
Even suffering such blows, the indie business is not dead, at least not yet. Indie producers have always demonstrated incredible resourcefulness in piecing together financing, even if it comes in the form of exotic tax credits, government subsidies, or indulgences from American egomaniacs, Arab oil sheiks, or Asian tycoons entranced with a movie fantasy. So even if the pre-sales game is moribund, they will likely find other ways of raising money to make movies. But unless they also devise a new model to distribute them in America, no one will see them.
(My new book,
The Hollywood Economist, will be published next month by Melville House)

Wednesday, January 20, 2010

Quivering On The Edge Of The Digital Abyss

The video pirates of Shanghai have developed an amazingly successful business model for exploiting the home market. In the back rooms of video stores, shoppers fill their baskets while choosing from an almost endless inventory of DVDs that includes all of the studios’ new movies as well as a full compliment of Oscar screeners. You can also buy current television series—even the latest episodes of House, Lost, and 24. In addition, in a non-Internet form of video on demand, if a title is not on the shelves, the store gets it bicycled over from some other location in a matter of minutes.
In this business model, unlike Hollywood’s, there are no "windows" or artificial delays before a new movie is released on DVD, no ratings restricting audiences, and no zone restrictions that can prevent DVDs from being playable. Most are professionally burned from digital masters made from copies of the studios’ own DVDS. While their quality may not always be up to Hollywood’s standards they are priced to sell. Even at high-end stores I visited in Shanghai, a DVD cost less than $1.25. Other retailers—including street hawkers— charge much less. As a result of this aggressive pricing, people in China rarely go to movie theaters. Instead, they buy shopping baskets full of pirated DVDs. According to the most recent estimates, Chinese manufacturers sold well over 1.5 billion pirated DVDs in 2009, which, if true, exceeded the major studios’ sales of legal copies in America in 2009. Not surprisingly, China is by far the world's largest manufacturer of blank discs and DVD packaging (which they provide to the American studios as well). Since they do not pay any licensing fee, their main enterprise cost, aside from blank discs and boxes, are the pay-offs involved in stealing advanced copies of DVDs (which is greatly facilitated by studios’ practice of storing their DVDs for months in warehouses around the world while they wait for the DVD window to open at video stores.) The economic principle that the pirates have amply demonstrated in China is that the demand for entertainment is exquisitely elastic: DVDs priced at $15—the studios’ retail price—hardly sell in China; pirated DVDs priced $1.25 a copy (or lower on the street) sell like hot won-tons.
This economic lesson has not always played well in Hollywood. Up until the late 1990s, the studios placed a wholesale price of $55-$60 on most videos because video stores wanted a high price to protect their rental business. Even after the DVD was launched in the late 1990s, some studios still wanted to price them high to protect the video rental business. Sumner Redstone, who then controlled both Paramount and Blockbuster, famously argued: "The studios can't live without a video rental business—we [Blockbuster] are your profit." Despite such warnings, Warner Bros. and Sony decided to move DVDs in another direction. They offered Wal-Mart new titles on DVDs priced as low as $15.50 as traffic builders. With two years, Wal-Mart was selling 8 million DVDs a month, making it a major player in Hollywood. Under relentless pressure from Wal-Mart, which by 2005 accounted for 40 percent of the studios' DVD sales– and nearly 50 percent of their "bin sales"– the price for older DVDs was cut to as low as $6 a copy. Wal-Mart cut its own price under the $15 wholesale price on traffic-building new DVDs, losing money on each sale to draw more people into their stores. Other stores followed suit, leading one Warner Bros DVD executive to quip, "We have the only business in which the wholesale price is more than the retail price." These reduced prices, which turned DVDs into a retail juggernaut, only increased the studios' DVD revenue, which reached an all time high of $21 billion in 2005.
As DVD sales began to slide in 2006, and became less attractive as magnets to draw customers into its stores, Wal-Mart, briefly considered a plan to burn its own copies of DVDs in kiosks in its stores. Like the Shanghai pirates, the retail giant would stamp out copies for customers from blanks discs and cheap boxes (which would probably come from China). But, unlike the Shanghai pirates, they would pay a licensing fee to the studios for each copy it sold. The advantage to the customer would be that he could choose a title from among the tens of thousands of movies in the studios' libraries, and also possibly have it in the language and rated-version (G, PG, R, or NC-17) he prefers, while the studios would save the cost of manufacturing, packaging warehousing, and returns. When Wal-Mart's scheme was proposed to an executive from Warner Brothers, he pointed out that the delay for the customer might be as long as a half-hour before he could pick up the DVD. "Great. Could you make it an hour?," the Wal-Mart executive shot back. From the point of view of Wal-Mart, the DVD need not make money itself, as long as it serves to draw—and keep—potential customers in its stores. The plan never got off the ground. The DVD was the cash cow and studios were unwilling to accept a licensing fee that could gradually reduce until it became, as one studio executive put it, "pocket change."
Fast-forward to 2010
Rapid increases in the availability of high-speed broadband threatens Hollywood with the same fate as the music industry, which saw much of its lucrative CD business replaced by downloads of MP3 files (which are much smaller than the digital files of movies). By 2010, the security codes protecting the DVD (and even the Blu-Ray) from digital copying had been irreparably broken so that virtually anyone, anywhere in the world, could download a movie. In addition, new forms of online storage, such as so-called "cyber-lockers," which are web sites capable of storing movie-sized files that can be downloaded by anyone who has been given a password, had become almost impossible to police for pirated content. So almost any new title can be downloaded free from the Internet before it is released in video stores (or, for that matter, on Pay-Per-View TV.) The studios could see the hand writing on the wall in South Korea, which, because of its online gaming culture, is ahead of America in broadband speed. In 2006, the studios had a rich $1.3 billion DVD market in South Korea. But after an increase in the bit-rate of its broadband in 2007 its DVD sales fell to $80 million with two years. What happened was that Koreans found it more convenient to download movies from cyber-lockers than to buy or rent DVDs. After all, a DVD is nothing more than a way of storing a movie’s digital formula, and if the same formula, can be as easily retrieved from the Internet, there is little reason to buy a DVD.
So the light Hollywood sees at the end of the tunnel is on a locomotive heading directly for it. The concept of licensing their titles for downloading, or as one executives put it, " "trading digital pennies for analog dollars," is anything but appealing to the studios. When Apple’s Itunes Music Store, Amazon’s Unbox Movies, and other Internet stores offered to sell (and rent) downloads of their titles at their on-line stores, the studios decided to price them at the same price as DVDs, even though they entail no manufacturing, packaging, warehousing, or other costs. The reason that the studios insisted on such a high price was, in a word, Wal-Mart, which in 2009 still accounted for 38 percent of their DVD sales. Wal-Mart executives had made it crystal clear that they would not pay a penny more for its DVDs than any competitor, including Apple or Amazon, paid. So the studios charge Internet stores the same $16-17 per copy to download as they charged Wal-Mart for DVDs. (Some stores, such as Apple’s Itune store, decided to sell studio movies at a loss to help sell other products, such as the Ipods.) By pricing downloads high, the studios in effect were replaying their losing battle against the Shanghai pirates. This time around, however, the pirates, were operating cyber-lockers in places such as Moldavia. Latvia, and Pacific islands that are unlikely to enforce US copyright law, and, As a Warner Bros. technical operations chief explained in 2008, a large number of cyber-lockers now serve as "facilitators to access pirated content." Unlike the Shanghai pirates, these pirates do not even need to buy blank discs or packaging. So they could provide free downloads of Hollywood movies and make their profit from ads on or memberships to their site.
Even with declining sales, DVDs, still provided the 6 major studios with slightly over $16 billion in 2009, and constituted their main source of revenue. But what of Hollywood’s imminent future? South Korea demonstrates that a DVD market can be wiped out within a year or so of broadband improvements that make it possible for anyone to download a free movies in 15 minutes from the Internet. So quivering on the edge of this digital abyss, the studios remain paralyzed by their fear of losing their once almighty Wal-Mart accounts.