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)

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.

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.

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.

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.

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.
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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.
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(My new book, The Hollywood Economist, will be published next month by Melville House)

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.
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Why Journalists Don't Understand Hollywood

There was a time, around the middle of the twentieth century, when the box office numbers that were reported in newspapers were relevant to the fortunes of Hollywood: studios owned the major theater chains and made virtually all their profits from their theater ticket sales. This was a time before television sets became ubiquitous in American homes, and before movies could be made digital for DVDs and downloads. Today, Hollywood studios are in a very different business: creating rights that can be licensed, sold, and leveraged over different platforms, including television, DVD, and video games. Box office sales no longer play nearly as important a role. And yet newspapers, as if unable to comprehend the change, continue to breathlessly report these numbers every week, often on their front pages. With few exceptions, this anachronistic ritual is what passes for reporting on the business of Hollywood.
To begin with, these numbers are misleading when used to describe what a film or studio earns. At best, they represent gross income from theater chains’ ticket sales. These chains eventually rebate about 50 percent of the sales to the distributor, which also deducts its outlay for prints and advertising(P&A). In 2007, the most recent year for which the studios have released their budget figures, P&A averaged about $40 million per title— more than was typically received from American theaters for a film in that year. The distributor also deducts a distribution fee, usually between 15 and 33 percent of the total theater receipts. Therefore, no matter how well a movie appears to fare in the box office race reported by the media, it is usually in the red at that point. So where does the money that sustains Hollywood come from? In 2007, the major studios had combined revenues of $42.3 billion, of which about one-tenth came from American theaters; the rest came from the so-called back end, which includes DVD sales, multi-picture output deals with foreign distributors, pay TV, and network television licensing.
The only useful thing that the newspaper box office story really provides is bragging rights: Each week, the studio with the top movie can promote it as "Number 1 at the box office." Newspapers themselves are not uninterested parties in this hype: in 2008, studios spent an average of $3.7 million per title placing ads in newspapers. But the real problem with the numbers ritual isn’t that it is misleading, but that the focus on it distracts attention from the realities that are reshaping and transforming the movie business. Consider, for example, studio output deals. These arrangements, in which pay-TV, cable networks, and foreign distributors contractually agree to buy an entire slate of future movies from a studio, form a crucial part of Hollywood’s cash flow. Indeed, they pay the overhead that allows studios to stay in business. The much more frequently in about 2004, can doom an entire studio, as happened in 2008 to New Line Cinema, even though it had produced such immense box office successes as the Lord of the Rings trilogy. Yet, despite their importance, output deals are seldom mentioned in the mainstream media.
As result, a large part of Hollywood’s amazing money making machine remains nearly invisible to the public. The problem here does not lie in a lack of diligence or intelligence on the part of journalists. It proceeds from the entertainment news cycle, which generally requires a story about Hollywood to be linked to an interesting current event within a finite time frame. The ideal example of such an event is the release of a new movie. For such a story, the only readily available data are the weekly box office estimates; these are conveniently reported on websites such as Hollywood.com and Box Office Mojo. If an intrepid reporter decided to pursue a story about the actual profitability of a movie, he or she would need to learn how much the movie cost to make, how much was spent on P&A, the details of its distribution deal and its pre-sales deals abroad, and its real revenues from worldwide theatrical, DVD, television, and licensing income. Such information is far less easily accessible, but it can be found in a film’s distribution report. But this report is not sent out to participants until a year after the movie is released, so even if a reporter could obtain it, the newspaper’s deadline would be long past. Hence the media’s continued fixation on box office numbers, even if reporters themselves are aware of their irrelevance in the digital age.
The purpose of my forthcoming book The Hollywood Economist is to close gaps like these
in the understanding of the economic realities behind the new Hollywood.

Who Burned Down The Reichstag-- And Brought Hitler To Power

On the night of February 27, 1933 in Berlin, the Reichstag, the home of the German Parliament and the symbol of the German state, was ablaze. While it was still smouldering, German police arrested Marinus Van der Lubbe, a Dutch communist with a history of setting buildings on fire. Also at the crime scene was Adolph Hitler, the newly appointed leader of a shaky coalition government. Only hours later he proclaimed that the crime was not the work of a lone arsonist but part of a wider Communist plot to overthrow the German government calling the it a warning"sign from heaven" of the impending Communist Putsch. With such rhetoric, he persuaded President Paul von Hindenburg to sign the Reichstag Fire decree, which temporarily suspended civil liberties in Germany and allowed the mass arrest of Communists, including its members in parliament. After a snap election, Hitler’s Nazi party had the majority necessary to pass the laws that would make Hitler dictator.
To provide evidence of a Communist plot, German authorities arrested Georgi Dimitrov, a Bulgarian Communist, and Stalin’s chief of covert operations in central Europe. They also arrested two his Communist associates, Vasil Tanev and Blagoi Popov. Together with Van Der Lubbe, they were charged with a conspiracy to overthrow the government. The Show trial ran from September to December 1933, and by almost any measure qualified as the trial of the century. It was presided over by judges fromGermany's highest court. It had Hermann Goring, the creator of Hitler’s Gestapo, and other senior Nazi leaders, as star witnesses, and it was one of the first trials to be broadcast live via radio to the entire world. It began on the morning of September 21, 1933 with the rambling testimony of Van der Lubbe. He admitted setting the fire but claimed he had acted entirely on his own. The prosecution then produced evidence found by firemen, including twenty bundles of inflammable material strategically located in different parts of the Reichstag, that cast doubt on the idea that Van der Lubbe, who was half blind, could himself have placed and rigged all these incendiary devices without help. Next Dimitrov, the operative accused of masterminding the conspiracy, was called to the stand. Though not a lawyer, he acted as his own defense lawyer. He agreed with the prosecutors that the fire had been set by a conspiracy, but, turning the tables on them, he argued that it was a Nazi not a Communist conspiracy, With great dramatic flair, he cross-examined Goring about his role in the investigation and the sequence in which evidence was uncovered. Allowing a worldwide radio audience to hear Stalin’s principal agent brutally interrogate Hitler’s alter ego in a German court room about inconsistencies in the investigation. At one point, he provoked a heated exchanges between himself and Goring on the nature of Communism. Dimitrov’s defense proved so effective that he, as well as his two Communist associates, were acquitted. Hitler and Goring were outraged at the verdict, but the chief judge explained that whereas the court was convinced that the fire resulted from a Communist conspiracy, the prosecutors had failed to prove Dimitrov and his associates was part of it. The only person convicted was the hapless Van der Lubbe, who was beheaded in 1934.
While the Leipzig trial was still under way, a counter-trial was staged in London by Willi Münzenberg, the brilliant propaganda chief for the Stalin-controlled Communist International. The evidence it produced took the form of dramatic revelations from masked men who claimed to be Nazi defectors, including one who identified himself as a former storm trooper and testified that his unit in Berlin had set the fire on direct orders from Goring. Another witness identified Van der Lubbe as the homosexual lover of a top Nazi commander and was used as a fall guy. At the end of the one week counter-trial, Goring was convicted of burning down the Reichstag fire to bring Hitler to power. But though the counter-trial provided much grist for the media mill, it turned out that all its evidence had been faked by Münzenberg’s staff. The masked witnesses were not Nazi defectors but Communist loyalists acting out scripted parts. The "Nazi storm trooper," for example, was played by Albert Norden, the editor of the leading Communist newspaper in Germany. By blending together a cocktail of fact and fiction, the counter-trial served to further pollute the evidentiary waters.
When the Red Army captured Berlin in 1945, it also captured the Gestapo archive. Stalin ordered this trove of documents, including some 50,000 pages of legal proceedings and Gestapo investigations bearing on the Reichstag fire, transported under seal to Moscow. For over three decades, they remained a state secret. Then, after the collapse of the Soviet Union in 1990, part of this archive was opened to researchers. The documents , which presumably had been vetted (and possibly added to) by the KGB, showed no evidence that Stalin or Communist party officials had burnt the Reichstag. They did, however, contain evidence showing that the Nazis had been preparing to arrest Communists before the fire. In addition, there was one intriguing report suggesting that the fire had been set by the Nazis themselves. It described a Berlin prison guard telling police investigators that Adolf Rall, a prisoner arrested for theft, had been overheard bragging to other prisoners that he had been part of a Nazi squad that entered the Reichstag through a tunnel and sprinkled flammable liquid inside the building. German investigators were unable to confirm this story. No record of Rall’s interrogation by the Gestapo was ever found and Rall himself had been murdered on the outskirts of Berlin in November 1933 (while the trial was still in progress). So the lead was a literal dead end. In any case, since both the Gestapo and KGB had custody of an archive, and neither agency was above with tampering with documents, the evidentiary value of the documents is at least questionable.
As a result, little more is known seven decades later about one of the most political explosive crimes of the twentieth century. Indeed, all that is known for certain that the Reichstag was deliberately destroyed. Whether a lone arsonist or a conspiracy, the resulting conflagration forever changed history.
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The Anthrax Case Falls Apart

The vast anthrax investigation, code-named Amerithrax, ended as far as the public knew on July 29 2008 with the death of Dr. Bruce Ivins, a microbiologist/wiki/Biodefense at the United States Army Medical Research Institute of Infectious Diseases in Fort Detrick, Maryland, at the nearby Frederick Memorial Hospital. The proximate cause of death was an overdose of the pain-killer Tylenol. No autopsy was performed, and there was no suicide note. Less than a week after his apparent suicide, the FBI declared Dr. Ivins to have been the sole perpetrator of the 2001 Anthrax attacks, and the person who mailed deadly anthrax spores to the NBC, the New York Post, and Senators Tom Daschle and Patrick Leahy accompanied by a photo-copied warning. These attacks killed 5 people, closed down the Senate’s Office Building, caused a national panic, and nearly paralyzed the postal system. The FBI’s 6 year investigation of it was the largest inquest in its history, involving 9000 interviews by its agents, the issuance of 6000 subpoenas, and the examination of tens of thousands of photo-copiers, typewriters, computers, and mail-boxes.
But., as massive as it was, it failed to find a shred of evidence that identified the Anthrax killer– or even a witness to the mailings. With the help of a task force of scientists, it found a flask of anthrax that closely matched through its genetic markers the attack anthrax. This flask had been in the custody of Dr. Ivins, a senior biological warfare researcher, who had published no less than 44 scientific papers over three decades, and who was working on developing vaccines against anthrax. As custodian, he provided samples of it to other scientists at Fort Detrick, the Battelle Memorial Institute, and other facilities involved in Anthrax research. According to the FBI’s reckoning, over 100 scientists had been given access to it. Any of these scientists (or their co-workers) could have stolen a minute quantity of this anthrax and, by mixing it into a media of water and nutrients, used it to grow enough spores to launch the anthrax attacks. Consequently, Dr. Ivins, who was assisting the FBI with its investigation, as well as all the scientists who had access to it, became suspects in the investigation. In what approached an inquisition, they were intensely questioned, given polygraph examinations, and played off against one another in variations of the prisoner’s dilemma game. And their labs, computers, phones, homes, and personal effect were scrutinized for possible clues.
As the Amerithrax proceeded over more than a half a decade, the FBI ran into frustrating dead ends, such as its relentless 5 year pursuit of Steven Hatfill, that ended with his exoneration in 2007 and his receiving a $5.8 million settlement from the US government as compensation for the damage inflicted on him. Another scientist became so stressed by the FBI’s games that he began to drink heavily and died of a heart attack. Eventually, the FBI zeroed-in on Dr. Ivins. Not only did he have access to the anthrax, but FBI agents suspected he had subtly misled them into their Hatfill fiasco. A search of his email turned up pornography and bizarre emails which,, though unrelated to anthrax, suggesting that he was a deeply disturbed individual. As the FBI turned the pressure up on him, isolating him at work, and forcing him to spend what little money he had on lawyers to defend himself. He became increasingly stressed. His therapist reported that Ivins seemed obsessed with the notion of revenge and even homicide. Then came his suicide (which as Eric Nadler and Bob Coen show in their documentary The Anthrax War was one of four suicides among bio-warfare researcher.) Since Dr. Ivins odd behavior closely fit the FBI’s profile of the mad scientist it had been hunting, his suicide provided an opportunity to finally close the case. So it pronounced Dr. Ivins the anthrax killer.
But there was still a vexing problem– Silicon.
Silicon was used in the 1960s to weaponize anthrax. Through an elaborate process, anthrax spores were coated with silicon to preventing them from clinging together so as to create a lethal aerosol. But since weaponization was banned by international treaties, research anthrax no longer contains silicon, and the flask at Fort Detrick contained none. Yet, the anthrax grown from it had silicon, according to the US Armed Forces Institute of Pathology. This silicon explained why when the letters to Senators Patrick Leahy and Tom Daschle were opened, the anthrax vaporized into an aerosol. If so, then somehow silicon was added to the anthrax. But Dr. Ivins, no matter how weird he may have been, had neither the set of skills nor the means to deliberately attach silicon to anthrax spores. At minimum, such a process would require highly-specialized equipment, such as a jet mill, that did not exist in Ivins’ lab– or, for that matter, anywhere at the Fort Detrick facility. As Richard O. Spertzel, a former bio-defense scientist who worked with Ivins, explained, the lab didn’t even deal with anthrax in powdered form, adding "I don't think there's anyone there who would have the foggiest idea how to do it." So while Dr. Ivins’ death provided a convenient fall guy, the silicon content still had somehow to be explained.
The FBI’s answer was that the anthrax contained only traces of silicon and those, it theorized, could have been accidently absorbed by the spores from the water and nutrient in which they were grown. No such nutrients were ever found in Ivins’ lab, nor, for that matter, did anyone ever see Dr. Ivins attempt to produce any unauthorized anthrax (a process which would have involved him using scores of flasks.) But since no one knew what nutrients had been used to grow the attack anthrax, it was at. least possible that they had traces of silicon in them which accidently contaminated the anthrax.
Natural contamination was an elegant theory that ran into problems after Congressman Jerry Nadler pressed FBI Director Robert S. Mueller III in September 2008 to provide the House Judiciary Committee with a missing piece of data: the precise percentage of silicon contained in the anthrax used in the attacks. The answer came seven months later. According to the FBI lab, 1.4% of the powder in the Leahy letter was Silicon. "This is a shockingly high proportion," explained Dr. Stuart Jacobson, an expert in small particle chemistry. "It is a number one would expect from the deliberate weaponization of anthrax, but not from any conceivable accidental contamination." Nevertheless, in an attempt to back up its theory, the FBI contracted scientists at the Lawrence Livermore National Labs in California to conduct experiments in which anthrax is accidently absorbed from a media heavily-laced with silicon. When the results were revealed to the National Academy Of Science in September 2009, they effectively blew the FBI’s theory out of the water. The Livermore scientists had tried 56 times to replicate the high silicon content without any success whatsoever. Even though they added increasingly high amounts of silicon to the media, they never even came close to the 1.4 percent in the attack anthrax. Most results were indeed an order of magnitude lower, with some as low as .001 percent. What these tests inadvertently demonstrated is that the anthrax spores could not have been accidently contaminated by the nutrients in the media. " If there is that much silicon , it had to have been added, " Jeffrey Adamovicz, who supervised Ivins work at Fort Detrick, wrote to me. He added that the silicon signature in the attack anthrax could have been added via a large fermerntor– which Battellle and other labs use" but "we did not use a fermentor to grow anthrax at USAMRIID [and] We did not have the capability to add silicon compounds to anthrax spores."
If Dr. Ivins had neither the equipment or skills to weaponize anthrax with silicon, then some other party, with access to the anthrax, must have done it. Even before these startling results, Senator Leahy had told Mueller , "I do not believe in any way, shape, or manner that [Ivins] is the only person involved in this attack on Congress." So, even though the public believed that the Anthrax case had been closed more in 2008, the FBI investigation was back to square one in late 2009.

Who Killed God's Banker

On June 11, 1982, Roberto Calvi, the chairman of the Banco Ambrosiano, who had become know as "God’s Banker" because of the investments he made for the Vatican, vanished from Italy with a black briefcase full of documents. One week later, his body was found hanging from an orange noose under Blackfriar's Bridge in London; his feet submerged in the swirling waters of the Thames. His black bag was gone. Also missing was $1.2 billion from bank's subsidiaries in the Bahamas, Nicaragua, Peru, and Luxembourg. And the Vatican was missing one-half billion dollars in loans. How did God’s banker come to be dangling at the end of a rope over the Thames?
When the London river police cut down his body from scaffolding under the bridge on the morning of June 19,1982, they found seven large bricks stuffed in his pockets and grey suit. He did not appear to be the victim of a robbery since he had an expensive Patek Phillippe watch on his wrist and about $14,000 in Swiss francs, British pounds and Italian Lire in his wallet. He also had in his pockets a bogus Italian passport in the name of "Gian Roberto Calvino" (which he had used to get into Britain.)
The autopsy, conducted by Professor Frederick Keith Simpson, one of England's most experienced pathologist, only intensified the mystery. There was no river water in his lungs, so he had not drowned. Instead, the cause of death was asphyxia by hanging. Since his neck had not suffered the kind of injury that would have occurred in a free-fall, Professor Simpson determined that Calvi could not have dropped more than 2 feet before his fall was broken by the water. There was no medical evidence whatsoever of foul play such as marks on the arms to indicate he had been restrained, puncture marks on to indicated he had been injected with a drug and no traces of suspicious chemicals in his stomach of drugs (other than the residue of a sleeping pill he had taken the previous night).
The time of the death added further to the mystery. His Patek Phillippe watch, which was not water-proof, stopped at 1:52. While the watch could have stopped for reasons other than water damage, the water marks on the face of it, when taken together with the dropping level of the tide that night at Blackfriar's Bridge, established the latest time at which his body could have been suspended from the scaffolding. After 2:30 am, the level of the water in the Thames at Blackfriar's bridge would not have been high enough to have reached Calvi's wrist (as was calculated from the length of the rope he was hanging by when he was found), so he must have been hanging before then. But he could not have hung himself before 1 a.m. because the river level then would have been above his mouth and left river water in his body. So, if he committed suicide, it he could only have been between 1:00 and 2:30 a.m.
The coroner's jury in 1982, finding no evidence of murder, concluded that Calvi had hung himself.
But suicide during these hours, if possible at all, would require extraordinary activities from a sixty-two year old man, who was over-weight and suffered from vertigo. Despite the darkness, he would have had to find the scaffolding from the walkway along the river, which, since it was nearly submerged, could be seen only by leaning over the parapet wall at a strategic point. He would also have to have found in the dark the bricks (which were identified as coming from a construction site about a block away) and the rope to hang himself. Next, he would have to had hoisted himself over the parapet on the bridge and climbed twelve feet down a nearly vertical iron ladder to the level of the temporary scaffolding. He then would have to step across the two and one-half feet gap onto the scaffolding's rusty poles, which were arranged like monkey-bars in a children's playground, and edge his way about 8 feet along them to tie the rope to the eyelet. After that, he would to shimmy down to the next level of the scaffolding (otherwise the drop from the higher level would have resulted in far more neck damage than there had been.) Finally, after having put the bricks in his pockets and pants fly, and his head in the noose, he would have had to ease himself into the swirling water three feet below by clutching onto the poles (again, avoiding a free fall).
While such an acrobatic maneuver is possible, it would presumably leave some traces such as rust under his fingernails, splinters or abrasions on his hands, tears in his suit. "The long and short of it is we do not know how Calvi's body got onto the end of that rope," Deputy Superintendent John White explained to me. "We don't even know how he got from his hotel, four and one half miles away, to Blackfriar's Bridge."
Since he was "God’s Banker," and in the headlines of every major newspaper, the British authorities, aided by MI-6, continued to investigate even after the suicide verdict. They established that Calvi had arrived in London on June 15 in a chartered plane under a false name (Calvino) and checked into an inexpensive suite in the Chelsea Cloisters, a second-rate residential hotel. When the police searched it after his death, they found his personal belongings-- including his toilet kit-- neatly packed inside two locked suitcases, as if they were waiting to be picked up by someone, but no other trace of his stay there. No hotel employee recalled seeing Calvi leave. the London police spent months canvassing taxi drivers and other potential witnesses, but they could not find anyone in London who had seen him that night. Nor could they find in London any witness to his activities during the three days he had been in London prior to his death. During these London days, he was, as Superintendent White put it, "the invisible man."
Italian authorities ran into a similar stone wall. His flight from Italy was clearly aided by an elaborate conspiracy. He used three false identities, eight separate private plane flight around Europe, a speed boat, four different cars, and 14 temporary residences in getting to the Chelsea Cloisters, in a convoluted itinerary that took him from Rome to Venice by plane, then to Trieste by car, Yugoslavia by a smuggler’s motor boat, Austria by car. He flew to London in a leased jet, and disguised as a Fiat executive. His facilitators included Flavio Carboni, a Sardinian businessman ( who had received $11 million from Calvi for organizing the escape,) Silvano Vittor, a cigarette smuggler, who served as his bodyguard in London, and two strikingly beautiful Austrian sisters, Manuela and Micheala Klienszig. . When they were later arrested, they all denied seeing Calvi the night he disappeared. So there were no witnesses at all.
Seven years later, Carlo Calvi, Calvi's only son, hired Kroll Associates to re-investigate the case. After locating, authenticating and re-assembling the original scaffolding Calvi had hung from, forensic experts retained by Kroll conducted a simple experiment. They had a stand-in for Calvi— same size and weight— walk the possible routes along the scaffolding poles that Calvi would have to walk if he tied the rope and hung himself. The stand-in wore pairs of Calvi's hand-made loafers that were similar to the one he had on when he was found, After each trial, these shoes were then put in water for the same time Calvi's shoes had been submerged, and then microscopically examined by a forensic chemist, who had worked in the London police laboratory for 18 years. In each case, he found that the soles of the stand-in's shoes had picked up yellow paint smears that matched those on the scaffolding poles. Given the pressure of the shoe on the narrow pole, he concluded such tell-tale traces were "unavoidable." Yet, when he examined the soles of the shoes Calvi had actually worn that day with a microscope, he found no traces of yellow pain on the soles. Since there was no way he could have hung himself except to have walked on the scaffolding, Kroll concluded "Someone else had to have tied him to the scaffolding and killed him."
After the Kroll investigation, The coroner's jury quashed its verdict of suicide and declared it was unable to decide between murder and suicide. So like God’s banker, the question of how he met his end was left dangling.
But how could Calvi have been murdered. He couldn't have been forced, alive, onto the scaffolding, without leaving signs of struggle on his body. Nor could he have been drugged unconscious without the drugs showing up in the autopsy examination. But he could have been strangled somewhere else with a rope– death was by asphyxia not drowning and then transported to the scaffolding. Kroll’s investigators came up with the theory that his dead body was taken to the bridge in a small boat sometime around midnight when the high tide would make it possible to moor the boat to Blackfriar’s Bridge, tie the rope to the scaffold, and unload Calvi’s body. The problem with this murder scenario is that it would be visible to anyone passing by the bridge on either bank– hardly a recipe for a perfect crime– and there were many potential potentials. Yet, neither the police nor Kroll could ever find any witness to such a bizarre scene.
As a result, the case remains unsolved.

Annals of Unsolved Crimes: Who Killed Zia?

On August 17, 1988, at 3:58 PM, Pak One, an American built Hercules C-130b transport plane,
carrying its VIP capsule the President of Pakistan, General Zia-ul-Haq, most of his top generals,as well as two American guests– US Ambassador, Arnold L. Raphel and US military missionhead General Herbert Wassom– crashed to earth only 18 miles from the airport in centralPakistan from where it took off. It had been a. bright clear day, and dozens of eye witnesses could see the giant aircraft lurch up and down three times in the sky, as if were on an invisible roller coaster, and then plunge straight into the desert and explode in a fire ball. All 30 persons on board, including four crew members, were dead. Within hours, army tanks sealed off public building and television stations, signifying the change in power. Zia’s reign, which had begun with his own military coup on July 5, 1977, now had ended with his death. But even though the crash altered the face of politics in Pakistan in a way in which no simple Presidential assassination or coup d'etat could have done, its cause remains a mystery.
Former Prime Minister Benazir Bhutto, whose father he had allowed to be executed (and who
herself was assassinated in 2007,) said in the epilogue to her book, Daughter of Destiny "Zia's
death must have been an act of god". But divine intervention is not what brought the plane
down. According to the 365-page report of the forensic investigation done by six American Air
Force experts, headed by Colonel Daniel E. Sowada, no evidence of a accidental mechanical
failure or pilot error had been found. A conclusion of assassination was all but inescapable.

The aviation investigators, following the precepts of Sherlock Holmes, used on a process of
elimination. First, they ruled out the possibility that the plane had blown up in mid air. If it had exploded in this manner the pieces of the plane, which had different shapes and therefore
resistance to the wind, would have been strewn over a wide area-- but that had not happened. By re-assembling the plane in a giant jigsaw puzzle, and scrutinizing with magnifying glasses the edges of each broken piece, they could established that the plane was in one piece when it had hit the ground. They thus concluded structural failure--ie. The breaking up of the plane-- was not the cause. Next, they eliminated the possibility of a missile attack. If the plane had been hit by a missile, it would have generated intense heat which in turn would have melted the aluminum panels and, as the plane dived, the wind would have left tell-tale streaks in the molten metal. But there were no streaks on the panels. And no missile part or other ordinance had been found in the area.
They further rule out the possibility that there was an inboard fire while the plane was in the air since, if there had been one, the passengers would have breathed in soot before they died. Yet, the single autopsy performed, which was on the American general seated in the VIP capsule, showed there was no soot in his trachea, indicating that he had died before, not after, the fire ignited by the crash.
If it was not a missile or fire, the power might have somehow failed in flight. If this had
happened, the propellers would not have been turning at their full torque when the plane crashed, which would have affected the way their blades had broken off and curled on impact. But by examining the degree of curling on each broken propeller blades, they determined that in fact the engines were running at full speed when the propellers hit the ground.
Had the fuel been sabotaged? They ruled out the possibility of contaminated fuel by taking
samples of the diesel fuel from the refueling truck, and, by analyzing the residues still left in the fuel pumps in the plane, they could also tell that they had been operating normally at the time of the crash. They then ruled out any problem with the electric power on the plane because both electric clocks on board had stopped at the exact moment of impact, which they determined independently other evidence.
The final possibility of mechanical failure was that the controls did not work. But the Hercules
C-130 had not one but three redundant control system. The two sets of hydraulic controls were
backed up, in case of a leak of fluid in both of them, by a mechanical system of cables. If any one of them worked, the pilots would have been able to fly the plane. By comparing the position of the controls with the mechanisms in the hydraulic valves and the stabilizers in the tail of the plane (which are moved through this system when the pilot moves the steering wheel), they established that the control system was working when the plane crashed. This was confirmed by a computer simulation of the flight done by Lockheed, the builder of the C-130. They also ruled out the possibility that the controls had temporarily jammed by a microscopic examination of the mechanical parts to see if there were any signs of jamming or binding.
That left the possibility of pilot error. But the crash had occurred after a routine and safe take
off in perfectly clear daytime weather and the hand-picked pilots were fully experienced with the C-130 and had medical check-ups before the flight. Since the plane was not in any critical phase of flight, such as take off or landing, where poor judgment on the part of the pilots could have resulted in the mishap, the investigators ruled out pilot error as a possible cause. Based on this investigation, Pakistan’s Board of Inquiry concluded that the only other possible cause of the crash of Pak-One was a criminal act “leading to the loss of control of the aircraft." It suggested the pilots must have been incapacitated but this was as far as it could go since there was no black box or cockpit recorder on Pak One and no autopsies had been done on the remains of the pilots.
What had happened to the pilots during the final minutes of the flight? When I went to
Pakistan in February 1989, I attempted to answer that question. There were three other planes in the area tuned to the same frequency for communications– the turbojet carrying General Aslam Beg, the Army’s vice chief of staff, which was waiting on the runway at Bahawalpur airport to take off next; Pak 379, which was the backup C-130 in case anything went wrong to delay Pak One; and a Cessna security plane that took off before Pak One to scout for terrorists. With the assistance of the families of the military leaders killed in the crash, I managed to locate pilots of these planes-- all of whom were well acquainted with the flight crew of Pak One and its procedures-- who could listen to the conversation between Pak One and the control tower in Bahawalpur. They independently described the same sequence of events. First Pak One reported its estimated time of arrival in the capital. Then, when the control tower asked its position, it failed to respond. At the Same Time Pak 379 was trying unsuccessfully to get in touch with Pak One to verify its arrival time. All they heard from Pak One was "stand by" but no message followed. When this silence persisted, the control tower got progressively more frantic in its efforts to contact Zia's pilot, Wing Commander Mash'hood. Three or four minutes passed. Then, faint voice in Pak One called out "Mash'hood, Mash'hood". One of the pilots overhearing this conversation recognized the voice. It was Zia's military secretary, Brigadier Najib Ahmed who apparently, from the weakness of his voice, was in the back of the flight deck (where a door connected to the VIP capsule.) If the radio was switched on and was picking up background sounds, it was the next best thing to a cockpit flight recorder. Under these circumstances, the long silence between "stand bye" and the faint calls to Mash'hood, like the dog that didn't bark, was the relevant fact. Why wouldn't Mash'hood or the three other members of the flight crew spoken if they were in trouble? The pilots aboard the other planes, who were fully familiar Mash'hood, and the procedures he was trained in, explained that if Pak One's crew was conscious and in trouble they would not in any circumstances have remained silent for this period of time. If there had been difficulties with controls, Mash'hood instantly would have given the emergency "may day" signal so help would be dispatched to the scene. Even if he had for some reason chosen not to communicate with the control tower, he would have been heard shouting orders to his crew to prepare for an emergency landing. And if there had been an attempt at a hijacking in the cockpit or scuffle between the pilots, it would also be overheard. In retrospect, the pilots of the other aircraft had only one explanation for the prolonged silence: Mash'hood and the other pilots were unconscious while the thumb switch that operated the microphone had been kept opened by the clenched hand of a pilot..
The account of the eyewitnesses at the crash site dove-tailed with the radio silence. They had
seen the plane slowly pitching up and down. According to a C-130 expert I spoke to at
Lockheed, C-130's characteristically go into a pattern known as a "phugoid" when no pilot is
flying it. First, the unattended plane dives towards the ground, then the mechanism in the tail
automatically over-corrects for this downward motion, causing it to head momentarily upwards. Then, with no one at the controls, it would veer downward. Each swing would become more pronounced until the plane crashed. Analyzing the weight on the plane, and how it had been loaded on, this expert calculated the plane would have made three roller-coaster turns before crashing, which is exactly what the witnesses had been reported. He concluded from this pattern that the pilots had been conscious, they would have corrected the "phugoid"-- at least would have made an effort, which would have been reflected in the settings of the controls. Since this had not happened, he concluded, that they were paralyzed or unconscious
One hypothesis he advanced was that the flight crew might have been incapacitated by an
extremely rapid acting chemical agent, such as "VX" nerve gas. It is odorless, easily
transportable in liquid form, and a soda-sized can full would be enough to causes paralysis and
loss of speech within 30 seconds. Nerve gas would leave behind traces of phosphorous, and, as it turned out, the chemical analyzes of debris from the cockpit showed such traces of phosphorous.
So why were autopsies not performed on the bodies of the flight crew to determine whether a
nerve gas or other toxic agent had paralyzed them? The explanation given in the report was that Islamic law requires burial within 24 hours. But this could not been the real reason since the bodies were not returned to their families for burial until two days after the crash, as relatives confirmed to me. Nor were they ever asked permission for autopsy examinations. And, as I learned from a doctor for the Pakistan Air Force, Islamic law not withstanding, autopsies are routinely done on pilots in cases of air crashes. I was further told by doctors at the military hospital in Bahawalpur that parts of the victims' bodies had been brought there in plastic body bags from the crash site on the night of August 17, and stored there, so that autopsies could be performed by team of American and Pakistani pathologists. But before the pathologists had arrived, the hospital received orders to return these plastic bags to the coffins for burial.
These orders to literally bury the evidence came directly from the Army which was now
under the authority of General Beg, who, after having his turbojet pilot circle over the burning
wreckage of Pak One, few immediately back to the capital, Islamabad, to assume command.
For its part, Pakistani military authorities concentrated their investigation on the possibility
that Shi'ite fanatics were responsible for the crash. The co-pilot of Pak One, Wing Commander
Sajid, was a shi'ite (as are more than ten per cent of Pakistan's Moslems), as was one of the
pilots of the back-up C-130. This pilot, though he protested his innocence, was kept in custody
for more than two months and roughly interrogated about whether Wing Commander Sajid had discussed a suicide mission. Finally, the army abandoned this effort after the Air Force
demonstrated that it would have been physically impossible for the co-pilot alone to have caused a C-130 to crash in the way it did.
The government then appointed a commission headed by Justice Shafiur Rehman, a wellrespected judge on the Supreme Court, to establish the cause of the crash. Five years later, in 1993, it issued a secret report concluding that the Army's had so effectively obstructed the
investigation that the perpetrators behind the crash could not be brought to justice. The one
uncounted casualty of Pak One was thus the truth