Twenty Percent of a Picture of a Dog

Also ESG accounting, ESG rebranding, ESG shorting, GameStop earnings and rogue Bitcoin mining.

Let’s say you have a thing that generates cash flows of $1 million a year. A business, a rental building, a pile of credit card receivables, whatever. Let’s say you can capitalize those cash flows at 5%. So the thing is worth $20 million. You want some more money now. You slice the thing into shares and sell some of them. You sell 20% of the thing, maybe. That 20% of the thing comes with cash flows of $200,000 a year and is worth about $4 million. This is all standard stuff; this is the main move in finance. Sometimes it is called “securitization,” though that is almost too fancy a title. If you have a business and sell 20% of it, that’s just called “stock.”

Now let’s say you have bought a picture of a dog online for $4 million. The picture of the dog carries no cash flows and no real exclusive rights — it is just a digital picture of a dog, anyone can copy it and use it and look at it to their heart’s content. But, you see, you have an exclusive pointer to the dog picture on some blockchain. And it’s funny to “own” this picture of a dog on the blockchain. And you made a lot of money investing in crypto and it feels sort of fake anyway. Why not blow $4 million on a picture of a dog, who cares, easy come easy go.

Now you sell “shares” of the picture of the dog. How many shares? Who cares? Each share carries precisely no cash flows and no rights to the picture of the dog, so it doesn’t really matter how many shares you sell. How much are the shares worth? I dunno, I mean, in one sense, you paid $4 million for the picture of the dog, so when you slice it into shares their total value should be about $4 million. Like, 1% of the picture of the dog should be worth $40,000. Maybe a bit more: Maybe the general logic of securitization implies that slicing it into more affordable shares will increase the pool of potential investors and raise the total value. Maybe a bit less: Maybe the whole point of “buying” this picture of a dog online is a sort of vanity status thing, and selling it in affordable chunks destroys that appeal. You could argue either way, but you would be wrong either way, because here is the actual answer (from last week):

Okay! Look. The fact that the picture of the dog originally sold for $4 million is a totally arbitrary fact, driven by comedic value and status competition and weird market dynamics among crypto millionaires. The fact that 20% of it sold for $45 million is also totally arbitrary! There is no reason those two numbers should be related to each other at all! Why should 20% of a picture of a dog be worth 20% as much as the picture of the dog? Neither of those things is anything! You don’t own the picture of the dog, you don’t own 20% of the picture of the dog, it is just, like, you come in every day and someone is playing a new weird game and you try to get the high score in today’s game and tomorrow will be a different game.

Imagine writing the investment memo for “20% of a picture of a dog” and being like “the most we should pay is probably about $2 million because the whole picture of the dog sold for $4 million three months ago and it can’t realistically have appreciated more than 150% since then; even if the whole picture of the dog is worth, aggressively, $10 million, this share would be worth $2 milllion.” What nonsense that is! I mean obviously by traditional finance standards, but even by buying-digital-pictures-of-dogs-for-millions-of-dollars standards! Imagine using logic and comparisons to try to price 20% of a digital picture of a dog!

One model here is that everyone on earth wants to pay $4 million for a unique picture of a dog, so if you make one unique picture of a dog and sell it for $4 million you’ll get $4 million but if you cut it into 17 billion slices each one will sell for $4 million? I realize that sentence makes no sense in like nine different ways.

Another model is that the value in an NFT comes from a concept, and the value in a fractionalized NFT comes from, like, two concepts. “Take an object / Do something to it / Do something else to it,” Jasper Johns wrote. The essential transaction in an NFT is:

In a fractionalized NFT you have a slightly richer context:

It’s two jokes so it’s worth 55 times as much. I don’t know!

That’s from last week; it has since fallen back to about 1.3 cents. I am so tired. Think about how many productive assets you could buy for $45 million! You bought 20% of a picture of a dog!

We talked yesterday about ESG loans, bank loans in which companies pay a slightly lower interest rate if they meet certain environmental, social and governance (ESG) targets, but pay a slightly higher interest rate if they miss those targets. These discounts and penalties are generally quite small, usually one or five basis points in either direction. One can be — and I was — fairly cynical about this. “I think there is probably a lot of value to be created by telling people soothing things about ESG,” I wrote, “and in practice, if someone creates that value, a lot of intermediaries in the chain will capture some of it.” If you say “we have agreed to do good ESG things, and we have an economic incentive to follow through,” that is the main thing; nobody will necessarily care what the good ESG things are or how big the incentives are.

I also said, you know, there are good reasons that the swings are pretty small. If you are a company signing a credit agreement, you might want to improve your ESG metrics, but you don’t want to add financial risk; significantly increasing your interest costs for failing to meet some ESG goal seems like a bad financial decision. If you are a bank, on the other hand, having a big swing between the good-ESG and bad-ESG outcomes creates weird incentives: As an economic matter, wouldn’t you always try to buy the ESG loans of companies that will miss their targets? Doesn’t that feel bad?

But a reader pointed out another, stranger aspect of these loans, which is accounting. Basically if you are a company you like your borrowing to be accounted for as borrowing. You borrow $100, you add $100 to your assets (as cash) and $100 to your liabilities (as long-term debt), you have an interest expense every year, it is fairly simple stuff. But some sorts of debt have what are called “embedded derivatives.” A classic sort of embedded derivative is a structured note issued by an investment bank: The buyer gives the bank $100, and the bank promises that in three years it will pay back, you know, $100 plus twice the increase in the S&P 500 index minus half the increase in the price of Tesla stock, or whatever. The bank does not account for that as a $100 liability; the bank marks that to market each quarter. Its balance sheet reflects the fair value of the liability — based on what the S&P and Tesla did that quarter — and its income statement reflects the changes in that fair value. If the S&P goes up and Tesla goes down, the bank owes investors more money, so its liability is bigger and it has a loss in earnings.

That is an obvious one — that is a bond that is set up explicitly to be a derivative — but a fun game for accountants is spotting other, less obvious embedded derivatives. If you issue a bond or a loan, and there is some unusual provision in it that changes how much you have to pay in some circumstances, that might be an embedded derivative. Not always — a floating-rate loan based on Libor or whatever, for instance, generally isn’t treated as having an embedded derivative — but a lot of the time. 1 And so if you have some feature like that in a debt contract, some accountant might say “aha, an embedded derivative,” and make you mark it to market.

And if they say “aha, your interest rate will change depending on if you hit ESG goals, that’s an embedded derivative,” then you will have to (1) figure out how much it’s worth, (2) figure out how much its value changes each quarter, and (3) reflect that in earnings. If you hire a few extra white men this quarter, that makes it less likely that you will hit your ESG targets, which makes it more likely you’ll pay more interest in the future, which increases the value of your liability (the amount you owe), which reduces your earnings for this quarter. In general, if you do bad ESG stuff in a quarter, that will reduce your earnings; if you do good ESG stuff, that will increase your earnings.

Arguably that’s great! Arguably it is sort of magical and wonderful for ESG investors to have some mechanism for turning “bad ESG stuff” into a reduction in earnings, and “good ESG stuff” into higher earnings.

But in practice it is awfully weird and hard to measure, and it’s not obvious that the specific way that this turns ESG performance into earnings is useful for investors. Here is an ISDA paper, from this week, called “Accounting Analysis for ESG-related Transactions and the Impact on Derivatives”; it says that many ESG loans have embedded derivatives under U.S. generally accepted accounting principles (though arguably not under international financial reporting standards 2 ) and argues that “the existing accounting frameworks, as they relate to ESG-linked transaction activity, do not provide decision-useful information to users of the financial statements”:

The fact that the interest-rate step-ups and step-downs are one or five basis points helps with that: If your cash flows don’t change very much based on ESG performance, you don’t have to do much to account for the future interest cost of your current ESG performance. If your interest rate varied a lot based on hitting climate and diversity targets, you would have a large mark-to-market derivative liability, and you’d have to spend a lot of time each quarter thinking about how your ESG performance affected the value of that liability.

I don’t know, it is just a fun little puzzle. At some level of abstraction, ESG loans work perfectly with existing accounting rules to give investors and companies and activists exactly what they (should) want: An ESG loan gives a company a financial stake in improving its ESG performance, and the accounting for that loan lets investors measure, each quarter, the company’s overall progress on its ESG goals and see how much that progress saves (or costs) the company economically. But in reality the result is that companies are like “ugh I do not want weird accounting stuff to affect my earnings,” and the result is that ESG loans don’t have much in the way of financial stakes at all.

Hmm, hmm, hmm:

On the one hand, “there is probably a lot of value to be created by telling people soothing things about ESG, and in practice, if someone creates that value, a lot of intermediaries in the chain will capture some of it.” Putting the word “Sustainable” in the name of a mutual fund, and doing nothing else, clearly creates value: It makes people who buy the fund slightly happier than they would otherwise be.

On the other hand, why not? There are people whose job is basically “pick companies that are good and buy their stocks.” This used to be a big popular job, and mutual fund companies employed lots of those people. Now, in the traditional form — “pick companies whose stocks will go up” — it is a bit disfavored; people like passive investing (or YOLOing GameStop calls), not active mutual funds. But there is a close-enough variant, “pick companies that are good citizens of the world and buy their stocks.” Why shouldn’t active managers retool and become sustainable managers?

Here is a fun piece from AQR Capital Management’s Cliff Asness on “Shorting Your Way to a Greener Tomorrow,” arguing that if you want to be an ESG investor you should not just buy companies with good ESG performance, and not just avoid companies with bad ESG performance, but actively short companies with bad ESG performance.

Most of this is so intuitive to me that I will not spend a lot of time on it — yes, right, if you think a company is evil you should short it — though the fact that Asness felt compelled to write it suggests that others do not find it intuitive.

But I do want to quote what he writes about measurement:

One way to have net zero climate impact is to only buy companies that don’t use any oil (or gas-powered electricity, etc.), but that seems really hard. Another way is to buy companies that use some oil in a judicious way, and also plant lots of trees, or pay people not to cut down existing trees: You contribute to climate change by the activities of your portfolio companies (flying to business meetings, manufacturing stuff, etc.) but you offset that impact by planting or preserving trees to capture carbon. 3

But a third way to do it is to buy the stocks of companies that use some oil in a judicious way, and then also short a bunch of oil-company stocks. The companies you own contribute a bit to climate change, which makes you sad, but the companies you short contribute even more to climate change, and you get to reverse the sign: By shorting their stock, you subtract their contribution to climate change from your portfolio.

Is that valid? Sure, I dunno, why not. One thing that I like to think about short selling is that it creates new shares of a company, and to some extent those shares compete with the shares issued by the company. If you short a bunch of oil-company stock, someone who wants to buy oil-company stock might buy it from you instead of from the company. In the limit, if enough people embrace the idea of shorting oil stocks, they will crowd out the oil companies; it will be impossible to finance oil drilling because any money you put into oil stocks will go to short sellers, not drilling.

But it feels very financial, using the abstract workings of the financial system to make bold claims about a real-world result. If you are, say, Jim Chanos and you run a short-focused fund, presumably the overall carbon impact of your portfolio is very negative (because most companies, in any industry, are using some carbon to make stuff or fly to meetings or whatever, and so if you’re shorting a bunch of companies you have a negative position on a lot of carbon use). Could Jim Chanos just like fly in circles in a private jet while eating beef and taking long showers and saying “I am the greatest climate hero in the history of the world,” because of his short selling? Maybe?

No idea, man:

As of noon today the stock was down about 5% from yesterday’s close, which seems bad, but the stock is still up 900% year-to-date and down only about 16% in the seven months since I wrote, about GameStop, “I tell you what, if we are still here in a month I will absolutely freak out.”

Basically Bitcoin is a way to turn electricity into money: You plug in some computers, they burn a lot of electricity, they “mine” Bitcoin, the Bitcoins that they mine are worth money. There is a complicated algorithm, but its input is electricity and its output is Bitcoin. At a high level, the business of Bitcoin mining is the business of finding the cheapest possible electricity.

But most of the electricity that you use, most of the time, is free, or at least “free.” If you use electricity at your house you pay for it. But that’s the exception. If you go to a coffee shop you can buy a muffin, plug in your laptop and sit for an hour (or you could pre-Covid, anyway); they generally won’t charge you for electricity. If you go to your office, you can turn on your computer and use it all day to work, and also probably to send personal emails and check sports scores; they don’t charge you for that electricity either. They let you charge your phone at the office. All free. Free electricity everywhere.

Of course you are expected to use only a reasonable personal amount of that free electricity, but if you ignore those expectations, a certain amount of scamming is possible:

Ahahaha well sure. Also I am trying to figure out exactly what sort of highly technical investigative processes were involved?

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To contact the author of this story: Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story: Brooke Sample at bsample1@bloomberg.net