Indexes, Accounting and ATM Fees

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Indexing.

The Vanguard Group attracted $236 billion of net inflows last year, "the largest annual flow of money to a mutual-fund company" ever, as indexing keeps getting more popular. (Disclosure: I am a Vanguard customer, and thus a Vanguard owner.) Indexing is a delightful little prisoners' dilemma insofar as:

  1. Indexers outperform active investors, on average, because on average everyone gets the market return, and indexers get it with lower fees.
  2. But if everyone indexed it'd be a huge mess, since someone has to actually decide which projects to allocate capital to.

The index investors, as it were, free ride off the work of the active investors, and the active investors in aggregate get the worst of the deal. You get a little sense of that from Nevsky Capital, a global equities hedge fund that announced plans to shut down. The Bloomberg headline is "Nevsky's Taylor Blames Algos in Closing $1.5 Billion Hedge Fund," but Nevsky's actual letter is much more nuanced and worth reading in full. My favorite sentence is:

In such a world dominated by index and algorithmic funds historically logical correlations between different asset classes can remain in place long after they have ceased to be logical. 

A main purpose of stock markets is to make sure that stock prices correctly reflect the underlying value of the companies. One way to do this is to conduct fundamental research on the underlying companies, and then buy stocks that are undervalued and sell stocks that are overvalued. That was Nevsky's approach, and it used to be the only approach. But modern markets have replaced a lot of that fundamental research with automated statistical approaches: If you know that Company X and Company Y usually move together, and you get good fundamental news on Company X, you can go push up the price of Company Y too. This is good! On average it does make prices more efficient (more accurate), and it is cheaper and faster than doing ground-up fundamental research on every company every day. But it is obviously imperfect, relying as it does on historical correlations, and if you are not doing the ground-up fundamental research each day you might miss the point where those correlations ought to break down.

Meanwhile in hedge funds, "If you have 'been to the right schools', as it were, you can raise money, but for the general run of the mill it is going to be a very difficult period." And: "William Ackman Fund Ends 2015 With a 20.5% Loss." 

Feel the Bern.

It's always a little embarrassing to talk about presidential candidates' plans for financial regulation, since they seem so unlikely to be enacted even if the candidate wins, but at least Bernie Sanders seems to mean his attack yesterday on Wall Street corruption, too-big-to-fail banks, and $4 ATM fees. I mean, I wouldn't hold my breath for a complete breakup of the largest banks within the first year of a Sanders presidency, but I don't think that President Sanders would just forget about that promise, either. And honestly I feel like the president of the U.S., if he really put his mind to it, probably could get ATM fees capped at $2? Like I can't point you to a constitutional provision that gives the president power to set ATM fees, but I just think that the bully pulpit of the presidency extends at least that far.

There is also stuff about sending bankers to prison, turning credit rating agencies into nonprofits, capping credit-card interest rates, monkeying with the Federal Reserve, and postal banking. Sanders's frequent refrain is "that fraud is the business model on Wall Street. It is not the exception to the rule. It is the rule." His speech yesterday adduced a lot of examples, taking the fact that "Since 2009, major financial institutions in this country have been fined $204 billion" as evidence that they're just committing fraud all the time. And I suppose the fines are evidence that there is a lot of fraud. But they are not evidence that the business model is fraud: They are evidence that fraud is frowned upon, and zealously punished (or at least fined). I like to point out that the area of American life whose business model is actually fraud -- where the way to succeed is by lying, and where lying is not only consequence-free but constitutionally protected -- is actually politics. If the government were fined for every time a politician lied about the benefits of a program, or for every time it funded tyranny or conflict, those fines would get above $204 billion really quick.

That said: "JPMorgan Chase & Co. will pay $48 million to settle the last in a series of missteps in its handling of foreclosures after the 2008 credit crisis, according to the Office of the Comptroller of the Currency." And the Financial Industry Regulatory Authority has listed its regulatory priorities for 2016, which include Wall Street culture as well as spoofing.

DVA to AOCI.

Every so often you can read articles criticizing companies for reporting earnings numbers that don't comply with generally accepted accounting principles. The implicit theory is that these companies are trying to avoid the gritty reality of GAAP numbers and dress themselves up in fantasy. And sometimes I guess that is true. But when you read those stories, it is worth remembering DVA, or "debt-valuation adjustment," a GAAP concept that requires banks to mark some of their own debt to market and "to record losses when the debt was considered safer and rose in value and to log gains when the debt was considered riskier and declined in value." So when a bank is in worse shape, and its debt goes down in value to reflect higher risks, the bank's income statement reflects a gain from that decline in value.

I have a soft spot in my heart for DVA, which sort of reflects economic reality, or an economic reality anyway. (Like: It's now cheaper for the bank to buy the debt back, for one thing, or just more generally the amount of value in the company attributable to the equity holders has gone up to the extent the value attributable to the debt holders has gone down.) But it is an obvious embarrassment, the banks hate it, investors hate it, analysts hate it, journalists hate it, Jamie Dimon "has called the rule 'one of the more ridiculous concepts that’s ever been invented in accounting,'" and yesterday the Financial Accounting Standards Board voted to get rid of it. (Or, rather, to move DVA adjustments from net income to other comprehensive income.) The New York Times headline is "Bank Rule Distorting Performance Is Repealed."

The easy lesson here is that GAAP is sometimes dumb, and that sometimes adjusting earnings to strip out some features of GAAP (as banks frequently did with earnings ex-DVA) is more informative for investors than just sticking to the GAAP numbers. But the deeper lesson is that there is no one correct way to write down simple numbers that perfectly capture the economic reality of a company, much less a bank. DVA is not wholly nonsense, I think, though I might be in the minority on that one; it does say something about the economic reality of the bank. So does income-ex-DVA. Neither is a wholly correct, regardless of which one is enshrined in GAAP.

Designated lender counsel.

Andrew Ross Sorkin's column this week is about how the practice of private equity firms designating the law firm to negotiate loan documents on behalf of banks is a dangerous conflict of interest, though even he isn't so sure about that: "Of course, the choice of which law firm will represent a bank on a big private deal will not lead to the next financial crisis." It will not. A law firm that makes its living as lender's counsel in leveraged loan deals is not going to intentionally betray its bank clients, and even if it did, those bank clients are, you know, big banks. They have big legal departments and some expertise in negotiating loan deals; I am confident they can take care of themselves.

Of course competitive pressures and/or foolishness might lead those banks to lend too much money with too little protection to too many leveraged buyouts, but that is a business issue, not a legal one, and choosing different lender counsel won't help with that. Yves Smith points out that lead lenders in leveraged loans often don't end up holding much of the loan on their own books, so their own incentives to scrutinize the loan terms carefully are attenuated. This is true, I suppose, but again it has nothing to do with designated lender counsel; those incentives are the same even if the arranging banks choose their own lawyers.

On the other hand I don't want to minimize the importance of negotiating leveraged buyout financing documents; getting even a single word wrong can lead to disaster, so you do need good lawyers.

Twitter10K.

Twitter, the company that can feel no shame, sort of let slip yesterday that it is planning to allow tweets of up to 10,000 characters sometime in the next few months, prompting much dismay and sarcasm on Twitter. Re/code first reported the plans, and then Twitter Chief Executive Officer Jack Dorsey confirmed them by means of a tweet with an attached screenshot of text, which would be rendered obsolete by expandable long tweets. Dorsey:

We've spent a lot of time observing what people are doing on Twitter, and we see them taking screenshots of text and tweeting it.

Instead, what if that text ... was actually text?

It's a reasonable question? On the one hand, look, fair; people do tweet a lot of screenshots of text, and tweeting the actual text might be an improvement. You might optimistically read this as an instance -- rare recently with Twitter -- of Twitter doing something to build on and improve the experience (or at least lower the data usage) of its actual frequent users, rather than just an effort to appeal to non-users by making Twitter less like Twitter and more like Facebook.

On the other hand it also looks a lot like an effort to make Twitter less like Twitter and more like Facebook? I mean, "brevity is the soul of not being Facebook," as I once tweeted. And tweets that expand into longer posts are not too different from Facebook's Instant Articles, though with a much more confused rollout. The motivations are probably the same: to obviate the link, and to keep people on Twitter to read things instead of sending them to other sites where the things were published. That makes sense for Facebook, whose goal seems to be to become a walled garden that replaces the Internet. It's more awkward on Twitter, which has always been a more interactive and link-friendly place. But I guess capturing readers, rather than directing them elsewhere, is where the money is.

Also Re/code reports that this effort is called "Beyond 140" at Twitter, and I am sort of disappointed by that bland literalness. Why not Project Loquacity, or Operation Chatterbox, or Shminstant Shmarticles?

Separately, JPMorgan will be publishing earnings next week on its own website, rather than via press release, and will be announcing those earnings by tweeting out a link. (Also by press-releasing a link.) See? The core use case of Twitter is links. I guess next quarter JPMorgan could just tweet the whole earnings release, but realistically I think that character limits and formatting issues would make that tough. "On the other hand bank compliance departments probably rejoicing that they'll now be able to stick disclaimers under their employees' tweets," says a guy on Twitter.

Elsewhere, Facebook was apparently intentionally breaking its Android app as a test of user loyalty, which is pleasingly dystopian. And Mark Zuckerberg wants to run 365 miles this year, possibly while being chased by a murderous sentient baby monitor

Blockchains.

I may have mentioned once or twice that I am underwhelmed by claims that the blockchain will revolutionize finance by, like, getting rid of paper stock certificates. We already did that! The technological problem of how to make a centralized database of security ownership was solved decades ago; the blockchain is a clever way to make a decentralized, trustless database, but that doesn't seem to be what anyone in the financial industry wants. Anyway, as you'd expect, I enjoyed this post by Tony Arcieri calling the bitcoin blockchain "the world's worst database":

Would you use a database with these features?

  • Uses approximately the same amount of electricity as could power an average American household for a day per transaction
  • Supports 3 transactions / second across a global network with millions of CPUs/purpose-built ASICs
  • Takes over 10 minutes to “commit” a transaction
  • Doesn’t acknowledge accepted writes: requires you read your writes, but at any given time you may be on a blockchain fork, meaning your write might not actually make it into the “winning” fork of the blockchain (and no, just making it into the mempool doesn’t count).

We talked the other day about how Nasdaq's Linq blockchain can replace Microsoft Excel as a way to keep corporate cap tables. But why would you want it to?

People are worried about stock buybacks.

Bernie Sanders isn't, especially, but here is Stephen Maher in Jacobin Magazine arguing that "Buybacks are better understood as a tool of corporate executives seeking to manage investors in service of their medium- and longer-term strategic plans" rather than as a symptom of short-term focus. It is funny to imagine the actual Jacobins discussing the merits of stock buybacks.

People are worried about bond market liquidity.

"A large share of Wall Street securities dealers believe that the growing presence of high-frequency trading firms has made it more difficult to operate in the market for U.S. government debt, according to a Federal Reserve survey published on Tuesday," which sounds like a liquidity concern but is probably more of a competitive concern. High-frequency traders probably make it harder for dealers to operate in the Treasury market, sure. Elsewhere: "Bond sales picked up after a three-week lull, as highly rated firms from Walt Disney Co. to Ford Motor Co. tapped the market in a sign of confidence in a U.S. economic recovery entering its eighth year."

Things happen.

Uncertainty About Stock-Selling Ban Clouds China’s Markets. North Korean Bomb Is a Blip for Markets Focused on China Turmoil. Centerview Benefits From Wall St.’s Pivot to Smaller Banks. Pressure Grows on Saudi Arabia to Ditch Dollar PegOil M&A Seen Picking Up as Further Pain Forces Producers to Sell. Valeant Names Howard B. Schiller Interim CEO. Admati et al.: The Leverage Ratchet Effect. Mark Holman on Novo Banco. The Celebrity Surgeon Who Used Love, Money, and the Pope to Scam an NBC News Producer. My Tinder date with ‘Pharma bro’ Martin Shkreli. Wu-Tang Clan's RZA Doesn't Regret Shkreli Album Sale. New elements$100 doughnut. "It’s better to buy appreciating assets than depreciating." 

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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

To contact the editor responsible for this story:
Zara Kessler at zkessler@bloomberg.net