Bond Buybacks and Bloody Fingerprints

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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Deutsche Bank.

Deutsche Bank's nervous investors were soothed yesterday by reports that Deutsche might buy back some of its own bonds at prices below par. The idea of the buyback would be to transform liquidity into capital: Deutsche Bank, the mooted buyback implies, has plenty of liquidity -- plenty of money lying around -- but wants to shore up its capital -- basically, its debt/equity ratio -- by reducing debt and booking an accounting profit on the difference between the price it pays for the bonds and their par value. Confidence in banks is based both on their liquidity and their capital, and if a bank has plenty of one and not enough of the other, it can boost confidence in itself by shifting the mix.

Both capital and liquidity are important,  but liquidity is a very real and immediate thing, while capital is a subjective accounting construct. If you are a bank, and you run out of liquidity -- cash to pay your debts -- then you cannot be a bank any more. But if some measure of your capital goes below some threshold, the consequences are considerably less dire. People worry, for one thing, which puts a strain on your liquidity. Also there are regulatory consequences; you will probably be restricted from making payments that further reduce your capital. This seems to have been the worry about Deutsche Bank: There were concerns that one rather recherché measure of its accounting capital, its Available Distributable Items under German commercial law, would not be sufficient for it to make payments on its Additional Tier 1 capital instruments. (Deutsche reassured investors that the AT1 ADI was fine.) More generally, there are concerns that Deutsche's Basel regulatory capital ratios are lower than its competitors', which might eventually require it to sell stock and further dilute investors.

But these worries are regulatory worries, accounting worries, not immediate cash worries. Until recently it was the rule in U.S. accounting that when banks' own debt lost value they booked a gain in their own income statements. Everyone sort of agreed that was crazy, and the rule was changed. The theory behind the rule was, more or less, that if a bank's debt lost value, the bank could buy the debt back at a discount and book a profit -- so it might as well reflect the profit even without buying it back. Ha ha ha, everyone said: Being able to buy back your own debt at a discount, because you have gotten riskier and your credit has deteriorated, is no way to make a "profit." But that is exactly what Deutsche Bank is rumored to be considering now, and markets love it. And if Deutsche Bank actually buys debt below par, that will be a profit for accounting purposes, and will boost regulatory capital. 

One thing this tells you is that the worries about Deutsche Bank aren't very acute. I mean, you can worry about Deutsche's long-term profitability or capital position or legal expenses or ability to transform itself or whatever; those are all real and substantive worries. But bank panics aren't about long-term profitability. They're about liquidity: They're sparked by the worry that the bank won't have enough money to pay you back. The fact that the market would reward Deutsche Bank for reducing its liquidity to improve some theoretical accounting metrics suggests that its concerns about Deutsche Bank just aren't that pressing.

Not everyone is a fan of the buyback idea; Martien Jan Peter Lubberink writes that "these buyback transactions are generally disappointing," because they boost capital "at the expense of liquidity and solvency, thus not contributing to financial stability." More generally, there has been a lot of negativity about bank hybrid capital instruments -- contingent convertibles, additional Tier 1 capital notes, and other words for what are more or less preferred stock -- because, you know, when people worry about banks, those instruments lose value. My own view is that that is what's supposed to happen: These are risk-bearing instruments, and when banks get riskier that should be reflected in hybrid prices. But there are worries that the people who hold the instruments didn't quite understand what they were getting into, or that the instruments' drop in value might have follow-on effects in, for instance, the credit-default swaps market. Anyway, here are three explainers about contingent convertibles.

Elsewhere in banks.

It is not particularly cheery. "UBS Group AG has frozen salaries at its investment bank at least until the second quarter when it plans to revisit compensation," even for people who've been promoted, which seems like rather a kick in the teeth. "Morgan Stanley’s top trading executive warned that the first quarter was shaping up to be another tough one for Wall Street, as volatile markets take a toll on investors’ desire to buy and sell with banks." HSBC is deciding whether to move its headquarters out of London, with Hong Kong the most likely alternative, though for some reason "Canada, the U.S., China, Australia, Singapore, France and Germany" are all on the list. Goldman Sachs plans to "take a particular and energetic look at continued cost cuts when revenues are stalled."

Speaking of Goldman Sachs, its top trades were bad trades: "Just six weeks into 2016, the New York-based bank has abandoned five of six recommended top trades for the year." I assume someone has done this, but I would like to see an empirical study of how banks' "best ideas" perform compared to their regular recommendations. My guess would be that the best ideas are somewhat more volatile than the regular ideas, but not much better directionally.

In weirder bank news, the Consumer Financial Protection Bureau wants them to ... make payday loans?

“I personally believe banks and credit unions can be low-cost providers of small-dollar loans,” Mr. Cordray told The Wall Street Journal. “I think that working with banks and regulators involved, there would and should be an ability for them to offer decent products.”

Generally speaking it is easier for regulators to prevent bankers from offering products than it is to make them offer products. The CFPB's approach so far seems to involve "jawboning."

Oil & gas.

It is all a bit gloomy for the banks, but that's nothing compared to the energy companies. I mean:

The cost for U.S. junk-rated energy companies to borrow in the bond market exceeded 20 percent for the first time ever after Goldman Sachs Group Inc. said oil may drop below $20 a barrel.

Those are market index levels, not actual issuance levels, but the gloom is pervasive:

“Today our goal is to survive,” Danny Campbell, chairman of the Permian Basin Petroleum Association, began his welcoming remarks at a dinner here for oil executives last month. “Keep your name in the phone book and your debt low.”

But enjoy your dinner! Elsewhere, Anadarko cut its dividend by 81 percent to preserve cash, and Standard & Poor's took ratings actions on 45 junk-rated exploration and production firms; not all of those actions were downgrades, but plenty were. 

Market structure.

If you are following the saga of IEX's efforts to become a public stock exchange, you might be aware that IEX recently published a note about "A NYSE Speed Bump You Weren't Aware Of," alleging that the New York Stock Exchange's Binary gateway offers faster access than its FIX gateway, and that NYSE does not properly disclose the latency difference. On Monday, NYSE sort of responded, in the form of a comment letter to the Securities and Exchange Commission about IEX's own exchange application. I am not quite sure what this has to do with IEX's application, and neither is NYSE really: "While we believe that it is necessary to correct IEX’s misleading public statements about NYSE," it writes, "we do not believe that the correction we provide here is any more relevant to the SEC’s decision regarding IEX’s exchange application than are IEX’s misstatements." NYSE also argues that its opposition to IEX does not come from a fear of competition:

NYSE Group does not oppose competition, innovation or the introduction of new exchanges. When BATS applied to become an exchange in 2008, NYSE did not oppose or comment on the filing. When EDGX and EDGA applied to become exchanges in 2009, NYSE did not oppose or comment on the filings. When BATS Y applied to become an exchange in 2010, NYSE did not oppose or comment on the filing. When NASDAQ OMX PHLX introduced a cash equities exchange in 2010, NYSE did not oppose or comment on the filing despite its introduction of a market model that de-emphasized speed. And, most recently, when the National Stock Exchange proposed to re-launch trading operations, NYSE did not oppose or comment on the filing.

There are a lot of exchanges. Elsewhere in market structure, new proposed SEC rules to limit leverage and derivatives and improve liquidity in exchange-traded funds may be really good for exchange-traded notes, which unlike ETFs "are not required to physically hold anything" and so can be levered and illiquid to their hearts' content. One way to think about this may be that ETNs better address the "liquidity illusion" than ETFs do: If you hold a thing that is explicitly an unsecured note of a bank, then it's easy to understand that you may have a tough time getting your money back.

Magic.

The FBI considers the "sovereign citizens movement" a domestic terrorist movement, but it is hard not to love them a little:

For decades, in courthouses and government offices all across the US, people have been filing bizarrely worded pseudo-legal documents filled with strange symbols, secret coded language, and even bloody fingerprints in an effort to unlock secret bank accounts set up for them by the evil impostor government that runs this country.

There is a lot of this, and it is all madness:

They use red ink (or sometimes even blood) instead of blue or black ink to signify to the evil shadow government and their puppet judges that it is the true flesh-and-blood person who is signing a particular document and not the corporate shell.

This is a signal to the judge both that the individual knows the secret code that will unlock his sovereignty (and Treasury account) and that the signature on the document is not to be interpreted as the individual signing over his sovereign rights in a contract with the shadow government.

It all seems vaguely related to "prime bank" scams and the rest of the cargo-cult nonsense that attaches itself to the modern financial system. Some people shuffle papers and get rich; some papers have the power to evict people from their homes. People who are familiar with the financial system understand the logic behind these processes, but from the outside, they can look like magic. And so some outsiders want to learn how to do the magic themselves, and are drawn to occult websites that promise to teach them how. And when those occult websites say that they need to stamp documents with bloody fingerprints, well, why not, that's how magic works.

Twitter.

Twitter reports earnings this afternoon, and while I still mostly enjoy the product, the discussion about it has already entered the acceptance stage of grief. Here is Paul Ford on "the big free hotel" of Twitter. Here is Steven Russolillo comparing Twitter with Yahoo (and here is Vauhini Vara on "Why Yahoo Couldn't Adapt to the Smartphone Era"). And here is Ben Thompson on the winner-take-all nature of online advertising, which starts with the four grimmest paragraphs about Twitter that I've ever read. It begins:

When it comes to ad-supported services, pundits everywhere are fond of the adage “If you’re not the customer you’re the product”. It’s interesting, though, how quickly that adage is forgotten when it comes to evaluating the viability of said services.

As a Twitter user, I like Twitter because it is not Facebook, and I cannot understand the logic of wanting to change Twitter to become Facebook. That will alienate Twitter's current users, but seems to me unlikely to attract the billions who use Facebook. But I am not Twitter's customer, so who cares what I think. The customers are the advertisers, and all they want is Facebook. Elsewhere: "Announcing the Twitter Trust & Safety Council." 

Shkreli.

Here is an 11-minute video from Ghostface Killah of the Wu-Tang Clan that starts with some very funny insults about former pharmaceutical executive and accused securities fraudster Martin Shkreli, and then segues into what seems to be an infomercial for the health benefits of WuGoo-branded cannabis oil. I suppose I recommend it -- the video, not the cannabis oil, I haven't tried the cannabis oil -- though it gets less funny as it goes on. Elsewhere, an artist who made portraits of the Wu-Tang Clan "for the fan website WuDisciples.blogspot.com" is apparently suing Shkreli and others for copyright infringement because ... I don't know ... the portraits appeared in some Shkreli video? I suppose for some people it is fun to be involved in the Shkreli saga, however tangentially. 

People are worried about unicorns.

"Public Markets Are Sending Some Ominous Signals to Private Tech Companies"! "Tech Stocks Have Fallen Faster and Further Than Broader Market"! Sure, but on the other hand:

“The public markets haven’t become more attractive, but the opportunity in the private market is less attractive,” says Cully Davis, co-head of Americas equity capital markets at Credit Suisse. “There is that equilibrium.”

The world outside the Enchanted Forest of the Unicorns remains a cold and harsh place, but the Enchanted Forest itself is getting increasingly chilly. Where will the unicorns go? Stay tuned I suppose, though Lloyd Blankfein is betting on more initial public offerings.

People are worried about bond market liquidity.

As a former Goldman Sachs employee, I was pleased to see that, while Blankfein was worrying about unicorns, his deputy Gary Cohn went on Bloomberg Television to worry about liquidity. Meanwhile, BlackRock released a "Viewpoint" that begins "Over the past few years much has been written about bond market liquidity." BlackRock, as a huge bond mutual-fund and exchange-traded-fund complex, is relatively sanguine about liquidity; the thrust of the Viewpoint is that the bond investor base is actually pretty diverse, so worries that a lack of liquidity will lead to runs on mutual funds are overblown.

Often these reports express concern regarding what might happen when market sentiment changes. While the data cited are factually accurate and reflect structural changes occurring in the bond markets, these discussions do not present a complete picture of bond market participants or innovations that are supplementing traditional means of obtaining market liquidity. In particular, there is seldom any discussion around the myriad of unrelated investment objectives and constraints that drive bond holder behavior in disparate ways, making market participants unlikely to react to changing market conditions in the same way. Further, the dialogue has not fully acknowledged the growing role of bond exchange-traded funds (ETFs) as a source of bond market liquidity.

Elsewhere, Bloomberg Gadfly's Lisa Abramowicz introduces a novel bond-market-liquidity worry: Are some bonds too liquid? And the New York Fed's latest entry in its liquidity series has the rousing title "Further Analysis of Corporate Bond Market Liquidity."

Things happen.

US Foods Plans to Go Public, Months After Failed Sysco Merger. As Hedge Funds Stumble, One Firm Prepares to Buy Illiquid Stakes. Carlyle starts $200m share buyback as quarterly profits drop. Steven Davidoff Solomon on earnings stripping. EU Plans 1-Year Extension of MiFID II Market Rule Starting Date. Monsanto to Pay $80 Million to Settle Charge of Improper Accounting. Ackman's Latest Herbalife Punch Is Video of Purported Victims. "Wealthy kids from all over the world will learn things about private aviation, social media, quality of diamonds, types of caviar, mixed in with economics and other fundamental undergrad and grad classes." The Math Revolution. "Kim Kardashian is still better at Twitter than ISIS, says the State Department." NJ Teen Arrested (Again) For Seducing Finance Exec & Stealing His Watches. Conspiracy-theory cruise. What's American Pharoah up to? Drive-by gatoring.

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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:
James Greiff at jgreiff@bloomberg.net