Margin, Leverage and Money Laundering

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.
Read More.
a | A

Greece

Here's a pretty cheery article: Greece and Germany are having "very friendly" meetings and working together on a compromise that would let Greece continue to get European Union aid while cutting back on some of the onerous elements of its current bailout program. Quick, let's go to the game theory! Seth Stevenson has a refresher course in negotiation acronyms (what's Greece's BATNA?), but here's Tyler Cowen's leading model:

The Greek government will cave so cravenly on the substance that they want to have it on the record books that they supplied some expressive goods for a few weeks’ time, namely insulting the Germans and claiming that the Troika is dead and buried.

You could phrase that more kindly; the expressive goods retain most of their value even if a genuine compromise is reached. Indeed, the cross-border flow of expressive goods is central to the negotiations; Guan Yang points out that "which euphemism to use is the most crucial part of a debt for euphemism swap."

Margin vs. leverage.

If you're a bank and you have a big pile of cash, that makes you safer, versus not having a big pile of cash. If you're a bank and you have fewer assets relative to your equity, that makes you safer, versus having more assets for a given amount of equity. These facts are in conflict. A pile of cash is an asset. Adding assets, without adding equity, makes you more leveraged and thus riskier. But adding equity is expensive. (There is disagreement on this point, but not at banks.) So when regulators tell banks (1) to have big piles of cash and (2) not to be too leveraged, the banks feel rather aggrieved. In the olden days, this grievance was solved by risk-weighting assets: A pile of cash didn't require any equity, because it was such a good asset, while a pile of junk bonds required a lot of equity. But that risk-weighting went rather awry in the financial crisis, so now the binding constraint seems mostly to be the leverage ratio, which does not risk-weight assets and treats piles of cash and risky junk bonds the same.

With the leverage ratio, there are (mostly) only two categories: Things that count as assets (not necessarily things that are assets for accounting purposes), and things that don't. Things that count are expensive, things that don't are free. Some of the expensive things are things that you'd really want banks to have. Piles of cash, that sort of thing. This produces lots of tensions. Here's one, from Timothy Massad of the Commodity Futures Trading Commission:

Under the rule, the margins that banks hold for customers on their cleared swaps transactions would count as assets on a bank’s balance sheet, Mr. Massad said. As a result, banks would have to hold more capital against the margin, even though it is “legally segregated” and banks can’t touch the cash.

These piles of cash from customer margin make banks safer, in the eyes of the CFTC, but make banks riskier, in the eyes of the supplementary leverage ratio. And so now the regulators will fight about whether the piles of cash should be relatively encouraged or discouraged. The CFTC is of course right on this particular point, but the more exceptions you make to the simple leverage rules -- "you can't have assets of more than X times your equity" -- the more nervous the bank-capital people get.

Who will catch the money launderers?

What should we make of this story about conflicts in JPMorgan's anti-money-laundering operations? JPMorgan "has invested in new automated systems and installed executives skilled in making bank operations more efficient," at the expense of old-school-y investigators who I guess wander around in trenchcoats and fedoras chain-smoking and wisecracking while tailing money launderers. Obviously the investigators think that the human touch is necessary to catch money launderers; the executives are fine with the robot touch. I can't really tell who's right; I tend to be skeptical both of humans who think they're irreplaceable by computers, and of executives who want to do things cheaper.

One thing to think is that JPMorgan's obligation is not so much to catch money laundering as it is to persuade regulators -- both before and after any money laundering occurs -- that it has the right systems in place to detect money laundering, that it's making a good-faith effort to catch money laundering, that it's not ignoring red flags, etc. In that regard, highly auditable computer systems that track lots of transactions might be better than relying on the judgment and experience and gut instinct of human investigators, even if the investigators actually catch more money laundering. The audience is the regulators, not the money launderers. If you measure bank culture, you'll get a culture that can be measured.

Are hedge funds bad?

I don't know, there was kind of a lot of writing on that yesterday? Protégé Partners, a fund-of-funds firm best known for its bet with Warren Buffett that a basket of funds of hedge funds (yes, a basket of funds of funds) would outperform the S&P 500 over 2008-2018, published a note explaining why it's losing that bet so badly. The note is ... not persuasive if you were already inclined to be skeptical of hedge funds. In particular:

After adjusting for the market environment, hedge funds had a positive residual return amounting to slightly more than the amount of fees they received. With all the hullaballoo created by lovers and haters of the investment vehicle, we appear to have a tie.

Ohhhhhh. The S&P is up 63.5 percent; the basket-of-funds-of-funds is up 19.6 percent. That's a tie, once you separate it out into factors. Look behind you, it's math! Here's a good thing to read about positive residual return, from last week. Here's Adam Samson explaining Protégé's defense, and Josh Brown and Cullen Roche making fun of it. My Bloomberg View colleague Barry Ritholtz has further criticism of hedge funds.

But here is the anonymous "Lady FOHF" (for "fund of hedge funds") on hedge fund performance and fees, nothing that " a number of reports and polls including last month from Barclays indicate that on balance allocators intend to increase their allocation to hedge funds in 2015, fees notwithstanding." And: "With larger allocators targeting lower volatility return and hedge fund managers obliging with lower volatility strategies there is a very small amount of 'wiggle room' in returns before fees look expensive."

Some monetary policy.

Wal-Mart issues gift cards. It also issues stock. So why doesn't Wal-Mart issue gift cards that are tied to the value of Wal-Mart stock? Or, wait, no, even better, why not issue gift cards that are tied to the stocks of "Wal-Mart, K-Mart, Kroger, and maybe 20 retailers"?

If your answer is "because that is that so, so dumb," then, congratulations, you are qualified to work in equity derivatives. If your answer is "HEY SOUNDS GREAT," then, congratulations, you're qualified to be a U.S. Senator and demand oversight over the Federal Reserve because what do they know about money compared to Rand Paul:

This gets back to the whole idea of whether money has to be exchangeable for something to have value. What if Bitcoin or Wal-Coin was exchangeable for Wal-Mart stock? What if Wal-Mart, K-Mart, Kroger and maybe 20 retailers got together and issued a coin to deal against a basket of stocks? I think that might be something I'd be interested in investigating. If they do it with a goal of -- I hope Visa and Mastercard are not listening -- eliminating the credit card companies from the equation -- what if Wal-Mart's doubling their profits from 4 percent to something like 8 percent?

There is a lot of economics going on here (note Paul's views on how firms in competitive markets set prices!), but let's focus on "the whole idea of whether money has to be exchangeable for something to have value." The nice thing about the dollar, as money, is that it is exchangeable for just about anything. It's super useful for me that I can exchange my dollars for coffee and clothes and books and a place to live, all at known and relatively stable rates. A currency that was only exchangeable for goods at Wal-Mart would be much less useful. A currency that was exchangeable for goods at Wal-Mart, in quantities that fluctuated based on the prices of 20 retailers' stocks, would be even less useful. Here's Jordan Weissmann

Higher education.

Stereotypically, law schools aspire to be liberal arts graduate institutions, and hate the idea of being mistaken for trade schools that might teach someone how to actually be a lawyer. But here is a story about how some law students are learning accounting and stuff so they can graduate and be somewhat useful to business clients. Well done, law schools!

Meanwhile, business schools aspire to be two-year sleepover parties for future CEOs, and they're right on track. Here's a Bloomberg News article about how expensive it is to go to all the right b-school parties at Stanford and Wharton and Harvard. Don't change a thing, business schools! Though here is Quartz on some complainers at Harvard Business School:

“Make academics more rigorous,” one student wrote. “People are simply here for a vacation, which really makes me feel sorry for all those people who wanted to get in but could not.”

Shouldn't HBS be training the empathy out of that person?

Things happen.

Who will be Derek Jeter's investment bank? Why Shaquille O’Neal still invests in penny stocks. Yahoo's Spinco seems to be coming at a big discount. Shire's $1.6 billion AbbVie breakup fee is probably tax-free. Interlocking boards. Once you cross-subsidise bank services can you ever go back? (Earlier.) And lookback options in foreign exchange trading. SEC Admin Judge Will Apply Newman To Insider Trading Case (see explanation, and some personal disclosure, here). Why does financial sector growth crowd out real economic growth? Jon Stewart could make $100 million a year, says guy, and wouldn't it be funny if he went to work at Goldman Sachs or something? Wall Street mistresses are winning the internet age. 7 leadership lessons from 'Fifty Shades of Grey.' Don't reply to e-mail at work.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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

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