Facebook Earnings and Swap Hedges

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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Facebook earnings.

"They are showing remarkably consistent results at massive scale" is pretty much the verdict. Mark Zuckerberg, speaking about Messenger and WhatsApp monetization, said "we ask for some patience on this to do this correctly":

Facebook, whose stock is up about 31 percent over the past year, has largely earned that patience from investors because of its steady performance over the last two years, as it shifted from a web-focused company into a mobile one, and invested in new businesses while increasing the size of its old ones. 

moaned a bit yesterday about Twitter and the fickle, short-term nature of the public capital markets, but Facebook is a counterexample. Facebook doesn't do stock buybacks, and it doesn't change its plans every three months in a desperate effort to please analysts. Facebook spends buckets of money on weird unprofitable businesses like Instagram and WhatsApp and Oculus, and then runs them as more or less independent companies with no particular rush to profit. And nobody complains. This is in part because Zuckerberg controls the company through dual-class stock and said at the time of the IPO that he wouldn't run the company for short-term profit, but I wouldn't overstate the governance formalism. The real explanation is just that Facebook has proven to be colossally successful at making counterintuitive long-term investments that pay off financially.

Again: Wall Street "short-termism" is just about who should get to make decisions with capital. If you are bad at investing capital, investors will keep you on a short leash, and ask for their capital back if you have any to spare so they can put it to better uses. If you are great at investing capital, sure, buy a virtual-reality headset company, build driverless cars, shoot rockets to Mars, whatever, go nuts. Long-term corporate investment and deep basic research is possible, but you have to earn it.

Bank earnings.

In that context I guess it's weird that bank shareholders pretty much always want capital return, are terrified of capital raises, and reward banks for getting out of businesses, but of course banks do have some recent history of investing capital in building businesses that work out poorly for shareholders. Deutsche Bank's "financial performance does not reflect our tremendous potential," said new co-chief executive officer John Cryan after reporting earnings that beat estimates for profit and revenue. Cryan seems to have big plans, but they are all about getting smaller:

"We must be disciplined in how, where and with whom we do business. We must critically review any countries, business lines, products and relationships that are unattractive," he said.

"We must shrink our balance sheet, focusing on our many low-return assets. We must reduce organisational complexity, which inhibits effective decision making, blurs accountability and embeds wasteful cost."

And "The Royal Bank of Scotland said on Thursday that its profit rose 27 percent in the second quarter, a positive sign as it accelerated efforts to shrink itself and refocus its business." It is a theme.

Regulatory arbitrage.

If you're a bank and Hedge Fund X comes to you and asks to get short a total return swap on a million shares of IBM, you write the swap and go sell a million shares of IBM to hedge your market risk on that position. (If the stock goes down, you have to pay Hedge Fund X, but your short position pays you, and vice versa.) And then you go figure out how much regulatory capital you need to support the swap (a derivative with a hedge fund counterparty) and how much you need to support the hedge (shorting a pile of stock). But then Hedge Fund Y comes to you and asks to get long a million shares of IBM via total return swap. Your hedge for that trade would be to buy a million shares of IBM. The X and Y trades cancel, so you buy in your IBM short and are just left with Hedge Fund X's swap hedging Hedge Fund Y's, and vice versa. And then you go figure out how much capital you need. And it's less:

But if a bank has two clients using total-return swaps to take opposing bets on the same stock, it could offset the securities it has bought and sold as hedges against those positions so they don’t tie up additional capital.

If the bank had to buy securities to hedge a single client swap, without the offset, the hedge would have gone on its balance sheet.

If that happens naturally, great. If not -- well, if you've got Hedge Fund X short a million shares on swap, and Hedge Fund Y just owns a million shares of actual stock, you call up Hedge Fund Y and ask "hey would you like to switch into a swap?" And you promise attractive terms and sometimes they agree.

Sometimes they don't: A total return swap has the same market risk as the underlying stock, but has added liquidity risk (it might be harder to trade the swap than the stock) and counterparty risk (the swap only pays off if the bank is around to pay up). Of course this is true for the bank too: Hedging one swap with physical shares has less liquidity and counterparty risk than hedging it with a different swap with a different hedge fund. So it's weird that hedging swaps with swaps would create lower capital requirements than hedging swaps with stock. It should be the other way around!

Insider trading and the Supreme Court.

The Justice Department has until Monday to appeal the Newman insider trading decision to the Supreme Court, and is mulling its options

While the likelihood of an appeal at first seemed slim, many experts say Judge Rakoff’s recent Ninth Circuit decision may have shifted the tide. In early July, Judge Rakoff upheld the insider trading conviction of Bassam Yacoub Salman, ruling that the Supreme Court's 1983 decision in Dirks v. SEC did not require evidence that a tipper received a monetary benefit in exchange for a tip even in a case where the tipper and tippee were close relatives or friends. Insofar as the Second Circuit meant otherwise in Newman, Judge Rakoff said he couldn’t agree with it.

We talked about the Salman decision a few weeks ago. Basically the Supreme Court said in 1983 that it's only illegal to trade on inside information if the tipper gets some personal benefit for the tip, and then for 30 years courts more or less thought the Supreme Court was kidding about that, and then last year in Newman the Second Circuit said, no, that was serious, it's not a crime if there's no personal benefit. And then this month in Salman, the Ninth Circuit said, well, we agree with Newman and all, but, no, that requirement wasn't serious, it can still be a crime if there's no personal benefit. Those two decisions are ... different. (Salman is, of course, much more attractive to prosecutors.) And reconciling different views on the law from different appeals courts is pretty much the Supreme Court's job. I've said before that Newman is a tough appeal, just because Todd Newman and Anthony Chiasson, the defendants there, really do look innocent. But I've also said that the rules in Salman and Newman look like they should be reconcilable, but that it's not easy. Maybe the Supreme Court could do it.

ITG is in trouble.

As I understand it, when you run an equity dark pool, you have a bunch of customers coming in and placing orders to trade stock, and you let them trade with one another, but then you are tempted to say, well, I have all these orders, why don't just trade with them and capture the spread, and then later you are tempted to say, well, I have all this secret customer information, why don't I use it to inform my trading decisions? I guess that is what happened with Investment Technology Group, which announced that it may pay a $20.3 million fine over badness in its Posit dark pool. It is not the first to succumb to temptation.

Hillary Clinton and UBS.

My view is that, since Bill and Hillary Clinton and their charitable foundation can raise pretty much limitless amounts of money on the value of their celebrity and influence, they are unlikely to have raised any particular amount of money in any sort of direct quid pro quo for their influence. Why take a bribe when people are lining up to give you money anyway? So when I read this Wall Street Journal story about how Hillary Clinton, as secretary of state, was involved in the negotiations between UBS and the IRS on tax-secrecy issues, and "announced a tentative legal settlement" herself, and then UBS increased its donations to the Clinton Foundation and "paid former president Bill Clinton $1.5 million to participate in a series of question-and-answer sessions," I am pretty sure that there was no connection between those events. (UBS calls such a connection "ludicrous and without merit"; the Clinton campaign says that "Any suggestion that she was driven by anything but what’s in America’s best interest would be false.") Still it is not the best look!

People are worried about bond market liquidity.

Here is Tracy Alloway arguing that bond market liquidity worries are really a symptom of big investors herding into bonds, in part by taking down big chunks of bond issues that then trade up -- giving them a mark-to-market gain -- because so many of the bonds are locked up in long-term investors' hands. If this reversed and the big investors had to sell, they'd give up the gains from that trade. Which all seems right but is not precisely a liquidity issue, or a "corner" for that matter. It is generally hard to disentangle "people are worried about bond market liquidity" from "people are worried that the prices of their bonds will go down." Sometimes they say the former when they mean the latter.

Elsewhere here is Lisa Abramowicz on bond funds that are hedging against illiquidity by holding more cash and liquid assets. Part of the plan here is to buy when everyone is selling:

Both Western Asset and Loomis Sayles are planning for a dislocation in which they can be on the other side of the trade, buying bonds in the case of a forced sale.

In Treynor terms, value investors provide the outside bid on bonds. It is hard for mutual funds to be the value investors providing the outside bid, just because they are vulnerable to investor withdrawals and might have to sell even as they see value. But if they have a lot of cash that makes it easier.

Me yesterday.

I wrote about a company that tried to under-value itself, which led to trouble in Delaware.

Things happen.

"As representatives of Greece’s international creditors started arriving on Wednesday in the Greek capital for a new round of tough negotiations," oh man. Here is Yanis Varoufakis on treason. Buy Greek wine! Sovereign equity. The majority of U.S. junk bonds this year have been issued in private placements. Timing Stock Trades for Personal Gain: Private Information and Sales of Shares by CEOs. Judge dismisses 'pyramid scheme' lawsuit versus Herbalife, CEO. CFA Level III Scores Posted Prematurely on Institute Website. Is It Ever OK Not to Be Clear in a Contract? Blythe Masters on the blockchain. Move to San Francisco and live in a shipping container. South Florida is tops in fraud. "My violent rants are therapy: reputed mobster."

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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 on this story:
Matt Levine at mlevine51@bloomberg.net

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