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Nomura Bond Traders Bought Low and Sold High

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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Here's something that Ross Shapiro and Michael Gramins allegedly did:

On or about November 22, 2013, GRAMINS, SHAPIRO and others electronically chatted with Victim 1's representative about JPMAC 2006-WMC1 A4 and, after Victim 1's representative said that he does not "usually buy things when they get to 80," SHAPIRO responded saying, "80 is just a #!"

All in violation of Title 18, United States Code, Section 371.

What ... specifically ... was the violation? Shapiro was a managing director in charge of Nomura's residential mortgage-backed securities trading desk, where Gramins and Tyler Peters also worked. Shapiro was trying to sell some JPMorgan mortgage bonds to "Victim 1." He was trying to get Victim 1 to buy those bonds at about 81.5 cents on the dollar; Victim 1 was trying to buy them for 80 cents on the dollar. The room for rational argument here was narrow. Shapiro did not argue for a higher price based on the compelling relative value of JPMAC 2006-WMC1 A4 versus other residential mortgage bonds of its vintage and structure. Victim 1 did not argue for a lower price based on concerns about JPMorgan's mortgage underwriting and marketing, which just three days earlier had led to a $13 billion settlement.  Shapiro did not make a bullish case for the housing market or argue for better-than-consensus prepayment rates; Victim 1 did not make a bearish case for default risk or express worries about negative convexity.

Instead Victim 1's argument was that he does not "usually buy things when they get to 80." And Shapiro's argument was "80 is just a number!" though he put it even more succinctly. These arguments are both dumb. They're not even dumb, really, they're fine, they're just not arguments. One guy said that he'd prefer to pay less. The other guy said that he'd prefer to be paid more. Obviously. That diversity of desires is what makes a market. Apparently it also makes an illegal conspiracy to defraud the United States. How odd.

Oh fine no the conspiracy is that Shapiro, Gramins and Peters allegedly lied to Victim 1, and a bunch of other victims, about the prices they had paid for various mortgage bonds. They are now facing federal criminal charges, as well as a Securities and Exchange Commission civil case. So here's the full story on that JPMAC bond:

On or about November 22, 2013, GRAMINS, SHAPIRO and others chatted electronically with a representative of Victim 1. During the chat, GRAMINS misrepresented to Victim 1 that a third-party seller offered RMBS JPMAC 2006-WMC1 A4 at 81-16 when, in truth, it had been offered at 80.

On or about November 22, 2013, GRAMINS spoke by phone with a representative of Victim 8, during which GRAMINS misrepresented to Victim 8 that GRAMINS had a 78.75 bid on RMBS JPMAC 2006-WMC1 A4, when, in fact GRAMINS had been instructed by Victim 1 to put in a bid at 80.00.

On or about November 22, 2013, Salesperson 1 and GRAMINS spoke by phone regarding the information that Nomura would provide to Victim 1 about JPMAC 2006-WMC1 A4. Salesperson 1 suggested that GRAMINS say "I'm sorry, I can't get them to you at 80" and to "keep it in a chat because if I (Salesperson 1) call, he (Victim 1's representative) is going to get suspicious."

This is not entirely clear, but the gist seems to be that Victim 8 ("a global asset management fund headquartered in California") had those JPMAC bonds and wanted to sell them for 80, Victim 1 ("an investment fund headquartered in New York, with affiliated offices around the world") wanted to buy them at 80, and Nomura's desk, rather than simply matching up a willing buyer and a willing seller at an agreed price, worked to interpose itself to buy them from Victim 8 at 78.75 and sell them to Victim 1 at 81.5 (81 and 16 ticks, i.e. 81 and 16/32 cents on the dollar),  for a healthy cut of 2.75 percent of their face value. The story trails off there, so I'm not sure if it worked, but the criminal indictment, and the SEC complaint, contain similar stories of consummated deception.  

But the criminal and civil cases also contain stories of ... I don't know ... this, for instance :

On March 18, 2011, Peters learned that Nomura had purchased a block of the bond JPMMT 2006-A3 2A1 at 71-08. Shortly thereafter, Peters contacted a representative of a Nomura customer (“Customer E”) and falsely claimed that the bond was being offered at 75-24, implying that a third-party, and not Nomura, owned the bond. Peters then elaborated on the misrepresentation, saying that the “seller” (who did not exist) probably had “a little room” (meaning, to lower the price) but that the bond’s price likely would not fall by more than a point. The Customer E representative directed Peters to “FOK” (short for “fill or kill,” which is industry jargon for “last and final offer”) at 74-24, to which Peters replied, “FOK worked!” By misleading the Customer E representative about the fictional bid from the phantom seller, Peters extracted over $117,000 in additional profits for Nomura.

So what happened there? I think it's this:

  1. Nomura bought a bond for its own account at 71.25.
  2. Nomura offered to sell the bond for 75.75.
  3. Fine, okay, 74.75, if you ask nicely.
  4. Customer E bought the bond for 74.75.

Go find the lie in that paragraph! I couldn't. The SEC says that Peters "falsely claimed that the bond was being offered at 75-24," but of course that's wrong. The bond was being offered at 75-24. By Peters. To Customer E. The SEC says that Peters "elaborated on the misrepresentation" by "saying that the 'seller' (who did not exist) probably had 'a little room,'" but again the SEC is obviously wrong. The seller existed. The seller was Peters. Peters, as I read the SEC's complaint, wanted to sell the bond to the customer for more than Nomura had paid for it. There is no law against that. But it is socially awkward; making 3.5 points on a trade feels a little greedy. So Peters (allegedly) softened the awkwardness. If he had said "I want to sell you these bonds for 75.75," then the customer might reasonably have asked "how much did you pay for them," and then Peters would have had to either tell the truth (and irritate the customer) or lie (and, I guess, somewhere in the far future, irritate prosecutors). So he went halfway. He told the customer that bonds were being offered at 75.75, which was true, but never mentioned by whom they were being offered (him). If the customer assumed -- as the SEC seems to think he did -- that the bonds were being offered by a third party, well, that is how this game is played.

There are other instances like this in the complaints, where the Nomura traders didn't lie, exactly, but instead took advantage of small lacunae in their customers' awareness to make some extra money. One customer told Gramins to bid 18-1 (i.e. 18 and 1 tick, or 18-1/32 cents on the dollar) for a bond. "A short time later, Gramins confirmed that he had purchased the bond, without explicitly confirming the price at which he bought it, leading Customer C to believe Nomura purchased the bond at 18-1. Gramins, however, in fact purchased the bond for Nomura at 17-17," and ultimately got the customer to pay 18-9 inclusive of a commission of 8 ticks (0.25 points). Again, you can't quite find the lie in this transaction. The customer bid to buy the bond at 18-1 plus commission; that price seems to have been the customer's idea. Gramins got the customer his bond, at 18-1 plus commission. Obviously if Gramins had told the customer, "good news, I was able to get it for 17-17," the customer would have been happy to pay less. He did not. That is not great customer service. Nor is it exactly a lie. Not exactly. 

I do not know what to tell you. The prosecutorial crackdown on sharp practices in the bond market strikes me as one of the murkiest stories in financial regulation. There are few clear rules. For instance, it seems like you probably shouldn't straight-up lie to the customer about how much you paid for bonds, if you're asked directly, or make up elaborate stories about negotiations that you're conducting with phantom sellers. That's what former Jefferies RMBS trader Jesse Litvak was convicted of doing, and his case has led to a re-evaluation of practices throughout the industry. But his case is also up on appeal, and the appeals court seems sympathetic. So maybe even a certain amount of straight-up lying is allowed.

In any case, surely at least some amount of opacity is allowed. The basic job of a bond trader is to know who wants to sell bonds and who wants to buy them, and to buy low from the sellers and sell high to the buyers to make a bit of money for himself. That information -- who's buying and selling, and for how much -- is pretty much all the trader has to live on. Ross Shapiro was not doing careful fundamental analysis of the creditworthiness of JPMAC 2006-WMC1 A4. He made money by having information -- not about mortgage fundamentals, but about buyers and sellers and prices -- that no one else had. Of course you can't expect him to be totally transparent with that information.

And yet it seems like prosecutors expect just that. The SEC complaint repeatedly mentions the traders' "lies and omissions" as the basis for fraud; the criminal indictment says that "The purpose of the conspiracy was for SHAPIRO, GRAMINS, PETERS and others to enrich Nomura and themselves by making materially false and fraudulent misrepresentations and omissions to Nomura's victim-customers." And many of the featured stories really were sins of omission rather than of invention. These guys don't seem to have been in the same league as Litvak, as far as inventing fake customers goes. Sometimes, the SEC and prosecutors allege, they lied about the price and provenance of bonds. But many other times, they were just strategic about leaving out some of that information. Surely they, and most bond traders, thought that was fine? 

Of course, they thought lots of things were fine :

On or about March 8, 2012, Trader 4 chatted electronically with Salesperson 5, asking if a trade "is exclusive to [Nomura] b/c I shaded it." Trader 4 also stated that "you gotta take opps when they are available" and that he "lied, i [sic] marked up 2 pts." Salesperson 5 replied, "haha sick . . . well played."

You gotta take those opps. Obviously these guys played the game a bit more aggressively than the SEC or prosecutors would have liked. Certainly they played it more aggressively than their customers would have liked. Here's a revealing paragraph from the SEC complaint :

The misrepresentations by Shapiro, Gramins, and Peters about RMBS and MHABS were material to their customers’ investment decisions. Had the customers known the true prices at which Nomura bought or sold RMBS and MHABS – rather than the misrepresented prices that Shapiro, Gramins, and Peters provided – many customers would have conducted their negotiations differently, including seeking better prices on trades, trying to renegotiate trades, or even ceasing to do business with Nomura entirely.

That last bit is the traditional punishment for this sort of thing: If you get caught being too aggressive or too deceptive with markups, your customers put you in "the penalty box" for a bit. They stop trading with you for a while, or forever, or at least give you less business. Justice tends to be dispensed by unsatisfied customers in the form of reduced business -- not by prosecutors in the form of multi-year prison sentences

I've said before that the line between what sorts of sharp bond-trading practice are allowed, and what sorts are illegal, seems to be drawn mostly by market practice and custom. If you lie about things that everyone lies about, then no one is deceived, or at least not materially deceived. If you lie about things that everyone is honest about, then you upset expectations and create problems. This is obviously not something that prosecutors want to hear. Prosecutors would like to believe that the line is drawn by prosecutors, and that "everyone is doing it" is no excuse for fraud. And so now they are trying to put people in prison for using "long-acceptable trading tactics."

But look at this case. Many of the alleged frauds here consisted of the defendants telling the truth, but in contexts where, combined with background expectations, it implied something false. So Peters totally accurately said that there was a seller of a bond at 75.75, thereby (allegedly) deceiving the customer into thinking that there was a third-party seller at that price. Gramins totally accurately reported that he'd bought a bond for his customer, thereby (allegedly) deceiving the customer into thinking that he'd bought it at the price the customer had bid. The prosecutors and the SEC rely on unspoken customs and market expectations to make out the case for fraud. But if, as many bond traders think, those unspoken customs and market expectations include an expectation that all bond traders lie a bit, where does that leave the fraud case?

  1. That seems to have nothing to do with anything, but weird timing, right?

  2. The defrauding the U.S. part is because at least one customer was part of "The United States Department of Treasury's Legacy Securities Public-Private Investment Program ('PPIP')," which in turn "was a part of the United States Government's Troubled Asset Relief Program ('TARP')," and so was using taxpayer funds to pay (or overpay) for the bonds. (See paragraph 25 of the criminal indictment.) 

  3. The Nomura conversations are mostly expressed in ticks, or 1/32 of a point, so 81-16 means 81 and 16/32.

  4. Here is a reasonably straightforward one from paragraph 48 of the SEC complaint:

    On January 12, 2012, Peters received a bid from a representative of a Nomura customer (“Customer F”) to buy a block of NAA 2004 R2 A1 (“NAA”). The Customer F representative instructed Peters to offer the seller “97-16.” He also told Peters that he would “pay on top,” meaning that he would pay Nomura an amount, yet to be agreed upon, above the price that Nomura ultimately paid for the securities on Customer F’s behalf. Later that day, Nomura purchased the block of NAA from the seller at 97-01, and Peters received an e-mail confirming the details of the trade. After Nomura had acquired the securities, Peters communicated with the Customer F representative by chat, telling him “buying … 5.625mm NAA 2004-R2 A1 … seller appreciated us stepping up, gave us 8 ticks back. let us know where you want to write it.” Peters’ statement falsely implied that Nomura was buying the bond at 97-08 (i.e., 8 ticks below Customer F’s 97-16 bid). The Customer F representative asked Peters point-blank “so you paid 97-08, right,” and Peters falsely replied “yes.” The Customer F representative told him to “use 97-18” and Nomura sold the securities to Customer F at that price. As a result of Peters’ deception, the Customer F representative believed Nomura had paid 97-08 and agreed to give Nomura 10 ticks in compensation for intermediating the trade. In reality, Nomura actually earned 17 ticks and over $2,700 in additional profit. 

  5. Paragraph 47 of the SEC complaint.

  6. This story is from paragraphs 41 and 42 of the SEC complaint.

  7. I mean the customer's idea was actually 18, but whatever:

    On March 16, 2011, Gramins reached out via Bloomberg to a representative of a Nomura customer (“Customer C”), soliciting a bid for the bond INDX 2005-AR14 A1B2 (“INDX”). After the Customer C representative opined that the bid amount should be 18, Gramins asked him: “[C]an I talk you up? [O]r can you firm up?” Gramins further encouraged the Customer C representative to bid a higher amount for the bond, telling him: “[T]his is where we look back and say can you believe we bought that at 19!” The Customer C representative then agreed to “firm up” (i.e., submit a definite bid) and asked Gramins to “use” a bid of 18-1 in Gramins’ communications with the selling party. 

    That's paragraph 41 of the SEC complaint. Disclosure (?): I work for Bloomberg.

  8. That reminds me: Isn't it weird that this case was brought now? With Litvak still up on appeal? Is the hope to try to get a plea before Litvak is decided? That seems unlikely.

  9. From paragraph 36(q) on page 14 of the criminal complaint.

  10. Paragraph 30.

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