Libor Villains and Risky Options

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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Tom Hayes.

One would have to say that former UBS swaps trader Tom Hayes was pretty guilty of manipulating Libor, insofar as he gave 82 hours of recorded confessions in which he said things like "I probably deserve to be sitting here because, you know, I made concerted efforts to influence Libor." Still it is not clear to me that that is a sufficient reason to send him to prison for 14 years? Here is a fascinating Bloomberg Businessweek story about Hayes's rise and fall, from his childhood with Asperger's, through his "light-bulb moment" at UBS when he realized that he could manipulate Libor through interdealer brokers, to his disastrous efforts at Citi -- when he arrived, he told the rate setters "Nice to meet you. You can help us out with Libors," and immediately offended a risk manager -- and the strategic miscalculations that led to his trial and conviction. And the Wall Street Journal is running a five-part series this week about Hayes, if you just can't get enough of his downfall.

Elsewhere here is a fascinating "Lunch with the FT" with federal judge Jed Rakoff, who is now speaking out against the evils of mass incarceration:

Rakoff tells me his experiences as a judge have led him to believe that heavy prison sentences are “counterproductive for all concerned”.

He still wants to put more bankers in prison though. 

What percentage of product recalls are caused by stock options?

Standard corporate finance theory says that executives should be paid with stock options in order to incentivize them to take risks. Compared to diversified shareholders, executives have more of their wealth tied up in their company, and so will want to avoid expending efforts on risky projects that might enhance the company's value but might also risk its survival. Diversified shareholders will prefer that the managers take positive-expected-value risks. So the shareholders give the managers options, which increase in value with volatility, to align the managers' incentives with the shareholders' goals by making the managers more willing to take risks.

Standard journalistic theory says that, for any level of risk, executives should take less risk.

Here is Gretchen Morgenson on a new paper finding "that product recalls are often linked to abundant option grants handed to chief executives." I suppose that is kind of what the standard theory would predict -- options encourage risk-taking, and risks don't always work out -- but it is fun to see everyone taking that theory so literally. Here is Adam Wowak at Notre Dame, one of the paper's authors:

“Of course, not every product recall that happens is caused by stock options,” Mr. Wowak said. “And it’s possible to pay a lot in options and not have a product recall. But boards are wise to have a balanced view of the potential downside to building in heavy option components to executive pay.”

Nothing is caused by anything; the incentives operate in diffuse and mysterious ways. No one has ever said "hey let's put lead paint in this children's toy so my stock options will be worth more." That would make the options worth less.

Grandma versus the HFTs.

I thought that the place we had gotten to in the high-frequency trading debate was something like:

  1. Most of the time, it is basically good that electronic market makers allow for essentially instantaneous trading of stock at extremely tight bid/ask spreads.
  2. Those benefits come at some risk of instability and flash crashes.
  3. There's a bunch of creepy stuff going on with dark pools and latency arbitrage which might disadvantage some institutional investors in ways that feel unfair and that should probably be cleaned up a bit.

I mean, I don't know, your mileage on those things may vary, but I really did think we had moved past the idea that it's unfair that some professional high-frequency traders have faster computers than your grandmother does. But oh man here is former New York Stock Exchange chief executive Dick Grasso

Mr. Grasso said in the television interview that a good rule of thumb for market changes was to ensure that “little old grandma in tennis shoes” also benefited.

If “you’ve taken care of her, you’ve taken care of everyone else,” he said.

No come on that is obviously wrong. Grandma shouldn't be trading individual stocks on a rapid basis. If someone else's data feed is 100 microseconds faster than Grandma, Grandma shouldn't care. Someone will always trade faster than Grandma. Grandma should buy and hold low-cost diversified mutual funds, and market structure should cater to the giant professional investors who fund most actual people's retirements. Similarly:

“Creating an advantage to an institutional user or a particular type of trader that disadvantages the retail investor is bad for the country, bad for the markets and bad for your business,” he said in the interview on Wall Street Week, which aired on Sunday

Nope nope nope nope nope, though I'll add that retail traders -- who get $10 instant trades inside the national best bid and offer -- do seem to be advantaged by modern market structure. 

Elsewhere in market structure, what happened with exchange-traded funds on August 24?

Activism and reputation.

Here is a fun paper about activism:

We model activist hedge fund reputation as managers' belief about the activist's willingness to initiate a proxy fight. Our model predicts two channels through which reputation improves activism's effectiveness: activists more-frequently incur the cost of proxy fights as an investment in their reputation, and managers accommodate demands from high reputation activists without a proxy fight. Consistent with these predictions, we find costs often exceed short-term benefits for activists in proxy fights and target companies accommodate high reputation activists by increasing payouts.

The authors, Travis Johnson and Nathan Swem at the University of Texas, find that "Activists pursue long, costly, activist campaigns costing in excess of $10 million despite median position sizes of $49 million." That only makes sense if they can amortize that cost over future activist campaigns in which management, in deference to the activists' reputation for bloodthirstiness and persistence, roll over immediately and give the activists what they want without a fight. 

"Pitfalls for the Unwary Borrower Out on the Frontiers of Banking."

The pitfall is that if you borrow from a marketplace lender you have to pay it back.


Here is a Buzzfeed list called "47 Unicorns Taking Silicon Valley By Storm" that is just 47 pictures of unicorns, each sparklier than the last. Honestly the tech industry has only itself to blame for this one.

Elsewhere: Many of the Companies That Went Public in the Past Year Are Trading Below Their Offering Price.

People are worried about stock buybacks.

This tag is usually about how stock buybacks nebulously connect to short-termism or excessive executive pay, but here is an argument "that the IRS has misinterpreted the Tax Code" and that "buybacks should actually be taxed as dividends." The idea -- based on this paper by Wanling Su and Rahul Goravara -- is that buybacks and dividends are both ways to distribute cash to shareholders, but a dividend is taxable to all shareholders, while a buyback is taxable only to those who sell (and, for them, only on their gain). A buyback that is "essentially equivalent" to a dividend is taxable as a dividend, but Su and Goravara argue that the Internal Revenue Service interprets that requirement too generously and should be taxing buybacks more. Possibly Hillary Clinton should give them a call.

People are worried about bond market liquidity.

Here is Barclays on the "first mover advantage" in a run on high-yield bond mutual funds. They see this as a risk primarily in open-end mutual funds, not in exchange-traded funds, which strikes me as reasonable.

And the Bank for International Settlements is out with its new BIS Quarterly Review. There's a special feature on "Volatility and evaporating liquidity during the bund tantrum" of May and June 2015, and I feel like for all the talk about bond market liquidity we don't hear enough about bund market liquidity. 

Me Friday.

I wrote about the upcoming settlement between banks and investors over antitrust accusations in the market for credit default swaps.

Things happen.

"The old monetary-policy machine sits at the bottom of a lake of excess reserves." China Unveils Overhaul of Bloated State Sector. Fears grow over US stock market bubble. Bank of America Vote Brings Out Broader Complaints. Donald Trump says things. Felix Salmon on financial innovation and effective altruism. Jeb Bush's tax plan is "an appalling edifice of flimflam." Here's a story about enhanced surveillance of traders' telephone conversations that comes with a sidebar quiz on trader slang. SEC Charges Five Arizona Residents With Stealing Millions From Investors to Fund Travel and Entertainment SpreesNouriel Roubini hot tub update

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

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Matt Levine at

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