Stress Tests and Empty Trading Floors

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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How's the bathroom situation at Goldman?

Here is the grim tale of 200 West Street, 6th Floor, which formerly housed a lot of Goldman Sachs traders, but then housed fewer and fewer traders, until "Lloyd C. Blankfein, the bank’s chief executive, mentioned to one of the heads of trading at the firm, Pablo Salame, that the gaps were unsightly," and Salame consolidated all the traders onto the fourth and fifth floors, leaving 6 almost empty. Almost empty:

One impediment to the move was that the fifth floor did not have enough window offices — a treasured privilege of Goldman’s much-vaunted partners. Rather than do without, some partners chose to keep their offices on the largely empty sixth floor.

Another problem was that the increased population on the two lower floors taxed bathroom facilities built for fewer people. More toilets were eventually installed. Nonetheless, some traders still go up to the sixth floor when the lines become too long, creating some of the small amount of activity in the wide-open space.

Imagine surviving the last decade of market turmoil and huge structural changes to reach the traditional pinnacle of a financial career, a partnership at Goldman Sachs. And then ending up with an office on a floor where the only activity is bathroom tourism. The glory days of banking are truly over. Elsewhere, is Goldman Sachs a bumblebee?

Stress tests.

Here is a fascinating post on the New York Fed's Liberty Street Economics blog asking whether bank holding companies are "mimicking the Fed." That is: The way the Dodd-Frank Act stress test works is that the Fed publishes a stress scenario, and the banks calculate how they'd do in that scenario, and the Fed calculates, and then they compare answers. The Fed's answer is in many practical senses "right": For instance, the Fed's answer, not the bank's, determines whether the bank gets to return capital. But the Fed doesn't tell the banks its methodology, and doesn't want them to guess too accurately: The point of the bank's calculation is not so much to guess what the Fed will calculate, as it is for the bank to go through the independent exercise of evaluating its risks in a stressed scenario and figuring out what it will do. And if banks are too good at guessing what the Fed thinks, that could itself be bad:

Evidence of BHCs mimicking the Fed would be problematic if it meant that the BHCs are not really independently modelling their own risks. Convergence poses a potential risk to the financial system, since a financial system with monoculture in risk measurement models could be less stable than one in which firms use diverse models that collectively might be more likely to identify emerging risks. 

The authors find some evidence of convergence and some evidence against it, "a mixed message for those concerned about model monoculture." Of course just modeling a single set of stress scenarios set by the Fed, and managing your risk to that stress test, is its own sort of monoculture, though perhaps better than the practical alternatives. Meanwhile at the Bank of England: "Bringing together stress testing and capital models – a Bayesian approach."

Hug a banker.

Joris Luyendijk talked to a lot of bankers and wrote a Guardian blog and then a book about it, and he has some opinions about the industry:

Critics have often called bankers “psychopaths” but Luyendijk believes they’ve got the wrong personality disorder. “Psychopaths are impulsive and spontaneous. Banking is about conformity: make these hours, be predictable. Narcissists have no self-worth, so they need a status symbol outside themselves. That can be a job, and they lose their existential validation without it.” Banks excel at “sucking in” narcissists. “They approach them at university and tell them they need never feel insecure again.” 

I feel like that trade went really poorly for a lot of people. I guess so does Luyendijk:

Luyendijk believes we shouldn’t feel angry at bankers, we should pity them: “If you take an honest look at how a banker lives — whatever conversation they’re having with a loved one, they have to keep an eye on their phone — they are the best paid victims. We should hug them. They can deal with blame and reproach, but if you say: ‘I’m really sorry, but there are therapists to help you with your bonus addiction and status disorder.’ Then, they get angry.”

Enforcement, etc.

There is so much:

  1. Here's a Securities and Exchange Commission settlement with First Eagle Investment Management for "improperly using mutual fund assets to pay for the marketing and distribution of fund shares." The important thing to remember is that it's actually fine to use mutual fund assets to pay for marketing; as with almost everything in finance, no matter how distasteful it sounds, you just have to disclose it properly. First Eagle apparently didn't.
  2. Here's an SEC stock manipulation case against "two men behind a scheme that defrauded investors in YaFarm Technologies Inc., a company that purported to provide stem cell therapy." YaFarm was initially "a web development and web hosting company," but pivoted to stem cells, or at least purported stem cells, around the time it acquired a new president who was "a recent Graduate of Colorado State University, where he obtained a degree in Exercise Science obtaining a thorough knowledge in the exercise development field and rehabilitation of the human body." 
  3. Here is an alleged scam that "included telling victims they could join a real estate investment alongside Buffett and Berkshire Hathaway Inc.," and that "sent statements from dummy companies, including one called Bradley Cooper Financial Services."
  4. Galen Marsh, the Morgan Stanley private wealth manager who "used the Bank’s computer systems to access, without permission or authority, confidential information about certain Clients serviced by FAs and CSAs outside of his Group," pled guilty to a federal felony and faces up to five years in prison.
  5. Eric McPhail of the Oakley Country Club in Watertown, Mass., was sentenced to 18 months in prison for insider trading. You may remember McPhail as the guy who obtained inside information on the golf course and then tipped his buddies, telling them "I like Pinot Noir and love steak....looking forward to getting paid back." You may remember Oakley as the golf course with all the insider trading.

Meta-efficient markets.

Here are Nicolae Gârleanu and Lasse Pedersen on a model of "Efficiently Inefficient Markets for Assets and Asset Management," which predicts:

(1) Informed managers outperform after fees, uninformed managers underperform after fees, and the net performance of the average manager depends on the number of “noise allocators.” (2) If investors can find managers more easily, more money is allocated to active management, fees are lower, and security prices are more efficient. (3) As search costs diminish, asset prices become efficient in the limit, even if information-collection costs remain large. (4) Managers of complex assets earn larger fees and are fewer, and such assets are less efficiently priced. (5) Allocating to active managers is attractive for large or sophisticated investors with small search cost, while small or unsophisticated investors should be passive.

Prediction (1) is not unrelated to my own crude model of hedge fund fees. The key point here is that just because the average hedge fund underperforms, that doesn't mean that big institutions shouldn't invest in hedge funds. It just means that they shouldn't invest in the average hedge fund, and if they are sophisticated, they won't.

There are still foreign mergers.

The great problem of taxation is that it is hard to tax foreigners living abroad, so as long as the U.S. has tax rates that are higher than tax rates elsewhere, there is always a risk that people and companies will choose elsewhere. You can change various rules, but you ultimately can't stop companies from going elsewhere, so those rule changes can only do so much:

In the year since the Treasury Department tightened its rules to reduce the tax benefits of such deals, six U.S. companies have struck inversions, compared with the nine that did so the year before.

Meanwhile, foreign takeovers of U.S. companies have soared, with similarly draining effects on U.S. coffers. 

Volkswagen.

One piece of inevitable news about Volkswagen is that a Justice Department probe "adds the specter of criminal proceedings to challenges the world's biggest automaker already faces from regulators." Really how could there not be a criminal investigation? But another piece of almost-as-inevitable news is that Volkswagen also faces scrutiny from Bafin and shareholders over what it disclosed when. An oddity of the U.S. legal system, which we now seem to have exported to Germany, is that if a public company does anything bad, it has at least two ways to get in trouble: One for doing the bad thing, and the other for not disclosing it promptly enough to shareholders. This always feels a little surreal -- what, Volkswagen should have disclosed a risk factor in its annual report saying "we engineer our cars to game U.S. emissions tests, and if we're caught we could be in big trouble"? -- but it does seem to be a permanent fixture. 

People are worried about bond market liquidity.

I have, as you may have noticed, become something of a connoisseur of bond market liquidity worries. One of my favorite sub-genres of those worries is the one about how bond mutual funds promise near-instantaneous liquidity to their investors but own much less liquid bonds, leading to a "liquidity mismatch" in which redeeming investors will force bond funds to sell illiquid bonds at fire-sale prices, with the lower prices leading to more redemptions, etc., in a vicious cycle. This sort of worry peaked a few months ago, and then went quiet after the events of August utterly failed to ruffle the bond market. 

But now the Wall Street Journal is back with a classic of the genre: "The New Bond Market: Some Funds Are Not as Liquid as They Appear." The thesis is that "10 of the 18 largest funds that invest meaningfully in corporate debt have significant holdings of seldom traded bonds," despite Securities and Exchange Commission guidelines that mutual funds should have no more than 15 percent of their money in investments that can't be sold within seven days:

In March, Lord Abbett’s short-duration bond fund had $271 million, or 0.75% of its assets, invested in a single Air Lease Corp. bond that would have taken 369 days to sell based on average trading volume at the time. The Dodge & Cox Income fund had $496 million, or 1.1% of the fund, invested in debt backed by Brazil’s troubled oil company Petróleo Brasileiro SA that would have taken 155 days to liquidate.

Of course, the fact that that Air Lease bond traded $734,000 worth on an average day (i.e. $271 million divided by 369) doesn't actually mean that it would take Lord Abbett 369 days to sell it. One reason that a bond might not trade a lot is that no one wants to sell it; if someone wanted to sell it, it would trade more. My apartment has traded once in the past five years or so; that doesn't mean it would take me five years to sell it. Still, right, liquidity mismatch.

Elsewhere, people are worried about bond transaction costs. From Larry Harris at the University of Southern California:

Much bond market trading is now electronic, but the benefits largely accrue to dealers because their customers often do not trade at the best available prices. The trade through rate is 43%; the riskless principal trade (RPT) rate is above 42%; and 41% of customer trade throughs appear to be RPTs. Average customer transaction costs are 85 bp for retail-size trades and 52 bp for larger trades. Estimated total transaction costs for the year ended March 2015 are above $26 billion, of which about $0.5 billion is due to trade-through value while markups on customer RPTs transfer $0.7M to dealers. 

People are worried about stock buybacks.

Specifically bond investors are, according to another article in the Journal's big series on the bond market: 

They say the debt binge is weakening corporate balance sheets, which could lead to credit-rating downgrades, hurt bond prices and make it more difficult for companies to pay down their debt in the future. Debt investors dislike debt-funded buybacks because they say companies are effectively transferring capital from bondholders to shareholders, increasing leverage without investing to expand the business.

People are worried about risk parity.

If I write that sentence every day for three months something will have gone very wrong, but there has been rather a lot of it. Enough to draw responses both from Cliff Asness of AQR Capital Management ("risk parity simply isn’t big enough to generate the level of trading necessary to create very large market gyrations and most certainly not to the degree witnessed recently") and from Ray Dalio et al. of Bridgewater Associates:

All Weather is a strategic asset allocation mix, not an active strategy. As such, All Weather tends to rebalance that mix, which leads us to tend to buy those assets that go down in relation to those that went up so that we keep the allocations to them constant. This behavior would tend to smooth market movements rather than to exacerbate them. As mentioned, not all risk parity managers operate this way and we are not knowledgeable enough about what they do to comment on it. However, we can say that the amount of money that is invested in risk parity strategies is relatively small in relation to the amount of money that is managed in active strategies, especially those that tend to sell in response to price declines. For example, equity mutual fund investors tend to sell in response to price declines because they get nervous, and they are much larger. And, suppose they did tend to do that; what should be done about it—prevent those who want to sell when prices fall from doing that? 

You see their point, though of course I am on record saying that "If you want to stop a stock market decline, you should (1) mandate buying and (2) ban selling." 

Things happen.

Xi Jinping argues, not entirely incorrectly, that China's stock market "rescue was akin to acts taken by governments in 'some mature foreign markets.'" Happy Bank of America shareholder vote day! Wall Street Cracks Down on Free Sharing of Analysts' Notes. Bitcoin Computer. Greek Vote Spells Investor Opportunity. Trading Meat for Tires as Bartering Economy Grows in Greece. Fortress Investment Group Is Shutting Down Part of Hedge-Fund Business. So much drama at the PCAOB. A tax story. Jeffrey Sonnenfeld still thinks Carly Fiorina was a terrible CEO, also has a lot of powerful friends. Harvard grad keeps talking about Harvard. Do you know Phil Falcone? (Via.) Pope and iPhone fight for the roads on east coast. Happy an CCXXIV, citoyens! Happy Long-Expected Party Day, hobbits! "There’s not much we can contribute to in a constructive way to the overthrow of capitalism." Is bridge a sport? Tennis ball stuck to your phone could make for great dog selfies. Selfie spoon. "Hardwickz, which makes Doritos-style chips but in millennial-friendly flavors like coffee, internet, and handcrafted vodka." 1,524-pound cheese sculpture named world's largest. 

Money Stuff will be off for the holiday tomorrow; we'll see you back here on Thursday. If you'd like to get Money Stuff in handy e-mail form, right in your inbox, please subscribe at this link. Thanks! 

(Corrects spelling of Jeffrey Sonnenfeld's name, and year of French Revolutionary calendar, in last item.)

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