Panthers and Preschools

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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Preschool arbitrage.

A derivative is more or less a bet on the future value of some underlying quantity. If you think the underlying quantity will go up, or go down, or stay within a range, or whatever, and I think the opposite (or, at least, I can hedge it), then we get together and make a bet on it. But the underlying quantities -- and the ranges and so forth -- are not just given to us in the world. We have to choose them, and we have to agree. You want to bet on an underlying quantity that you think will go up (or whatever). I want to bet on an underlying quantity that I think will go down (or whatever). For the bet to actually happen, we need to reach agreement on some underlying quantity on which we have opposite views. 

Sometimes that is easy and straightforward: You think rates will go up, I think they'll go down, we write each other a swap. Often, though, the work of a derivative designer is to build a bet on some underlying quantity where he has a specific and well-supported intuition about the specific quantity one way, and where his counterparty has a vague and general intuition about the world the other way. This is the central scandal of the Abacus, etc., mortgage-backed securities cases: A bank, or a hedge-fund client, would build a collateralized debt obligation filled with specific mortgage bonds that it thought would perform poorly, and would then sell it to an investor whose intuition was that mortgages generally would do well. This, of course, ended in tears, and in accusations that those investors were tricked into buying bonds that were "designed to fail." 

Here is the story of a Utah preschool program that was funded by a social impact bond sold to Goldman Sachs. That bond is basically a derivative whose underlying quantity is the success of the preschool program: If the program's success is above X, Goldman will earn an above-market return; if the success is below X, Goldman will get a below-market return or a loss (the details are unclear). This is a good idea! For Goldman and its "philanthropic partner," the success-based payment provides incentives to make sure that the programs they fund actually work well. For the school district, they're a hedge: If the program works well, the district should be happy to pay a bit more for it; if it doesn't, then at least the district saves some money it can use to try something else.

But what does "success" mean, and what is X? Well, the measure was the percentage of "at-risk" children in the preschool program who avoided special education, and the barrier for success was 50 percent. The program achieved a success rate of "almost 99 percent," so Goldman (and, one assumes, the children) won. But the way that the children were identified as "at-risk" seems to have been over-inclusive: A child is "at-risk" if he scores below 70 on a test called the P.P.V.T., but most children who score that low do not actually end up needing special education anyway.

Before Goldman executives made the investment, they could see that the Utah school district’s methodology was leading large numbers of children to be identified as at-risk, thus elevating the number of children whom the school district could later say were avoiding special education. From 2006 to 2009, 30 to 40 percent of the children in the preschool program scored below 70 on the P.P.V.T., even though typically just 3 percent of 4-year-olds score this low. Almost none of the children ended up needing special education.

When Goldman negotiated its investment, it adopted the school district’s methodology as the basis for its payments. 

You see the problem? The measurements -- which were the district's measurements! -- seem to have had the result of rigging the bet in Goldman's favor. The district (apparently) had a general worry about failure, Goldman (apparently) had a specific view about the actual metrics used to measure success, and Goldman capitalized on the district's metrics to make a profit. Or not -- the evidence for all of this is pretty circumstantial -- but it is not hard to believe. (Disclosure: I used to build derivatives at Goldman.) The scandal is that this preschool was designed to succeed

Poor Panther.

Michael Coscia, the head of Panther Energy Trading, became the first person convicted of criminal spoofing in the U.S. yesterday; the jury "deliberated for about an hour before finding" him guilty of placing deceptively large orders on one side of various commodity and currency markets so that he could trade smaller orders on the other side. I have not been following this case particularly closely, but from the initial charges and what I've read about the trial, I am willing to believe that he is in fact guilty. And I am willing to believe -- though smart people disagree -- that spoofing is bad and should be prohibited.

But Coscia's "fraud counts each carry a maximum sentence of 25 years in prison," and really you'd think that a civilized society would not lock someone in prison for decades for writing a computer algorithm to create lopsided buy and sell orders in soybean futures markets? That 25 years is mostly just a scare number, though; in fact, "If convicted, the Court must impose a reasonable sentence under federal sentencing statutes and the advisory United States Sentencing Guidelines."

But this also leads to strange results. There is essentially one sentencing guideline -- section 2B1.1 -- for any sort of "fraud," and the primary determinant of the sentence is just the amount of loss caused by the fraud. Coscia's "fraud" consisted of programming a computer to play a cat and mouse game with high-frequency trading firms, in a way that has never been prosecuted before and that some people think helps markets. But, under the law, this is treated more or less the same as running a Ponzi scheme that intentionally steals money from retirees. Those things strike me as different in morally relevant ways, but the law mostly doesn't care. As for Coscia, the prosecution "claimed he made an illegal profit of about $1.4 million," though awkwardly prosecutors "focused on six transactions" with total profits of $1,070, so I'm not sure they proved the full $1.4 million. But if they did, this handy sentencing guidelines calculator gives me an estimate of about four years in prison for that $1.4 million profit, which seems pointlessly cruel.

How's the Internet?

Twitter changed its "favorite" star to a "like" heart, which took a team of 12 people a "few weeks," meaning that we're looking at at least half a person-year of work to change one icon, and remember that when people talk about the scalability of social networks. Also it resulted in this absurd announcement claiming that, compared to the star, "the heart is more expressive, enabling you to convey a range of emotions and easily connect with people." This decision was wrong and made many people sad but, you know, Twitter's imperative is to become Facebook, and this takes it one step -- oh, right, here's Rusty Foster:

Meanwhile, Facebook is training artificial intelligences to send parrots to your office and answer arbitrary questions, but I’m sure they’re paying keen attention to this single-emoji Twitter update as well.

Over at the DealBook conference, venture capitalist Chris Sacca talked about Twitter and diversity. And is it time to nationalize Twitter

Meanwhile Google is building a tool that will automatically draft replies to e-mails for you, and imagine if Twitter was even that ambitious? I want this tool, but what I really want is a tool that will automatically draft and send replies to e-mails without any intervention from or notice to me. I honestly don't care what they say -- they could say "go, and never darken my towels again" -- as long as I don't have to do anything about them. 


I have mixed feelings about the idea that investment debates are best viewed as personal battles between long and short hedge fund managers. (In this I find myself in uncomfortable agreement with a lot of what Andrew Left had to say in this Bloomberg interview: "It's not personal; this is business.") On the other hand both Bill Ackman and John Hempton are smart and entertaining, and they have crossed swords on both Herbalife and Valeant, so I can't really object to this story about their "long-running feud":

One investor who has knowledge of both said Ackman can be a "Master Of The Universe type" while Hempton behaves like an underdog who wants to get even. Both are "wound way too tight," the investor said.

Elsewhere, BlueMountain has exited its Valeant position, so I guess that's a point for Hempton. 


I guess seller financing is not all that uncommon in the sale of private businesses, but it is a little worrying? Like, I am not sure I would take the business my family had spent generations building and just hand it over to a buyer in exchange for a promise to pay me later? Especially if the buyer is a newly formed entity named "Integrated Whale"? I don't know. Here is the story of the Forbes family, which sold about 95 percent of Forbes Media to Integrated Whale Media Investments in 2014 for about $475 million, of which about $215 million was paid up front (mostly for Elevation Partners' 45 percent stake) and the rest was in the form of promissory notes, which Integrated Whale immediately stopped paying. "The family asked for the rest of the purchase price, but the Hong Kong-based owners — 'typical deadbeat debtors,' according to the US suit — refuse to pay up." Here is the (redacted) complaint.

People are worried about stock buybacks.

BlackRock's Larry Fink has worried about stock buybacks before, but he spoke at the DealBook conference yesterday and worried about them again:

Mr. Fink noted that companies in the Standard & Poor’s 100-stock index are paying out 108 percent of their earnings to shareholders.

“That can’t last,” he said.

I mean, if growing businesses fund themselves primarily through private capital, and if the public market for the biggest 100 companies in America is mostly about those companies giving money back to investors, it kind of can?

Elsewhere at the DealBook conference, Goldman's Gary Cohn said that Lloyd Blankfein is doing well in his fight against cancer. Carl Icahn "entertained once again," which I assume means he didn't say much? He did change his mind again about whether he'd be Donald Trump's Treasury Secretary. (He was at no, then yes, now no again.) And Morgan Stanley's James Gorman, who is delightfully mean about his employees in public, referred to wealth management as "ballast" and said that people on Wall Street aren't all that special.

People are worried about bond market liquidity.

Here is a paper on "Dealer Behavior in Highly Illiquid Risky Assets" that frames some liquidity issues in corporate bonds:

We find that previous liquidity has little effect on the spreads dealers charge customers; for some rating categories, observed spreads are higher for the most actively traded bonds. Consistent with this finding, dealers’ holding periods do not necessarily decline as liquidity increases; in fact, dealer’s holding periods are lowest for some of the most illiquid bonds. Dealers are also more likely to sell all of an initial purchase of bonds on the same day for the less liquid bonds. 

That is: If a bond trades a lot, when a dealer buys it from a customer, the dealer will hang on to it for a while. If a bond almost never trades, when a dealer buys it from a customer, the dealer will sell it almost immediately. One assumes that the former behavior is market making (the dealer puts the bond in inventory) and the latter is riskless principal trading (the dealer only buys the bond when she's already lined up a buyer on the other side). But if you just observe it naively, it might make you think that liquidity worries aren't that bad: Even bonds that trade very rarely, when they need to trade, can be traded quickly.

Me yesterday.

I wrote about a Securities and Exchange Commission insider trading case against a salsa-dancing day trader who allegedly told his bank analyst girlfriend "that insider trading was not a big deal."

I mentioned it briefly in that post, but yesterday the SEC also settled a case against Fenway Partners and some of its executives for private-equity fee badness. The accusation is that "Fenway Partners and the four executives caused certain portfolio companies to terminate their payment obligations to Fenway Partners and enter into consulting agreements with an affiliated entity named Fenway Consulting Partners LLC." Fees paid to Fenway Partners were offset against management fees charged to Fenway's investors; fees paid to Fenway Consulting were not. But Fenway Consulting "provided similar services to the portfolio companies often through the same employees," so the switch looks a bit shammy. I have been skeptical of other SEC private-equity fee cases, but I have to say that this one looks pretty straightforward?

Things happen.

Some Options for Addressing Puerto Rico’s Fiscal Problems. Probe Widens Into Treasury Debt AuctionsBank Bonuses Should Be Tied to Gender Balance, U.K. Report Says. How a BlackRock Bet on African Gold Lost Its Luster. Growth in leveraged deals prompts credit risk warning. Google, Apple, And Amazon Are Forming A Financial Services Lobby. MiFID II transforms market for researchThird Point Re Posts Biggest Loss Since IPO on Investments. Biased Shorts: Short Sellers’ Disposition Effect and Limits to Arbitrage. Ex-NYSE Manager Drops Suit Claiming Firing Over 'Daily Show.' Hot buzzwords. Ex-Trader Convicted Of Libor Manipulation Made Written Request To Colleague Not To Put Libor Manipulation Requests In Writing. The smartest people are successful because they're sarcastic, Harvard researchers conclude. New Jersey Man Doesn’t Regret Getting Huge ‘World Champs 2015’ Mets Tattoo. 

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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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