Interest Rates and Stock Splits

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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Happy Fed Boxing Day.

Yesterday the thing that everyone expected to happen happened, and people were pretty happy about it, not so much because they like higher interest rates but because they like being right. There are those who thought, and think, that it is misguided to raise rates with low inflation and slack in the labor market, but I like my Bloomberg View colleague Noah Smith's take, which is that it was getting to be really weird to have zero interest rates, and so the Fed just had to raise rates to make things less weird. You could have a simple model in which weirdness is itself bad for growth -- in which keeping emergency interest rates in a non-emergency situation undermines economic confidence -- and in which raising rates a little bit off zero could actually be stimulative. In the limit, that model looks a bit like Neo-Fisherianism, which is itself quite weird, but I guess we just live in unavoidably weird times.

Here are the projections. Here is the implementation note, which includes a fed funds target rate of 0.25 to 0.50 percent, interest on excess reserves of 0.50 percent, a discount rate of 1.00 percent, and unlimited reverse repurchase operations at 0.25 percent. Here is more on reverse repos from the New York Fed, Bloomberg and the Wall Street Journal. The prime rate is also going up, though deposit rates aren't yet.

In human-interest Fed stories, apparently Wall Street prepared for the Fed's decision yesterday by making dumb jokes and punching things, which actually doesn't make Fed Day sound all that different from any other day? It's weird that there's no Wall Street memoir titled "Bad Jokes and Punching" yet, but feel free to use it. Here's a Rube Goldberg machine. Here's "Who Wins, Who Loses, Who Goes Meh" from the rate hike. And here is BuzzFeed on what was happening the last time the Fed raised rates, in June 2006, though it unaccountably omits the fact that the last time the Fed raised rates, BuzzFeed was founded a few months later.

Financial engineering.

This story is better if you don't know what it's about:

Kansas City Life Insurance Company (KCLI) will effect a one for two hundred fifty (1-250) reverse stock split, immediately followed by a two hundred fifty for one (250-1) forward stock split of its outstanding common stock.

It's fine if you know what it's about. There's a clue in the next sentence: "Stockholders who hold fewer than 250 shares immediately prior to the reverse stock split will have their interests converted to cash." This is in a sense a forced share buyback; everyone with fewer than 250 shares will get cashed out at $52.50 per share, while everyone with 250 or more shares will remain as they are. (Yes, if you own 251 shares, you keep 251 shares; the fractional cash-out is only for holders with fewer than 250 shares. See page 7 here.) The company expects to be buying back about $30 million of stock, give or take, from small shareholders (see page 38), or a bit over 5 percent of its stock. More importantly, though, it will be getting rid of a lot of its shareholders, as all the small holders are getting cashed out. If it gets its number of shareholders below 300, then it can stop being a public company that has to file Securities and Exchange Commission reports, which is the goal of this transaction. (SEC reports are expensive, and being a public company can be annoying; just ask a unicorn.) This is all above-board and out in the open: There was a proxy, explaining that the company is doing this to go private, and a fairness opinion, and a shareholder vote, though of course there is also an activist investor objecting to the transaction. It is not a particularly uncommon way for companies to escape the public markets; here is a 1-for-500-for-1 split from 2014, and a 1-for-30,000-for-1 from 2010.

But like I said it's better if you don't know what it's about. Imagine being the first person to come to a company and say: "A good trade for you to do would be to give each shareholder one share for every 250 shares he holds, and then immediately give him back 250 shares for each one share he holds. You can create a lot of value that way. That's a good thing to spend your time on." None of that is wrong, exactly; just as it makes sense for some companies to go public, it can make sense for other companies to go private. But the mechanism just sounds so silly. When people complain that finance is just shuffling paper around without creating any value in the real world, I will point them to this deal and smile inscrutably.

Junk bonds. 

Third Avenue has changed its mind about putting its Focused Credit Fund into a liquidating trust so it can sell bonds in peace and return money to investors eventually. Its new plan is to keep the fund open as it liquidates, but not allow redemptions, so it can sell bonds in peace and return money to investors eventually. The distinction is a little hard to see, but if you are a blown-up bond mutual fund, you really do have to sweat the small stuff, and it seems that the Securities and Exchange Commission prefers the fund-without-redemptions approach over the liquidating-trust approach. Or at least, Third Avenue's groveling application to the SEC mentions that "Commission staff expressed concerns during discussions with Fund and TAM" about the previous plan. That application is for the SEC to approve the new plan, and I suppose the SEC could say no to that one too, in which case Third Avenue would just have to meet redemptions as they came in, even if that meant dumping bonds and driving down the value of the remaining investors' shares:

Approximately 65% of the value of the Fund’s shares is held by shareholders in the Fund’s Institutional Class, and the rest is held by investors in its Retail Class.  If the relief is not granted, and the Fund is unable to suspend redemptions, the institutional investors would likely be best positioned to take advantage of any redemption opportunity, to the detriment of those investors – most likely, retail investors – who remain in the Fund.  These remaining investors would suffer a rapidly declining net asset value and an even further diminished liquidity of the Fund’s securities portfolio.

Given that the SEC has in the past expressed concern about just that issue, I assume it will say yes, though perhaps with some grumbling. Elsewhere in high-yield, the CDX index looks scary, the worst junk bonds aren't rallying along with the rest of the market, and a guy who was a junk bond manager before there were junk bonds has had a rough December.

Financial regulation.

The Commodity Futures Trading Commission approved rules saying that if a bank's affiliates trade with themselves, they don't have to post initial margin, except that if they trade with an insured-bank affiliate they have to post initial margin to the insured bank, because that keeps the insured bank safe from eeeeeevil derivatives. But because this sort of stuff is contested at the level of pure symbolic politics, there's a long and passionate dissent ("This decision seems to reflect a forgetfulness about how we, as a country, allowed the last financial crisis to happen," etc.), and congressional criticism that doesn't quite capture what is going on ("banks will continue to move their risky trades onto the books of their subsidiaries -- which are insured with federal tax dollars -- and the American people may have to bail them out if their trades go south"). 

On the other hand, the Department of Labor's fiduciary rule seems to have survived the budget bill, for now. But: "Accounting industry and SEC hobble America’s audit watchdog." Meanwhile in China, "Beijing Probes Architects of Stock-Market Rescue."

Canarsie.

Remember Canarsie Capital, the hedge fund run by the former head of risk management at Morgan Stanley and a 28-year-old former Galleon trader, which blew up in January, prompting Owen Li, the former Galleon trader, to tell investors that he was "truly sorry" for losing all their money? Well, Li pled guilty to securities fraud yesterday. Here's the criminal case against him, and the Securities and Exchange Commission press release and order. I have to say, it sure sounds like Canarsie's risk management was terrible. And prosecutors and the SEC make out a fair enough case for fraud, in that Li submitted fictitious trades to his prime broker to get more margin, and lied to investors about his performance in some months. But that stuff doesn't seem closely related to the actual blow-up, which was achieved in the time-honored way of putting all the money into risky options and hoping for the best:

Beginning on or around December 31, 2014 and continuing through January 15, 2015, Li used cash in the account and proceeds from stock sales to buy long positions in market index options. Virtually all of these purchases were in long call options with an expiration date of January 17—in other words, short-dated long options. At the same time, Li took down and eventually eliminated all short positions in the account. The result was an entirely long portfolio with no hedge.

On January 16, the market for index options moved against Canarsie’s positions, resulting in losses of approximately $39 million (approximately $28 million in expired premium and approximately $10.5 million in trading losses), leaving the Master Fund with no equity, short or options positions, and only $211,685 in cash (plus approximately $289,568 in its bank account). As a result of Li’s risky trading, Li caused the Master Fund to incur approximately $56.5 million in losses between December 31, 2014 and January 16, 2015, substantially depleting all of the Master Fund’s assets.

I often tell you that, if you have material nonpublic information about a merger, you shouldn't use it to go buy short-dated out-of-the-money call options on the target. But buying short-dated call options with all of your investors' money with no information, as a pure gamble for redemption, doesn't seem great either.

People are worried about unicorns.

Yesterday's Fed decision is a convenient receptacle for all the worries, and you might expect that the beginning of the end of easy money would also mark the beginning of the end of the unicorn cycle. It has been "the best time for any kind of business in any industry to raise money for all of history, like since the time of the ancient Egyptians," and surely some small part of that has to do with the Fed keeping interest rates as low as they've been since the Middle Kingdom. We'll see, but for now, the unicorn herd gallops on; yesterday "Facebook announced a partnership with Uber, the ride-hailing service, that will for the first time allow users in the United States to summon a vehicle from within the Messenger smartphone app." Of course Uber actually is a smartphone app for summoning a vehicle, so I do not really understand why it needs to be embedded in a different and worse smartphone app, but I suppose the answer is that I am not a teen. Here is Ben Thompson on the Messaging Epoch; he thinks that it's Slack's epoch to win ("it’s hard to see anyone — including Microsoft — having a bigger opportunity than Slack"), though to my untrained eye Facebook sure seems to be doing some epochal messaging stuff.

Elsewhere, here is the story of how artisanal-food-delivery startup Good Eggs ran into trouble because, basically, being Uber for kale is hard. And: "It's like the Death Star but for your lunch."

(The Middle Kingdom thing was a joke, by the way; there is no data for it in Sylla and Homer, but contemporary Mesopotamia had double-digit interest rates. There is no reason to think that the ancient Egyptians had a particularly robust venture capital industry.)

People are worried about stock buybacks.

Yesterday's Fed decision is a convenient receptacle for all the worries, so here is Greg Ip on worries that companies used cheap debt mostly "not to expand their business operations, but to buy one another and their own stock," but have by now borrowed so much that, in the words of a Treasury report, "even a modest default rate could lead to larger absolute losses than in previous default cycles."

People are worried about bond market liquidity.

Yesterday's Fed decision is a convenient receptacle for all the worries, so Greg Ip goes on:

This time, the illusion has been fed by promises from mutual funds and exchange-traded funds that investors can redeem their shares daily or during the day at close to the funds’ underlying value. But those funds hold bonds that are increasingly difficult to trade as dealers become less willing to take such bonds onto their books. 

Meanwhile, 24 buy-side firms signed up for credit default swap clearing.

Things happen.

Shkreli, CEO Reviled for Drug Price Gouging, Arrested on Securities Fraud Charges. Argentina Eliminates Currency Controls With Plans to Float Peso. Are You Ready to Buy Bonds From Iran? Valeant CEO Pearson's Defiant New Tone Reassures Shareholders. Ethan Allen, Hedge Fund Activism and Prevailing Over Conventional Advice and Practice. "Offered a sticky bun, Mr Milken declined on the ground that 'I’ve already had a pre-breakfast breakfast with a Nobel prize-winner.'" The 50 Worst Things On The Internet In 2015 (the title is correct, do not click this). 1983 Chateau d’Yquem and the Jets. Elf on shelf. The gift of socks. Lamp dog. "After the coffin experience, I realised I should try to live a new style of life." 

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

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