Lottery Arbitrage and SIFI Breakups

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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Powerball.

An uncharitable view of investing success is that financial markets are random, successful investors have won a coin-flipping contest, and advice on how to be a successful investor is mostly post-hoc rationalization of meaningless and unpredictable events. This is not really fair, but on the other hand what should you make of advice on how to be a successful Powerball player? Hoo boy is there a lot of it. We talked a bit yesterday about the Great Lottery Arbitrage, in which you buy 292.2 million tickets, one for each possible winning combination, and then sit back and let your winnings roll in. The consensus is mostly that this doesn't work, but here is a plucky argument from the Wall Street Journal that you should give it a shot. The key insight is that the cost of your losing tickets would be deductible from your winnings for tax purposes, so if you won $1.1 billion-ish ($930 million cash jackpot, increased by $118 million for your own purchases, plus $93.5 million in smaller prizes), and paid $584.4 million for tickets, you'd only pay about $230 million in federal taxes and still come out ahead. The Journal, however, only waves at the real problem with this scheme, time and pencils:

First, you need to purchase every ticket. If you’re doing this in New York, for example, you’re going to have to find a string of bodegas to buy your tickets. Each play slip has space for five games, so you would need a stack of over 58 million to fill out. You could probably do this with a printer, a lot of ink, and a computer program to fill in your choices of number.

Whenever a can't-lose get-rich-quick scheme arrives at the "assume a computer" stage, that's probably when you should hop off. 

The other problem with the Great Lottery Arbitrage is that it loses money if you have to split the jackpot with anyone else. Andy Kiersz at Business Insider points out that not only is there a higher probability of splitting the jackpot in a massive drawing like today's, but also that that probability becomes a certainty if more than one person runs the Great Lottery Arbitrage. This is sort of a no-arbitrage argument against the Great Lottery Arbitrage -- if you find every lottery ticket on the ground, someone has already picked them all up -- though it is complicated by the prisoner's-dilemma nature of the problem; perhaps everyone else has been correctly scared away from the Great Lottery Arbitrage by the risk of splitting, and only you are dumb enough to actually do it and so will win an undivided pot.

If all this advice on how to win the lottery feels a bit too sensible and down-to-earth for you, then I recommend Forbes's personal-finance advice column "How To Win Powerball: 5 Secrets From A Lottery Expert"; the expert's tips include "Never miss a drawing" and "Once you’ve determined which numbers are 'good,' (he recommends a specific way to find these in his book) don’t switch them, play them every time." And here is "A Game Theoretic Argument for Publicizing Lottery Numbers," along with a website that lets you publicize yours. 

Even after you've won the lottery, though, the flow of free Internet advice doesn't stop. For instance: Should you take the lump-sum cash payment (currently $930 million), or the full $1.5 billion prize paid out over 29 years? At the New York Times, Josh Barro makes a pretty good case for the annuity, arguing that it's a very low-risk 2.8 percent tax-free investment that comes with the added bonus of not letting you lose all your money at once on some dumb scheme. ("Again, I don’t know all about you, but I do know you buy lottery tickets, so let’s consider the possibility that you are not one of your generation’s great financial minds," says Barro.) I am not convinced, though: Taking the annuity leaves you with counterparty risk (to the Multi-State Lottery Association, which buys government bonds to fund your prize, and which seems like a pretty good credit, but still), tax risk (what if tax rates go up?), interest-rate risk, inflation risk, etc. Of course taking the cash prize and investing it yourself probably involves the same risks, but at least you can diversify. If you win the lottery, that prize will be by orders of magnitude your largest financial asset -- at least, it had better be -- and you might not want to put all of it in any basket. If I win, I'll probably take the lump sum, invest some of it in government bonds, some of it in unicorn stock, and some of it in rural land and ammunition. Oh, disclosure, I am long Powerball tickets.

Here's more advice from Mark Cuban ("Don't make investments") and from Bloomberg (start a family office). Here is the Powerball FAQ, which is absolutely wonderful; it doesn't answer my question (is Powerball bankruptcy remote from the states that sponsor it?), which is perhaps not frequently asked, but it does answer questions like "I got an email saying that I won the lottery; is it legitimate?" (it is not) and "My numbers are: XX-XX-XX-XX-XX-XX; did I win?" (go check the website), and it gets quite philosophical at times ("Do Powerball tickets expire?" "Yes. The Universe is decaying and nothing lasts forever."). I suppose if I spent a lot of time answering questions about a life-changing game of random chance I would incline to philosophy as well.

Elsewhere: Tontines. Economic FOMO. El Gordo. And what on earth even:

An employee at B&J Newsstand on Lexington Avenue in New York told CNBC that he has had about one customer per day buying $2,000 to $3,000 worth of Powerball tickets over the last several days. 

Are those ... office pools? Great Lottery Arbitrage arbitrageurs? People taking Fox News's advice

De-SIFI-fication.

MetLife has spent a lot of time sulking (and suing) about its designation as a "systemically important financial institution," and now it is doing something about it: Yesterday it announced "a plan to pursue the separation of a substantial portion of its U.S. Retail segment," so that the retail business can get out of SIFI status and avoid "higher capital requirements that could put it at a significant competitive disadvantage." MetLife will keep fighting its SIFI designation, but in a sense it has already lost: Surely the point, or point anyway, of SIFI regulation was to break up the too-big-to-fail entities. MetLife was declared too big to fail, and it disagrees, but the important thing is that it is breaking up anyway.

Argentina. 

Today in New York, officials of Argentina's government will meet with its holdout creditors to try to negotiate a resolution to the country's long-running debt fight. People are optimistic: "There is a lot of hope since Mauricio Macri’s election because clearly this is a government that is interested in returning to international markets," says one bondholder, and the peso has rallied. I still sometimes chuckle about the time that Axel Kicillof, the economy minister in the previous Argentine government, flew to New York to negotiate with bondholders just before a default deadline. Hopes were high then too, and when Kicillof walked into the room and presented the government's offer, the fact that the offer was nothing was a genuinely unexpected punch line. If the new government shows up and offers nothing it will be an amazing callback of that joke, but it sure sounds like Macri wants to compromise:

“It’s very important that we resolve the problems of the past,” Macri said in a press conference in Buenos Aires. “We want to stop being a country that’s branded as not honoring its pledges and we want to resolve all outstanding issues.”

Kicillof, whose idea of negotiation is so idiosyncratic, has some tips from the sidelines

“If the government goes and negotiates, that doesn’t seem bad to me,” Mr. Kiciloff said in an interview. “What would be bad is if they go against the interests of Argentina.” 

Stock in lieu of taxes.

Here's a fun op-ed from Dean Baker asking what if "instead of taxing corporate profits, we required companies to turn over an amount of stock, in the form of nonvoting shares, to the government." The idea is that instead of taking 35 percent of a company's taxable profits each year, the government would just take a 35 percent nonvoting equity stake in the company, which would entitle the government to 35 percent of the company's (economic) profits in perpetuity. Baker argues -- probably correctly -- that this would cut down on tax structuring, which right now is mostly about trying to make economic income not look like taxable income. (It would also be a bit weird for the government, which tends to want its taxes in cash rather than unrealized appreciation; "the shares would be nontransferable.") But I confess that I like this idea mostly as a blank slate for new tax structuring opportunities. Thirty-five percent of what? A thousand preferred stocks, convertible bonds, contingent value rights, earnouts, joint ventures, tracking stocks, executive-compensation plans, etc. etc. etc. etc. would bloom. I might have to go back to corporate equity structuring if this ever happens; it would be too good to miss.

Predictions.

Jeffrey Gundlach has apparently succeeded Bill Gross as Bond King, an unofficial title but one with enough power that his 2016 market outlook webcast yesterday was not only expected to draw "thousands" of expected listeners but also got a Bloomberg preview about what he might predict. Here's what he did predict:

“This is a capital-preservation market, not a money-making environment,” said Gundlach, co-founder of Los Angeles-based DoubleLine Capital. For economic growth, “2016 is not looking all that great, potentially.”

He also worried about "more destabilizing devaluations of the yuan," argued against raising U.S. interest rates, and predicted "that stocks are going to follow high-yield bonds down and low oil prices may lead to political instability." Also "he plans to wait and see whether the 10-year Treasury rate goes up or down," which is I guess why he's the Bond King.

All of that looks downright chipper next to Royal Bank of Scotland's European rates research team, who in a note titled "The bears have killed Goldilocks" predict a "fairly cataclysmic year ahead," compare it to 2008, and recommend that you "sell mostly everything." Gawker is pleased

Compensation.

Tidjane Thiam might be a McKinsey alumnus bringing a consultant's cold cost-cutting mentality to Credit Suisse, but honestly this is a fair point:

“The battle ground is remuneration,” Thiam said at a conference in Paris on Tuesday. “The business is structurally quite profitable provided the pay can go up and down. It’s the ‘and down’ that they don’t accept,” he said, referring to bankers in the securities unit.

And:

"A business model where you have a cyclical revenue stream and fixed salary base does not work,” Thiam told the audience that included International Monetary Fund Managing Director Christine Lagarde, Bank of England Governor Mark Carney and Bundesbank President Jens Weidmann. “And that’s the simple truth” but it “has not penetrated all the circles in investment banking and that’s what’s taking the return on equity to 7 percent.”

In the bankers' defense, though, it hasn't penetrated all the circles in bank regulation either, with European regulators at least suspicious of variable compensation in banking. 

People are worried about bond market liquidity.

Here's Anthony Perrotta of the TABB Group with "The Inherent Danger of Ignoring Illiquidity," which among other things rejects the idea that low reported bid-ask spreads mean that bond liquidity is fine:

An investor asks a dealer for a bid on $10MM XYZ bond that is currently quoted +185/180 bps over the US10Y. The dealer is willing to provide immediacy for $2MM, but requests an order on the balance. After hours of working the order, another investor emerges and provides a bid of +188 bps for the remaining $8MM. The first investor accepts the terms and the dealer acts as riskless principal in the transaction, while working for a basis point or two. The trade is reported to TRACE as a buy at +190 and a sell at +188, essentially a 2 basis point spread. In reality, the liquidity premium associated with the trade is 5 bps.

Meanwhile, "Anheuser-Busch InBev NV will start selling bonds Wednesday backing its takeover of SABMiller Plc in what’s expected to be the first part of the biggest global bond deal ever," and that's just "the first in a series of mega-deals slated to fund some $630 billion of takeovers that could weigh on corporate debt prices this year." And: "Junk-Bond Selling Hurt Some Fund Firms."

Things happen.

Republicans and Democrats Agree: We Hate Wall Street. Crude Falls Below $30 a Barrel for the First Time in 12 Years. U.S. Exports First Freely Traded Oil in 40 Years. Illiquid investments slow shutdown of SAC Capital. China to set up unit to co-ordinate economic and financial policy. Xi Calls for a China in 2016 Where 'Nobody Dares to Be Corrupt.' The Dubious Logic of Stock-Market Circuit Breakers. Reporting rule adds $3tn of leases to balance sheets globally. "The percentage of companies reporting adjusted earnings has increased sharply over the past 18 months or so." One of the Biggest Bond Market Players Has No EmployeesRadiohead's business model. Hedgeye Risk Management Acquires Potomac Research Group. Bernie Sanders voted for the "audit the Fed" bill. "As a society we’re irrational about it, but government has to accept that irrationality rather than fight it." The Wall Street Journal explains Snapchat (and "bae"). Phantom liquidity in the market for Picasso sculptures. What Will HBO’s Sesame Street Look Like? Per Se is bad now. Is Harvard Law School also bad now? Fake islands. Drone store. Dog pants

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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