MetLife, Hedge Funds and Scandals

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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SIFIs.

On the one hand, it is a bit surprising that a federal judge yesterday rejected the Financial Stability Oversight Council's attempt to classify MetLife as a "systemically important financial institution" subject to enhanced prudential regulation by the Federal Reserve. Classifying and monitoring too-big-to-fail firms was in many ways the centerpiece of post-crisis financial reforms, and judicial review of FSOC's designations was supposed to be limited and deferential. Certainly MetLife is big and owns lots of financial assets, and, while it came through the crisis more or less fine, its fellow giant insurer, American International Group ... did not.

On the other hand, it isn't that surprising. A "systemically important financial institution" can't just be, you know, a big company with a lot of money. Apple has a lot of money. Vanguard, good lord, has so much money. (More than $3 trillion under management, versus $878 billion of assets at MetLife.) Any sensible SIFI designation can't just be about bigness and money; it has to be about whether a company's financial distress could damage the broader financial system. (Or, as section 113 of the Dodd-Frank Act puts it, whether "material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.")

In some vague sense that is true of any big company -- if Apple disappeared tomorrow, things would get weird -- but it seems to me that the real damage comes from companies that could be subject to runs. (Here again I follow Morgan Ricks, Gary Gorton and others in thinking about financial panics as primarily a problem of short-term debt, broadly defined.) That's why the Fed regulates banks: because banks are preeminently in the business of funding long-term assets with short-term debt (deposits), a model that we have long known creates the risk of instability. But the last crisis featured runs on companies -- investment banks, asset-backed commercial paper conduits, AIG -- that weren't banks, but used similar funding models without the prudential regulation and capital buffers of banks. 

On that theory, FSOC's job is really to subject runnable non-banks to prudential regulation by the Fed. That job is in some ways less important than it sounds, just because a lot of the runnable non-banks from the last crisis have disappeared on their own: The big investment banks have become, or been bought by, Fed-regulated banks; asset-backed commercial paper has vanished. But AIG's still around! So it is natural that the FSOC would start with AIG, and would, reasoning by analogy, figure that other big insurers are also systemically important.

But the argument that MetLife is particularly run-prone seems pretty weak. MetLife is an insurance company. As it said in its briefing in this case:

Like other conventional life insurers, MetLife writes long-term policies and invests premiums in long-term assets to satisfy its obligations when they come due. Unlike banks, which take liquid, short-term deposits and wholesale funding and invest in long-term assets such as commercial loans, MetLife matches its long-term liabilities with long-term assets, and its investment portfolio is linked to, and driven by, the profile of its insurance liabilities.

You don't see a lot of runs on life insurance policies; though I suppose it is possible. (MetLife argues that the FSOC relies on the "irrational and ahistorical supposition that distress at MetLife would lead its customers to surrender their policies en masse--despite evidence that customers do not hold insurance contracts for liquidity purposes and would face adverse tax consequences and contractual penalties associated with surrender.")

But who can say in advance what will be subject to runs? AIG is an insurance company too, but its policies were not the problem in 2008. The problems came from its securities lending business, which does have characteristics of short-term financing, and from its derivatives business, which kind of doesn't, but which did feature run-like demands for collateral as AIG's credit deterioriated. (The FSOC's ruling designating MetLife as a SIFI points to its derivatives liabilities and securities lending business as potential sources of exposure, though they don't seem to be as significant as AIG's were.) And while the FSOC seems to have given up on regulating the big asset managers as SIFIs, there has been a lot of talk recently about the risk of a run on mutual funds -- which was not really something people thought about a few years ago.

In any case, it is hard to know what yesterday's decision means, because the judge issued it under seal; a possibly redacted public version will be issued after April 6. Perhaps the judge found some minor flaw in the FSOC's work, and it can revise and resubmit and make MetLife a SIFI again. Or perhaps the FSOC will win on appeal. But MetLife's win might make FSOC regulation of mutual fund activities more difficult. It also makes it a little weird that MetLife already announced that it will break itself up, partly to avoid the SIFI designation. That now seems a bit hasty.

In other too-big-to-fail news, here is Euromoney on Neel Kashkari's "radical and very public campaign to end too-big-to-fail," which it calls "the monetary equivalent of trolling."

Asset management.

Elsewhere in just-barely-non-SIFI news, BlackRock "plans to cut about 400 jobs in what may be the biggest round of layoffs to date at the world’s largest money manager." But BlackRock is fine: It "attracted $54 billion in net new money in the fourth quarter," and "expects to end the year with a higher headcount" despite the layoffs. The hedge fund industry has perhaps bigger worries:

Pension funds, insurers and university endowments helped pump up hedge funds to a record $3 trillion in assets over the last decade. But with results falling behind a more traditional mix of stocks and bonds for six straight years and the high-fee structure now politically sensitive in some states due to uneven results, many of them are pulling back.

From New Mexico to New York, big investors are dramatically reducing their commitments and opting for cheaper imitations. Investors globally asked for more money back from hedge funds than they contributed in the fourth quarter of 2015, according to HFR Inc.—the first net quarterly withdrawal in four years. They pulled an additional $15.3 billion in this year’s first two months, according to eVestment.

And at least some of them are using "liquid alternatives" instead, to get sort-of-hedge-fund-like exposures at much lower costs. It seems pretty reasonable that a lot of the work that hedge fund managers do could be replicated by computers, though I guess it would be more flattering if those computers were, like, Go-playing neural nets rather than systematic investing strategies.

Speaking of hedge fund managers and neural nets:

Two hedge fund “quants” have come up with an algorithm that diagnoses heart disease from MRI images, beating nearly 1,000 other teams in one of the most ambitious competitions in artificial intelligence.

They both actually seem to be former hedge fund employees (at Crabel Capital and Two Sigma). You sometimes hear complaints that in modern financial capitalism people with the talents to cure cancer end up programming computers to trade stocks instead. But on the other hand, it's possible that the lure of financial-industry riches creates an environment in which a lot of smart ambitious young people are trained to solve problems using big data and artificial intelligence. And then they can go cure cancer in their spare time.

Banks.

Or maybe technology will put everyone in the financial industry out of work, and then they'll have no choice but to cure cancer. Here's Nathaniel Popper:

Up to 30 percent of the current employees in the banking industry may lose their jobs to new technologies in the next 10 years, according to new projections from Citigroup.

A 112-page report, “Digital Disruption,” released on Wednesday, said that the number of employees at American banks would drop to 1.8 million people in the year 2025, down from 2.6 million last year and 2.9 million before the financial crisis.

Here is the report. Don't worry too much about it, though, if you're an investment banker or trader: Many of the expected cuts seem to come from the branch network, as "we are at an inflection point for retail banking driven by automation and digitalization," and "the return on having a physical network is diminishing." Though, I mean, sure, probably worry if you're a trader of an easily electronifiable product. Honestly worry even if you're a trader of a high-touch product, since technology is not the only thing that might take your job:

Global investment banks suffered declines of as much as 56 per cent in their trading businesses in the first three months of the year, analysts believe, stoking fears of further lay-offs for staff and lower dividends for shareholders.

Scandals.

Here is a multi-part investigation by Fairfax Media and The Huffington Post into Unaoil, a private Monaco company that helps Western companies win contracts in oil-rich countries. From that description, you can probably guess what the investigation is about. If not, here is a hint: The headlines at the top of Part 1 are "The Bribe Factory," "World's Biggest Bribe Scandal," and "Unaoil: The Company That Bribed the World." I find the bribery industry fascinating just because it so closely resembles the investment banking industry: In both, you give the customer free benefits now in the hope of lucrative contracts later, and in both, "the customer" who pays you is a faceless entity, but the way you win the lucrative contract is by buttering up actual individual decisionmakers. In a way this is true of most sales jobs, and it is perhaps not surprising that not every society draws the line between sales and bribery in the same way that the U.S. does. 

Here, meanwhile, is a story about the effects of the U.S.'s vigorous crackdown on money laundering and sanctions violations by U.S. and foreign banks:

Fearing steep financial penalties for failing to spot a wayward customer, many banks now shun anyone who looks risky. That leaves ostracized companies to seek alternatives—such as toting bags of cash overseas—a practice that allows hundreds of millions of dollars to leave the global banking system, according to a bipartisan group of lawmakers that in January asked for a review of the problem by the Government Accountability Office, the investigative arm of Congress.

“The whole flow of money goes underground, and that becomes counterproductive to the original purpose of being able to track” it, said Dilip Ratha, head economist of the World Bank’s unit that studies remittances. “It’s a bit paradoxical.”

Oops! One thing that I tend to think is that the U.S. does a lot of regulation by prosecution, and in the heat of the moment it is hard for a prosecutor to resist the urge to demand huge fines and big shows of remorse from banks that have, you know, financed terrorists or drug cartels. And that probably does have a good deterrent effect: It's probably harder for terrorists and drug cartels (as well as lots of innocent people) to get financing or move money, which is a win against terrorism and drugs. On the other hand, it's also a lot harder for law enforcement to track terrorists and drug cartels if they can't follow the money. A non-punitive, systemic outlook might achieve better results, but how can a prosecutor resist the lure of punishment?

Elsewhere: "1MDB Probe Shows Malaysian Leader Najib Spent Millions on Luxury Goods." Here's a story about the prison where Icelandic bankers are imprisoned for causing a financial crisis; it sounds reasonably humane, though the setting is so dramatic as to be a bit alarming. Here's a story about how Finn Caspersen's tax issues weren't that big a deal. Here's a Securities and Exchange Commission settlement with a biotech venture capitalist who allegedly "took money from the Burrill Life Sciences Capital Fund III under the guise of 'advanced' management fees and spent it on family vacations to St. Barts and Paris as well as jewelry, gifts, car service, and private jets." Maybe wait to spend your management fees until you've earned them. Here's a story by Roddy Boyd and Teri Buhl about a lawsuit against Bear Stearns executives. Here's the first public appearance by Erin Montella -- formerly Erin Callan, briefly the chief financial officer of Lehman Brothers -- since the financial crisis, on CNBC yesterday.

People are worried about unicorns.

Guess what, there were no initial public offerings by technology companies in the first quarter of 2016. Perhaps all the unicorns will stay in the Enchanted Forest forever, and we will miss them, and one day an intrepid young child will embark on a quest into the forest to bring back the lost unicorns, and she will come to a clearing, and there they will all be, covered in dried rainbow gore, dead of dread diseases like down rounds and mutual-fund markdowns. Or maybe the IPO markets will open up in the second quarter, I don't know. Anyway Fidelity has marked down some unicorns some more.

Elsewhere, here's a story about a new kind of startup incubator, the kind that is I guess slightly smaller than other startup incubators? This one is called Expa and was started by an Uber co-founder, who asks, "Do you want a class size of 100, or a class size of eight?" One day ambitious parents will worry more about their children's startup incubator applications than about their college applications. Also: What's it like to be the chief financial officer at a tech startup? What's it like when venture capitalists run an NBA team? (Are the Warriors, in their way, a unicorn?)

Oh, by the way, yesterday I somewhat dismissively called Betterment "only a .7icorn," but in fairness I should point out that that was by choice: "CEO Jon Stein says he chose not to take a $1 billion 'unicorn' valuation in lieu of better terms."

Investors offered Betterment deals at higher valuations, Stein says, but those offers had “unfriendly terms” including liquidation preferences, ratchets, and “all kinds of structure,” he says. “We have zero structure. The most clean, vanilla 1x preference.”

As Betterment's Boris Khentov put it to me, "'zero structure' is the new unicorn."

People are worried about bond market liquidity.

Pimco isn't though! Here's a blog post from Pimco's William De Leon:

While PIMCO agrees that market conditions have changed from pre-crisis times and there are pockets of diminished market liquidity, we do not believe that conditions are as substantially different as some may perceive. Instead, we think the period of lower volatility when interest rates were near zero and the Federal Reserve seemed to be on hold “forever” has given way to a period of higher volatility due to more uncertain central bank policy.

Additionally, some investors and regulators have concerns about the potential for large liquidations of fixed income assets causing a “run” on mutual funds. We believe this is incorrect for several reasons: First, mutual funds cannot have a true “run” as they are not leveraged entities; they would sell the assets they own and shareholders would receive the value of these assets. Second, asset/fund managers have liquidity buffers and diversification programs to help mitigate these risks. Third, if sales occur across multiple asset managers, it signifies a change in view on an asset class, not a fund-specific issue.

You might see higher volatility and wider bid/ask spreads, argues De Leon, but that could be about "asset re-pricings -- not liquidity events."

Things happen.

Valeant Said to Offer Lenders More Money to Relax Loan Terms. How Wall Street's Favorite Solar Company Spent Itself to the Brink. Elliott Management spent about $117 million for Argentine bonds that will pay off about $2.4 billion. Rethinking Corporate Governance for a Bondholder Financed, Systemically Risky World. Crash Beliefs from Investor Surveys. China’s Banks Report Slowest Profit Growth in 10 Years for 2015. S&P cuts China’s debt rating outlook. Peak index fund? NYSE Margin Debt Falls to Lowest Since 2013. Did Johnson & Johnson Hide the Dangers of Baby Powder for Decades? Let Duke have its basketball and academics, Yale will always be first in endowment returns. Donald Trump vs. the Harvard Lampoon. Gourmet Soylent. Cool teen slang. Hedge-fund groupies. The U.S. State Department Warns Americans That No One Could Possibly Find You Attractive.

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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:
James Greiff at jgreiff@bloomberg.net