Inflated Expenses and Fake Earnings

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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Inflated expense reports.

There have been a lot of bigger banking scandals in recent years, but in some ways this Massachusetts Securities Division case against State Street might be the most embarrassing. Here is what allegedly happened:

  • State Street billed its custodial clients for "out-of-pocket expenses" including "courier services, stamp duties, telex, expenses related to wires, and Society for Worldwide Interbank Financial Telecommunication (hereinafter 'SWIFT') messages."
  • It doesn't cost State Street much to send a SWIFT message -- maybe as little as 25 cents.
  • But it charged the clients $5.

Now that is obviously a significant markup in percentage terms ("as high as 1,900%," the Securities Division helpfully calculates), and if you send a lot of SWIFT messages it adds up over time: State Street itself announced in December that, "over the 18-year period for which it has accessible records, approximately $200 million or more of expenses may have been incorrectly invoiced." But it is also, let's face it, inflating your expense reports, $4.75 at a time, over and over again, millions of times, for 18 years. You might as well overbill the client for photocopying, or for staples, while you're at it. It is such a grimly dogged scandal that it hardly seems worth it: Sure you are $200 million richer, but did you have any fun getting there?

As in every banking scandal, there are unfortunate e-mails, but these e-mails are not full of misspelled gleeful cackling about putting one over on the client. These guys are already embarrassed themselves:

As State Street employees began to obtain more information in April 2009 regarding the true cost associated with SWIFT Messages, State Street Employee One stated in an email, "Why we are marking up SWIFT charges is beyond me. I understand OOP's [out-of-pockets] as pass through charges."

Only  hours later, State Street Employee One again emailed, stating, "I'm telling you. I learn something every day. Simply not amazed at anything that goes on here any more."

I sympathize. It is not amazing.

Are earnings lies?

Applying Benford's Law to financial statements is one of the best-known financial-accounting party tricks -- aha, your company is a fraud because your balance sheet has more 2s than 1s! -- and now Deutsche Bank's "financial scientists" have built a Benford-y "model that scans for potential problems" in Securities and Exchange Commission filings. I suppose that is very public-spirited of them, though I wish they'd built a model that scanned for potential problems in their own metaphors:

“Accounting numbers are like volcanoes. When they lie dormant, people forget how dangerous they can be,” Deutsche Bank said in a recent note.

Perhaps even better-known than Benford's Law, though, is the fact that a million dollars, or even $999 million, isn't cool. You know what's cool? A billion dollars. Companies know this:

Accounting professor Derrald Stice, working alongside his accounting-professor father Earl and siblings Han and Lorien (both accounting-Ph.D. candidates), gathered 65 years’ worth of sales figures for U.S. public companies. Analyzing the data, they found companies were significantly more likely to report sales just a little above a round number than below. The effect was more pronounced at prominent round amounts like $1 billion.

Charmingly, though, the accounting professors think this is mostly on the up-and-up, though I don't know what Deutsche Bank's model would think:

Chances are, says Derrald Stice, that there is some gaming of sales figures going on. But he thinks the bigger driver is elbow grease.

Just as major league ball players are nearly four times as likely to bat .300 over a season than .299, companies put in extra effort to surpass a round-number threshold. The sales force goes all out, for example, the marketing department ramps up advertising, and the shipping department strives to fill orders.

That seems about right. On the other hand, should we get rid of quarterly earnings entirely? The SEC is thinking vaguely about it:

The agency unveiled a broad “concept release” last week that explores the myriad rules and regulations around financial disclosures. Included in the 285-page document is a discussion on quarterly earnings requirements, and whether they should be changed.

This appears to be at least partly in response to renewed complaints that cropped up last summer. The law firm Wachtell, Lipton, Rosen & Katz started a crusade against quarterly reports, calling on the SEC to end the practice, and Hillary Clinton among others jumped aboard the crusade against what has been dubbed “quarterly capitalism.”

I am in general a skeptic of "short-termism" worries like this, but even leaving that aside I don't really see the public markets moving in a direction of less transparency. If you want to give your money to a company that will invest it in long-term projects with no immediate concerns about profitability, there are plenty of venture-capital opportunities, or Amazon. Elsewhere: wind metaphors.

The ByRD is the word.

Oh man, today the New York Stock Exchange "will commence trading of Binary Return Derivatives (ByRDs)":

Trading on the NYSE Amex Options platform, ByRDs are based on an underlying equity security, such as a stock or an ETP. They offer a fixed return of $100.00 per contract, based on whether the volume-weighted average price of the underlying security is above or below a given level on a defined future date. They also provide a capped maximum risk to the seller of $100.00 per contract, less the premium received for selling the option.

Binary options are basically the daily fantasy sports of investing: They distill a slow nuanced long-term process into a quick-hit coin-flip gamble. A lot of modern financial innovation is about offering small investors access to simple easy-to-use diversified products that replace the need for complicated advice or difficult do-it-yourself stock-picking. Now a robot on your phone can just tell you how to invest, and you can buy the entire market in the form of one cheap exchange-traded index fund. I am a fan, but I imagine that some people feel like this all takes a bit of the thrill out of investing. I imagine that other people, on the brokerage side, worry that it takes a bit of the fees out of investing. And I suspect that there is some loose law of conservation of fees and thrills: It used to be that you got your fun buying individual stocks and trying to beat the index; now you can just buy the index in an ETF, but you can get your thrills with binary options on that ETF. 

In any case: Great name! You don't see enough financial product acronyms these days that (1) are cleverly misspelled real words and (2) use the first and last letter of one of the constituent words. When I think about ByRDs, I feel for a moment like it's 2006 again.

Elsewhere in ETFs and thrills: "ETFs’ ‘Spider Woman’ Argues for a Bitcoin Fund." And elsewhere in market structure, Liberty Media did another tracking-stock reshuffling this week, which resulted in some briefly very silly stock charts:

Much has been made of the plunge in Liberty Braves Group Class A and C tracking shares since their first trades at 9:30 a.m. Monday in New York. The A shares in particular look like lemons, entering the market at $36 and then ending the day at $19.95.

The stock opened at $36, yes, but "very few people bought or sold while it was there," and it quickly settled down to a more normal and expected level. I am not particularly an expert in tracking stocks -- I gather that no one is, except Liberty Media -- but it seems to me that there is not much of an arbitrage there to smooth the transition. One day you have one stock, the next day you have multiple different stocks, and the ownership gets reshuffled according to near-term supply and demand, without any sort of cross-market arbitrage to keep prices in line with fundamental values. So you get a few weird trades for a while. Speaking of weird trades, never use market orders.

Hedge funds.

I never quite know what to make of broad hedge-fund industry aggregates. So for instance:

Investors pulled a net $15 billion between January and March, reducing assets under management to $2.86 trillion from $2.9 trillion, Chicago-based Hedge Fund Research Inc. said Wednesday. The last time outflows were higher was in the second quarter of 2009, when $43 billion was redeemed.

Clients are redeeming after many hedge funds failed to protect them during market turmoil in the second half of last year and again at the start of 2016. Managers including John Paulson, Chase Coleman, Andreas Halvorsen, Ray Dalio and Bill Ackman posted losses in some of their funds last quarter, even as global stocks edged out a small gain with dividends reinvested.

I feel like the circumstances that would cause you to sour on Ray Dalio (a quiet risk-minimizing asset allocator) and those that would cause you to sour on Bill Ackman (a concentrated activist equity investor) would be different, no? What do industry-wide withdrawals (of, you know, like 50 basis points, but still) tell you about the industry? The main common thread binding the hedge-fund industry is, famously, the fee structure; perhaps that's the theme:

Fed up with paying “exorbitant fees” for poor returns, the New York City Employees’ Retirement System has cut its $1.5bn programme, pulling money from managers including Perry Capital and Brevan Howard. The shift comes about 18 months after California’s pension scheme also scrapped hedge funds from its portfolio.

Among the underperformers is Blackstone's "multi-strategy fund Senfina, which means 'everlasting' in Esperanto," and if I worked there I'd be so embarrassed about the name that I wouldn't even worry about the performance. Senfina is not the only underperforming multi-strat fund; "Millennium and Citadel lost about 4.2 per cent and 6 per cent respectively in the first quarter," and the "declines are casting a new light on the multi-strategy approach that won over so many investors last year."

Activism is similarly grim: "Activist investors, many of them nursing losses for a second straight year, offered no notable new investment opportunities and sounded less confident about upcoming corporate board fights at a prominent industry conference in New York on Tuesday." 

In ... happier? sadder? weirder? ... news, there is this thing:

Keep an eye on Huddlestock, a Norwegian-based crowd-investing platform now in beta testing that aims to launch this summer. It intends to provide a new way for investment strategists to freelance their best ideas, away from the hedge funds and established institutional asset managers where many now toil to make the key men wealthy, by building a distribution capacity to reach retail investors.

Is there really an appetite for an online platform where you can guess who might be a good investor and then trade based on their stock tips? It sounds so unpleasant to me, but I feel like I keep seeing startups that offer something like that. I suppose that, like ByRDs, it's a way to re-enchant the financial world for investors who have gotten bored with index funds.

Too big to etc.

Here is a story about how BlackRock is pretty good at lobbying and dealing with regulators, and so has avoided being treated as "systemically important" by the Financial Stability Oversight Council. There is perhaps an implication here that, e.g., MetLife is less good at lobbying, which is how it ran afoul of the FSOC. There is also perhaps an implication that being too good, or too persistent, at lobbying can itself be bad: "'They are wearing out their welcome,' said one person involved in the process."

But the main implication seems to me to be that the "systemically important" designation remains hazy and subjective and subject to political pressures rather than coherent theory. Here is what apparently "galvanized the firm around a crusade to elude more aggressive oversight from the Fed":

In 2014, BlackRock Inc. executives obtained a copy of a confidential Federal Reserve PowerPoint presentation that argued part of the giant money manager could pose the same financial-system risk as big banks.

“If it looks like a bank, quacks like a bank...” read the title of two slides, according to a copy of the presentation reviewed by The Wall Street Journal.

Does BlackRock quack like a bank? On what axis do you measure its quack? BlackRock looks like a bank in some ways (big, uses money, does some sort of maturity transformation), and not like a bank in other ways (no deposit insurance, invests mostly in public securities, doesn't promise to give you back the same amount of money you put in). Which aspect of its quack is salient? I do not think that the old quacking adage really gets you very far; you are forced to decide BlackRock's systemic riskiness by reasoned argument rather than by pat analogy. I guess the gist of the story is that BlackRock argued its case and won, but the contents of that argument and the criteria for winning remain pretty mysterious, at least to me.

Elsewhere, here is Dan Davies on the banks' living wills:

To adapt a maxim, it appears that the banks have failed to prepare because they are not prepared to fail. The Fed asks for a set of liquidity forecasts, and a bank offers a blithe assumption that it has enough money on hand to prepare for the worst. The F.D.I.C. asks another bank what will happen to assets that are effectively trapped in its foreign subsidiaries, and the bank assumes that everyone will coöperate and money will flow freely across borders. Again and again, the banks’ position is “Let’s not meet trouble halfway.”

League tables.

Yesterday I mentioned that the point of a league table is to show that your bank is the best at whatever sort of deal you are pitching, and that a league table ranking is a subjective artifact of marketing rather than an objective reflection of reality. This is not exactly a unique insight of mine; everyone has known this forever. But it seems to be getting more attention recently; last week, the U.K. Financial Conduct Authority published an "Investment and corporate banking market study" that, among other things, examined banking league tables with hilarious earnestness:

League tables are used extensively by banks when assessing their own performance internally and when pitching to clients, and also, to differing degrees, by clients when choosing their bank. We found that league tables can be misleading because some banks carry out sole-led, loss-making transactions purely to generate credit in league tables. Furthermore, banks routinely present league tables to clients in a way that inflates their own position. Many clients are aware of these practices, nonetheless we believe they impede effective client choice.

"Based on the evidence we have received," said the FCA, "we consider that many league tables are not always presented in a way that best aligns with a client’s needs," and it "would like to see banks and advisers adopting better practices by presenting league tables in pitches that are more meaningful for clients and in clients’ interests." (On the other hand, it did "not consider that it is appropriate in these circumstances for the FCA to take on production of standardised league tables.") 

The financial industry has a -- perhaps not entirely unjustified -- reputation for being unusually dishonest, but when you see things like this it's useful to imagine applying them to other industries. As far as I can tell every wireless carrier has America's best network; every car has a top safety rating and is number one in customer satisfaction. There are lots of rankings, lots of axes on which to rank, and -- here is the critical thing -- you only have to advertise the ones that make you look good. Imagine if all advertising had to present rankings "that are more meaningful for clients and in clients' interests," rather than just the ones that flatter the advertiser.

People are worried about unicorns.

Uber, the Ubercorn, is perhaps the ur-source of unicorn worries; here are some:

But the beating heart of today's unicorn worrying is of course Theranos, the Blood Unicorn, and here are Peter Henning and Steven Davidoff Solomon speculating a bit on all of the inquiries into Theranos. Here is a reminder that the Securities and Exchange Commission is keenly interested in investigating potential securities fraud at unicorns. And here is an article about how "The Theranos Downfall Was Inevitable," which I suppose would have been more helpful before Theranos raised hundreds of millions of dollars at a $9 billion valuation. Elsewhere: fintech for wedding loans. And: Down to Lunch.

People are worried about bond market liquidity.

Here is Bloomberg Gadfly's Lisa Abramowicz worrying about bond indexes, especially for emerging-market bonds, which is liquidity-ish enough for me:

But there’s also a risk that at some point, another macroeconomic shock will send foreign investors running away from developing nations in mass, yanking money from indexed funds. This means money will flood away from all countries included in these benchmarks, including Argentina, leaving fragile countries with loads of debt and fewer ways to pay it back and frenzied investors with losses.

Of course that would be true without the indexes too: Indexing is a convenient way to express the herd instinct, but it probably didn't create that instinct.

Things happen.

Harriet Tubman will be on the front of the new $20 bill. Amazon same-day delivery and race. The $2 Trillion Project to Get Saudi Arabia’s Economy Off OilBanks pile into equities trading as salve for bond wounds. Mobile-phone securitization. Caesars, oil and the Trust Indenture Act. Follow-on stock offerings by oil exploration and production companies are going pretty well. Aswath Damodaran thinks Valeant is a buy at $32. SunEdison’s Failed Deals Could Bite Back in Bankruptcy. "This means in our lifetime, something is going to happen to Yahoo." Blythe Masters Sees Tech Answer to Banks' Existential Woes. Steve Cohen just can't unload his $72 million penthouse. Trump on Yellen. Trump Vodka. Expensive matzo. Medieval Times. Naked restaurant. Smaller Mac. Big pot.

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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