Financial Innovation and Trading Lies
It is hard to measure, but I think there's a decent case to be made that financial innovation has done good things for a lot of real-world businesses. Junk bonds and real estate investment trusts and master limited partnerships and receivables securitizations and other capital-structure developments have helped companies raise money and lower their costs and attract investors and grow. There are success stories, though many of them are kind of boring.
But hoo boy are the failures entertaining. Enron is of course the all-time poster child for the dangers of bringing too much financial cleverness to an industry, but SunEdison's bankruptcy filing yesterday has brought out a lot of gloating about the failure of its essentially financialized business model:
The collapse is full of the usual cautionary tales, of corporate hubris and excessive debt, but also offers a new one in its industry: the dangers of financial engineering taken to extremes.
SunEdison's engineering was centered around its "yieldco" model, "designed to attract money from dividend-hungry investors and to free up the parent company’s balance sheet to start new projects." That was kind of the company's pitch:
SunEdison did not have any clear technological advantage. Instead, it offered what Brian Wuebbels, then chief financial officer, described in 2014 as “capital innovation”.
People bought it:
SunEdison was beloved of hedge fund managers, who revelled in the idea they had spotted a lucrative opportunity hidden in the weeds of its financial filings. David Einhorn, the founder of Greenlight Capital, who has invested $243m in the company, hailed its prospects at the Robin Hood investment conference in 2014. He told the audience in New York that SunEdison’s “complicated” financial statements “make it challenging to decipher the economic value of the company from a cursory review of the balance sheet or income statement”, but that leads the market to “undervalue” the shares.
"It was a magic money machine," says an analyst. It worked, as they say, until it didn't. SunEdison's yieldcos raised some pretty awkward governance issues, like when one yieldco's independent committee of directors refused to do a deal with SunEdison, and SunEdison fired them and replaced them with more accommodating directors. But in cases like this I find myself rooting for the financial innovation. There is nothing necessarily wrong with optimizing capital structures, with dividing the risks and rewards of a project up in a way that offers different sets of investors exactly what they want. If the people running SunEdison got a bit over their skis, did too many deals, and borrowed too much money, well, that's their fault. Don't rush to blame the capital structure for that.
Anyway, now SunEdison is "'something of a graveyard' for hedge funds." Here's a list of some of them. And elsewhere in financially innovative hedge-fund hotel/graveyard news: "Valeant Finalizing Contract With Perrigo’s Joseph Papa as Next CEO." In brighter news, though, Pershing Square is up 12 percent so far in April.
Here's a case out of the U.S. Court of Appeals for the Seventh Circuit that might be of interest to some bond traders and salespeople. A guy named David Weimert worked for a bank called AnchorBank, and he set up a deal to sell some AnchorBank assets to two buyers. He also acquired a minority stake in the assets for himself by convincing the buyers that AnchorBank wanted him to take the stake, by convincing AnchorBank that the buyers wanted him to take the stake, and, one supposes, by sitting in the middle and carefully controlling communication between the two sides. He was convicted of wire fraud. The Seventh Circuit reversed his conviction and declared him innocent:
Federal wire fraud is an expansive tool, but as best we can tell, no previous case at the appellate level has treated as criminal a person’s lack of candor about the negotiating positions of parties to a business deal. In commercial negotiations, it is not unusual for parties to conceal from others their true goals, values, priorities, or reserve prices in a proposed transaction. When we look closely at the evidence, the only ways in which Weimert misled anyone concerned such negotiating positions. He led the successful buyer to believe the seller wanted him to have a piece of the deal. He led the seller to believe the buyer insisted he have a piece of the deal. All the actual terms of the deal, however, were fully disclosed and subject to negotiation. There is no evidence that Weimert misled anyone about any material facts or about promises of future actions. While one can understand the bank’s later decision to fire Weimert when the deception about negotiating positions came to light, his actions did not add up to federal wire fraud.
We talk sometimes around here about when people (especially bond salespeople) are allowed to lie to their customers. The key question is materiality: You can't tell customers you're selling them a sure-thing bond when it's already defaulted, but you can tell them you're wearing blue socks when you're actually wearing green ones. All of the interesting questions are in the gray areas: When you are negotiating a price with a customer, can you lie about the price that you paid for the bonds? Can you lie about your reservation price, about the price where you'd make a profit, about the price you'd be willing to sell for? The Seventh Circuit is quite right that "it is not unusual for parties to conceal from others their true goals, values, priorities or reserve prices":
To take a simple example based on price, suppose a seller is willing to accept $28,000 for a new car listed for sale at $32,000. A buyer is actually willing to pay $32,000, but he first offers $28,000. When that offer is rejected and the seller demands $32,000, the buyer responds: “I won’t pay more than $29,000.” The seller replies: “I’ll take $31,000 but not a penny less.” After another round of offers and demands, each one falsely labeled “my final offer,” the parties ultimately agree on a price of $30,000. Each side has gained from deliberately false misrepresentations about its negotiating position. Each has affected the other side’s decisions. If the transaction involves interstate wires, has each committed wire fraud, each defrauding the other of $2,000? Of course not.
The recent bond-trader cases -- against Jesse Litvak, against some Nomura traders, and others in the works -- are not quite as easy as that. Lying about the price that you actually paid for a bond, as opposed to the price you'd be willing to sell it for, misleads the customer about market data as well as your own negotiating position. Still the Weimert case is very sensible, and it has to be encouraging to bond salesepeople who have been caught up in criminal investigations for their aggressive negotiations. Here is Peter Henning on the Weimert case.
Speaking of misleading bond sales tactics, here is Jesse Eisinger on the Goldman Sachs Abacus case, that great, puzzling, infuriating oddity of the financial crisis. (One question there was: If you are buying a synthetic collateralized debt obligation -- just a two-party zero-sum bet on mortgages -- is it material to you who the short party on the other side is?) Eisinger's story is about a lawyer at the Securities and Exchange Commission, James Kidney, who thought that "the agency should continue to investigate more senior executives at Goldman and John Paulson & Co." But it didn't, and just brought a case against Goldman Sachs itself and midlevel salesman Fabrice Tourre. An interesting counterfactual to consider is: What if the SEC had brought cases against some somewhat higher-level traders and John Paulson, as Kidney wanted? I don't think civil charges against Tourre's boss, Jonathan Egol, would have satisfied the public desire to punish, like, Lloyd Blankfein. And as for Paulson, he is a big name, but it would be odd for the biggest mortgage-crisis case to be against a hedge fund manager who correctly predicted it rather than the banks that caused it.
Also of course if Paulson is the villain of the Abacus story, then all of the heroes of "The Big Short" should also be in trouble. After all, they decided that mortgages were going to crash, they picked the worst mortgage bonds, and they sold them short. Who do you think bought them?
Elsewhere in hideously embarrassing Goldman news -- and, disclosure! I used to be more or less a midlevel salesman there -- it settled the Tibco case this week. That was the case where Vista Equity Partners agreed to pay $4.2 billion for Tibco, but then everyone realized that Goldman Sachs, which was Tibco's adviser, was using the wrong share count in a spreadsheet, so Vista was only paying $4.1 billion. Tibco's shareholders had an understandable though perhaps not iron-clad case that someone should give them that extra $100 million back. Apparently in the settlement Goldman and Vista combined will give them back $30 million. As is often true in embarrassing Goldman stories, there are hints of conflicts of interest:
Vista was founded in 2000 by a former Goldman banker. The private-equity firm, known for midsize technology buyouts, has often hired Goldman for advice and financing on its deals.
Though I have to say, you don't mess up a share-count spreadsheet to curry favor with the other side. You mess up a share-count spreadsheet because you're not getting enough sleep. I doubt Vista was impressed by any of this.
Elsewhere, here is Gillian Tett on "How Goldman Sachs's vampire squid became a flattened slug."
Too big to fail.
In my view, we are at a point today that if a systemically important financial institution in the United States were to experience severe distress, it would be resolved in an orderly way under either bankruptcy or the public Orderly Liquidation Authority.
I think that means: "No bank is too big to fail any more." Remember when most of the big banks got failing grades on their "living wills," and the headlines interpreted that as "Regulators Warn 5 Top Banks They Are Still Too Big to Fail"? That was just last week. Perhaps a lot has changed in a week? Or perhaps Gruenberg is wrong, or the rest of the FDIC and the Federal Reserve disagree with him. But I think there is a better explanation, which is:
- The living wills are a useful exercise in forcing banks to confront their risks, improve their systems and processes, and generally manage themselves better.
- The banks are not quite up to the standard that the regulators want on that exercise.
- They have practically nothing to do with the question of "too big to fail," which is a simpler question with a simpler answer.
- Big banks can in fact fail in an orderly way through the Dodd-Frank "Orderly Liquidation Authority" mechanism whether or not their living wills are any good.
Be careful about interpreting the Fed's and FCIC's dissatisfaction with the banks' living wills as meaning that the banks are still too big to fail. The head of the FDIC doesn't interpret it that way.
Here is the story of Scott Scherr, the Chief Executive Officer of Ultimate Software Group, a $6 billion software company that had $22.7 million of net income last year. Scherr made $38.3 million. Seems high, right? What if I told you this:
Under Scherr, Ultimate’s shares are up more than 1,000 percent since the end of 2008 (roughly 43 percent a year), triple the average return of its competition and easily trouncing the market.
Doesn't sound so bad now, does it? He's made investors a few billion dollars in excess returns, and he's kept, like, 1 percent of those returns for himself. That's a better deal than most hedge funds will give you. But investors complain:
“We avoided this stock for a long time because we find the compensation policy to be somewhat egregious,” said Bill Mann, the chief investment officer at Motley Fool Asset Management, which oversees $1.5 billion and is an Ultimate shareholder. “We reconciled it with the fact they’re very good operators. We really do like the management team, we just wish their compensation practices were a little more rational.”
One question is: Would more rational pay attract a less likable management team?
We talk a certain amount around here about capital-structure innovation, about financial technology, about too-big-to-fail banks. But it is worth remembering sometimes that, um, for some reason there are about 85 federally chartered credit unions that are run out of people's homes?
Citing the safety and comfort of its examiners, the National Credit Union Administration in late 2013 proposed a rule that would have required all of its members to operate out of commercial locations, a potentially lethal blow for the roughly 85 home-based credit unions around the U.S.
The NCUA, which regulates federally chartered financial cooperatives, said among other things that sometimes its examiners were forced to work in unheated basements and risked being attacked by unfriendly dogs when they visited home-based credit unions.
I am of course a huge dog lover but this makes me really appreciate the modern conveniences of smartphone banking, as well as the promised future of cloud-based online mobile gamified social you know what I don't even care, I will bank in bitcoins if I have to, I just do not want to have to go to someone's house to deposit my paycheck. Come on. Incidentally the NCUA dropped the no-houses rule after strong resistance and this proposed compromise:
“It’s pretty easy to fix—you just lock up the dog in another part of the house,” said John Blank, treasurer of the Franklin Regional Schools Federal Credit Union, which operates out of a room on the second floor of his home in rural Jeannette, Pa.
Imagine Fed examiners coming to Goldman Sachs and Lloyd Blankfein being like, hang on a minute, I have to lock up the dog.
People are worried about unicorns.
Yesterday venture capitalist Bill Gurley published the Moby-Dick of unicorn worrying, a massive essay about "a fundamental sea-change in the investment community that has made the incremental Unicorn investment a substantially more dangerous and complicated practice." One danger: sharks with dirty termsheets.
Who are the Sharks? These are sophisticated and opportunistic investors that instinctively understand the aforementioned biases of the participants and know exactly how to craft investments that can exploit the situation. They lie in wait of these exact situations, and salivate at the opportunity to exercise their advantage.
“Dirty” or structured term sheets are proposed investments where the majority of the economic gains for the investor come not from the headline valuation, but rather through a series of dirty terms that are hidden deeper in the document. This allows the Shark to meet the valuation “ask” of the entrepreneur and VC board member, all the while knowing that they will make excellent returns, even at exits that are far below the cover valuation.
Gurley, as you may have gathered, is not a fan; he thinks that entrepreneurs should prefer to take "clean" financing at a down valuation rather than give investors "dirty" provisions like "guaranteed IPO returns, ratchets, PIK Dividends, series-based M&A vetoes, and superior preferences or liquidity rights":
If you cannot handle a down valuation you should seriously consider abandoning the CEO position. Being a great leader means leading in good times as well as tough times. Taking a dirty deal is jeopardizing the future of your company, solely because you are afraid to lead through difficult news.
There is a lot more on the evils of dirty termsheets, and on the circumstances ("voracious unicorns" who need cash, entrepreneurs and investors who don't want to announce a down round) that lead to them.
My lens on this stuff is always "private markets are the new public markets," and I used to help public companies issue convertible debt. Mature multibillion-dollar public companies have a range of financing options other than "clean" common equity, and generally speaking those options trade off equity upside for more downside protection. Gurley's "dirty" terms -- ratchets and so forth -- are the same basic idea: The investor gives up some equity upside (by investing at a higher headline valuation), in exchange for some protection in low-exit-price scenarios. You can see why this is upsetting for a traditional Silicon Valley venture capitalist, whose business is about hitting home runs with equity upside. And it does raise some real governance concerns. But, in a way, you could also read it as a sign of the unicorn market's maturity.
Elsewhere, Uber "has settled two closely watched class-action labor disputes covering 385,000 drivers in California and Massachusetts that will let Uber continue classifying drivers as contractors." And the partnership between Walgreens and Theranos is not going so great.
People are worried about bond market liquidity.
Hmm I guess you can count this as a bond market liquidity solution: Morgan Stanley "is joining corporate and government bond-trading desks" from its investment bank and its brokerage, "to give wealth-management clients access to the broader pool of securities and research available to institutional customers."
“That was a proof of concept, that by putting them together, we outpaced the Street by a lot, we increased our share,” Saperstein, 49, said in a telephone interview. “It allows you to have more inventory, more scale in the market when looking for inventory. It’s also more effective to manage risk across the book when they’re not separate.”
One assumes that the institutional desks are mostly providing inventory to the retail investors, rather than the reverse, but who knows. If no one else will buy bonds, perhaps wealth-management clients will.
Elsewhere in bonds: Dell "likely will pay an interest rate in the neighborhood of 10% in coming months to sell as much as $9 billion of unsecured junk bonds backing the acquisition" of EMC.
Also this morning I wrote about Elizabeth Warren and Steve Cohen's eventual return to managing outside money.
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