Bonus Clawbacks and Closet Indexing

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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Bank governance.

James Surowiecki asks why, if the new U.S. rules requiring deferral of bankers' pay are likely to reduce risk and improve bank performance, the banks didn't just adopt similar rules themselves. After all, they want to avoid risk and make more money: Why not defer pay in order to create the right incentives, without waiting for the regulators? Surowiecki sees a coordination problem:

Bonus clawbacks, for example, reduce the chances that bank employees will take foolish risks or engage in fraud, and so would seem to make banks “safer.” But banks are competing against each other for talent. And, in that competition, any bank that insisted on clawbacks would be at a disadvantage. Even smart traders or executives can make bad bets in financial markets. So, all else being equal, prospective employees would almost certainly opt for a contract that didn’t include the threat of clawbacks over one that did. This competitive pressure therefore discouraged widespread adoption of a practice that, if all banks did it, would improve their long-term health. Like helmetless N.H.L. players, the banks were stuck in an inefficient equilibrium, because no one wanted to be the first one to switch.

I actually think there's a different answer, or maybe three different answers:

  1. They did. Most of the big banks already pay a good chunk of bonuses, especially to senior people, in the form of deferred cash or stock. The named executives at Goldman Sachs and JPMorgan, for instance, mostly get more than 60 percent of their bonuses in deferred stock already, the new requirement for executive bonuses, though some of the mechanics may need to change. And even at lower levels, deferral and stock-based pay are more common than they used to be. The new rules will increase bookkeeping requirements, but I'm not sure they'll radically change too many people's pay structure.
  2. Banks like risk. Banks are very levered entities and shareholders have an option on their value. Option value increases with volatility. The trick, then, is not to steadily make money and avoid blowups by doing positive-expected-value low-variance trades, but to take risks that increase volatility and thus the value of the option. Risk is the natural preference of a bank governed on behalf of its shareholders, and bank regulation is largely about forcing banks to think about someone other than their shareholders. 
  3. Conversely: Banks are socialist collectives run on behalf of their workers, not their shareholders, and so a pay package that is pleasant for the workers will be adopted in preference to a pay package that creates good incentives to maximize shareholder value.

These explanations are perhaps mutually inconsistent and yet somehow I think they are all true.

Elsewhere in bank governance, here is a weird story about a fight on Deutsche Bank's supervisory board, "with the deputy chairman publicly criticizing another member, Georg Thoma, for going too far in probing potential wrongdoing." And here is a story about the rise of the "analyst-activist": Sell-side research analysts are "going well beyond simple buy or sell recommendations, urging investors to get behind a particular cause," particularly in the banking industry. I feel like a central element of the activist investor pitch is that activists take large concentrated stock positions to demonstrate to other investors that their interests are aligned. I guess I do not fully understand the analyst-activist pitch.

Closet indexing.

I find "closet indexing" or "closet tracking" to be a fascinating regulatory problem because it is plausibly a good thing. Like, standard capital markets theory would tell you that diversification is good, eliminating idiosyncratic risk is good, even reducing trading cost is good. So a manager who buys a wide range of stocks in different industries and doesn't trade them too much might well be doing a better job for her investors than one who buys a small concentrated industry-tilted portfolio and trades a lot. And if the first manager's performance ends up closely matching her benchmark index, well, again, that's better than most active managers do.

But if she charges 1 percent fees for this sort of "closet indexing," instead of the handful of basis points that actual index funds tend to charge, then, sure, that does seem a little scammy. (Whereas the concentrated-active-portfolio guy is presumptively allowed to charge whatever he wants.) Anyway here is an article about how "investor campaigners have labelled closet tracking a form of mis-selling and called on regulators to name and shame asset managers guilty of running such funds," and it is hard to really disagree with that, but on the other hand one possible result of that campaign would be to push asset managers to do a worse job for their investors. More-or-less-indexing might be the right thing for many managers to do, and if they can't do that any more, they might just do something worse. 

Elsewhere, here is a fun story about how real estate investment trusts will be reclassified by S&P and MSCI as their own sector, rather than as a subset of financial stocks. Many investment managers dislike REITS, but after the reclassification, "fund managers that are not allowed to stray too far from the benchmark weighting of any particular sector will have to come somewhat closer to the market weighting of Reits when they are a standalone sector, rather than just being able to fill the financials sector bucket with extra banks and asset managers and anything but Reits, as they are able to do now." One shouldn't be too dogmatic about market efficiency and the benefits of indexing and diversification.


The basic business of banking is taking money from depositors and lending it to people who want to build businesses or buy houses or whatever. Sometimes most of the people who borrow money pay it back and the bank does well, but other times people have trouble paying back their loans and the bank loses money. The bank can mitigate its risk by diversifying its loans and by only lending to people with good credit, but the loans will always be somewhat correlated and the business will always be cyclical: When the economy turns bad, lots of people who looked like they had good credit will have trouble paying back their loans, and the bank will have trouble making money.

The basic business of an oil company is taking oil out of the ground and selling it. When the price of oil goes down, this business becomes less attractive, and the oil company might lose money. Unless it is, you know, Saudi Aramco, it is entirely at the mercy of the market. And it is hard to diversify: If you are good at taking oil out of the ground, you might also be good at taking natural gas out of the ground, but that is pretty correlated with oil prices; you probably won't also be good at some entirely uncorrelated activity.

But you might be good at trading oil. And it turns out oil companies can make a lot of money trading oil even when oil prices go down. Loosely speaking, trading is a good business when volatility is high, and periods with rapidly falling prices tend to have high volatility. So having an oil-trading division can be a very good idea for a big oil company, because it acts as a natural hedge for a business that is otherwise pretty totally dependent on the cycle of oil prices. And so today "BP Plc, the first oil major to report first-quarter earnings, posted a surprise profit as a stronger-than-expected refining and trading performance helped mitigate the lowest crude prices in more than a decade."

One thing that you sometimes hear is that banks shouldn't be gambling with depositors' money, and that the basic business of simple banking -- deposits, loans -- shouldn't coexist with the swashbuckling Wall Street business of trading. And it is true that banks do not exactly have an unblemished record of using their trading businesses to hedge their lending businesses; in times of high volatility and declining loan performance, banks are perhaps more likely to lose money on trading than to make it. Still the theory is appealing. Here is Matt Yglesias on the "clash of regulatory visions" between those who want to break up the big banks and those who "quietly think that it's safer to have an economy dominated by well-balanced universal banks like JPMorgan Chase than by institutions that focus on a narrow set of business lines."

How's Bill Gross doing?

Well, his Janus Global Unconstrained Fund is up 1.8 percent since he took over in October 2014, while the Pimco Unconstrained Fund is down 1.64 percent, which means that life is good:

“My whole evening is dependent on whether I beat them,” Mr. Gross said. “You see, I have to prove it all over again. Every day.”

It is hard to resist Gross's extreme psychological openness; in some ways he'd fit in very well at Bridgewater. (In other ways: very badly.) I mean, what even is this:

In fact, over the years, Mr. Gross has consistently asked one question of prospective employees: What drives you?

The twist is that they must pick one of three answers: money, power or fame.

Strangely to him, no one has ever picked fame.

“It is the one thing I have always wanted,” he said. “When I was starting out at Pimco in 1972, I told my mother and father that I was going to become the most famous bond manager in the world.”

Imagine saying that in 1972. ("I just wanted to run money and be famous," Gross has previously said.) The most famous bond manager in the world! Why would that be a thing? It's like saying in 1972 that you wanted to be the world's most famous cosmetic dentist, or lichen biologist, or Vine star. So much of business success is just identifying underserved niches and jumping into them wholeheartedly. Bill Gross knew, decades ago, that the world wanted a larger-than-life superstar eccentric bond manager, and set out to give it one.

Elsewhere in famous bond managers, here's Paul Singer on his fight with Argentina:

In the absence of enforceability, the bonds of sovereigns with questionable credit quickly could drop to near-zero at the first sign of trouble. After all, who is going to want such bonds if holders can’t enforce their rights and sovereigns can pay whatever price, and to whichever creditors, they wish? Such a world would be far more chaotic than the imperfect but workable set of legal fallbacks that investors rely on today.

There must be a fair balance of power between sovereign debtors and their creditors, and the key to achieving that balance is the rule of law.

Market structure.

One of the big issues with IEX's long-delayed application to become a public stock exchange is that its "magic shoebox," which it considers essential to keeping its market fair, delays orders by about 350 microseconds. That fits awkwardly with the Securities and Exchange Commission's guidance that exchanges can't intentionally delay order execution. One possible way of dealing with this awkwardness is just to ignore it: IEX are so nice, so surely giving them a 350-microsecond grace period will be fine. The SEC does not seem inclined to take that approach, though, and has instead proposed giving every exchange a one-millisecond (1,000-microsecond) grace period: If you delay orders by less than a millisecond, it's "de minimis" and doesn't count. 

It turns out that lots of people hate that approach

Critics and fans of IEX’s application alike are arguing that regulators are veering into dangerous territory.

“There’s a lot of fear that we’re going to open a Pandora’s box,” said James Angel, a finance professor at Georgetown University in Washington. “It’s a legitimate fear.”

Even IEX can't quite get behind the SEC's efforts to help it get approved, writing in a comment letter that "the IEX 'speed bump' is a specific and unique response to the desire of long-term investors to access the best and most accurate prices in competition with the fastest short-term traders" and that its exchange application "should be considered separate and distinct" from the "de minimis" interpretation. As we've discussed before, the big problem in the IEX application is that IEX are nice, so a lot of people want the SEC to let them do some new weird market-structure things. But the SEC is a general regulator, and if it lets IEX do those things, it sort of has to let everyone. And not everyone is so nice.

Elsewhere: "CFTC Spoofing Witness Says He's Oystacher Whistle-Blower."

Don't do this.

Come on:

HSBC Holdings Plc was sued for unfair dismissal by an equity derivatives trader who was fired for sending client data to his personal Yahoo! Inc. e-mail address.

The trader, Ben Lazimy, sent a 1,400-page spreadsheet listing all the bank’s equities transactions in 2010 that included client names and margins, HSBC lawyer, Clarisse Lebigot, told a Paris employment tribunal Friday.

Come on. I realize that European traders have sued banks after being fired for even more egregious misbehavior -- it seems to be a competition over there, to see who can be most implausibly aggrieved about being fired -- but you're really not supposed to send a list of all of your bank's positions and clients to your personal e-mail. That is the sort of thing that is very much frowned upon, even if "the spreadsheet was widely available within the bank -- even to interns." 

Elsewhere in things not to do:

The chairman of a Chinese e-financing firm suspected of having fled with 1 billion yuan (HK$1.19 billion) of investors’ money has emerged to say he has not absconded but was merely meditating in the Gobi Desert over the firm’s direction.

Yang Weiguo, chairman of peer-to-peer online lending platform Wangzhou Fortune, on Monday said he would be “right back” after staff and clients failed to contact him for several days.

Though I guess if you are going to do that, the old implausible-grievance strategy is still the way to go:

“I decided to clear my mind by travelling for 10 days, cutting all telecommunications contact and being undisturbed ... to think over strategies and rebuild confidence,” the letter read, adding that he was shocked and angered over the accusation that he had fled with investors’ money.

"American Psycho The Musical."

Bloomberg's Amanda Gordon interviewed Wall-Street-ish people after they saw "American Psycho The Musical." They can relate:

“You get to Tunnel or Dorsia -- or Verboten and Estela, in our case -- and at the end of the day, life is empty,” said 27-year-old Evan Konstantinou, a corporate lawyer.

I confess that I had never heard of Verboten. Apparently it is in Williamsburg? Things really have changed since the '80s! The meaninglessness of life is at least consistent, but there too the modern financial industry has discovered a cure for alienation:

“Nowadays, someone feeling a little alien at a place like Pierce & Pierce is probably more likely to jump over to private equity than go insane,” said Patrick McCarthy, 23, who works at a boutique investment bank.

I like -- well, I like everything about that quote, but I particularly like the implication that a career in private equity is a close substitute for a secret life as a serial murderer. "Oh, we were worried about Patrick, what with all the dismembered corpses in his apartment, but then he discovered carried interest and now he's all better."

People are worried about unicorns.

We have discussed previously the difficult question of whether Ant Financial counts as a unicorn. On the one hand, it is an affiliate of Alibaba rather than a purely venture-backed company, and also ants are ants, not unicorns. On the other hand, it is a giant private technology company, and maybe ants can be unicorns? In any case Ant "has raised $4.5bn from mostly state-backed investors, in what it said was the largest private placement by an internet company globally," making it, if it is a unicorn, a very big unicorn indeed. The linked article also has a picture of Ant's logo/mascot, which you might want to take a look at. As you might expect, he (she?) is an ant. (Albeit with fewer legs than a normal ant.) Like most ants, he has two antennae. But there is also a single ... pointed protuberance, let's say, at the top of his head. Is it a horn? Is he in fact a unicorn ant? The mystery deepens.

People are worried about bond market liquidity.

Are they? I have read plenty of worries that the European Central Bank's program of buying corporate bonds would dry up liquidity in that market. Here is a contrary take:

“For highly rated corporate bonds, this is a bonanza time,” said Sanjay Joshi, head of fixed income at asset manager London & Capital.

Unilever has "sold €300 million of bonds maturing in 2020 with a coupon of 0%, offering investors a yield of just 0.08%," as one tranche of a larger bond deal, "one of the lowest-yielding euro corporate debt sales on record." Obviously you can simultaneously (1) worry about bond market liquidity and (2) keep buying bonds at record-low rates, but it makes it a little hard to tell that you're worried.

Things happen.

Turkish terror scam yields millions for conmen. Saudi Aramco to Become Holding Company With Listed Subsidiaries. You can livestream the Berkshire Hathaway annual meeting this year. Some questions about Credit Suisse's "rogue bonds" (previously). Africa's diverging currency pegs. Universal basic income. Standard Chartered Shares Soar as Bad Loans Ease. Regulators to Call for Banks to Have Year’s Worth of Liquidity. Why I’m Still Not a Bank Customer at Goldman Sachs. Tilton's Patriarch Partners sued by the Zohar funds she created. Regulators Recommend Approval of Charter-Time Warner Cable Deal. SunEdison's Chatila Still CEO of Complicated Clean-Energy Giant. Hong Kong’s Li Ka-shing pumps $1.3bn into Husky Energy. Volkswagen’s Legal Endgame in Emissions Scandal. Soon you'll have to tip your Uber driver. "New York City is worried about millennials." Tyler Cowen interviews Camille Paglia. A profile of the Bronx Defenders. "Amazing Grace" on a cabbage. Tiny treehousesPromposals. Schoolie McSchoolface. Chicken donuts. Robot longshoremen. Dogs hate hugs.

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