Interrogation Methods and Blockchains

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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Fund management.

Insider trading law is so weird because, while on the one hand prosecutors try to send people to prison for years for talking to corporate investor-relations employees about upcoming earnings, on the other hand not only are investment managers allowed to meet with companies and ask them questions, they're even trained in Central Intelligence Agency interrogation techniques to try to get useful information out of the companies:

“Our fund managers spend a lot of time interviewing management teams of the companies they would like to invest in or are already invested in, and the behaviour assessment techniques such as reading body language for incongruences are specifically designed to help them hone their skills in doing this,” said a spokesperson for Jupiter.

“Ultimately, the aim is to give us a competitive edge in delivering outperformance, over the longer term, to our clients.”

The theory -- in the U.S.; Jupiter Asset Management is U.K.-listed so the rules are somewhat different -- is that no material nonpublic information is disclosed in those meetings. Despite the CIA interrogation techniques. It seems like a strange theory to hang criminal law on.

Anyway though you know the basketball-passing-and-there's-a-gorilla video that is a famous cliché about not paying attention, with 6.4 million YouTube views? It's apparently part of CIA training:

One exercise involved the fund managers watching a video of a basketball game and counting the number of passes made by one team. Only one of the fund managers spotted a large yeti walking across the basketball court during the video.

I feel safe.

Meanwhile, here is a post by pseudo-Jesse Livermore titled "Index Investing Makes Markets and Economies More Efficient," arguing that as long as there are some active investors, a high share of passive investment -- even 98 percent -- can't reduce market efficiency or the information content of prices:

Setting price in a market, however, isn’t about controlling a certain amount of money or flow.  It’s simply about placing an order.  If all other players in a market have opted to be passive and not place orders, then “price” for the entire market can effectively be set by the single individual investor who does place an order, no matter how small she may be in size.

He also makes the important point that if there are, say, inflows into S&P 500 index funds from other asset classes, then that will push up the price of S&P 500 stocks relative to bonds or whatever, but that is not a function of passive management. It's a function of active asset allocation, from bonds or whatever into stocks. If people think they should have more S&P 500 exposure, they'll buy more index funds, and the S&P 500 will go up, but that is a genuine reflection of considered demand for stocks, not just an artifact of passive management.

That said, you could still have concerns. You can imagine the market being made up of three types of traders: dumb traders, smart traders and passive traders. The passive traders always get the market return. In a world with lots of dumb traders and a few smart traders, the smart traders will get above-market returns and have incentives to find information. In a world where all the dumb traders have given up and bought index funds, the smart traders will compete with each other and average out to only market returns. Do they have less incentive to find out information? Obviously we're not there yet, what with the CIA interrogation techniques, but I feel like that is the worry.

Elsewhere, secretive hedge funds do well in good markets and badly in bad markets, presumably because secrecy is a good way to make beta look like alpha. And: "More than half of the donations from the top money managers so far are to Republican groups, but none to Donald Trump." 

Fintech.

The big news in financial technology is that the guy who everyone thought was Satoshi Nakamoto -- not the guy named Satoshi Nakamoto, but the other one -- is Satoshi Nakamoto:

Craig Steven Wright, an Australian entrepreneur, identified himself as the creator of bitcoin almost five months after he was outed in media reports as the man behind the virtual currency.

Wright said in a blog post and interviews with three media organizations that he developed the original bitcoin software under the pseudonym Satoshi Nakamoto. Wright provided technical proof, including the original encryption keys, that have been confirmed by prominent members of the bitcoin community, the BBC reported.

Here's his announcement, which starts with a Sartre quote and devolves quickly into hash functions. "Satoshi is dead," he says, for some reason (he is not dead), "but this is only the beginning."

He's right: His creation has gone on to conquer the world. Not so much bitcoin, which is still pretty tough to use as money, but if you are any sort of self-respecting financial or finance-adjacent professional these days, you had better be inserting the word "blockchain" into random sentences to prove that you're up to speed. The governor of Delaware, of all people, knows what I'm talking about:

Delaware Gov. Jack Markell is scheduled to discuss details of the Delaware Blockchain Initiative at an industry conference in New York on Monday.

“This is something we’re very interested in,” Gov. Markell said in an interview. “We think the benefits could really be tremendous.”

Delaware will supposedly "start a pilot program to move state archival records onto the open-ledger technology known as blockchain," and while I don't think that's literally true -- I think it's more, like, helping companies put their share registries into blockchains, plus something involving smart contracts -- it would be pretty perfect. What earthly good could come from putting state archival records into a blockchain? Besides, you know, that you get to say the word "blockchain" a lot.

Anyway, here is David Andolfatto with some thoughts on the "Monetary policy implications of blockchain technology." And elsewhere in fintech, here is some praise of SoFi from Andy Kessler, and some worrying from John Cochrane that regulators will ruin its paradisal existence as an equity-financed bank that is careful about credit quality. And here is a story about "Varo Money Inc., a startup that may one day take the rare step of seeking its own bank charter."

Taxes.

Meanwhile in innovation in the traditional banking industry, this is neat:

Barclays' tax loss was made possible because it sold its Barclays Global Investors (BGI) business tax free in Britain, but had part of the sale proceeds -- $9 billion in Blackrock shares – paid to a subsidiary in Luxembourg.

That way, Barclays was able to offset the risk of the shares losing value, something not normally possible in a tax-free deal. A rise would have netted Barclays profits. When instead the shares fell, Barclays used the loss to claim a tax deduction in Luxembourg that was not available in the UK.

If you just sell a business for stock, you don't pay taxes on the sale, but you also don't get a new basis in the stock. But apparently if you route the stock through Luxembourg, you can. Obviously it is better to sell a business for stock that doesn't lose value, though.

Elsewhere in traditional banking, "the UK financial watchdog’s findings of 'serious' and 'systemic' failings in relation to financial crime after a review of Deutsche’s UK unit last year could not have come at a worse time for the bank, which has agreed to submit to an independent probe of its efforts to improve anti-money laundering controls."

Valeant.

On Friday, Valeant finally filed its delayed annual report; other than the accounting problems Valeant had already announced, everything was fine. And yet things are bad at Valeant. Its proxy statement addresses the issues euphemistically, noting that "Our Board has accelerated the refreshment process in light of recent events." That just means that Valeant got rid of some directors and replaced them with new directors, but it sounds like the board now starts drinking during meetings instead of waiting for the cocktail hour afterwards.

In any case, former Chief Executive Officer Michael Pearson is out, and new CEO Joseph Papa will soon take over. Pearson remains controversial:

​In early 2015, when Valeant Pharmaceuticals International Inc.’s top brass met to set prices on a soon-to-be-acquired cardiac drug, some executives suggested slow, staggered price increases. Chief Executive Michael Pearson disagreed.

To reach Valeant’s internal profit targets, Mr. Pearson lobbied for a single, sharp increase. Hospitals could still make a profit at the higher price, he argued, which meant patients would still have access to the drug. The team deferred. The day it completed its February 2015 purchase of the drug, called Nitropress, Valeant tripled the cost.

The proxy filed on Friday also revealed that Pearson was in line to make up to $2.66 billion if Valeant's compounded annual total stockholder return would "equal or exceed 50% over the period" from January 2015 through January 2020, "which is equal to a share price of $1,181.81." That would involve creating hundreds of billions of dollars of value for shareholders, and giving him just a tiny fraction of the value created. I realize that there is a strand of Valeant explanation that locates the company's original sin in the way its compensation scheme rewarded executives for creating shareholder value. There is some obvious truth to that, yet it leaves me uneasy. If you are massively (and, yes, yes, asymmetrically) rewarded for creating massive shareholder value, you will be targeting massive shareholder value rather than cautious incremental growth. Often that's a good thing, though! Valeant's problem is not that its managers worked hard, creatively and aggressively to create value for shareholders, or that its compensation scheme rewarded that. There's nothing wrong with rewarding managers lavishly for creating shareholder wealth by, like, finding a cure for cancer or building an electric car. Valeant's problem is that its business model seems to have consisted mostly of arbitraging the insurance system to pay for drug-price increases. It's not the incentives that were wrong, it's the business to which they were applied. Anyway Gretchen Morgenson is not a fan of Papa's, either.

How was Buffettpalooza?

Did you go? Did you eat the foods and play the games and buy the products and generally bask in the glories of Omaha in spring? I experienced the Berkshire Hathaway annual meeting mainly through recaps and videos of the Oracle of Omaha's pronouncements, which were generally in-character and perhaps disappointingly un-oracular; Warren Buffett doesn't even seem to have given out so much as a TV spoiler. A brief rundown:

  • Derivatives are bad.
  • Hedge funds are bad.
  • Valeant is bad (but the Sequoia Fund is still good).
  • Trump is fine.
  • Coke is good.
  • CNBC is bad. Not the TV channel, I mean, but this pun: "There's no problem like CNBC: Cyber, Nuclear, Biological, Chemical attacks."

Here are more highlights. Apparently there was a Hogwarts comparison

The most attractive investment bankers work in ECM.

The most attractive people at investment banks work in equity capital markets, says science. Disclosure: I used to work in ECM. Not in regular ECM, though, but on a desk that combined the sheer physical beauty of ECM with the intellectual sophistication of derivatives and the cultural élan of convertible bonds. We were regular deities of investment banking, a perfect combination of brains and beauty. Why did I leave?

People are worried about unicorns.

"This Tech Bubble Is Bursting," writes Christopher Mims, in an article that also includes lines like "the record fundraising actually is a bearish sign"; "without a doubt, the fear cycle is what we're living through right now"; and "empirically, there are so many unicorns that many of them have to pop." On the other hand, Stuart Peterson of Artis Ventures -- which funded Stemcentrx, which was just sold to AbbVie for billions of dollars -- argues that you don't need to worry about the good unicorns:

"If you want to fund DogVacay and you want to fund Vessel and some of these incremental companies that aren't doing real hard science and tackling problems that we need to solve on a global basis, how can you cry about a lack of liquidity?" Peterson asked. "If you and I go out there and tackle something like cancer and show real life advantage and we start curing people of the most lethal cancers, what do you think the odds are that we are going to have as much liquidity as we want? I think it's damn near 100 percent and this deal shows that."

Yes I can see how curing cancer would be a bigger market opportunity than providing vacations for dogs, though honestly I can also see the argument the other way. Elsewhere: "The fall of the unicorns brings a new dawn for water bears." It doesn't make much more sense after you read the article.

People are worried about stock buybacks.

You sometimes see McKinsey & Co. mentioned as a metonym for all the evils of shareholder-focused capitalism, but even McKinsey is worried about stock buybacks. Here's a note titled "How share repurchases boost earnings without improving returns":

For example, to improve EPS, managers at one company committed to an aggressive share-buyback program after several years of disappointing growth in net income. Five years later, managers had retired about a fifth of the company’s outstanding shares, increasing its EPS by more than 8 percent. Yet the company was merely retiring shares faster than net income was falling. Investors could see that the company’s underlying performance hadn’t changed, and the company’s share price dropped by 40 percent relative to the market index.

That's good! If a company is in a declining business, it should return money to shareholders rather than keeping it itself. Why reinvest in a business that isn't making any money? Yes I know the answer is "because if you reinvest, maybe the business will start making money again," but maybe it won't. If you give the money back to shareholders, they'll definitely have it. Put another way: If you have 100 shares outstanding and make $100, for earnings per share of $1, and the next year you make $80, maybe you should buy back 20 shares to keep EPS constant, not because you are "manipulating EPS" or whatever, but because your business opportunity is smaller now and so your company should be smaller too.

People are worried about bond market liquidity.

Here is a speech by New York Fed President William Dudley about "Market and Funding Liquidity"; the first part -- on market liquidity -- is pretty much what you'd expect from the New York Fed on bond market liquidity ("the evidence that market liquidity has diminished is mixed," etc.). The second part -- on funding liquidity for securities firms -- is perhaps more interesting, arguing that "an important issue is to identify and address gaps in the lender-of-last-resort function":

In the U.S., given the restrictions on central bank lending, if a securities firm were to lose access to funding the remaining options available would be finding a means of replenishing the firm’s capital, selling assets, or selling all or part of the securities firm’s operations. While this might be manageable in the case of a firm-specific idiosyncratic shock, it might prove more difficult if a common shock was broadly hitting the securities industry. In this circumstance, the failure of one firm could increase the stress on other firms that were facing similar difficulties. If all of the requirements for Section 13(3) are met, the central bank could provide liquidity support. However, since this is not a certainty, it is worth considering possible alternatives. Now that all major securities firms in the U.S. are part of bank holding companies and are subject to enhanced prudential standards as well as capital and liquidity stress tests, providing these firms with access to the Discount Window might be worth exploring.

One result of the 2008 crisis seems to be widespread political distrust for the lender-of-last-resort function, which looks too much like a bailout for comfort. But in the world of central banking, lend-freely-against-good-collateral-at-a-penalty-rate is the procedure for addressing financial crises, and if you want to avoid crises, expanding the lender-of-last-resort role seems more promising than limiting it.

Things happen.

Puerto Rico Will Default on Government Development Bank Debt. Halliburton, Baker Hughes Call Off $28 Billion Deal. Apollo Global lifts offer for Apollo Education Group. China Lending Inflates Real Estate, Stocks, Even Egg Futures. Slow Bleed From Low Bond Yields Drains Returns for Life Insurers. Norway’s oil fund to target high executive pay votes. Sovereign funds ignore climate risk. "When asked if they supported the general principle behind IEX’s selectively delayed exchange model, no one raised their hand." Dark Side of Equity Gifts by Corporate Executives. Numeracy Improves Financial Outcomes and Can Be Taught. Dogs hate divorce. Dog saves bees. Large hadron weasel. Lawsuit says Starbucks' iced drinks have too much ice

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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