Rogue Bonds and Leveraged Loans

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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The Credit Suisse self-catastrophe bonds.

I once wrote a little prose poem about my love for Credit Suisse's plan to sell bonds insuring itself against its own rogue-trading risk. Those bonds are launching "as early as this week," and they're maybe slightly tamer than I had hoped. Here's the basic structure:

The insurance feature of the bonds would be triggered if Credit Suisse’s annual operational risk-related losses cross $3.5 billion. Buyers have a level of comfort, however, because it’s a “second-event” bond. The most any single event could contribute to the trigger is $3 billion, meaning it would take more than one event to cross the threshold. The odds of that are remote: Credit Suisse has put them at roughly 1 in 500, the people said.

"In general, operational risk is the possibility of losses resulting from insufficient internal controls, errant systems or rogue employees." But the bonds cover only direct losses from rogue trading, technology problems, etc., not the resulting government fines. Obviously the next step in financial technology is to package and sell the risk of bank fines. You think I'm kidding! I am, a little. But two things about bank fines are:

  1. They are paid by shareholders.
  2. Everyone kind of thinks they should be paid by bankers.

So there is the solution! Build a bank-fine catastrophe bond that pays, like, 8 percent interest, and is written down dollar-for-dollar to pay any fines that the bank incurs. Sell a few billion dollars of it to investors who are optimistic about banker behavior, and then give a few billion dollars of it to senior bankers as part (or all) of their bonuses. Credit Suisse has a long track record of rummaging around in the attic of its risks to find weird structured bonds to give its bankers as bonuses; the fine-bond would be no weirder a bonus than PAF2. This is a good idea and I will license it to Credit Suisse for a reasonable fee.

They should at least give bankers some operational-risk-catastrophe-bonds as part of their bonuses. Like, if you work in the back office, and half of your pay goes poof if there's a rogue trader, you'll be extra careful about not allowing rogue traders, no?

Leveraged lending.

One of my favorite battles in financial regulation is the one over leveraged lending. U.S. regulators got it into their heads that banks shouldn't make loans to companies with excessive leverage, and suggested a rule of thumb that too many loans at a ratio of more than six times debt to Ebitda might be taken amiss. In some ways this seems like a sensible prudential requirement that you might expect from a banking regulator; in other ways, it is an unusual micromanagement of banks' lending portfolios, as opposed to the more common approach of setting capital requirements and letting banks make the lending decisions. The banks sort of passive-aggressively ignored it for a while. 

Eventually they got on board though. Here is a post from the New York Fed's Liberty Street Economics blog about the impact of the leveraged lending guidance. It finds that the guidance does seem to have reduced the volume of leveraged loans, with that reduction especially pronounced at big banks overseen by the "Large Institution Supervision Coordinating Committee." On the other hand, "nonbanks increased their leveraged lending":

Even though not all lenders have cut their leveraged lending in response to the regulators’ guidance it appears that key players, such as LISCC banks, have. This reduction in lending, however, did not necessarily result in an equivalent risk reduction because nonbanks increased their borrowing from banks, possibly to finance their growing leveraged lending activity. This evidence highlights an important challenge of macroprudential policies. Since those policies reach beyond individual banks and target risk in the entire banking system, they are more likely to trigger significant responses that may have unintended consequences.

Get that tattooed on your forehead. On the one hand, that's a good result: It's pushed banks up a level in seniority, so that now instead of lending to overlevered companies, they lend to overlevered shadow banks, which then lend to the overlevered companies. The banks have two levels of security instead of one. On the other hand that extra security can be misleading, and the concentration of risk in less-regulated firms that are funded by banks anyway might be systemically worrying.

Financial technology.

I started out half-joking about this, but I've become more and more convinced that my toy model of financial advice is basically correct:

  1. Financial advisers think that their value proposition is talking to customers, understanding their personal situation, giving them customized advice and holding their hands in tough markets.
  2. Customers just want the advisers to pick stocks that will go up.

It is a disconnect! I suppose it is less of a problem at the high end, where the clients are looking for advice on minimizing taxes and setting up trusts. Here is a story about how UBS's U.S. wealth management division is teaming up with SigFig Wealth Management, a robo-adviser:

The technology will allow the advisers to spend more time talking to clients and less time constructing investment portfolios and other activities that lend themselves to automation, said Tom Naratil, the president of UBS Americas.

“It’ll make them more effective in helping clients to make better choices,” he said.

This makes sense if you think that the advisers' job is to talk to clients and understand their unique financial circumstances, and that portfolio construction is a minor administrative chore that the advisers will be happy to hand off to a robot. But if the customers just want their stocks to go up, and the robots are better at picking stocks that will go up than the advisers are, then exactly what are the advisers bringing to the relationship? In any case, the clients won't get to interact directly with the robots: "We’ll give them some tools, but we’re not going down the self-serve route," says Naratil.

Elsewhere, here are examinations of Renaud Laplanche's final days at LendingClub, from Bloomberg ("people close to the firm describe broader consternation on the board over a perceived breakdown in communication with their chairman and CEO during those events, and at a particularly precarious time") and the Wall Street Journal ("the board was presented evidence that Mr. Laplanche knew many of the details of the $22 million loan sale and wasn't upfront with directors about what he knew"). And of course LendingClub got a grand jury subpoena, because every self-identified scandal at a public company requires an after-the-fact Justice Department investigation. And: "Startup Touts Blockchain Exchange That’s as Simple as E-Mail."

Hedge funds.

Here's a profile of Mark Spitznagel's tail-risk fund and cheese-making operation. I mean they are two separate operations. It is not, like, Universa Hedge Fund and Cheese Shoppe. Though there are synergies:

The libertarian hedge fund manager sees a close similarity between what he is trying to achieve at Idyll Farms — which he built in 2010 with winnings from the financial crisis — and his investment strategy and deeply-held Austrian economic philosophy.

“It’s all about sustainable use of resources. Modern farming has completely broken down the traditional system of agriculture. It’s become a machine. We’ve manipulated away its natural productivity and robustness, just like what we’ve done with markets,” he says. “Markets don’t have a purpose any more — they just reflect whatever central planners want them to.”

The analogy is perhaps a little forced? The guy is buying out-of-the-money put options funded by selling other options to hedge clients against a broad market downturn. The markets equivalent of sustainable agriculture is, I don't know, long-only environmental/social/governance stock-picking, or maybe crowdfunding local businesses. Options strategies are pretty much the genetically modified organisms of markets. That said, I have previously compared some of Spitznagel's goat operations to black-swan funds, so I cannot object too much to the analogy.

Elsewhere, "Bridgewater Associates recently won approval to register a wholly owned subsidiary in Shanghai." Here is Michelle Celarier on Citadel's use of leverage. And while I suppose it doesn't quite count as hedge-fund news, Citadel Securities "is acquiring the equity-trading operations of Citigroup’s Automated Trading Desk division, one of the pioneers of high-frequency trading." And in 13F news, a bunch of hedge funds sold out of Valeant last quarter. (But Andrew Left, who once called Valeant "the Pharmaceutical Enron," is now "long for a trade.")

Rate fixing.

Australia is in the midst of its rate-fixing scandal, and like the Northern Hemisphere's Libor-fixing scandal, Australia's bank bill swap rate manipulation features lots of dumb e-mails, chats and recorded conversations. We talked about Westpac's yesterday; here's an article about ANZ's:

In new documents released as part ASIC’s case against ANZ for alleged manipulation of the bank bill swap rate (BBSW), senior traders thanked each other for setting the rate and joked about the manipulation of the headline rate in instant messaging.

“nice rsates et (sic),” Jim Vouziotis a former senior FX dealer wrote in an message to a Sean Collier at the short term funding group on November 5 2010.

“guess you can thank ANZ,” Mr Collier replied.

“llucky (sic) the rate sets are all legit and there is no manipulation within the Australian financial system.”

“ahahah” Mr Vouziotis replied in ironic hysterics.

Obviously the defense here is that he literally said the rates are all legit and there is no manipulation! And then the other guy laughed with relief! On the internet, no one can tell if you're being ironic. This is not legal advice, nor is it particularly internet advice.

One key difference between Libor and BBSW is that Libor manipulation is magically efficacious: Libor is set based on a poll of banks, so to manipulate Libor all you have to do is say the number you want. The BBSW is a market-based rate, so you have to work for it. From the Australian Securities and Investments Commission allegations:

“ASIC alleges that on these days ANZ had a large number of products which were priced or valued off BBSW and that it traded in the bank bill market with the intention of moving the BBSW higher or lower.”

Yeah but it had to actually trade in the bank bill market to do that. Compared to Libor manipulation, that seems exhausting, and risky, and practically honest.

People are worried about unicorns.

And they are worried about non-GAAP accounting, making for an unusually efficient twofer: 

To project a healthy business to skeptical VCs, job candidates, and potential business partners, companies have started shouting to the world how they are (or soon will be) profitable—at least, by some definitions of the term.

And: "Tech startups are increasingly touting a mix of less common financial metrics, even as their public counterparts move more toward generally accepted accounting principles." So for instance SpoonRocket, a meal-delivery company, has so far "failed to achieve profitability by conventional definitions," but is "contribution margin positive," i.e., profitable excluding "costs of customer service, central employees, office rent, and marketing to drivers." So that's something.

I generally don't worry that much about non-GAAP accounting, in part because I believe in market efficiency, and in part because I don't believe in the Platonic correctness of U.S. generally accepted accounting principles. (They are U.S. GAAP, after all, and different accounting principles might be accepted within the Enchanted Forest.) Here, I mean, you are pitching venture capitalists; I assume they are not too deceived by what "contribution margin positive" means. And it is an obviously useful statistic! If you have a startup that charges less to deliver a meal than it costs to make the meal, and plans to make it up in volume, then that is a deep problem, and one that I gather is pretty common among startups. Delivering profitable meals and making up the office rent in volume is ... well it is at least possible, no?

Elsewhere, the founders of Xfund, an ex-fund (no, I kid, it is a "beleaguered" but still extant $100 million venture capital fund), are "breaking new and belligerent ground in the normally discreet world of technology investors." (Though I have to say: I am on Twitter, and have never noticed technology investors to be especially discreet.) One of them, Hugo Van Vuuren, is suing the other one, Patrick Chung, for a variety of alleged misdeeds including just meanness:

Mr. Chung called Mr. Van Vuuren a “spiteful moron” and “a trivial person pursuing trivial things” in emails, according to court documents. Mr. Chung also wrote that working with Mr. Van Vuuren was “like working with a retarded person” and that Mr. Van Vuuren would be worth more “dead than alive once we have key-man insurance.”

Related: Unicorn Tears Gin Liqueur.

People are worried about stock buybacks.

I feel like it was just yesterday that people were worrying about the decline in stock buybacks. Because it was:

Announced repurchases dropped 38 percent to $244 billion in the last four months, the biggest decline since 2009, data compiled by Birinyi Associates and Bloomberg show.

So it was bracing, and confusing, to read today about the rise in stock buybacks:

Based on preliminary data, share repurchases are 20 per cent higher in the first three months of the year versus the fourth quarter and 31 per cent above the year-ago period, according to S&P Dow Jones Indices.

Some of that may be about the measurement period (four months versus the first quarter), but I suspect the difference is mostly that announced buyback programs (i.e. planned future buying) are down, while completed buybacks are up. In some ways announced buybacks aren't as good as completed ones -- companies that announce buybacks aren't obligated to complete them -- but in other ways they're much better. If you like buybacks, you might reasonably prefer buybacks in the future to those in the past.

People are worried about bond market liquidity.

Yesterday I complained that the U.S. Department of the Treasury was insufficiently worried about bond market liquidity, so naturally today Treasury and the Securities and Exchange Commission have a big new liquidity initiative. Or at least a transparency initiative:

The U.S. Department of the Treasury  and the Securities and Exchange Commission  today announced that they are working together to explore efficient and effective means of collecting U.S. Treasury cash market transaction information.  As part of those efforts, the agencies are requesting that the Financial Industry Regulatory Authority (FINRA) consider a proposal to require its member brokers and dealers to report Treasury cash market transactions to a centralized repository.

Sometimes trade reporting requirements are controversial because people worry that they might reduce liquidity: If everyone knows you need to buy a lot of bonds, they'll charge you more for them. (This is the Mifid II worry in Europe.) But in a fast electronic market like Treasuries there is probably less reason to worry that regulation will change much; electronic traders presumably already can figure out if you need to buy a lot of bonds. So this is just about helping regulators keep up:

“The need for more comprehensive official sector access to data, particularly with respect to Treasury cash market activity, is clear,”Antonio Weiss, a senior Treasury official, said in the statement.

Me earlier.

I wrote about an autonomous company that lives on the blockchain. So did Izabella Kaminska.

Things happen.

How Donald Trump Made Wall Street Kiss His ... Ring. Dell Said to Get $80 Billion of Demand on Bonds for EMC Deal. Berkshire Hathaway's investment "signals a change in the kind of company Apple is." Also Warren Buffett didn't make that investment, his lieutenants did. The gold standard is having sort of a moment. John Cochrane on equity-financed banking. Cliff Asness on correlations and beta. Pimco Total Return Doubles Junk-Bond Limit to 20% of Holdings. Herding is bad. BlackRock’s Fink Expresses Concern About China’s Rising Debt. State Street Nears Settlements to End Probes Into Alleged Overcharges. Valeant Pharmaceuticals Expands Drug Discount Offer After Criticism. Barclays Agrees to Sale of Precious Metals Storage Business. Twitter to Stop Counting Photos and Links in 140-Character Limit. "There is not a single example of a business putting its values to music without mass humiliation." Who Is A Millennial? Spinning bus. Nostalgic food. Cheese glut. Clubbing couple. Dog immortality.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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Matt Levine at

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